Author: BoringBiz_
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As Warren Buffett took the helm of Berkshire Hathaway for nearly six decades and finally handed over the reins, I reread and began studying all of his annual shareholder letters.
If you would like to read the lessons learned from the letters from 1977-1980, please see here: 1977-1980 letters
Here are some classic lessons that are applicable to both investors and operators.
1981 Letter to Shareholders
Standards for Merger and Acquisition Decisions
"Our M&A decisions are aimed at maximizing real economic benefits, not at expanding management's reach or pursuing accounting figures. (In the long run, management teams that emphasize accounting appearances rather than economic substance usually end up with neither.)"
"Regardless of the impact on immediate earnings, we would rather purchase 10% of a superior company, T, at a price of X per share than purchase 100% of T at 2X. However, most company management prefers the latter and never lacks reasons to justify their actions."
Why are CEOs willing to pay a premium for mergers and acquisitions (M&A) and leveraged buyouts (LBO)?
"We suspect that the following three motivations (often unwritten) are the main drivers in most high-premium acquisitions, either individually or in combination:"
- Leaders, whether in the business world or other sectors, rarely lack "animal spirits"—they often crave increased activity and challenges. At Berkshire Hathaway, the company's pulse has never been stronger when there's a prospect of a merger or acquisition.
- Most organizations, whether in business or elsewhere, tend to measure themselves by size, and are measured by size by others. Compensation for management is far more often measured by "size" than by other standards. (Ask a manager at a Fortune 500 company where their company ranks on that prestigious list; the number they'll immediately say will be the one ranked by sales volume; they might not even know where their company ranks in Fortune's equally faithful profit margin rankings.)
- Many managers were clearly too heavily influenced by the story of "The Frog Prince" during their formative years—in which a handsome prince imprisoned inside a frog is reborn through a kiss from a beautiful princess. Therefore, they are convinced that their "management kiss" can create miracles for their target company, T.
This optimism is essential. Without this pleasant illusion, why would the shareholders of acquiring company A support buying company T's equity at 2X instead of buying it directly on the secondary market at X?
Investors should seek to buy the "priceless prince" at a "frog price".
"Investors can always buy frogs at market price. If investors fund 'princess's' who are willing to pay double the price to kiss frogs, then those kisses had better actually be powerful."
We've observed many kisses, but rarely have we seen miracles. Nevertheless, many management "princesses" remain confident in the effectiveness of their future kisses—even if their company backyards are already overflowing with unresponsive frogs.
We occasionally attempted to buy frogs at low prices, the results of which have been detailed in past reports. Clearly, our kisses were complete failures. We did well with a few "princes"—but they were princes when they were acquired. At least our kisses didn't turn them into frogs. Finally, we occasionally managed to very successfully buy partial stakes in easily identifiable "princes" at "frog-like" prices.
What makes a successful merger and acquisition?
"We must acknowledge that some M&A records are indeed very impressive. They can be mainly categorized into two types:"
The first category involves companies that, through careful planning or sheer chance, acquire only businesses that are particularly well-suited to an inflationary environment. These favored businesses must possess two characteristics:
- It has the ability to raise prices more easily (even when product demand is flat and production capacity is not fully utilized), and there is no need to worry about a significant loss of market share or sales.
- They possess the ability to handle massive dollar-denominated business growth with minimal additional capital investment (this growth is often driven by inflation rather than real growth). Even mediocre management teams have achieved remarkable success in recent decades by focusing on acquisitions that meet these criteria. However, very few companies possess both of these characteristics simultaneously, and competition to acquire such companies has now become exceptionally fierce, even self-destructive.
The second category involves management geniuses—those rare talents who can identify the prince disguised as a frog and possess the managerial ability to tear away the disguise. We pay tribute to these managers.
A stable price level is like a chastity
"We have already explained how inflation can render our seemingly satisfactory long-term performance illusory when measuring the true investment results for owners."
We appreciate the efforts of Federal Reserve Chairman Volcker and note that growth across various price indices has moderated.
However, our view on the long-term inflation trend remains pessimistic. Like chastity, a stable price level seems sustainable, but not irreparable.
On equity risk premium
"The economic basis for justifying equity investment is that, in general, the application of management and entrepreneurial skills to equity capital will generate additional returns that are higher than those of passive investments (i.e., interest on fixed-income securities)."
