1982
Click here to read the letter.🧠 Key Takeaways
When costs and prices are determined solely by competition and there's excess production capacity, and consumers are indifferent to the source of the product or service, the industry's economics are likely to be unattractive or even disastrous.
If a company's stock is trading below its intrinsic value, using it as currency for acquisitions (issuing shares to make acquisitions) means it's essentially paying more for the acquired asset than what it's worth. This ultimately results in value destruction for shareholders because the acquirer effectively trades more valuable assets for less valuable ones.
There are three ways for an acquiring company to avoid destroying value for its existing shareholders when issuing shares for acquisitions: true business-value-for-business-value merger, using overvalued stock as currency, and repurchasing the shares issued to make the acquisition (damage control).
✍️ Memorable Quotes
“The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”
As Terry Smith would say, your goal as an investor is to: Buy good companies, don’t overpay, and do nothing. Regarding which companies are the good ones, you’ll have to decide that for yourself.
In the same way that we are expected to take responsibility for our own lives and actions, investors are expected to take responsibility for the decisions they make in their portfolios. The market rewards investors who do their due diligence and make investment decisions based on their own independent research, and is unsympathetic to those who do not.
You have to think for yourself. And as a brand new investor, you have to work on acquiring the tools to be able to think for yourself. This means spending time learning about companies, understanding how to read financial statements, etc.
If you’re not willing to do the work, and if you’re not willing to learn how to do the work, then you’re better off sticking with ETFs and mutual funds. There’s nothing wrong with that, either. You just need to decide how hands-on you want to be.
“Even if our partially-owned businesses continue to perform well in an economic sense, there will be years when they perform poorly in the market. At such times our net worth could shrink significantly. We will not be distressed by such a shrinkage; if the businesses continue to look attractive and we have cash available, we simply will add to our holdings at even more favorable prices.”
The performance of the companies you own might be on an upward trajectory, with rising sales, profits, and free cash flow, yet their share prices may still head in the other direction. There’s no need to panic in such situations. Instead, it presents a good buying opportunity.
If the business fundamentals remain strong and the company is performing well, a lower share price simply means that you can purchase its stock at a discounted rate, obtaining more shares for the same dollars invested. You have a chance to enhance your position in the company at a better valuation, which is a good thing.
“Businesses in industries with both substantial over-capacity and a “commodity” product...complicated manufacturing facilities must be planned and built.”
This was Warren’s take on “commodity” businesses, and it is an extremely long quote—too long to put here in full. Nonetheless, here is my breakdown.
Businesses in industries with both excess production capacity and undifferentiated products are likely to have issues with profitability. These challenges can be alleviated through various means of price or cost control, such as through legal channels like government intervention, illicit actions like collusion, or arrangements that skirt legality, such as involvement in foreign cartels like OPEC.
When costs and prices are determined solely by competition and there's excess production capacity, and consumers are indifferent to the source of the product or service, the industry's economics are likely to be unattractive or even disastrous.
Companies in such industries constantly try to differentiate their products or services to attract customers. While this might work for some products like candy bars (where brand matters), it's ineffective for products like sugar, where differentiation is hard to achieve. As Warren said, “How often do you hear, ‘I'll have a cup of coffee with cream and C & H sugar, please.’”
Some companies may consistently perform well if they have a significant and sustainable cost advantage. However, such exceptions are rare, and in many cases, they don't exist.
“Our share issuances follow a simple basic rule...Don’t ask the barber whether you need a haircut.”
This was Warren’s take on share issuances. Once again, it is an extremely long quote—too long to put here in full. Nonetheless, here is my breakdown.
When companies consider acquisitions, they may first look at using cash or debt. However, if the CEO desires expansion beyond the available cash and credit resources, they might resort to issuing new shares of the company to raise capital. This becomes problematic if the stock is undervalued in the market compared to its intrinsic value.
If a company's stock is trading below its intrinsic value, using it as currency for acquisitions means it's essentially paying more for the acquired asset than what it's worth. This is because the market sets the value of the stock used for acquisition, not its intrinsic value.
This ultimately results in value destruction for shareholders. The acquirer effectively trades more valuable assets for less valuable ones.
Despite the value destruction, managers may still attempt to rationalize their actions, driven by the desire for growth and pressure from investment bankers who benefit from the transactions.
“There are three ways to avoid destruction of value...turn a bad stock deal into a fair cash deal.”
This was Warren’s take on how to avoid destruction of value when shares are issued. For the third time, it’s an extremely long quote that spans multiple paragraphs. I recommend you read the shareholder letter to get the full context, but here is my breakdown of the quote.
Warren says there are three ways for an acquiring company to avoid destroying value for its existing shareholders when issuing shares for acquisitions:
True Business-Value-for-Business-Value Merger: This method aims to ensure fairness to shareholders of both the acquiring and acquired companies, and involves each party receiving as much as it gives in terms of intrinsic business value. However, these mergers are rare because they are difficult to execute successfully.
Using Overvalued Stock as Currency: This happens when the acquiring company's stock is trading at or above its intrinsic business value. In this scenario, issuing stock as currency may actually benefit the acquiring company's owners.
Repurchasing Shares: If the acquiring company's stock is undervalued or if the acquisition was not well-received by the market, the acquirer can repurchase shares equal to those issued in the merger. This basically converts the stock-for-stock merger into a cash-for-stock acquisition, repairing the damage caused by the initial transaction.
While repurchases that enhance shareholder wealth directly are preferred, damage-repair repurchases are welcomed when necessary to mitigate losses and convert a bad stock deal into a fair cash deal.