How to Think Like Warren Buffett, Part 26

Filed in archive Warren Buffett on October 23, 2007

Part 26 of our loooong, ongoing series looking at the wisdom found in the Letters to Berkshire Hathaway Shareholders penned by the one the only Warren Buffett.

This installment-the year 2002... which was a good one, especially considering a not-so-hot economy still hungover from 9/11:

Our gain in net worth during 2002 was $6.1 billion, which increased the per-share book value of both our Class A and Class B stock by 10.0%. Over the last 38 years (that is, since present management took over) per-share book value has grown from $19 to $41,727, a rate of 22.2% compounded annually.

A parable about success, in this case Buffett's yearly statement about finding the best managers and leaving them alone:

My managerial model is Eddie Bennett, who was a batboy. In 1919, at age 19, Eddie began his work with the Chicago White Sox, who that year went to the World Series. The next year, Eddie switched to the Brooklyn Dodgers, and they, too, won their league title. Our hero, however, smelled trouble. Changing boroughs, he joined the Yankees in 1921, and they promptly won their first pennant in history. Now Eddie settled in, shrewdly seeing what was coming. In the next seven years, the Yankees won five American League titles.

What does this have to do with management? It's simple - to be a winner, work with winners. In 1927, for example, Eddie received $700 for the 1/8th World Series share voted him by the legendary Yankee team of Ruth and Gehrig. This sum, which Eddie earned by working only four days (because New York swept the Series) was roughly equal to the full-year pay then earned by batboys who worked with ordinary associates.

Eddie understood that how he lugged bats was unimportant; what counted instead was hooking up
with the cream of those on the playing field. I've learned from Eddie. At Berkshire, I regularly hand bats
to many of the heaviest hitters in American business.

Interesting story on a 2002 acquisition (one of many acquisitions that year, including Fruit of the Loom, and Garan):

The largest acquisition we initiated in 2002 was The Pampered Chef, a company with a fascinating history dating back to 1980. Doris Christopher was then a 34-year-old suburban Chicago home economics teacher with a husband, two little girls, and absolutely no business background. Wanting, however, to supplement her family's modest income, she turned to thinking about what she knew best - food preparation. Why not, she wondered, make a business out of marketing kitchenware, focusing on the items she herself had found most useful?

To get started, Doris borrowed $3,000 against her life insurance policy - all the money ever injected into the company - and went to the Merchandise Mart on a buying expedition. There, she picked up a dozen each of this and that, and then went home to set up operations in her basement. Her plan was to conduct in-home presentations to small groups of women, gathered at the homes of their friends. While driving to her first presentation, though, Doris almost talked herself into returning home, convinced she was doomed to fail.

But the women she faced that evening loved her and her products, purchased $175 of goods, and TPC was underway. Working with her husband, Jay, Doris did $50,000 of business in the first year. Today - only 22 years later - TPC does more than $700 million of business annually, working through 67,000 kitchen consultants.

On frugality:

We cherish cost-consciousness at Berkshire. Our model is the widow who went to the local newspaper to place an obituary notice. Told there was a 25-cents-a-word charge, she requested "Fred Brown died." She was then informed there was a seven-word minimum. "Okay" the bereaved woman replied, "make it 'Fred Brown died, golf clubs for sale'."

I won't go into it here, but Buffett spends a long time explaining the danger of derivatives, a subject most of us can not get our heads around. Buffett's explanation clears it up a bit, but it's really the bottom line that you probably need to know:

In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

A nice turn of phrase, in discussing the activities of certain executives during the recent stock bubble:

As stock prices went up, the behavioral norms of managers went down. By the late '90s, as a result, CEOs who traveled the high road did not encounter heavy traffic.

In the wake of the Enron debacle in late 2001, Buffett uses much of his 2002 Letter discussing the sicknesses of many a public company. In discussing the worth of "independent" board members at public companies, Buffett even offers a rather startling admission:

Over a span of 40 years, I have been on 19 public-company boards (excluding Berkshire's) and have
interacted with perhaps 250 directors. Most of them were "independent" as defined by today's rules. But the great majority of these directors lacked at least one of the three qualities I value. As a result, their contribution to shareholder well-being was minimal at best and, too often, negative. These people, decent and intelligent though they were, simply did not know enough about business and/or care enough about shareholders to question foolish acquisitions or egregious compensation. My own behavior, I must ruefully add, frequently fell short as well: Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders. In those cases, collegiality trumped independence.

Some direct advice to investors, something Buffett rarely gets into in his Letters:

Three suggestions for investors: First, beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a "non-cash" charge. 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. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a "non-cash" expense - a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?

This 2002 Letter may be the most interesting in terms of a complete look at Buffett's thoughts on corporate governance, as he was obviously deeply appalled at some of the behaviors exhibited by major league CEOs and top executives in the recent past (many of who found their way to jail cells soon after).