Essays of Warren Buffett lessons for investors and managers

The Essays of Warren Buffett: Lessons for Corporate America and the essay of warren buffett lessons for managers and investors
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The Essays of Warren Buffett: Lessons for Corporate America Essays by Warren E. Buffett Selected, Arranged, and Introduced by Lawrence A. Cunningham Includes Previously Copyrighted Material Reprinted with PermissionTHE ESSAYS OF WARREN BUFFETT: LESSONS FOR CORPORATE AMERICA Essays by Warren E. Buffett Chairman and CEO Berkshire Hathaway Inc. Selected, Arranged, and Introduced by Lawrence A. Cunningham Professor of Law Director, The Samuel and Ronnie Heyman Center on Corporate Governance Benjamin N. Cardozo School of Law Yeshiva University © 1997; 1998 Lawrence A. Cunningham All Rights Reserved Includes Previously Copyrighted Material Reprinted with PermissionTABLE OF CONTENTS INTRODUCTION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 PROLOGUE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 I. CORPORATE GOVERNANCE. . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 A. Owner-Related Business Principles................ 29 B. Boards and Managers............................. 38 C. The Anxieties of Plant Closings 43 D. An Owner-Based Approach to Corporate Charity. 47 E. A Principled Approach to Executive Pay.......... 54 II. CORPORATE FINANCE AND INVESTING. . . . . . . . . . . . . . . . 63 A. Mr. Market........................................ 63 B. Arbitrage.......................................... 66 C. Debunking Standard Dogma 72 D. "Value" Investing: A Redundancy................. 82 E. Intelligent Investing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 F. Cigar Butts and the Institutional Imperative 93 G. Junk Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 H. Zero-Coupon Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . ... 103 I. Preferred Stock 110 III. COMMON STOCK. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 119 A. The Bane of Trading: Transaction Costs..... . . . . .. 119 B. Attracting the Right Sort of Investor. . . . . . . . . . . . . .. 121 C. Dividend Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... 123 D. Stock Splits and Trading Activity 127 E. Shareholder Strategies 130 F. Berkshire's Recapitalization 132 IV. MERGERS AND ACQUISITIONS. . . . . . . . . . . . . . . . . . . . . . . .. 137 A. Bad Motives and High Prices. .. .. .. .. .. .. .. .. .. 137 B. Sensible Stock Repurchases Versus Greenmail 147 C. Leveraged Buyouts 148 D. Sound Acquisition Policies 151 E. On Selling One's Business 154 V. ACCOUNTING AND TAXATION. . . . . . . . . . . . . . . . . . . . . . . .. 159 A. A Satire on Accounting Shenanigans . . . . . . . . . . . . .. 159 B. Look-Through Earnings. . . . . . . . . . . . . . . . . . . . . . . . ... 165 C. Economic Goodwill Versus Accounting Goodwill. 171 D. Owner Earnings and the Cash Flow Fallacy 180 E. Intrinsic Value, Book Value, and Market Price. ... 187 F. Segment Data and Consolidation. . . . . . . . . . . . . . . . .. 191 G. Deferred Taxes.... .. .. .. .. .. . .. .. . .. .. .. .. . .. .. .... 193H. Retiree Benefits and Stock Options......... . . . . ... 196 I. Distribution of the Corporate Tax Burden 200 J. Taxation and Investment Philosophy 204 EPILOGUE 207 AFTERWORD AND ACKNOWLEDGMENTS. . . . . . . . . . . . . . . . . . . . .. 213 INDEX OF COMPANIES 215 INDEX OF NAMES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 217 CONCEPT GLOSSARY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 219INTRODUCTION Lawrence A. Cunningham Experienced readers of Warren Buffett's letters to the share­ holders of Berkshire Hathaway Inc. have gained an enormously valuable informal education. The letters distill in plain words all the basic principles of sound business practices. On selecting man­ agers and investments, valuing businesses, and using financial in­ formation profitably, the writings are broad in scope, and long on wisdom. Yet until now the letters existed in a format that was neither easily accessible nor organized in any thematic way. Consequently, the ideas have not been given the more widespread attention they deserve. The motivation for this compendium and for the sympo­ sium featuring it is to correct an inefficiency in the marketplace of ideas by disseminating the essays to a wider audience. is that the The central theme uniting Buffett's lucid essays principles of fundamental valuation analysis, first formulated by his teachers Ben Graham and David Dodd, should guide investment practice. Linked to that theme are management principles that de­ fine the proper role of corporate managers as the stewards of in­ vested capital, and the proper role of shareholders as the suppliers and owners of capital. Radiating from these main themes are prac­ tical and sensible lessons on mergers and acquisitions, accounting, and taxation. Many of Buffett's lessons directly contradict what has been taught in business and law schools during the past thirty years, and what has been practiced on Wall Street and throughout corporate America during that time. Much of that teaching and practice eclipsed what Graham and Dodd had to say; Buffett is their prodi­ gal pupil, stalwartly defending their views. The defenses run from an impassioned refutation of modern finance theory, to convincing demonstrations of the deleterious effects of using stock options to compensate managers, to persuasive arguments about the exagger­ ated benefits of synergistic