It is that time of year again - the time when the "Oracle of Omaha", the "greatest investor alive", the chairman of Berkshire Hathaway (BRKB), Warren Buffett, delivers his letter to shareholders (PDF). Whether or not an investor is a shareholder of Berkshire, Buffett's letter is always a great read, both due to his keen and focused business sense and his informal style of writing. To continue the tradition started a few years ago, it's time to look at 4 interesting points from the 2011 shareholder letter. For those interested, my talking points for 2010 and 2009 can be found at the links. The 2011 letter is probably a little less "meaty" than some of Buffett's past letters, but there are still some nuggets of wisdom in there that are worth talking about. So, here are four sets of quotes from the letter and some discussion on them that should interest anyone who follows Magic Formula Investing (MFI):
1) There is Room for Improvement in the General Business Environment
"estimating our current earning power, we are envisioning a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006."
"Now, as in 1776, 1861, 1932, and 1941, America's best days lie ahead"
Warren still sees room for improvement in general business conditions. 2010 was not the catastrophe that 2009 was, but nor was it a blowout year for American business. He goes on to talk about the pessimism in the media and then starkly contrasts our situation today with that of some of the times in the 20th century (two world wars, numerous smaller ones, a devastating depression, communism, etc.) and how well the market did during that century. It goes to show that to really succeed in business or investing, it pays to have an optimistic attitude, not a pessimistic one.
Consider this. Three years ago, in mid-March of 2008, before Lehman and AIG (AIG), and right before Bear Stearns, the S&P 500 closed at 1,293. On Tuesday, the S&P closed at 1,319. That is despite going through the largest global financial crisis since the Great Depression. If that doesn't make you believe in the resiliency of American capitalism, what will?
2) Return On Invested Capital is Key, and is Often A Function of Management
"Some companies will turn [retained capital] into fifty-cent pieces, others into two-dollar bills."
"... an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted."
Buffett is talking about the importance of good management to creating shareholder value. This relates to the return on capital metric used by MFI - how well does a company use its capital base to generate earnings? If it earns high returns on capital, it can either grow faster using it or return some of it to shareholders in the form of dividends and share buybacks. The capital not paid out (retained capital), can then be used to grow, either organically by hiring, increasing marketing spend or R&D, etc., or put to work buying new businesses. Firms that do this well turn those retained dollars into two-dollar bills for shareholders, ones that do not into fifty-cent pieces.
Farther in the letter, I thought it was interesting that Buffett actually comments on the earnings on un-leveraged net tangible assets that some of his businesses have. This is almost exactly what Joel Greenblatt's Magic Formula Investing strategy measures for its return on capital number. Buffett even gives ranges: "terrific" 25-100%, "good" 12-20%. This jives very well with what I've seen in MFI. Very few companies with sub-30% return on tangible capital ever get screened, unless they are absurdly cheap.
Also, the importance of a CEO focused on returns on invested capital is paramount. Buffett makes a nice comparison to investing a dollar in the late 1960's with (now bankrupt) Montgomery Ward vs. (now world's largest retailer) Walmart (WMT). Similar businesses, but much better management at Walmart. All CEO's are driven by something. Some are looking for personal enrichment, some to build empires - shareholders should look for managers looking to profitably grow the business. Buffett also mentions corporate culture and managers who love their businesses as keys to finding this kind of leadership. Quantitatively, two good metrics for finding this are significant insider ownership and a long tenure.
3) Don't Always Trust Net Income
"Regardless of how our businesses might be doing, Charlie and I could - quite legally - cause net income in any given period to be almost any number we would like."
Here Buffett is just commenting on how net income is not a very important metric for measuring Berkshire's success, as they have a massive amount of unrealized gains they can pull from at any given time to juice earnings. He also comments about the "game playing" with numbers that a lot of companies have, and continue, to engage in, especially on the income statement. Always remember that management can play loose and fast with the income statement. They are free to write-down assets to their choosing, expense vs. capitalize costs, print and talk about "pro-forma" results, and even choose when to recognize revenue. This is why investors should *always* compare reported earnings with reported cash flows, and if they do not agree, it is a huge accounting red flag.
4) Leverage Should Be Used In Moderation
"Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job."
