It is no secret that I admire Warren Buffett, partly is for his willingness to speak out on important topics such as corporate governance, executive compensation, cash flow management and investing theory. Each Berkshire Hathaway shareholder letter written by Buffett is excellent, but taken together, they likely provide more value than any college management course. Maybe one day in one of my four or five desired retirement jobs I’ll be able to teach a college or high school business course just using his annual shareholder letters. If so, I would focus on the following Buffett quotes from his 2016 letter:

Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.

This is reason #2 for holding ample cash. We never know when the markets are going to tumble, and when they do, we may not be able to borrow money to take advantage of the opportunity. Buffett has said that cash is a perpetual call option on all other assets with no expiration date, and its the foundation of my dynamic cash allocation methodology.  Most of us don’t have $86 billion of cash at our disposal, but we should aim to have enough to not only meet our traditional emergency fund needs (reason #1 for an emergency fund: to avoid credit card debt), but also to take advantage of down market opportunities, whether in the stock market, bond market (i.e. the 1980s), real estate or private equity opportunities.

I made one particularly egregious error, acquiring Dexter Shoe for $434 million in 1993. Dexter’s value promptly went to zero. The story gets worse: I used stock for the purchase, giving the sellers 25,203 shares of Berkshire that at yearend 2016 were worth more than $6 billion.

This is high on the list of why companies should not be issuing stock like its candy on Halloween, whether to its employees or for acquisitions.  What is the future value of the issuing company’s stock going to be compared to the future value of whatever it received in exchange for that stock? Overpaying for an acquisition using company stock is essentially overpaying twice, unless the company stock was also overvalued at the time. Apple, for example, issuing millions of dollars in stock to dozens of employees who leave after a couple of years is a tremendous destruction of shareholder value in many cases.

(Today, I would rather prep for a colonoscopy than issue Berkshire shares.)

Enough said.

Above all, it’s our market system – an economic traffic cop ably directing capital, brains and labor – that has created America’s abundance. This system has also been the primary factor in allocating rewards. Governmental redirection, through federal, state and local taxation, has in addition determined the distribution of a significant portion of the bounty….This economic creation will deliver increasing wealth to our progeny far into the future. Yes, the build-up of wealth will be interrupted for short periods from time to time. It will not, however, be stopped. I’ll repeat what I’ve both said in the past and expect to say in future years: Babies born in America today are the luckiest crop in history.

This battle between market forces and government “redirection” essentially sums up two of my law school classes. Buffett has profited tremendously from the former.

American business – and consequently a basket of stocks – is virtually certain to be worth far more in the years ahead. Innovation, productivity gains, entrepreneurial spirit and an abundance of capital will see to that. Ever-present naysayers may prosper by marketing their gloomy forecasts. But heaven help them if they act on the nonsense they peddle. Many companies, of course, will fall behind, and some will fail. Winnowing of that sort is a product of market dynamism. Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.” During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.

This is all great stuff, but it is the last sentence that somewhat sums up what I am looking to do with a portion of my portfolio: find companies with solid economic moats, have significnat profitability, compensate their employees reasonably and have great cash flow distribution policies, all of which flow from what Buffett has written in the past.

For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value….Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent. It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed. That certainly wouldn’t be the case if a management was buying an outside business. There, price would always factor into a buy-or-pass decision. When CEOs or boards are buying a small part of their own company, though, they all too often seem oblivious to price. Would they behave similarly if they were managing a private company with just a few owners and were evaluating the wisdom of buying out one of them? Of course not. It is important to remember that there are two occasions in which repurchases should not take place, even if the company’s shares are underpriced. One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt….The second exception, less common, materializes when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser….My suggestion: Before even discussing repurchases, a CEO and his or her Board should stand, join hands and in unison declare, “What is smart at one price is stupid at another.”

I discussed this in more detail in my most recent Monday Minute post and it ties into my next topic of researching the cash flow policies of companies.

Our definition of [interest] coverage is the ratio of earnings before interest and taxes to interest, not EBITDA/interest, a commonly-used measure we view as seriously flawed.

Here is what I believe to be a dose of accounting brilliance. The difference between EBIT and EBITDA is that the latter removes depreciation and amortization, and is therefore the greater number. Depreciation and amortization aren’t actually paid to anyone, but rather are cash-less deductions, as in they represent an annual portion of the price of something purchased in the past. When a machine is purchased, for example, the entire purchase price of $1,000,000 isn’t usually deducted on the company’s tax return.  Instead, some portion of that $1,000,000 is deducted each year for a preset number of years, as described over a few hundred pages of IRS rules. But large companies make so many purchases of assets each year that their depreciation and amortization expense, over time, will be roughly equal to their annual asset purchases, excluding special situations. To remove depreciation and amortization is to ignore that reality and overstate, sometimes drastically, a company’s financial position.

Our confidence is justified both by our past experience and by the knowledge that society will forever need huge investments in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects.

This pertains to Berkshire Hathaway’s investments in a large railroad and a large utility company. I am generally skeptical of companies that rely on government reimbursement for huge upfront capital expenditures, which is one of many reasons why I didn’t become a doctor 🙂

Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses. Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well.

Here Buffett highlights why earnings per share is largely useless, as it is too easily manipulated, which is why I prefer to look at operating cash flow and free cash flow. Buffett’s concerns are also minimized by looking at multiple years worth of cash flow as opposed to one quarter or one year.  If “restructuring costs” are incurred every year, then they should be considered part of the cost of doing business.  I largely ignore most GAAP and non-GAAP changes by focusing on the cash. I also want to avoid companies that care too much about these numbers, because that likely means that managers are too focused on their personal profitability.

To say “stock-based compensation” is not an expense is even more cavalier. CEOs who go down that road are, in effect, saying to shareholders, “If you pay me a bundle in options or restricted stock, don’t worry about its effect on earnings. I’ll ‘adjust’ it away.”

Buffett only pays cash to its managers. If they want to own Berkshire Hathaway shares, then they have to purchase the shares on the open market just like everyone else. I understand the desire to align management’s interests with that of shareholders by making management significant holders of their employer’s stock. Making them hold stock is different from giving them tremendous amounts of it as compensation, thereby diluting shareholders’ interests to the benefit of these managers. But even whether or not stock-based compensation is wrong is different than not expensing stock-based compensation. Aswath Damodaran, a Finance professor at NYU goes into a good explanation of this topic, and I believe that this exemplifies yet another reason why stock-based compensation along with consistent share repurchases tends to be a massive destroyer of shareholder value.

The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds…My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1% fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.

We as a society pay too much for average advice at best and at worst for gimmicks. Almost everyone, rich or not, should stick with a low-cost buy and hold portfolio tied to their risk tolerance.

-Richard

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