acquisitions and cash flow analysis. Buffett has applied the traditional principles as chief executive officer of Berkshire Hathaway, a company with roots in a group of textile operations begun in the early 1800s. Buffett took the helm of Berkshire in 1964, when its book value per share was 19.46 and its intrinsic value per share far lower. Today, its book value per share is around 20,000 and its intrinsic value far higher. The 56 CARDOZO LAW REVIEW Vol. 19:1 growth rate in book value per share during that period is 23.8% compounded annually. Berkshire is now a holding company engaged in a variety of businesses, not including textiles. Berkshire's most important busi­ ness is insurance, carried on principally through its 100% owned subsidiary, GEICO Corporation, the seventh largest auto insurer in the United States. Berkshire publishes The Buffalo News and owns other businesses that manufacture or distribute products ranging from encyclopedias, home furnishings, and cleaning sys­ tems, to chocolate candies, ice cream, footwear, uniforms, and air compressors. Berkshire also owns substantial equity interests in major corporations, including American Express, Coca-Cola, Walt Disney, Freddie Mac, Gillette, McDonald's, The Washington Post, and Wells Fargo. Buffett and Berkshire Vice Chairman Charlie Munger have built this 50 billion enterprise by investing in businesses with ex­ cellent economic characteristics and run by outstanding managers. While they prefer negotiated acquisitions of 100% of such a busi­ ness at a fair price, they take a "double-barreled approach" of buy­ ing on the open market less than 100% of such businesses when they can do so at a pro-rata price well below what it would take to buy 100%. The double-barreled approach has paid off handsomely. The value of marketable securities in Berkshire's portfolio, on a per share basis, increased from 4 in 1965 to over 22,000 in 1995, a 33.4% annual increase. Per share operating earnings increased in the same period from just over 4 to over 258, a 14.79% annual increase. These extraordinary results continue, in recent years in­ creasing at similar rates. According to Buffett, these results follow not from any master plan but from focused investing-allocating capital by concentrating on businesses with outstanding economic characteristics and run by first-rate managers. Buffett views Berkshire as a partnership among him, Munger and other shareholders, and virtually all his 15-plus billion net worth is in Berkshire stock. His economic goal is long-term-to maximize Berkshire's per share intrinsic value by owning all or part of a diversified group of businesses that generate cash and above-average returns. In achieving this goal, Buffett foregoes ex­ pansion for the sake of expansion and foregoes divestment of busi­ nesses so long as they generate some cash and have good management.1997 THE ESSAYS OF WARREN BUFFETT 7 Berkshire retains and reinvests earnings when doing so deliv­ ers at least proportional increases in per share market value over time. It uses debt sparingly and sells equity only when it receives as much in value as it gives. Buffett penetrates accounting conven­ tions, especially those that obscure real economic earnings. These owner-related business principles, as Buffett calls them, are the organizing themes of the accompanying essays. As organ­ ized, the essays constitute an elegant and instructive manual on management, investment, finance, and accounting. Buffett's basic principles form the framework for a rich range of positions on the wide variety of issues that exist in all aspects of business. They go far beyond mere abstract platitudes. It is true that investors should focus on fundamentals, be patient, and exercise good judgment based on common sense. In Buffett's essays, these advisory tidbits are anchored in the more concrete principles by which Buffett lives and thrives. Many people speculate on what Berkshire and Buffett are do­ ing or plan to do. Their speculation is sometimes right and some­ times wrong, but always foolish. People would be far better off not attempting to ferret out what specific investments are being made at Berkshire, but thinking about how to make sound investment selections based on Berkshire's teaching. That means they should think about Buffett's writings and learn from them, rather than try to emulate Berkshire's portfolio. Buffett modestly confesses that most of the ideas expressed in his essays were taught to him by Ben Graham. He considers him­ self the conduit through which Graham's ideas have proven their value. In allowing me to prepare this material, Buffett said that I could be the popularizer of Graham's ideas and Buffett's applica­ tion of them. Buffett recognizes the risk of popularizing his busi­ ness and investment philosophy. But he notes that he benefited enormously from Graham's intellectual generosity and believes it is appropriate that he pass the wisdom on, even if that means creat­ ing investment competitors. To that end, my most important role has been to organize the essays around the themes reflected in this collection. This introduction to the major themes encapsulates the basics and locates them in the context of current thinking. The es­ says follow. CORPORATE GOVERNANCE For Buffett, managers are stewards of shareholder capital. The best managers think like owners in making business decisions.8 CARDOZO LAW REVIEW Vol. 19:1 They have shareholder interests at heart. But even first-rate man­ agers will sometimes have