Berkshire 1989 Shareholder Letter, Part 2 - Cliff's Notes Version
This is second part of the thirteenth post in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2015. For all of the prior shareholder letters, see here.
The 1989 letter weighs in at 14,420 words, a 24% increase from 11,670 words the prior year. Berkshire's gain in net worth during 1989 was $1.515 billion, or 44% of beginning book value, up from a $569 million gain in 1988. Therefore 1989 represented the first year that net worth increased in excess of $1 billion for the company. This blog will cover the sections of the 1989 letter entitled "Zero Coupon Securities" and "Mistakes of the First 25 Years (A Condensed Version)".
ZERO COUPON SECURITIES AND NON-GAAP "ALCHEMY"
Zero coupon securities are an invention of Wall Street that have their place in the world of finance, however any invention can be detrimental to the general financial well being if it is used improperly. At the time Buffett was drafting the 1989 shareholder letter, what had begun as a novel and useful idea had become completely abused by practitioners of financial engineering:
In the last few years zero-coupon bonds (and their functional equivalent, pay-in-kind bonds, which distribute additional PIK bonds semi-annually as interest instead of paying cash) have been issued in enormous quantities by ever-junkier credits. To these issuers, zero (or PIK) bonds offer one overwhelming advantage: It is impossible to default on a promise to pay nothing.
The purveyors of zero coupon bonds obviously needed a marketing pitch to disguise the fact that their securities could cause a lot of damage, so they came up the term EBDIT (now known more mellifluously as EBITDA). As Buffett says, this new metric came in handy because if one ignores a real expense (in this case, depreciation), it increases the issuer's ability to repay debt securities--or so the purveyors of such metrics claim. Depreciation is a non-cash expense, the witch doctors emphasize, and therefore it doesn't count...right? Buffett disagrees:
Such an attitude is clearly delusional. At 95% of American businesses, capital expenditures that over time roughly approximate depreciation are a necessity and are every bit as real an expense as labor or utility costs. Even a high school dropout knows that to finance a car he must have income that covers not only interest and operating expenses, but also realistically-calculated depreciation. He would be laughed out of the bank if he started talking about [EBITDA]. Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. As businessmen, Charlie and I relish having competitors who are unable to fund capital expenditures. [emphasis added]
Confirming that there is indeed "nothing new under the sun", companies today are attempting to foist false metrics on investors to divert their attention from the true "economic" performance of publicly-traded companies. For example, there is widespread use of "non-GAAP" metrics in company earnings press releases that invariably present a rosier picture of financial reality than actually exists. Non-GAAP "adjusted" earnings and "adjusted" EBITDA typically exclude those "non-cash" or "non-recurring" expenses that companies just don't want to (or which they wish they didn't have to) count, but which are actual expenses in fact. Stock compensation is "non-cash" so it can be waived away. Loss on the extinguishment of debt is "non-cash", so investors should simply ignore it. The pitch seems to be: "If you close your eyes and try hard enough, investor, you can imagine whatever you want to imagine and believe whatever you want to believe (and if you do, those of us in the C-suite will be getting SERIOUSLY PAID thanks our stock options)".
Companies know that SEC disclosure requirements are so complex that investors don't have time to read full 10-K and 10-Q filings, which typically run over 100 pages, sometimes even stretching to 400 to 500 pages including exhibits. Lacking the time to do proper due diligence, one must rely on the 10-15 page management summaries contained in earnings press releases. The problem, of course, is that the rules governing disclosure in press releases are much less stringent than the rules governing 10-Ks and 10-Qs and thus the presentation of results by management is much easier to manipulate. Perhaps management teams across the country think they are doing their investors a favor by presenting an exceedingly optimistic picture of financial results, however if so they would be mistaken. While false non-GAAP earnings and EBITDA metrics may prop up a company's stock price temporarily, this isn't sustainable over the long term (in order to "grow" non-GAAP earnings when underlying GAAP earnings are not growing, management needs to put more and more expenses into the "non-recurring" and "non-cash" buckets over time--but eventually the result becomes a grotesque monstrosity that even gullible investors won't swallow). Moreover, causing the stock price to levitate to an artificially high level punishes new investors, while benefiting exiting shareholders--logically the opposite result that a company's management should desire to occur (that is, if such a levitation didn't also result in windfall compensation for said management).
