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 2000 letter.
Investments
The peak of the dot-com bubble occurred around March 2000. While composing the 2000 shareholder letter in February 2001, Buffett wrote in detail his thoughts on the mania and why Berkshire rode though it. In essence, the conglomerate has a disciplined investment process, focused on fundamental valuation, and he said this is the same for both the evaluation of stocks and businesses.
Buffett credited the ancient Greek storyteller Aesop for being the first one to essentially explain the principle of valuation with the insight "a bird in the hand is worth two in the bush." Buffett takes it a step further with three questions:
- How certain are you that there are indeed birds in the bush?
- When will they emerge and how many will there be?
- What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?
Instead of birds think dollars. And using the risk-free rate, this gets you to the absolute maximum you should offer for the asset. Buffett said investment axiom is immutable. He wrote:
"It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota - nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe."
Everything else is secondary. Dividend yields, the ratio of price-earnings or to book value and even growth rates are not valuation “except to the extent they provide clues to the amount and timing of cash flows into and from the business.” Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Buffett said people talking about growth and value styles are demonstrating ignorance, as the growth rate is just a component of any valuation.
While we know the risk-free interest rate, the certainty and levels of the cash flows and the timings of them are difficult to know precisely, and Buffett noted working with a range of possibilities is the better approach to find opportunities. He continued:
"Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT – Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights."
The uncertainty is higher for new businesses and rapidly changing industries. Buffett called these cases speculative. It was obvious speculation was rampant in recent years. He wrote:
"…investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to deliver such a return."
Buffett, fairly in my opinion as somebody who remembers the era, ripped into the financial promotors whose only goal was to close an initial public offering to bank fees. He said:
"But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street - a community in which quality control is not prized - will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest."
Berkshire searches for opportunities in which it has reasonable confidence “as to how many birds are in the bush and when they will emerge” Buffett recognized Berkshire can never precisely predict the timing of cash flows in and out of a business or their exact amount. Instead, the goal is to keep estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on Berkshire’s owners.
Full and fair reporting
Buffett also used the 2000 shareholder letter to opine on the accounting scandals of the age. Buffett and Munger simply wanted to see “all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business” in financial reporting. He wrote:
"When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder - does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something."
He then applauded Arthur Levitt, who had been the chairman of the SEC, for cracking down on the corporate practice of "selective disclosure" which gave certain “speculatively-minded institutions and advisors” an information edge over investment-oriented individuals.
"This was corrupt behavior, unfortunately embraced by both Wall Street and corporate America," he said.
Both Buffett and Charlie Munger (Trades, Portfolio) think its “both deceptive and dangerous” for CEOs to predict growth rates for their companies because these often lead to trouble. While the investor says it is fine to have internal goals and it is OK to express hopes for the future if accompanied by sensible caveats, it is silly to predict that its per-share earnings will grow over the long term at something like 15% annually.
That is because it can lead managements to engage in “uneconomic operating maneuvers so that they could meet earnings targets they had announced” or worse to employ accounting games to "make the numbers." Then, before you know it, this behavior snowballs often into outright fraud.
Buffett said it is hard for investors to know which managers will turn out prophetic and which will turn out to be charlatans and, as such, these predictions are essentially worthless.