interests that conflict with those of shareholders. How to ease those conflicts and to nurture manage­ rial stewardship have been constant objectives of Buffett's forty­ year career and a prominent theme of his essays. The essays ad­ dress some of the most important governance problems. The first is not dwelt on in the essays but rather permeates them: it is the importance of forthrightness and candor in commu­ nications by managers to shareholders. Buffett tells it like it is, or at least as he sees it. That quality attracts an interested shareholder constituency to Berkshire, which flocks to its annual meetings in increasing numbers every year. Unlike what happens at most an­ nual shareholder meetings, a sustained and productive dialogue on business issues results. Besides the owner-orientation reflected in Buffett's disclosure practice and the owner-related business principles summarized above, the next management lesson is to dispense with formulas of managerial structure. Contrary to textbook rules on organizational behavior, mapping an abstract chain of command on to a particular business situation, according to Buffett, does little good. What matters is selecting people who are able, honest, and hard-working. Having first-rate people on the team is more important than de­ signing hierarchies and clarifying who reports to whom about what and at what times. Special attention must be paid to selecting a CEO because of three major differences Buffett identifies between CEOs and other employees. First, standards for measuring a CEO's performance are inadequate or easy to manipulate, so a CEO's performance is harder to measure than that of most workers. Second, no one is senior to the CEO, so no senior person's performance can be mea­ sured either. Third, a board of directors cannot serve that senior role since relations between CEOs and boards are conventionally congenial. Major reforms are often directed toward aligning management and shareholder interests or enhancing board oversight of CEO performance. Stock options for management were touted as one method; greater emphasis on board processes was another. Sepa­ rating the identities and functions of the Chairman of the Board and the CEO or appointment of standing audit, nominating and compensation committees were also heralded as promising re­ forms. None of these innovations has solved governance problems, however, and some have exacerbated them.1997 THE ESSAYS OF WARREN BUFFETT 9 The best solution, Buffett instructs, is to take great care in identifying CEOs who will perform capably regardless of weak structural restraints. Outstanding CEOs do not need a lot of coaching from owners, although they can benefit from having a similarly outstanding board. Directors therefore must be chosen for their business savvy, their interest, and their owner-orientation. According to Buffett, one of the greatest problems among boards in corporate America is that members are selected for other rea­ sons, such as adding diversity or prominence to a board. Most reforms are painted with a broad brush, without noting the major differences among types of board situations that Buffett identifies. For example, director power is weakest in the case where there is a controlling shareholder who is also the manager. When disagreements arise between the directors and management, there is little a director can do other than to object and, in serious circumstances, resign. Director power is strongest at the other ex­ treme, where there is a controlling shareholder who does not par­ ticipate in management. The directors can take matters directly to the controlling shareholder when disagreement arises. The most common situation, however, is a corporation without a controlling shareholder. This is where management problems are most acute, Buffett says. It would be helpful if directors could sup­ ply necessary discipline, but board congeniality usually prevents that. To maximize board effectiveness in this situation, Buffett be­ lieves the board should be small in size and composed mostly of outside directors. The strongest weapon a director can wield in these situations remains his or her threat to resign. All these situations do share a common characteristic: the ter­ rible manager is a lot easier to confront or remove than the medio­ cre manager. A chief problem in all governance structures, Buffett emphasizes, is that in corporate America evaluation of chief execu­ tive officers is never conducted in regular meetings in the absence of that chief executive. Holding regular meetings without the chief executive to review his or her performance would be a marked im­ provement in corporate governance. Evaluating CEO performance is even harder than it may seem. Both short-term results and potential long-term results must be assessed. If only short-term results mattered, many managerial decisions would be much easier, particularly those relating to busi­ nesses whose economic characteristics have eroded. For an ex­ treme but not atypical example, consider Al Dunlap's aggressive plan to turn around ailing Sunbeam. Dunlap fired half of Sun-10 CARDOZO LAW REVIEW VoL 19:1 beam's workers and closed or consolidated more than half its facili­ ties, including some engaged in the textile business in New England. Boasting that he was attacking the entire company, Dun­ lap declared that his plan was as carefully plotted as the invasion of Normandy. Driven solely by the primacy of the short-term bottom line, that decision was easy. The decision