Two value investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about value investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio)t makes in these letters and my analysis of the lessons learned from them. In this discussion, we go over the 1981 letter.
General acquisition behavior
Buffett’s 1981 letter had a section on Berkshire Hathaway’s acquisition strategy under the headline “General Acquisition Behavior.”
First, Buffett reminded shareholders that Berkshire was “comfortable both with total ownership of businesses and with marketable securities representing small portions of businesses” and that he was always looking to employ large sums in each area, not least because the liquidity requirements of its insurance business require major investments in marketable securities.
"We try to avoid small commitments - If something’s not worth doing at all, it’s not worth doing well,” he wrote.
Buffett reminded readers the goal is “maximizing real economic benefits,” not empire building or showing high reported numbers for accounting purposes.
"In the long run, managements stressing accounting appearance over economic substance usually achieve little of either," he said.
The motivations of investors who pay high premiums
As Gurufocus readers will already know, Buffett would “rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share.” However, Buffett noted that most corporate managers prefer just the reverse and “have no shortage of stated rationales for their behavior.” He then illustrated this point in more detail:
"However, we suspect three motivations - usually unspoken - to be, singly or in combination, the important ones in most high-premium takeovers:
1. Leaders, business or otherwise, seldom are deficient in animal spirits and often relish increased activity and challenge. At Berkshire, the corporate pulse never beats faster than when an acquisition is in prospect.
2. Most organizations, business or otherwise, measure themselves, are measured by others, and compensate their managers far more by the yardstick of size than by any other yardstick. (Ask a Fortune 500 manager where his corporation stands on that famous list and, invariably, the number responded will be from the list ranked by size of sales; he may well not even know where his corporation places on the list Fortune just as faithfully compiles ranking the same 500 corporations by profitability.)
3. Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget)."
Optimism from management and shareholders drives this folly. Else, there is no reason for shareholders of Company A(cquisitor) to want to own an interest in T at the 2 times takeover cost rather than at the X market price they would pay if they made direct purchases by themselves in the market.
This was followed by some more classic Buffett language:
"Investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses - even after their corporate backyards are knee-deep in unresponsive toads."
Businesses that are particularly well adapted to an inflationary environment
Buffett then goes on to say that there are two major categories of mergers and acquisitions that have performed very well in recent times (remember the late 1970s and early 1980s was a period of high inflation):
"The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital."
This enabled “managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades.” Yet, very few enterprises possessed both characteristics, and as such competition to buy those that did was so fierce that to win a bidding war guaranteed overpaying for these companies.
High praise
Buffett, as he often does, went on to praise his “managerial superstars” who from the achieved that second category and recognized “that rare prince who is disguised as a toad,” and who had the managerial abilities that enabled them to peel away the disguise. He praised his managers Ben Heineman at Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at National Service Industries and “especially” Tom Murphy at Capital Cities Communications, who he described as “a real managerial 'twofer,' whose acquisition efforts have been properly focused in Category 1 and whose operating talents also make him a leader of Category 2.” Buffett then said he recognized “the difficulty and rarity of these executives’ achievements.” They were also highly disciplined, making “very few deals in recent years, and often have found repurchase of their own shares to be the most sensible employment of corporate capital”.
Buffett lamented that he himself “[did] not qualify for Category 2. And, despite a reasonably good understanding of the economic factors compelling concentration in Category 1, our actual acquisition activity in that category has been sporadic and inadequate.”
He continued:
"We have tried occasionally to buy toads at bargain prices with results that have been chronicled in past reports. Clearly our kisses fell flat. We have done well with a couple of princes - but they were princes when purchased. At least our kisses didn’t turn them into toads. And, finally, we have occasionally been quite successful in purchasing fractional interests in easily-identifiable princes at toad-like prices."
