This is the eighteenth 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 1994 letter weighs in at 9,600 words, a 13% decrease from 11,030 words the prior year. Berkshire's gain in net worth during 1994 was $1.45 billion, or 14% of beginning 1993 net worth.
BOOK VALUE VERSUS INTRINSIC VALUE
Often the advocates of so-called "value investing" refer to a company's "intrinsic value". The goal of this type of investing is to purchase stocks of companies whose intrinsic value significantly exceeds its market capitalization. So what exactly is the "intrinsic value" of a company? It is simply the discounted value of all of the net cash that can be extracted from a company over the course of its existence. The inverse of this concept is book value, which represents the current value of everything (calculated on a net basis) that has been invested in the applicable company by its owner's throughout its prior history. Thus intrinsic value is what can be taken out of a company in the future and book value is what has been put into a company during the past, each calculated on a net basis.
Buffett summarizes these two concepts with respect to Berkshire as follows:
We regularly report our per-share book value, an easily calculable number, though one of limited use. Just as regularly, we tell you that what counts is intrinsic value, a number that is impossible to pinpoint but essential to estimate. For example, in 1964, we could state with certitude that Berkshire's per-share book value was $19.46. However, that figure considerably overstated the stock's intrinsic value since all of the company's resources were tied up in a sub-profitable textile business. Our textile assets had neither going-concern nor liquidation values equal to their carrying values. In 1964, then, anyone inquiring into the soundness of Berkshire's balance sheet might well have deserved the answer once offered up by a Hollywood mogul of dubious reputation: "Don't worry, the liabilities are solid." Today, Berkshire's situation has reversed: Many of the businesses we control are worth far more than their carrying value. (Those we don't control, such as Coca-Cola or Gillette, are carried at current market values.) We continue to give you book value figures, however, because they serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value. Last year, in fact, the two measures moved in concert: Book value gained 13.9%, and that was the approximate gain in intrinsic value also.
Buffett uses the analogy of a college education of a person. The book value of the education equals the total amount paid for tuition, plus the foregone earnings of that person during his or her years in school (since the person could have opted to work straight out of high school and skipped college altogether). The intrinsic value of the education, conversely, equals the discounted present value of (x) the applicable person's expected future earnings, based on the job(s) such a person would be able to get with his or her college degree, minus (y) the applicable person's expected future earnings, based on the job(s) such a person would be able to get without a college degree. The return on capital would equal the intrinsic value divided by book value of the education. Buffett states that in almost every instance no rational person would believe that the intrinsic value of a college education would be less than its book value (if it were less consistently, then eventually people would realize this and stop going to college). Theoretically tuition could get so high and/or wages could stagnate or decline to an extent that it wouldn't make sense to attend a university or graduate school, but it seems that we are far from that point at present. In the corporate acquisition context, thought, many mergers exhibit this trait (value given up exceeds value gained).
Extending the college education analogy, Buffett compares dumb acquisitions to a person who is a senior, nearly ready to graduate and enter the workforce, swapping his future earnings for the earnings of a day laborer who is already gainfully employed. While this would immediately be "accretive" to the student's net income (currently a negative number, since he or she is still in school), it would be financially crazy from a long-term perspective, since the day laborer's earnings will barely rise in the future while the student's income should in short order explode upwards. Yet in the corporate context CEOs will regularly trumpet as "accretive" (and therefore desirable) the sale of part of their underlying company (which is what is actually happening in a stock swap) in return for the acquisition of another company (the target) which may have better earnings in the near future but a decidedly worse future earnings trajectory. These type of transactions may boost earnings per share in the short term but will actually leave the acquirer's shareholders poorer, since in a merger what really matters is (A) intrinsic value given up versus (B) intrinsic value acquired (note that even in all-cash deals this concepts applies, since $1 of cash obviously has an intrinsic value of $1). What an acquirer's management team should really be required to show its shareholders when proposing an acquisition is that the present value of the expected future cashflows obtained in the merger, less the costs incurred to do the merger, exceed the present value of the expected future cashflows given up as consideration to the target's shareholders--and preferably by a large enough extent to provide for a margin of safety if things do not work out as planned. This type of justification for a merger can then be retrospectively analyzed a few years later to see how things actually worked out (and, if the deal proved to be stupid, management can then be held accountable).