is much harder, however, if you recognize that superior long-term results can flow from earning the trust of social communities, as Buffett's consideration of the anxieties of plant closings suggests. The economic characteristics of Berkshire's old textile business had begun to erode by the late 1970s. Buffett had hoped to devise a reversal of its misfortunes, noting how important Berkshire's textile business was to its employees and local commu­ nities in New England, and how able and understanding manage­ ment and labor had been in addressing the economic difficulties. Buffett kept the ailing plant alive through 1985, but a financial re­ versal could not be achieved and Buffett eventually closed it. Whether Buffett would approve of Dunlap-style short-termism is not clear, but his own style of balancing short-term results with long-term prospects based on community trust is certainly differ­ ent. It is not easy, but it is intelligent. Sometimes management interests conflict with shareholder in­ terests in subtle or easily disguised ways. Take corporate philan­ thropy, for example. At most major corporations, management allocates a portion of corporate profit to charitable concerns. The charities are chosen by management, for reasons often unrelated either to corporate interests or shareholder interests. Most state laws permit management to make these decisions, so long as aggre­ gate annual donations are reasonable in amount, usually not greater than 10% of annual net profits. Berkshire does things differently. Shareholders designate charities to which the corporation donates. Nearly all shareholders participate in allocating millions of dollars per year to charitable organizations of their choice. This is an imaginative practical re­ sponse to a tension that is at the core of the management-share­ holder relationship. It is surprising that other American corporations do not follow this model of corporate charitable giv­ ing. Part of the reason may be the lack of long-term ownership orientation that characterizes the shareholder profiles of many American corporations. If so, this demonstrates a cost of the short­ term mentality of America's investment community.1997 THE ESSAYS OF WARREN BUFFETT 11 The plan to align management and shareholder interests by awarding executives stock options not only was oversold, but also subtly disguised a deeper division between those interests that the options created. Many corporations pay their managers stock op­ tions whose value increases simply by retention of earnings, rather than by superior deployment of capitaL As Buffett explains, how­ ever, simply by retaining and reinvesting earnings, managers can report annual earnings increases without so much as lifting a finger to improve real returns on capitaL Stock options thus often rob shareholders of wealth and allocate the booty to executives. More­ over, once granted, stock options are often irrevocable, uncondi­ tional, and benefit managers without regard to individual performance. It is possible to use stock options to instill a managerial culture that encourages owner-like thinking, Buffett agrees. But the align­ ment will not be perfect. Shareholders are exposed to the down­ side risks of sub-optimal capital deployment in a way that an option holder is not. Buffett therefore cautions shareholders who are reading proxy statements about approving option plans to be aware of the asymmetry in this kind of alignment. Many share­ holders rationally ignore proxy statements, but this subject should really be on the front-burner of shareholders, particularly share­ holder institutions that periodically engage in promoting corporate governance improvements. Buffett emphasizes that performance should be the basis for executive pay decisions. Executive performance should be mea­ sured by profitability, after profits are reduced by a charge for the capital employed in the relevant business or earnings retained by it. If stock options are used, they should be related to individual per­ formance, rather than corporate performance, and priced based on business value. Better yet, as at Berkshire, stock options should simply not be part of an executive's compensation. After all, ex­ ceptional managers who earn cash bonuses based on the perform­ ance of their own business can simply buy stock if they want to; if they do, they "truly walk in the shoes of owners," Buffett says. CORPORATE FINANCE AND INVESTING The most revolutionary investing ideas of the past thirty years were those called modern finance theory. This is an elaborate set of ideas that boil down to one simple and misleading practical im­ plication: it is a waste of time to study individual investment oppor­ tunities in public securities. According to this view, you will do12 CARDOZO LAW REVIEW Vol. 19:1 better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense. One of modern finance theory's main tenets is modern portfo­ lio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio-that is, it formalizes the folk slogan "don't put all your eggs in one basket." The risk that is left over is the only risk for which investors will be compensated, the story goes. This leftover risk can be measured by a simple mathematical term-called beta-that shows how volatile the security is com­ pared to the market. Beta measures this volatility risk well for se­ curities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule. Reverence for these ideas was not limited to ivory tower aca­ demics, in colleges, universities, business