Furthermore, this argument holds that because equity capital carries higher risks than passive investment, it "deserves" a higher return. The "appreciation" bonus generated by equity capital seems logical and certain.
But is that really the case? Decades ago, a return on equity (ROE) as low as 10% was enough to classify a company as a “good” business—meaning that in such a business, a reinvestment of $1 could logically be valued by the market as more than 100 cents.
Because when the yield on long-term taxable bonds is 5% and the yield on long-term tax-exempt bonds is 3%, a business operation that utilizes equity capital with 10% efficiency is clearly more valuable to investors than the equity capital used. This holds true even if the combination of dividend tax and capital gains tax reduces the 10% earned by the company to 6%-8% for individual investors.
The investment market at the time acknowledged this fact. During that period, the average return on equity for American companies was approximately 11%, and the overall price of stocks far exceeded their equity capital (book value), with an average price of over 150 cents per dollar of book value. Most businesses were "good" businesses because their earning power far exceeded their maintenance costs (the return on long-term passive capital). The total added value generated by equity investments was enormous.
That era is gone forever. But the lessons it taught us are hard to forget. While investors and management must look to the future, their memories and minds often remain stuck in the past. For investors, using historical price-to-earnings ratios, or for management, using historical business valuation standards, is far easier than constantly rethinking the premises.
When change is slow, constant rethinking is ineffective and slows down the response. But when change is dramatic, clinging to yesterday's assumptions comes at a huge cost. And the pace of economic change has become breathtaking.
Inflation is a parasite on businesses
In an inflationary environment, there is a particularly ironic punishment for owners of “bad” businesses. In order to maintain the status quo, these low-return businesses must typically retain most of their profits—no matter how much this policy punishes shareholders.
The rational approach is, of course, the opposite. If someone holds a 5% interest bond with many years to go before maturity, they won't use the interest from that bond to buy more 5% bonds at 100 cents each, especially when similar bonds are readily available (for example, as little as 40 cents). Instead, they will collect the interest from that low-yield bond and—if they intend to reinvest—look for the opportunity with the highest available safe return. Good money doesn't waste itself chasing after bad money.
The logic that applies to creditors also applies to shareholders. Logically, a company with high historical and expected returns should retain most or all of its profits so that shareholders can earn a premium return through enhanced capital.
Conversely, low returns on equity imply a policy of extremely high dividend payouts to encourage owners to redirect capital to more attractive areas. (The Bible holds the same view. In the parable of responsibility according to talent, the two high-yielding servants received a 100% retained earnings bonus and were encouraged to expand. However, the third servant, who yielded no earnings, was not only rebuked—"wicked and lazy"—but also required to transfer all his capital to the best performer. Matthew 25:14-30)
But inflation is like taking us to the Mirror Mirror in Alice's Adventures, where everything is upside down. When prices keep rising, "bad" businesses must retain every penny they can get. This isn't because it's attractive as a place to hold equity capital; on the contrary, it's precisely because it's unattractive that low-return businesses must adhere to high retention policies. If it hopes to continue operating in the future as it has in the past—which most entities, including businesses, want to do—it has no other choice.
Because inflation is like a giant "corporate termite." This termite preemptively consumes the dollars it needs to invest every day, regardless of the health of the host organism. Regardless of reported profit levels (even if they are zero), just to maintain last year's business volume, companies continue to need more dollars to invest in accounts receivable, inventory, and fixed assets. The worse the business is, the larger the proportion of available resources this termite consumes.
Under current conditions, a company with an 8% or 10% return on equity typically has no surplus funds for expansion, debt repayment, or distributing “real” dividends.
Inflation, that termite, merely cleaned the table. (The inability of low-return companies to pay dividends is often well-hidden. American companies are increasingly turning to dividend reinvestment plans, sometimes even including discount arrangements that practically force shareholders to reinvest. Others are "robbing Peter to pay Paul," selling newly issued stock to Peter to pay dividends to Paul. Be wary of "dividends" that can only be paid if someone promises to replace the distributed capital.)
1982 Letter to Shareholders
Set the preset standard
"Yardsticks are rarely discarded as long as the results are good. But when performance deteriorates, most managers tend to discard the yardsticks rather than the manager."
For managers facing deteriorating performance, a more flexible measurement system often comes to mind: first, shoot an arrow of business performance onto a blank canvas, then carefully draw the bullseye around where the arrow lands. We generally have more faith in pre-defined, long-term effective metrics with a smaller bullseye.