INTRINSIC VALUE, BOOK VALUE AND ACQUISITIONS
As an example of a deal that "worked" using the intrinsic value calculations, Buffett offers up Berkshire's Scott Fetzer Co acquisition that closed in early 1986. Buffett states that "[w]e paid $315.2 million [cash] for Scott Fetzer, which at the time had $172.6 million of book value. The $142.6 million premium we handed over indicated our belief that the company's intrinsic value was close to double its book value." So Berkshire gave up $315.2 million in intrinsic value in return for a company from which it extracted the following cashflows (via dividends) in just the first 9 years of ownership (and, importantly, without adding any leverage to the company during this period):
Dividends Extracted By Berkshire From Scott Fetzer:
1986 ............... $125.0
1987 ............... 41.0
1988 ............... 35.0
1989 ............... 71.5
1990 ............... 33.5
1991 ............... 74.0
1992 ............... 80.0
1993 ............... 98.0
One doesn't need to be a mathematician to determine that Berkshire acquired substantially more intrinsic value from the acquisition than it gave up. It extracted $652 million in dividends in just nine years post-acquisition in return for paying $315 million--and still had 100% ownership of an extremely healthy, unleveraged business with consistently growing earnings ($79 million in 1994 alone). In short, the deal greatly increased Berkshire's owners' wealth and likely substantially decreased the wealth of Scott Fetzer's former owners (the latter, however, failed to realize this at the time the agreed to surrender their shares for cash). Yet no mention of this fact was made in the N.Y. Times article from late 1985 that summarized the transaction (no doubt many Scott Fetzer shareholders at the time were solely focused on the "merger premium" they would get, not on how the amount Berkshire agreed to pay compared with the intrinsic value of the assets they were relinquishing in exchange for such cash):
Berkshire to Buy Scott & Fetzer
By RICHARD W. STEVENSON; Published: October 30, 1985
The Scott & Fetzer Company, which last month dropped a leveraged buyout attempt, said yesterday that it had agreed to be acquired by Berkshire Hathaway Inc. for $60 a share, or a total of about $400 million. Analysts said that Berkshire Hathaway, which is controlled by Warren E. Buffett, the Omaha investor, was probably attracted to Scott & Fetzer because of its steady cash flow. Mr. Buffett could not be reached for comment. Scott & Fetzer, which makes Kirby vacuum cleaners and The World Book Encyclopedia, ''appears to be a modest growth, but low volatility business,'' said one analyst, who asked not to be identified. ''They have a lot of cash, and they're a steady cash generator.''
Scott & Fetzer reported earnings last year of $40.6 million, or $6.01 a share, a 26 percent increase from $32.2 million, or $4.80 a share, the previous year. Sales last year were $695.4 million. The company had proposed a $62-a-share leveraged buyout with Kelso & Company, a New York investment concern, late last year. But the Labor Department objected to the plan's use of an employee stock ownership plan, and was ended in early September.
At that time, Scott & Fetzer, based in Westlake, Ohio, said that it would consider other proposals. The company had received several other bids in the last two years, including one from Ivan F. Boesky, the arbitrager.
Even if the deal is not completed, Berkshire Hathaway has an agreement to acquire 1.4 million Scott & Fetzer common shares and 890,000 convertible preferred shares at $55 a share, which would give Berkshire about a 25 percent stake. The deal is subject to approval by Scott & Fetzer shareholders. It must also be found in compliance with an Ohio antitakeover law, Scott & Fetzer said. On the New York Stock Exchange yesterday, Scott & Fetzer closed at $58.25, up $3.375.
One caveat to the Scott Fetzer discussion: At times the assets of a company can be worth much more in the hands of an acquirer than in the hands of the acquiree, simply due to the quality of management. If the target's existing management consistently squanders the company's assets (for example via mergers, dumb internal "growth" initiatives or simply due to outrageously high executive compensation), logically that company's shareholders should place a lower valuation on those assets than if the same assets were under the control of a Warren Buffett or a Steve Jobs (in which case, they should rationally agree to a deal where the acquirer obtains more intrinsic value than it gives up, so long as the intrinsic value of what they receive exceeds the intrinsic value of what they are giving up, preferably by a wide margin).