schools, and law schools, but became· standard dogma throughout financial America in the past thirty years, from Wall Street to Main Street. Many profes­ sionals still believe that stock market prices always accurately re­ flect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks. Being part of a distinguished line of investors stretching back to Graham and Dodd which debunks standard dogma by logic and experience, Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion. Accord­ ingly, Buffett worried that a whole generation of MBAs and lDs, under the influence of modern finance theory, was at risk of learn­ ing the wrong lessons and missing the important ones. A particularly costly lesson of modern finance theory came from the proliferation of portfolio insurance-a computerized technique for readjusting a portfolio in declining markets. The promiscuous use of portfolio insurance helped precipitate the stock market crash of October 1987, as well as the market break of Octo­ ber 1989. It nevertheless had a silver lining: it shattered the mod­ ern finance story being told in business and law schools and faithfully being followed by many on Wall Street. Ensuing market volatility could not be explained by modern finance theory, nor could mountainous other phenomena relating to the behavior of small capitalization stocks, high dividend-yield stocks, and stocks with low price-earnings ratios. Growing numbers of skeptics1997 THE ESSAYS OF WARREN BUFFETT 13 emerged to say that beta does not really measure the investment risk that matters, and that capital markets are really not efficient enough to make beta meaningful anyway. In stirring up the discussion, people started noticing Buffett's record of successful investing and calling for a return to the Gra­ ham-Dodd approach to investing and business. After all, for more than forty years Buffett has generated average annual returns of 20% or better, which double the market average. For more than twenty years before that, Ben Graham's Graham-Newman Corp. had done the same thing. As Buffett emphasizes, the stunning per­ formances at Graham-Newman and at Berkshire deserve respect: the sample sizes were significant; they were conducted over an ex­ tensive time period, and were not skewed by a few fortunate exper­ iences; no data-mining was involved; and the performances were longitudinal, not selected by hindsight. Threatened by Buffett's performance, stubborn devotees of modern finance theory resorted to strange explanations for his suc­ cess. Maybe he is just lucky-the monkey who typed out Ham­ let-or maybe he has inside access to information that other investors do not. In dismissing Buffett, modern finance enthusiasts still insist that an investor's best strategy is to diversify based on betas or dart throwing, and constantly reconfigure one's portfolio of investments. Buffett responds with a quip and some advice: the quip is that devotees of his investment philosophy should probably endow chairs to ensure the perpetual teaching of efficient market dogma; the advice is to ignore modern finance theory and other quasi-so­ phisticated views of the market and stick to investment knitting. That can best be done for many people through long-term invest­ ment in an index fund. Or it can be done by conducting hard­ headed analyses of businesses within an investor's competence to evaluate. In that kind of thinking, the risk that matters is not beta or volatility, but the possibility of loss or injury from an investment. Assessing that kind of investment risk requires thinking about a company's management, products, competitors, and debt levels. The inquiry is whether after-tax returns on an investment are at least equal to the purchasing power of the initial investment plus a fair rate of return. The primary relevant factors are the long-term economic characteristics of a business, the quality and integrity of its management, and future levels of taxation and inflation. Maybe these factors are vague, particularly compared with the seductive14 CARDOZO LAW REVIEW Vol. 19:1 precision of beta, but the point is that judgments about such mat­ ters cannot be avoided, except to an investor's disadvantage. Buffett points out the absurdity of beta by observing that "a stock that has dropped very sharply compared to the market ... becomes 'riskier' at the lower price than it was at the higher price"-that is how beta measures risk. Equally unhelpful, beta cannot distinguish the risk inherent in "a single-product toy com­ pany selling pet rocks or hula hoops from another toy company whose sole product is Monopoly or Barbie." But ordinary inves­ tors can make those distinctions by thinking about consumer be­ havior and the way consumer products companies compete, and can also figure out when a huge stock-price drop signals a buying opportunity. Contrary to modern finance theory, Buffett's investment knit­ ting does not prescribe diversification. It may even call for concen­ tration, if not of one's portfolio, then at least of its owner's mind. As to concentration of the portfolio, Buffett reminds us that Keynes, who was not only a brilliant economist but also a brilliant investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy. On that view, risk rises when invest­ ments and investment thinking are spread too thin. A strategy of financial and mental concentration may reduce risk by raising both the intensity of an investor's thinking about a business and the comfort level he must have with its fundamental