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Updated: February 28, 2010 10:45 IST

Business wisdom from Buffett’s annual letters

D. Murali
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Too much of a good thing isn’t bad, but wonderful. Many CEOs attain their positions because they possess an abundance of animal spirits and egos. How to manage a crisis is to do it in the manner of a fellow that has never met a lawyer.

These are some of the snatches from ‘Warren Buffett on Business: Principles from the Sage of Omaha’ compiled by Richard J. Connors (www.wiley.com). The book is not about how Buffett invests or how you can invest like him, the intro clarifies. “Rather, it is about his way of communicating with and treating employees and shareholders fairly and honestly; responsible corporate governance; ethical behaviour; patience and perseverance; admitting mistakes; having a passion for work; and having fun and a sense of humour.”

The Buffett/ Berkshire Hathaway model of managing a business should be required reading for all business executives, entrepreneurs, and business school students, says Connors, who has presented a course on Buffett at the Washington University in St Louis Lifelong Learning Institute.

Digging through Buffett’s letters to shareholders over many decades (1977-2008), the author finds nuggets on a variety of topics – ranging from communication to corporate culture, from time management to personal investing. “My most difficult task was deciding what not to include,” confesses Connors.

At the time of writing this, the top news about ‘Buffett letters’ is that this year’s annual letter to shareholders of Berkshire Hathaway Inc. will be released via the Internet on February 27 (www.berkshirehathaway.com), and mailed around March 12 to shareholders as part of the company’s annual financial report.

“When you do receive a communication from us, it will come from the fellow you are paying to run the business,” is an assurance of Buffett. “Your Chairman has a firm belief that owners are entitled to hear directly from the CEO as to what is going on and how he evaluates the business, currently and prospectively.”

A once-a-year report for stewardship should not be turned over to a staff specialist or public relations consultant who is unlikely to be in a position to talk frankly on a manager-to-owner basis, he insists.

The chapter on ‘communication’ has valuable insights on how companies should not communicate. Such as trumpeting EBITDA (earnings before interest, taxes, depreciation and amortisation), a pernicious practice! Because doing so implies that depreciation is not truly an expense, given that it is a ‘non-cash’ charge, Buffett reasons. “That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.”

Unintelligible footnotes are another warning sign, especially of untrustworthy management, cautions Buffett. “If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.”

A chapter on ‘management principles and practices’ instructs that ‘the primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.), and not the achievement of consistent gains in earnings per share.’ Buffett decries the common corporate practice of rewarding managers for earnings increases produced solely, or in large part, by retained earnings.

When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement, he notes. “You can get the same result personally while operating from your rocking chair. Just quadruple the capital you commit to a savings account and you will quadruple your earnings.”

A truly great business, according to the Sage of Omaha, must have an enduring ‘moat’ that protects excellent returns on invested capital. “The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns… Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.”

Buffett traces to 600 BC the formula for valuing all assets that are purchased for financial gain, as laid out by Aesop, thus: ‘A bird in the hand is worth two in the bush.’ Flesh out this principle by answering three questions, guides Buffett. “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?”

Aesop’s investment axiom – were you to think dollars rather than birds – applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants, says Buffett. He observes that common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with 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.”

The ‘humour and stories’ chapter, with which the book wraps up, narrates a favourite riddle of Abraham Lincoln: ‘How many legs does a dog have if you call his tail a leg?’ The answer is not ‘five,’ but ‘four,’ because calling a tail a leg does not make it a leg. Buffett exhorts managers to remember this tale, ‘even if an auditor is willing to certify that the tail is a leg.’

Recommended addition to the conscientious investors’ shelf.

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