Accounting is the starting point, not the end point, of business valuation.
"We prefer the concept of 'economic' surplus, which includes all undistributed profits, regardless of ownership percentage. In our view, the value of retained earnings to owners depends on how efficiently those earnings are used, not on the size of your ownership percentage. If you've held 0.01% of Berkshire Hathaway over the past decade, regardless of how your accounting system records it, you've economically fully shared in our retained earnings. Proportionally, you've received the same benefit as if you owned that glamorous 20% stake. However, if you've held 100% equity in many capital-intensive businesses over the past decade, the economic value of those retained earnings, fully and accurately recorded under your name according to standard accounting methods, might ultimately be negligible, or even zero."
This is not a criticism of accounting procedures. We don't want to be tasked with designing a better system. It's simply to illustrate that managers and investors must understand that accounting figures are the starting point, not the end point, for business valuation.
Retained earnings and market valuation
"Although the total retained earnings over the years have been converted into at least an equivalent amount of market value and returned to shareholders, this conversion is extremely uneven across different companies and is irregular and unpredictable in terms of timing."
However, it is precisely this imbalance and irregularity that provides opportunities for value-oriented buyers who purchase fractional portions of a company.
These investors can choose from almost all major U.S. companies, including many far superior to those that can be acquired entirely through negotiation. Furthermore, partial stake purchases can be made in the auction market, where prices are set by participants whose behavior sometimes resembles that of a pack of bipolar lemmings.
Within this vast auction house, our task is to select businesses with superior economic characteristics, ensuring that every dollar of retained earnings ultimately translates into at least one dollar of market value. Despite numerous mistakes, we have so far achieved this goal. In this process, we have received invaluable assistance from St. Offset, the patron saint of economists.
In other words, in some cases, retained earnings attributable to our ownership have a negligible or even negative impact on market value; while in other major holdings, one dollar retained by the investee companies has translated into two dollars or more in market value. So far, our top-performing companies have more than offset the underperformers. If we can maintain this track record, it will prove that our strategy of maximizing “economic” earnings is correct, regardless of its impact on “accounting” profits.
On Mergers and Acquisitions (M&A) Transactions
"When we look back at the major acquisitions other companies made in 1982, our reaction is not envy, but relief that we were not involved."
In many such acquisitions, management's rationality is shrunk in the competition with their adrenaline; the thrill of the chase blinds pursuers to the consequences of the capture. Pascal's observation seems apt: "I have found that all human unhappiness stems from a simple reason: they cannot stay quietly in their own rooms."
What affects a company's profitability?
"If an industry simultaneously possesses both the characteristics of 'severe overcapacity' and 'commoditized' products (lacking differentiation in dimensions that customers care about, such as performance, appearance, and service support), then it is a prime candidate for profitability problems. Admittedly, these problems might be avoided if prices or costs were administratively controlled in some way, thus at least partially decoupling them from normal market forces."
Such management can be implemented in the following ways: (a) legally through government intervention (until recently, this also included pricing for truck freight and deposit costs for financial institutions); (b) illegally through collusion; or (c) “outside the law” through foreign cartels like OPEC (with domestic non-cartel operators also benefiting).
However, if costs and prices are determined by full-blown competition, there is overcapacity, and buyers don’t care whose products or delivery services they use, then the industry’s economic situation is almost destined to be mediocre, or even disastrous.
Therefore, every supplier is constantly striving to establish and emphasize the unique qualities of their products or services. This works with candy bars (customers buy by brand, not by asking for "two ounces of candy bars"), but not with sugar (how often do you hear, "Give me a coffee, with cream and C&H brand sugar"?).
In many industries, differentiation simply doesn't make a difference. If a few producers possess a broad and sustainable cost advantage, they may continue to perform well. By definition, such exceptions are rare, and in many industries, they simply don't exist. For the vast majority of companies selling "commodity" products, a disheartening business economic equation prevails: persistent overcapacity + lack of administrative pricing (or cost management) = poor profitability.
Of course, overcapacity may eventually correct itself, either due to shrinking capacity or expanding demand. Unfortunately, for participants, this correction is often delayed for a long time. When it finally does occur, the widespread expansionary enthusiasm sparked by the return to prosperity often creates overcapacity again within a few years, leading to a new unprofitable environment. In other words, nothing is more likely to lead to failure than success.
