1981
Click here to read the letter.🧠 Key Takeaways
Because they have to report their earnings every quarter, publicly traded companies feel obligated to showcase positive numbers to the public whenever they report. As a result, managers may feel tempted to make decisions that only benefit the short-term (often at the expense of the long-term) or resort to accounting tactics that only create the illusion of favorable outcomes. In any case, this type of behavior gets in the way of genuine, sustainable long-term results, which is what Warren prioritizes in an investment.
Owning a higher quantity of a lower quality business is not preferable, especially when you have to pay more for it.
You should look for businesses that continue to thrive during times of high inflation. These businesses are special for two reasons: They have pricing power and they are able to do more business without having to spend more on expanding their facilities.
There are three possible mistakes an investor can make when investing in a company that will result in poor returns: You misjudged the management team’s strategy and/or ability to execute. You misjudged the growth prospects of the business, and/or your investment thesis was incorrect. You overpaid.
Inflation is like a “gigantic corporate tapeworm” because it continuously eats away at a company's profits, requiring it to retain and use more and more of its earnings just to maintain the same level of operations as before. Just as a tapeworm consumes nutrients necessary for its host's health, inflation consumes the financial resources a business needs to grow or even just to sustain its operations.
✍️ Memorable Quotes
“Our acquisition decisions will be aimed at maximizing real economic benefits, not at maximizing either managerial domain or reported numbers for accounting purposes. (In the long run, managements stressing accounting appearance over economic substance usually achieve little of either.)”
Because they have to report their earnings every quarter, publicly traded companies feel obligated to showcase positive numbers to the public whenever they report. As a result, managers may feel tempted to make decisions that only benefit the short-term (often at the expense of the long-term) or resort to accounting tactics that only create the illusion of favorable outcomes.
For instance, an abundance of adjustments in the earnings results can significantly skew reported figures, and may be a sign of potential financial tomfoolery.
In any case, this type of behavior gets in the way of genuine, sustainable long-term results, which should be the primary focus for investors.
Put more simply, an honest, negative period is far preferable to a false positive.
“Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated rationales for their behavior.”
Owning a higher quantity of a lower quality business is not preferable, especially when you have to pay more for it.
Warren has found that most managers act in an opposite manner, and he believes there are three reasons for this behavior:
“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.”
In other words, these managers seek acquisitions—and settle for lower quality assets—simply for the thrill of the hunt.
“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.)”
In other words, the more sales a company makes, the more the managers are paid. They’re financially incentivized to make more acquisitions.
“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.”
In other words, these managers believe that their management skills, akin to the princess's kiss, will magically improve the profitability of the company they're targeting. Essentially, they have an overly optimistic view of their abilities to turn around struggling companies.
Expanding more on this, Warren says:
“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.”
In other words, despite the confidence of these managers in their ability to identify transformable toads, the actual results often don't live up to the expectations. Warren has seen many attempts, but few successes.
Yet, these managers remain overly confident in their ability to bring about positive change, even when their efforts result in a lot of failed attempts.
“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 is Warren’s explanation on what makes for a good acquisition.
In other words, you should look for businesses that continue to thrive during times of high inflation. These businesses are special for two reasons:
First, they can raise their prices without losing customers or selling less, which indicates they have pricing power.
Second, they can handle doing a much higher dollar volume of business, with much of this increase due to inflation rather than actual growth, without having to spend much more money on expanding their facilities or equipment.
“We expect that undistributed earnings from such companies will produce full value (subject to tax when realized) for Berkshire and its shareholders. If they don’t, we have made mistakes as to either: (1) the management we have elected to join; (2) the future economics of the business; or (3) the price we have paid.”
There are three possible mistakes an investor can make when investing in a company that will result in poor returns:
You misjudged the management team’s strategy and/or ability to execute.
You misjudged the growth prospects of the business, and/or your investment thesis was incorrect.
You overpaid.
In writing this, Warren gives us some insight into the main things he looks at when analyzing a company. Here are some questions we investors can ask ourselves that touch on those three points:
Is the management team honest, competent, and capable?
Do you understand the business, and have confidence in its ability to grow in the future?
Is it at a good value that offers a margin of safety (just in case you’re wrong)?
“Inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the “bad” business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice. For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.”
Inflation is like a “gigantic corporate tapeworm” because it continuously eats away at a company's profits, requiring it to retain and use more and more of its earnings just to maintain the same level of operations as before. Just as a tapeworm consumes nutrients necessary for its host's health, inflation consumes the financial resources a business needs to grow or even just to sustain its operations.
This situation is particularly bad for “bad” businesses. Essentially, the worse off a business is, the more it is impacted by inflation. Just to maintain, it must divert more of its already limited resources just to keep things running as they have been, without any actual growth or improvement.