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Berkshire 1998 Shareholder Letter, Part 2 - Cliff's Notes Version

March 29, 2017

This is part 2 of the twenty-second 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 1998 letter weighs in at 12,020 words, a modest 1.9% increase from 11,800 words the prior year. Berkshire's gain in net worth during 1998 was $26 billion, or 48% of beginning 1997 net worth. Most of the net gain, however, resulted from issuing Berkshire shares at well above book value in the $22 billion General Re acquisition.

 

OPTIONS AND PRO FORMA ACCOUNTING - OR HOW TO LEGALLY MISLEAD SHAREHOLDERS

 

In the 1998 letter Buffett returns to a subject he discussed in earlier letters, namely the accounting treatment for stock options, as well as management's use of non-GAAP so-called 'pro forma' earnings numbers. On the first topic, accounting for options, at the time of the writing of the letter corporate America had been strongly lobbying Congress and other rule-making authorities to exclude the granting of options from GAAP expenses in the income statement [note that today these are included in financial statements as expenses]. Buffett had previously posited the following questions on the topic - "If options aren't a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?" He states that nobody ever gave him an answer to these questions. Buffett goes on to conclude as follows...

 

Whatever the merits of options may be, their accounting treatment is outrageous. Think for a moment of that $190 million we are going to spend for advertising at GEICO this year. Suppose that instead of paying cash for our ads, we paid the media in ten-year, at-the-market Berkshire options. Would anyone then care to argue that Berkshire had not borne a cost for advertising, or should not be charged this cost on its books?

         

Perhaps Bishop Berkeley -- you may remember him as the philosopher who mused about trees falling in a forest when no one was around -- would believe that an expense unseen by an accountant does not exist. Charlie and I, however, have trouble being philosophical about unrecorded costs. When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure. Similarly, if we contemplate an acquisition, we include in our evaluation the cost of replacing any option plan. Then, if we make a deal, we promptly take that cost out of hiding.

 

So much for that topic.

 

Moving on to 'pro forma' financial metrics offered up by management teams, usually in the merger and acquisition context, Buffett goes on to state the following [quoting in full the entirety of what he says seems quite timely today]...

 

I believe that the behavior of managements has been even worse when it comes to restructurings and merger accounting. Here, many managements purposefully work at manipulating numbers and deceiving investors. And, as Michael Kinsley has said about Washington: "The scandal isn't in what's done that's illegal but rather in what's legal."

         

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. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers -- CEOs you would be happy to have as spouses for your children or as trustees under your will -- have come to the view that it's okay to manipulate earnings to satisfy what they believe are Wall Street's desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.

         

These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don't produce the result hoped for, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired "earnings" or set the stage for them in the future.

         

Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals -- that is, their stock -- is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody's-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Son of Gresham: Bad accounting drives out good.

         

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. 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. In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share.

         

This dump-everything-into-one-quarter behavior suggests a corresponding "bold, imaginative" approach to -- golf scores. In his first round of the season, a golfer should ignore his actual performance and simply fill his card with atrocious numbers -- double, triple, quadruple bogeys -- and then turn in a score of, say, 140. Having established this "reserve," he should go to the golf shop and tell his pro that he wishes to "restructure" his imperfect swing. Next, as he takes his new swing onto the course, he should count his good holes, but not the bad ones. These remnants from his old swing should be charged instead to the reserve established earlier. At the end of five rounds, then, his record will be 140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92. On Wall Street, they will ignore the 140 -- which, after all, came from a "discontinued" swing -- and will classify our hero as an 80 shooter (and one who never disappoints).

         

For those who prefer to cheat up front, there would be a variant of this strategy. The golfer, playing alone with a cooperative caddy-auditor, should defer the recording of bad holes, take four 80s, accept the plaudits he gets for such athleticism and consistency, and then turn in a fifth card carrying a 140 score. After rectifying his earlier scorekeeping sins with this "big bath," he may mumble a few apologies but will refrain from returning the sums he has previously collected from comparing scorecards in the clubhouse. (The caddy, need we add, will have acquired a loyal patron.)

         

Unfortunately, CEOs who use variations of these scoring schemes in real life tend to become addicted to the games they're playing -- after all, it's easier to fiddle with the scorecard than to spend hours on the practice tee -- and never muster the will to give them up. Their behavior brings to mind Voltaire's comment on sexual experimentation: "Once a philosopher, twice a pervert."

         

In the acquisition arena, restructuring has been raised to an art form: Managements now frequently use mergers to dishonestly rearrange the value of assets and liabilities in ways that will allow them to both smooth and swell future earnings. Indeed, at deal time, major auditing firms sometimes point out the possibilities for a little accounting magic (or for a lot). Getting this push from the pulpit, first-class people will frequently stoop to third-class tactics. CEOs understandably do not find it easy to reject auditor-blessed strategies that lead to increased future "earnings." [emphases added]

 

Or to sum up with a picture...

'You know Homer, the traditional way to cheat at golf is to LOWER your score.' 

 

Things have recently gotten so bad that the SEC has recently been forced to issue comprehensive 'guidance' instructing managements on how NOT to cheat when issuing their 'pro forma' numbers [see summary here]. Of course, the reason why corporate executives should not massage the numbers upwards is clear--because for every seller, there's a buyer. While a management team may believe they have a duty to their existing shareholders to help pump up prices for their holdings, this only serves to benefit existing, selling shareholders at the expense of NEW shareholders [not coincidentally, most executives are net sellers of shares]. In the long term, this practice does nothing to benefit society, or for that matter the company's overall shareholder base, and can often lead to outright accounting scandals.

 

Nevertheless, crafty managements nationwide somehow seem to 'manage' to fudge the numbers upwards while still apparently staying within the letter of accounting and SEC rules. For example, they will divert shareholders from the company's SEC filings and direct them to look at non-filed documents such as shareholder presentations [usually Powerpoint slidedecks] that conveniently omit any negative language except for the 'Risk Factors' which appear in extremely small type on a single page. In addition, they will issue boldly optimistic pronouncements on earnings calls which statements never find their way into the company's legal filings. If one listens to these earnings calls, probably the most used phrase is 'remain confident' - as in, 'Don't worry, guys, things might look pretty grim if one myopically looks at our actual reported GAAP numbers, however we REMAIN CONFIDENT in our strategy and we reiterate our [inevitably bullish non-GAAP] guidance.' In other words, pay no attention to the man behind the curtain, folks.

 

Human beings, being sociable creatures and naturally willing to trust those in positions of authority, and moreover looking for reassurance in troubling times, naturally grasp on to the bullish predictions proferred by silver-tongued managements. Far too often to their detriment, however. Based on painful personal experience, we believe most investors would be much better off not listening to earnings calls or downloading investor presentations, but instead should focus solely on the applicable Form 10-K and 10-Q filings in order to judge whether he or she should 'remain confident' in his or her investment. More often than not, management's words mean absolutely nothing and should be ignored. The GAAP numbers don't lie, but unfortunately a company's C-suite and their cooked up non-GAAP numbers often do.

 

CONCLUSION

 

For the record, in 1998 Berkshire's stock was up 52%, outperforming the S&P 500 by 23.5%, the Yankees swept the Padres 4-0 in the World Series, the Broncos repeated as NFL champs by beating the Falcons 34-19 in Super Bowl XXXIII and on December 19th President Bill Clinton became the 2nd U.S. President ever to be impeached [with Andrew Johnson [not Tricky Dick, who resigned prior to impeachment] of course being the first].  Next up, 1999, the final year of the 20th century [or perhaps 2000 was actually the final year...].

 

 

 

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