Ultimately, the long-term profitability of such industries is determined by the ratio of "tight supply years" to "ample supply years." This ratio is usually appalling. (It seems the last time our textile business experienced a supply shortage—a few years ago—lasted only for about half a morning.)
However, in some industries, capacity constraints can persist for extended periods. Sometimes, actual demand growth exceeds projected growth for a considerable time. In other cases, increasing capacity requires a lengthy preparation period because complex manufacturing facilities must be planned and constructed.
Using equity as a means of payment in mergers and acquisitions transactions
"Our stock issuance follows a simple, fundamental rule: we will not issue stock unless the intrinsic value we gain from the business is equal to what we pay for. Such a policy seems self-evident. You might ask, why would anyone exchange a $1 bill for a 50-cent coin? Unfortunately, many company managers have always been willing to do so."
These managers might prefer to use cash or debt when making acquisitions. But CEOs often crave more than cash and credit resources (and I always have). Furthermore, this urge often arises when their own stock is priced significantly below the intrinsic value of the business. This situation creates a moment of truth. As Yogi Berra put it, “Just look, and you’ll see a lot.” Because shareholders will then discover which goal management truly prioritizes—expansion or preserving the wealth of the owners.
The reason for having to choose among these objectives is simple. Companies are often priced below their intrinsic business value on the stock market. But when a company wants to sell itself as a whole through a negotiated transaction, it inevitably wants—and usually can—to obtain the full value of its business in any form of currency.
If payment is made in cash, the seller's calculation of the value received is straightforward. If the buyer's stock is used as currency, the seller's calculation remains relatively easy: they only need to calculate the market cash value of the asset received through the stock.
At the same time, buyers who wish to use their own stock as currency for purchases have no problem if their stock is priced at its full intrinsic value in the market.
But suppose its selling price is only half of its intrinsic value. In this case, the buyer faces the painful prospect of purchasing it with a significantly undervalued currency.
Ironically, if the buyer were to become the seller of its entire business, it could also negotiate and potentially obtain the full intrinsic business value. But when a buyer engages in a self-"partial sale"—which is essentially what issuing stock to acquire a business—it typically cannot assign a higher value to its stock than the market would value it at.
Even so, the acquirer, forcing their way through, ultimately paid for an asset at its full valuation (based on negotiated value) with undervalued (market capitalization) currency. In effect, the acquirer had to forgo $2 of value to gain $1. In this scenario, a fantastic business bought at a fair price becomes a terrible deal. Because gold valued as gold cannot be smartly purchased using gold—or even silver valued as lead.
How CEOs Justify Value-Destroying Mergers and Acquisitions
"If the thirst for scale and action is strong enough, the acquiring company's managers can always find ample justification for such a value-destroying stock offering. A friendly investment banker will assure them of the legitimacy of their actions. (Never ask a barber if you need a haircut.)"
Here are some common excuses used by management when issuing stocks:
- "The companies we acquire will be even more valuable in the future." (Presumably, the same applies to the equity in the original businesses that were sold off; the future prospects are already included in the business valuation process. If we issue 2X shares to exchange for X, even if the value of both businesses doubles, the imbalance will still exist.)
- "We must grow." (People might ask, who is "we" here? For existing shareholders, the reality is that all existing businesses will shrink simply by issuing stock. If Berkshire were to issue stock tomorrow for an acquisition, Berkshire would own everything it has now plus the new business, but your stake in unparalleled businesses like See's Candy Shops and National Indemnity would automatically decrease. If (1) your family owns a 120-acre farm, (2) and you invite a neighbor with 60 acres of similar land to merge his farm into an equal partnership—with you as the managing partner—then (3) your managed territory will grow to 180 acres, but your family's ownership stake in the land and crops will permanently decrease by 25%. Managers who want to expand their territory at the expense of owners' interests should consider working in government.)
- "Our stock is undervalued, and we've already minimized its use in the deal—but we need to give the seller's shareholders 51% stock and 49% cash so that some of them can get the tax-free exchange they want." (This argument acknowledges that reducing stock issuance is beneficial to the acquirer, which we like. But if using 100% stock would hurt existing shareholders, then using 51% is likely to hurt them as well. After all, if a Cocker Spaniel dirties someone's lawn, they won't be okay with it just because it's a Cocker Spaniel and not a Saint Bernard. The seller's wishes cannot be the deciding factor in the buyer's best interests—who knows what would happen if the seller insisted on replacing the acquirer's CEO as a condition of the merger?)