characteristics before buying it. The fashion of beta, according to Buffett, suffers from inatten­ tion to "a fundamental principle: It is better to be approximately right than precisely wrong." Long-term investment success de­ pends not on studying betas and maintaining a diversified portfo­ lio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term in­ vestment success. Such "flitting from flower to flower" imposes huge transaction costs in the forms of spreads, fees and commis­ sions, not to mention taxes. Buffett jokes that calling someone who trades actively in the market an investor "is like calling someone who repeatedly engages in one-night stands a romantic." Invest­ ment knitting turns modern finance theory's folk wisdom on its head: instead of "don't put all your eggs in one basket," we get Mark Twain's advice from Pudd'nhead Wilson: "Put all your eggs in one basket-and watch that basket."1997 THE ESSAYS OF WARREN BUFFETT 15 Buffett learned the art of investing from Ben Graham as a graduate student at Columbia Business School in the 1950s and later working at Graham-Newman. In a number of classic works, including The Intelligent Investor, Graham introduced some of the most profound investment wisdom in history. It rejects a prevalent but mistaken mind-set that equates price with value. On the con­ trary, Graham held that price is what you pay and value is what you get. These two things are rarely identical, but most people rarely notice any difference. One of Graham's most profound contributions is a character who lives on Wall Street, Mr. Market. He is your hypothetical business partner who is daily willing to buy your interest in a busi­ ness or sell you his at prevailing market prices. Mr. Market is moody, prone to manic swings from joy to despair. Sometimes he offers prices way higher than value; sometimes he offers prices way lower than value. The more manic-depressive he is, the greater the spread between price and value, and therefore the greater the in­ vestment opportunities he offers. Buffett reintroduces Mr. Market, emphasizing how valuable Graham's allegory of the overall market is for disciplined investment knitting-even though Mr. Market would be unrecognizable to modern finance theorists. Another leading prudential legacy from Graham is his margin­ of-safety principle. This principle holds that one should not make an investment in a security unless there is a sufficient basis for be­ lieving that the price being paid is substantially lower than the value being delivered. Buffett follows the principle devotedly, not­ ing that Graham had said that if forced to distill the secret of sound investment into three words, they would be: margin of safety. Over forty years after first reading that, Buffett still thinks those are the right words. While modern finance theory enthusiasts cite market efficiency to deny there is a difference between price (what you pay) and value (what you get), Buffett and Graham regard it as all the difference in the world. That difference also shows that the term "value investing" is a redundancy. All true investing must be based on an assessment of the relationship between price and value. Strategies that do not employ this comparison of price and value do not amount to in­ vesting at all, but to speculation-the hope that price will rise, rather than the conviction that the price being paid is lower than the value being obtained. Many professionals make another com­ mon mistake, Buffett notes, by distinguishing between "growth in-16 CARDOZO LAW REVIEW Vol. 19:1 vesting" and "value investing." Growth and value, Buffett says, are not distinct. They are integrally linked since growth must be treated as a component of value. Nor does the phrase "relational investing" resonate with Buf­ fett. The term became popular on Wall Street and in the academy in the mid-1990s, describing a style of investing that is designed to reduce the costs of the separation of shareholder ownership from managerial control by emphasizing shareholder involvement and monitoring of management. Many people incorrectly identified Buffett and Berkshire as exemplars of this descriptive label. It is true that Buffett buys big blocks in a few companies and sticks around a long time. He also only invests in businesses run by peo­ ple he trusts. But that is about as far as the similarity goes. If Buffett were pressed to use an adjective to describe his investment style, it would be something like "focused" or "intelligent" invest­ ing. Yet even these words ring redundant; the unadorned term in­ vestor best describes Buffett. Other misuses of terms include blurring the difference be­ tween speculation and arbitrage as methods of sound cash manage­ ment; the latter being very important for companies like Berkshire that generate substantial excess cash. Both speculation and arbi­ trage are ways to use excess cash rather than hold it in short-term cash equivalents such as commercial paper. Speculation describes the use of cash to bet on lots of corporate events based on rumors of unannounced coming transactions. Arbitrage, traditionally un­ derstood to mean exploiting different prices for the same thing on two different markets, for Buffett describes the use of cash to take short-term positions in a few opportunities that have been publicly announced. It exploits different prices for the same thing at differ­ ent times. Deciding whether to employ cash this way requires eval­ uating four common-sense questions based on information rather