2009
Click here to read the letter.🧠 Key Takeaways
The thing about investing in the next transformational technology, whether it was cars, planes, TVs, or even the internet, is that even if it seems obvious that those innovations will change society in a pivotal way, it’s almost impossible to know which of the companies trying to establish those new technologies will actually survive.
A rapidly growing industry doesn’t automatically mean there will be an abundance of profits for the companies competing within it. Competition quickly becomes intense in these types of industries, and everyone starts pouring money (or burning it) into trying to become the eventual winner.
It is better to deal with the occasional bad decision that comes from decentralization than create a giant bureaucratic mess where decisions take forever to get made (or don’t get made at all).
Owning a business together is a lot like a marriage. You want to be partnered with people who share your goals and are generally on the same page. Otherwise, it’s probably going to make for an unhappy and short-lived “marriage.”
The main thing that’s important is that a business — no matter its capital intensity — is earning a decent return on the capital it invests. If a business constantly needs billions of dollars just to keep growing, that isn’t necessarily a bad thing as long as those billions of dollars are generating strong returns.
The irony of the stock market is that the easiest time to invest in a stock is often when everyone loves it. It feels like a no-brainer. But the best opportunities are often found when investing feels the most difficult — at the point of maximum pessimism, when nobody wants anything to do with the stock.
The CEO is the captain of the ship. At the end of the day, the ultimate responsibility is theirs. And any board of directors that doesn’t hold the CEO fully accountable for that responsibility isn’t doing its job either.
The more undervalued your own stock is, the worse of a currency it becomes for making acquisitions.
Human beings tend to behave in the way they’re incentivized to behave. Incentives are everything.
✍️ Memorable Quotes
“Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.”
The thing about investing in the next transformational technology, whether it was cars, planes, TVs, or even the internet, is that even if it seems obvious that those innovations will change society in a pivotal way, it’s almost impossible to know which of the companies trying to establish those new technologies will actually survive.
This is why Warren and Charlie tend to stick with proven business models. It’s not as exhilarating as investing in the “next big thing,” but it comes with a lot less risk and, typically, a much better chance of actually making money.
“Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes.”
Essentially, this is just a follow-up to Buffett’s previous quote.
Even though an industry may be poised for tremendous growth, like the AI industry today, it’s still unclear what returns (and subsequently, what profits) will ultimately be generated from all of the capital currently being invested to build out this new technology.
In other words, a rapidly growing industry doesn’t automatically mean there will be an abundance of profits for the companies competing within it. Competition quickly becomes intense in these types of industries, and everyone starts pouring money (or burning it) into trying to become the eventual winner.
Instead of investing in the midst of all that uncertainty, Warren and Charlie would rather stick with businesses that are more tried-and-true, where the fundamentals of the business and its ability to generate profits well into the future are much easier to predict.
“We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that both operating and capital decisions are occasionally made with which Charlie and I would have disagreed had we been consulted. Most of our managers, however, use the independence we grant them magnificently, rewarding our confidence by maintaining an owner-oriented attitude that is invaluable and too seldom found in huge organizations. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly - or not at all - because of a stifling bureaucracy.”
Here, Warren is talking about the decentralized nature of how they operate Berkshire, where the management teams of their subsidiaries more or less have free rein to operate their businesses as they see fit. And Warren says that comes with some tradeoffs.
On one hand, the risk is that managers will occasionally make decisions that Warren and Charlie wouldn’t have made themselves. They might also be slower to recognize when there’s a problem because they’re not constantly looking over everyone’s shoulder. That’s the downside.
On the other hand, the benefit is that Berkshire’s subsidiaries aren’t bogged down by bureaucracy and red tape. That allows their managers to make decisions and execute more quickly without having to get approval from the higher ups every step of the way.
More importantly, the freedom they give these managers also helps instill more of an owner mindset. Warren and Charlie trust them to run these businesses as if they were their own, which naturally makes them care more about the job they do and the results they produce.
At the end of the day, Warren and Charlie trust their managers, and the managers are a big part of the reason why they were interested in these businesses in the first place. Warren speaks on the importance of that a lot throughout his letters, and so in his eyes, the benefits of operating Berkshire this way far outweigh the drawbacks.
The bottom line is that he would rather deal with the occasional bad decision than create a giant bureaucratic mess where decisions take forever to get made (or don’t get made at all).
“We make no attempt to woo Wall Street. Investors who buy and sell based upon media or analyst commentary are not for us. Instead we want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand and because it’s one that follows policies with which they concur. If Charlie and I were to go into a small venture with a few partners, we would seek individuals in sync with us, knowing that common goals and a shared destiny make for a happy business “marriage” between owners and managers. Scaling up to giant size doesn’t change that truth.”