Below are a couple random examples of the "alchemy of non-GAAP 'adjusted' numbers" from just the past week; note how they invariably seem to make results seems better than they really are for shareholders.
February 2, 2017 - Crown Holdings, Inc. (NYSE: CCK) earnings press release:
In Q4 2016, a $0.47/share GAAP EPS result becomes transformed into a $0.71/share non-GAAP EPS result, or a massive 51% higher, and a full year 2016 $3.56/share GAAP EPS result becomes transformed into a $3.93/share non-GAAP EPS result, or 10% higher. The numbers in 2015, as can be seen above, were even more distorted. Deducting for "provision for asbestos" and "restructuring and other" is truly ludicrous because these items seem to occur every year--so how can they possibly be termed "non-recurring" or "unusual"? Evidently investors, sedated by the easy money of the past seven-year bull market, no longer care, since the stock price just goes up and up:
February 2, 2017 — ACETO Corporation (Nasdaq: ACET) earnings press release:
Again, we see the same pattern: In Q4 2016, a negative $0.02/share GAAP EPS result becomes transformed into a $0.24/share non-GAAP EPS result, or a massive 1,200% higher, and a July-December 2016 $0.13/share GAAP EPS result becomes transformed into a $0.52/share non-GAAP EPS result, or 300% higher. Investors seem to be catching on a bit, though, as ACET's price took a large hit on Friday, February 3rd, although it still trades at an extremely high EPS multiple versus the GAAP numbers (over 60X the run-rate GAAP EPS for the 2nd half of 2016):
What the wise man does in the beginning (buying ACET at $6/share in 2011), the fool does in the end (buying ACET at $30/share in late 2015 based on fake "non-GAAP EPS" numbers). Buffett (as usual) sums all of the foregoing up rather aptly:
But in the end, alchemy, whether it is metallurgical or financial, fails. A base business can not be transformed into a golden business by tricks of accounting or capital structure. The man claiming to be a financial alchemist may become rich. But gullible investors rather than business achievements will usually be the source of his wealth... Our advice: Whenever an investment banker starts talking about [EBITDA]--or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures--zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures.
(Note - for anyone wishing to read more regarding recent non-GAAP financial shenanigans, please see the January 19, 2017 writeup regarding Allergan (AGN) under the Research tab on our website (link here).)
MISTAKES OF THE FIRST TWENTY-FIVE YEARS (A CONDENSED VERSION)
Finally, Buffett lays out in the 1989 letter the principal mistakes he committed during his first quarter century running Berkshire (we are now in the 53rd year of his reign). The key mistake he identifies? Buying Berkshire in the first place:
My first mistake, of course, was in buying control of Berkshire. Though I knew its business--textile manufacturing--to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal. If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit. Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces--never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre. [emphasis added]
Rather than sifting through the junk heap to find the next cigar butt or two, Buffett concludes that "when buying companies or common stocks, we [now] look for first-class businesses accompanied by first-class managements."
A corollary lesson from this emerges: focus on stepping over one-foot business hurdles rather than trying to clear a bar set at Olympic high-jump height:
After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them... The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. On occasion, tough problems must be tackled as was the case when we started our Sunday paper in Buffalo. In other instances, a great investment opportunity occurs when a marvelous business encounters a one-time huge, but solvable, problem as was the case many years back at both American Express and GEICO. Overall, however, we've done better by avoiding dragons than by slaying them. [emphasis added]
The final lesson Buffett learns from his business mistakes is never to underestimate effect of the "institutional imperative" in the business environment (or, why smart people do dumb things):
My most surprising discovery: the overwhelming importance in business of an unseen force that we might call "the institutional imperative." In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn't so. Instead, rationality frequently wilts when the institutional imperative comes into play. For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.
For the record, in 1989 Berkshire's stock was up 85%, beating the market by a nifty 53%, the As swept the Giants in the "Earthquake" World Series in four straight, the 49ers demolished John Elway's Broncos by a score of 55-10(!) in Super Bowl XXIV and on April 15th the famous protests began on Tiananmen Square in China. Next up, 1990, the first year of the decade of grunge, Bill Clinton (and of course Monica), the OJ Simpson trial, Y2K and a host of other fascinating happenings, to be duly noted in our future posts covering Buffett's shareholder letters.