than rumor: the probability of the event occurring, the time the funds will be tied up, the opportunity cost, and the downside if the event does not occur. In all investment thinking, one must guard against what Buf­ fett calls the "institutional imperative." It is a pervasive force in which institutional dynamics produce resistance to change, absorp­ tion of available corporate funds, and reflexive approval of sub­ optimal CEO strategies by subordinates. Contrary to what is often taught in business and law schools, this powerful force often inter­ feres with rational business decision-making. The ultimate result of the institutional imperative is a follow-the-pack mentality pro-1997 THE ESSAYS OF WARREN BUFFETT 17 ducing industry imitators, rather than industry leaders-what Buf­ fett calls a lemming-like approach to business. All these investment principles are animated in Buffett's lively essays on junk and zero-coupon bonds and preferred stock. Chal­ lenging both Wall Street and the academy, Buffett again draws on Graham's ideas to reject the "dagger thesis" advanced to defend junk bonds. The dagger thesis, using the metaphor of the intensi­ fied care an automobile driver would take facing a dagger mounted on the steering wheel, overemphasizes the disciplining effect that enormous amounts of debt in a capital structure exerts on management. Buffett points to the large numbers of corporations that failed in the early 1990s recession under crushing debt burdens to dispute academic research showing that higher interest rates on junk bonds more than compensated for their higher default rates. He attrib­ utes this error to a flawed assumption recognizable to any first-year statistics student: that historical conditions prevalent during the study period would be identical in the future. They would not. Further illuminating the folly of junk bonds is an essay in this col­ lection by Charlie Munger that discusses Michael Milken's ap­ proach to finance. Wall Street tends to embrace ideas based on revenue-generat­ ing power, rather than on financial sense, a tendency that often perverts good ideas to bad ones. In a history of zero-coupon bonds, for example, Buffett shows that they can enable a purchaser to lock in a compound rate of return equal to a coupon rate that a normal bond paying periodic interest would not provide. Using zero-coupons thus for a time enabled a borrower to borrow more without need of additional free cash flow to pay the interest ex­ pense. Problems arose, however, when zero-coupon bonds started to be issued by weaker and weaker credits whose free cash flow could not sustain increasing debt obligations. Buffett laments, "as happens in Wall Street all too often, what the wise do in the begin­ ning, fools do in the end." The essays on preferred stock show the art of investing at its finest, emphasizing the economic characteristics of businesses, the quality of management, and the difficult judgments that are always necessary, but not always correct. COMMON STOCK Buffett recalls that on the day Berkshire listed on the New York Stock Exchange in 1988, he told Jimmy Maguire, the special-18 CARDOZO LAW REVIEW Vol. 19:1 ist in Berkshire stock, "I will consider you an enormous success if the next trade in this stock is about two years from now." While Buffett jokes that Maguire "didn't seem to get enthused about that," he emphasizes that his mind-set when he buys any stock is "if we aren't happy owning a piece of that business with the Exchange closed, we're not happy owning it with the Exchange open." Berk­ shire and Buffett are investors for the long haul; Berkshire's capital structure and dividend policy prove it. Unlike many CEOs, who desire their company's stock to trade at the highest possible prices in the market, Buffett prefers Berk­ shire stock to trade at or around its intrinsic value-neither materi­ ally higher nor lower. Such linkage means that business results during one period will benefit the people who owned the company during that period. Maintaining the linkage requires a shareholder group with a collective long-term, business-oriented investment philosophy, rather than a short-term, market-oriented strategy. Buffett notes Phil Fisher's suggestion that a company is like a restaurant, offering a menu that attracts people with particular tastes. Berkshire's long-term menu emphasizes that the costs of trading activity can impair long-term results. Indeed, Buffett esti­ mates that the transaction costs of actively traded stocks-broker commissions and market-maker spreads-often amount to 10% or more of earnings. Avoiding or minimizing such costs is necessary for long-term investment success, and Berkshire's listing on the New York Stock Exchange helped contain those costs. Corporate dividend policy is a major capital allocation issue, always of interest to investors but infrequently explained to them. Buffett's essays clarify this subject, emphasizing that "capital allo­ cation is crucial to business and investment management." In early 1998, Berkshire's common stock was priced in the market at over 50,000 per share and the company's book value, earnings, and in­ trinsic value have steadily increased well in excess of average an­ nual rates. Yet the company has never effected a stock split, and has not paid a cash dividend in three decades. Apart from reflecting the long-term menu and minimization of transaction costs, Berkshire's dividend policy also reflects Buffett's conviction that a company's earnings payout versus