Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we cover the 1998 letter.
Pick the best managers and let them get on with it
Buffett said telling outstanding CEOs how to run their companies would be the height of foolishness. Berkshire’s stable of CEOs, according to Buffett, are “the Mark McGwires of the business world” and need no advice on how to hold the bat or when to swing. He wrote:
"We give each a simple mission: Just run your business as if: 1) you own 100% of it; 2) it is the only asset in the world that you and your family have or will ever have; and 3) you can't sell or merge it for at least a century. As a corollary, we tell them they should not let any of their decisions be affected even slightly by accounting considerations. We want our managers to think about what counts, not how it will be counted."
This is quite an unusual set up as not many CEOs of public companies operate under this kind of mandate. That is because most shareholders focus on short-term prospects and reported earnings. As the saying goes, you get the shareholders you deserve and Berkshire has a shareholder base with a very longest investment horizon, giving Berkshire's stable of CEOs the ability to think and act for the long term.
That is not to say Buffett ignores the real-time operations of Berkshire’s businesses. He said that is “of great importance,” but Berkshire never wants short-term results to be achieved at the expense of building out an ever-greater set of competitive strengths.
Instead, Berkshire aims to create an environment that allows its managers to apply all their talents to what the conglomerate values most. Time and energy is not spent on board meetings, press interviews, presentations by investment bankers or talks with financial analysts.
Accounting
Buffett also spent a significant amount of time writing about the problems with accounting and financial reporting. Remember, this was pre-Enron, but problems persist today. The guru slammed the managements that purposefully work at manipulating numbers and deceiving investors. "The scandal isn't in what's done that's illegal, but rather in what's legal." He continued:
"It was once relatively easy to tell the good guys in accounting from the bad: The late 1960's, for example, brought on an orgy of what one charlatan dubbed 'bold, imaginative accounting' (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America's most-admired companies then shunned deception. In recent years, probity has eroded."
The guru said the problem is CEOs believe their job at all times is to encourage the highest stock price possible, a premise with which hs adamantly disagrees. Essentially, what he is saying is that too many CEOs worry about their stock price more than their business. In the end, the market will decide what the stock should be valued at and the only way the CEO can really succeed is by executing a strong strategy. Cosmetic things and things which are unadmirable, such as accounting gimmicks, frustrate Buffett immensely and he, like other smart investors, can see through these games. Management teams take advantage, with the support of their auditors, of flexibility in accounting rules and either manufacture the desired "earnings" or set the stage for them in the future.
Buffett noted the distortion du jour is the "restructuring charge," an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings. He goes on to describe what I like to call kitchen sinking:
"In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors. In some cases, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations."
Using a golf analogy, the investor said too many CEOs take shortcuts: “It's easier to fiddle with the scorecard than to spend hours on the practice tee.”
Another problem to watch out for is when it comes to deals, major auditing companies are prone to point out the possibilities for a little accounting magic.
When it comes to Berkshire, Buffett said:
"If we are to disappoint you, we would rather it be with our earnings than with our accounting. In all of our acquisitions, we have left the loss reserve figures exactly as we found them. After all, we have consistently joined with insurance managers knowledgeable about their business and honest in their financial reporting. When deals occur in which liabilities are increased immediately and substantially, simple logic says that at least one of those virtues must have been lacking -- or, alternatively, that the acquirer is laying the groundwork for future infusions of 'earnings.'"