Debt is not intrinsically bad, and is not something that should be avoided at all costs. But firms with a culture of financing growth and/or share buybacks with large amounts of debt should be highly scrutinized. While refinancing usually is possible, sometimes (like in 2008-09), it cannot, and if you are left without cash, you could be in big trouble. The Magic Formula does a good job of filtering out high debt / low cash firms by using enterprise value instead of market capitalization, but the fact is that some financially unhealthy companies do get screened from time to time.
1) There is Room for Improvement in the General Business Environment
"estimating our current earning power, we are envisioning a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006."
"Now, as in 1776, 1861, 1932, and 1941, America's best days lie ahead"
Warren still sees room for improvement in general business conditions. 2010 was not the catastrophe that 2009 was, but nor was it a blowout year for American business. He goes on to talk about the pessimism in the media and then starkly contrasts our situation today with that of some of the times in the 20th century (two world wars, numerous smaller ones, a devastating depression, communism, etc.) and how well the market did during that century. It goes to show that to really succeed in business or investing, it pays to have an optimistic attitude, not a pessimistic one.
Consider this. Three years ago, in mid-March of 2008, before Lehman and AIG (AIG), and right before Bear Stearns, the S&P 500 closed at 1,293. On Tuesday, the S&P closed at 1,319. That is despite going through the largest global financial crisis since the Great Depression. If that doesn't make you believe in the resiliency of American capitalism, what will?
2) Return On Invested Capital is Key, and is Often A Function of Management
"Some companies will turn [retained capital] into fifty-cent pieces, others into two-dollar bills."
"... an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted."
Buffett is talking about the importance of good management to creating shareholder value. This relates to the return on capital metric used by MFI - how well does a company use its capital base to generate earnings? If it earns high returns on capital, it can either grow faster using it or return some of it to shareholders in the form of dividends and share buybacks. The capital not paid out (retained capital), can then be used to grow, either organically by hiring, increasing marketing spend or R&D, etc., or put to work buying new businesses. Firms that do this well turn those retained dollars into two-dollar bills for shareholders, ones that do not into fifty-cent pieces.
Farther in the letter, I thought it was interesting that Buffett actually comments on the earnings on un-leveraged net tangible assets that some of his businesses have. This is almost exactly what Joel Greenblatt's Magic Formula Investing strategy measures for its return on capital number. Buffett even gives ranges: "terrific" 25-100%, "good" 12-20%. This jives very well with what I've seen in MFI. Very few companies with sub-30% return on tangible capital ever get screened, unless they are absurdly cheap.
Also, the importance of a CEO focused on returns on invested capital is paramount. Buffett makes a nice comparison to investing a dollar in the late 1960's with (now bankrupt) Montgomery Ward vs. (now world's largest retailer) Walmart (WMT). Similar businesses, but much better management at Walmart. All CEO's are driven by something. Some are looking for personal enrichment, some to build empires - shareholders should look for managers looking to profitably grow the business. Buffett also mentions corporate culture and managers who love their businesses as keys to finding this kind of leadership. Quantitatively, two good metrics for finding this are significant insider ownership and a long tenure.
3) Don't Always Trust Net Income
"Regardless of how our businesses might be doing, Charlie and I could - quite legally - cause net income in any given period to be almost any number we would like."
Here Buffett is just commenting on how net income is not a very important metric for measuring Berkshire's success, as they have a massive amount of unrealized gains they can pull from at any given time to juice earnings. He also comments about the "game playing" with numbers that a lot of companies have, and continue, to engage in, especially on the income statement. Always remember that management can play loose and fast with the income statement. They are free to write-down assets to their choosing, expense vs. capitalize costs, print and talk about "pro-forma" results, and even choose when to recognize revenue. This is why investors should *always* compare reported earnings with reported cash flows, and if they do not agree, it is a huge accounting red flag.
4) Leverage Should Be Used In Moderation
"Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job."
Debt is not intrinsically bad, and is not something that should be avoided at all costs. But firms with a culture of financing growth and/or share buybacks with large amounts of debt should be highly scrutinized. While refinancing usually is possible, sometimes (like in 2008-09), it cannot, and if you are left without cash, you could be in big trouble. The Magic Formula does a good job of filtering out high debt / low cash firms by using enterprise value instead of market capitalization, but the fact is that some financially unhealthy companies do get screened from time to time.