retention deci­ sion should be based on a single test: each dollar of earnings should be retained if retention will increase market value by at least a like amount; otherwise it should be paid out. Earnings retention is jus­ tified only when "capital retained produces incremental earnings equal to, or above, those generally available to investors."THE ESSAYS OF WARREN BUFFETT 1997 19 Like many of Buffett's simple rules, this one is often ignored by corporate managers, except of course when they make dividend decisions for their subsidiaries. Earnings are often retained for non-owner reasons, such as expanding the corporate empire or fur­ nishing operational comfort for management. Things are so different at Berkshire, Buffett said at the sympo­ sium, that under his test Berkshire "might distribute more than 100% of the earnings," to which Charlie Munger chimed in "You're damn right." That has not been necessary, however, for throughout Buffett's stewardship at Berkshire, opportunities for superior returns on capital have been discovered, and exploited. Stock splits are another common action in corporate America that Buffett points out disserve owner interests. Stock splits have three consequences: they increase transaction costs by promoting high share turnover; they attract shareholders with short-term, market-oriented views who unduly focus on stock market prices; and, as a result of both of those effects, they lead to prices that depart materially from intrinsic business value. With no offsetting benefits, splitting Berkshire's stock would be foolish. Not only that, Buffett adds, it would threaten to reverse three decades of hard work that has attracted to Berkshire a shareholder group comprised of more focused and long-term investors than probably any other major public corporation. Two important consequences have followed from Berkshire's high stock price and its dividend policy. First, the extraordinarily high share price impaired the ability of Berkshire shareholders to effect gifts of their equity interest to family members or friends, though Buffett has offered a few sensible strategies like bargain sales to donees to deal with that. Second, Wall Street engineers tried to create securities that would purport to mimic Berkshire's performance and that would be sold to people lacking an under­ standing of Berkshire, its business, and its investment philosophy. In response to these consequences, Buffett and Berkshire did an ingenious thing. In mid-1996, Berkshire effected a recapitaliza­ tion by creating a new class of stock, called the Class B shares, and sold it to the public. The Class B shares have 1I30th the rights of the existing Class A shares, except with respect to voting rights they have 1/200th of those of the A shares; and the Class B shares are not eligible to participate in the Berkshire charitable contribu­ tions program. Accordingly, the Class B shares should (and do) trade somewhere in the vicinity of 1I30th of the market price of the Class A shares.20 CARDOZO LAW REVIEW Vol. 19:1 The Class A shares are convertible into Class B shares, giving Berkshire shareholders a do-it-yourself mechanism to effect a stock-split to facilitate gift giving and so on. More importantly, the Berkshire recapitalization would halt the marketing of Berkshire clones that contradict all the basic principles Buffett believes in. These clones-investment trusts that would buy and sell Berkshire shares according to demand for units in the trust-would have im­ posed costs on shareholders. If held by people who do not under­ stand Berkshire's business or philosophy, they would have caused spikes in Berkshire's stock price, producing substantial deviations between price and value. The Class B shares are designed to be attractive only to inves­ tors who share Buffett's philosophy of focused investing. For ex­ ample, in connection with the offering of the Class B shares, Buffett and Munger emphasized that Berkshire stock was, at that time, not undervalued in the market. They said that neither of them would buy the Class A shares at the market price nor the Class B shares at the offering price. The message was simple: do not buy these securities unless you are prepared to hold them for the long term. The effort to attract only long-term investors to the Class B shares appears to have worked: trading volume in the shares after the offering was far below average for Big Board stocks. Some expressed surprise at Buffett and Munger's cautionary statement, since most managers tell the market that newly-issued equity in their companies is being offered at a very good price. You should not be surprised by Buffett and Munger's disclosure, however. A company that sells its stock at a price less than its value is stealing from its existing shareholders. Quite plausibly, Buffett considers that a crime. MERGERS AND ACQUISITIONS Berkshire's acquisition policy is the double-barreled approach: buying portions or all of businesses with excellent economic char­ acteristics and run by managers Buffett and Munger like, trust, and admire. Contrary to common practice, Buffett argues that in buy­ ing all of a business, there is rarely any reason to pay a premium. The rare cases involve businesses with franchise characteris­ tics-those that can raise prices rather easily and only require in­ cremental capital investment to increase sales volume or market share. Even ordinary managers can operate franchise businesses to generate high returns on capital. The second category of rare cases