Usually, however, it is the acquirer's shareholders (not the target's) that are left off poorer from acquisitions. Buffett explains why as follows:
The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer's management; and they are a honey pot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer's shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives. Do that enough, says John Medlin, the retired head of Wachovia Corp., and "you are running a chain letter in reverse." Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value. Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally. The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense. That's like asking your interior decorator whether you need a $50,000 rug. The acquisition problem is often compounded by a biological bias: Many CEO's attain their positions in part because they possess an abundance of animal spirits and ego. If an executive is heavily endowed with these qualities - which, it should be acknowledged, sometimes have their advantages - they won't disappear when he reaches the top. When such a CEO is encouraged by his advisors to make deals, he responds much as would a teenage boy who is encouraged by his father to have a normal sex life. It's not a push he needs. [emphasis added]
EXECUTIVE COMPENSATION--USUALLY A ONE-WAY STREET
Once again exposing the hypocrisy often seen in the corporate context, Buffett goes on in the 1994 letter to note how many companies falsely claim that their executive compensation schemes "align management's interests with those of shareholders". Buffett exposes this untruth by noting that "alignment means being a partner in both directions, not just on the upside. Many 'alignment' plans flunk this basic test, being artful forms of 'heads I win, tails you lose'". This is especially true in the context of option grants:
A common form of misalignment occurs in the typical stock option arrangement, which does not periodically increase the option price to compensate for the fact that retained earnings are building up the wealth of the company. Indeed, the combination of a ten-year option, a low dividend payout, and compound interest can provide lush gains to a manager who has done no more than tread water in his job. A cynic might even note that when payments to owners are held down, the profit to the option-holding manager increases. I have yet to see this vital point spelled out in a proxy statement asking shareholders to approve an option plan.
Due to compounding, even a savings account's "earnings" (i.e., interest payments) will inevitably increase in value assuming all prior interest payments are left in the account and interest rates remain level, even though the account holder has not lifted a finger. In the same vein, mediocre management teams should expect to see their companies' earnings levels (and stock prices) rise over time, assuming they withhold dividends, due to the same compounding effect and will thus benefit disproportionately from their option grants at the expense of their shareholders. Buffett states that, with respect to funds that are reinvested in the business, companies should assign their C-suite executives a cost-of-capital charge for the use of these assets in determining compensation (just as the company would be assigned such a charge, in the form of interest, by a bank if it were to borrow the same amount). Of course, almost no companies other than Berkshire appear to do this, for the obvious reason that compensation levels would consequently decrease and managers would be poorer (and shareholders wealthier). Conversely, a management team that sends money back to shareholders via dividends should get a credit for working with a lesser amount of capital, which should increase their compensation. If companies had rational compensation plans these kind of attributes, they would be much more shareholder-friendly than currently. Sadly, though, many companies continue to be run for the benefit of managers instead of owners / shareholders.
LESSON NUMBER 459 IN WHY "TRADING" IS A BAD IDEA
Many investors attempt to "trade around" core positions, thinking they will be able to guess where the prices of stocks they own (or wish to own) might go in the short run. Often these guesses revolve around macro views regarding the larger economy. So a person might look at a stock he or she wants to buy but hesitate because "it's too uncertain right now", or "the market seems pretty high" or, if the company's share price has been declining recently, "it might go down further". Conversely, the same person might sell shares of a business they love for similar reasons, or just to "lock in profits" (whatever that means--in doing this one could just as easily be "locking in" the absence of future profits if the stock continues to climb). Buffett dispels all such reasoning as flawed, as follows:
We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable. Why scrap an informed decision because of an uninformed guess? We purchased National Indemnity in 1967, See's in 1972, Buffalo News in 1977, Nebraska Furniture Mart in 1983, and Scott Fetzer in 1986 because those are the years they became available and because we thought the prices they carried were acceptable. In each case, we pondered what the business was likely to do, not what the Dow, the Fed, or the economy might do. If we see this approach as making sense in the purchase of businesses in their entirety, why should we change tack when we are purchasing small pieces of wonderful businesses in the stock market? [emphasis added]
Hence, the ideal time to (A) buy a demonstrably great business is: whenever it's available at a reasonable price; and (B) sell a demonstrably great business is: probably never.
For the record, in 1994 Berkshire's stock was up 25%, beating the market by 24%, the White Sox beat the Dodgers in the World Series in five games (oh wait, there was no World Series, because the owners and players couldn't decide how to divide up their billions of dollars), the 49ers waxed the Chargers 49-26 in Super Bowl XXIX (yes, Jerry Rice is the G.O.A.T.) and on December 15th Netscape (RIP) released the first version of its Netscape internet navigator (RIP). Next up, 1995, the year the world said hello to Gigi and Kendall (what would we do without this dynamic duo) and goodbye to NWA's Easy E.