How to avoid value-destroying mergers and acquisitions
Here are three ways to avoid destroying the value of existing shareholders when issuing stock for acquisitions:
The first type is a true "business value to business value" merger. This type of merger attempts to be fair to the shareholders of both parties, with each party contributing and receiving exactly the same amount of intrinsic business value. It's not that the acquiring party wants to avoid this type of transaction; it's just that such transactions are extremely difficult to achieve.
The second path occurs when the acquiring company's stock price is equal to or higher than its intrinsic business value. In this case, using stock as currency can actually increase the wealth of the acquiring company's owners. Many mergers between 1965 and 1969 were based on this premise. The result was the exact opposite of most events since 1970: the shareholders of the acquired companies received highly inflated currency (often a bubble inflated by questionable accounting and promotional tactics), and they were the ones who lost wealth in these transactions.
In recent years, the second approach has been effective for a very small number of large companies. The exceptions are mainly companies in attractive or promotional industries, for which the market temporarily values them at or above their intrinsic business worth.
The third option is for the acquiring party to continue the acquisition process, but subsequently repurchase the equivalent number of shares issued in the merger. In this way, the original "stock-for-stock" merger can be effectively transformed into a "cash-for-stock" acquisition. This type of repurchase is a "damage repair" measure. Regular readers of my letters will correctly guess that we prefer repurchases that directly increase owner wealth rather than those that merely patch up previous damage. Scoring a touchdown is more exciting than recovering a lost ball. However, when a loss occurs, recovering possession is crucial, and we strongly recommend this type of damage repair repurchase that transforms a bad stock trade into a fair cash deal.
Pitfalls to watch out for in M&A language
"The language used in mergers and acquisitions often obscures the issue and encourages managers to take irrational actions. For example, 'dilution' is often a pro forma calculation based on book value and current earnings per share (EPS), with particular emphasis on the latter."
When the calculation is negative (dilutive) from the acquirer's perspective, management offers an explanation (internal, if not external) that the curves will cross favorably at some point in the future. (While deals often fail in practice, forecasting never fails—if the CEO is clearly eyeing a potential acquisition, subordinates and advisors will provide the necessary projections to rationalize any price.) If the calculated figures are immediately positive for the acquirer—i.e., "anti-dilutive"—no explanation is needed.
There is an overemphasis on this form of dilution: current earnings per share (and even earnings per share for the next few years) is an important variable in the valuation of most businesses, but it is far from being the decisive factor.
Many mergers and acquisitions, while not dilutive in this limited sense, can instantly destroy value for the acquirer. Conversely, some mergers that dilute current and short-term earnings per share can actually enhance value. What truly matters is whether a merger dilutes or enhances the "intrinsic business value" (a judgment involving many variables). We believe that calculating dilution from this perspective is crucial (yet rarely done).
The second language issue relates to the exchange equation. If Company A announces a merger with Company B through a stock offering, this process is often described as "Company A acquires Company B" or "B sells to A." A more accurate, albeit clumsy, description would be: "A portion is sold in exchange for B" or "B's owners receive a portion of A in exchange for its assets." In trade, what you give is just as important as what you receive. This holds true even if the final settlement of your payment is delayed.
Subsequent issuances of common stock or convertible bonds to finance the transaction or restore balance sheet strength must all be factored into the underlying mathematical model used to evaluate the original acquisition. (If the outcome of a corporate mating is destined to be pregnancy, then the timing of recognizing this fact should be before the moment of ecstasy.)
Managers and directors can hone their thinking by asking themselves this question: Would they be willing to sell 100% of their business, given the opportunity to sell only a portion? If selling the entire business on that basis isn't smart, they should ask themselves why selling only a portion would be smart. A series of small managerial blunders accumulate to create a massive blunder—not a great victory. (Las Vegas is built on the transfer of wealth that occurs when people participate in seemingly small, unfavorable capital transactions.)
Value dilution in mergers and acquisitions (“double whammy” effect)
Finally, it's worth mentioning the "double whammy" effect on the acquiring company's owners when a stock issuance that dilutes value occurs. In this case, the first blow is the loss of intrinsic business value caused by the merger itself.
The second blow was a downward market valuation correction, which very rationally attributed the now diluted value of the business. This is because current and potential owners are naturally unwilling to pay such high prices for assets falling into the hands of management with a history of "destroying wealth through mergers and acquisitions"...