At the heart of it, Warren and Charlie are fully focused on the long term, as opposed to Wall Street, its analysts, and the financial media mouthpieces, whose primary concern is today’s breaking news, what it means for the share price today, and what next quarter’s earnings are going to look like.
Warren doesn’t want to attract that kind of shareholder, whose interests he ultimately has to serve. Instead, he wants to attract shareholder partners who, like him and Charlie, are fully focused on the long-term outlook of the business.
They understand how Berkshire operates, like the way Warren and Charlie run the company, and know that there will inevitably be some lumpiness from quarter to quarter and year to year depending on how the random events of the world play out.
The antithesis of that type of shareholder is a short-term trader, and that type of individual just doesn’t sync at all with who Warren and Charlie are or how they operate their business. It’s just not a good fit.
Like Warren says, owning a business together is a lot like a marriage. You want to be partnered with people who share your goals and are generally on the same page. Otherwise, it’s probably going to make for an unhappy and short-lived “marriage.”
“In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite willing to enter businesses that regularly require large capital expenditures. We expect only that these businesses have reasonable expectations of earning decent returns on the incremental sums they invest.”
Historically, Warren and Charlie have been more partial to capital-light businesses that don’t eat up a ton of capital just to continue growing.
Think of businesses that are heavy in manufacturing or public utilities that constantly have to invest in infrastructure, equipment, and other assets just to keep expanding. It’s one more thing that adds complication to a business, and it means there’s less cash available to send back to Berkshire.
Warren still says that capital-light businesses are the best businesses to own, but Berkshire has had to expand its horizons a bit over the years.
As the company has grown and started generating an ever-increasing amount of cash that needs to be put to work, Warren and Charlie have become more willing to invest in businesses that require a lot of capital to grow.
The main thing that’s important is that the business — no matter its capital intensity — is earning a decent return on the capital it invests. If a business constantly needs billions of dollars just to keep growing, that isn’t necessarily a bad thing as long as those billions of dollars are generating strong returns.
After all, that’s what really matters at the end of the day, and it can be found in both kinds of businesses.
“We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business - through the purchase of a small piece of it in the stock market - and what that business earns in the succeeding decade or two.”
As Warren says in the quote, it’s easy to buy a widely loved stock. When everyone is singing its praises and the outlook seems great, a lot of that optimism is probably already reflected in the share price, which means you’re probably going to have to pay up for it.
And that’s the irony of the stock market: the easiest time to invest in a stock is often when everyone loves it. It feels like a no-brainer. But the best opportunities are often found when investing feels the most difficult — at the point of maximum pessimism, when nobody wants anything to do with the stock.
In theory, this makes sense though, right? Because at the point of maximum pessimism, all of the hot air has been taken out of the share price. Nobody wants anything to do with the business, and that can give you the opportunity to buy it at a much cheaper valuation.
A very relevant example of that right now is Nike (NKE). As I’m writing this, its share price is down 75% over the past five years due to some strategic missteps within the company. Sales have stagnated, profits and free cash flow have dropped, and it’s going to take a lot of work to turn the ship around.
Unsurprisingly, everyone loves to hate on this stock right now. I don’t exactly know if it has reached the point of maximum pessimism yet, but Nike is nobody’s favorite at the moment.
Because of all the negative things going on with the company, it’s understandable that it would be hard to get excited about investing in it. But as a long-term investor, you have to look beyond the current sentiment and recent history and try to determine where a company like Nike can go from here.
If, through your own research and analysis, you’ve come to believe that the long-term future will be brighter than the recent past and Nike can eventually return to growth, then a beaten-down share price could give you the opportunity to invest at a much more attractive valuation.
But this is also the exact time when you’re most likely to see “sell” ratings from analysts and negative headlines everywhere. So it’s not an easy buy.
Like Warren says, though, what ultimately matters isn’t what everyone thinks about the business today. It’s the price you pay for it and what that business is able to earn over the next decade or two.
Sometimes you just have to plug your nose and dive in.
“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it - with the government thereupon required to step in with funds or guarantees the financial consequences for him and his board should be severe.”
This was written in the midst of the Great Financial Crisis, which is why Warren is referencing the government having to step in and essentially save a company, which it had to do for some of the major financial institutions during the GFC.
When this happened, Warren felt that the CEOs and boards of these companies weren’t held accountable nearly enough for allowing things to get to that point.
In his mind, they should have acted with more prudence and had a better respect for risk and uncertainty, which could have prevented them from needing to be saved by the government in the first place. And for any CEO who wasn’t capable of managing those risks, Warren thinks they didn’t deserve the job.
After all, the CEO is the captain of the ship. At the end of the day, the ultimate responsibility is theirs. And any board of directors that doesn’t hold the CEO fully accountable for that responsibility isn’t doing its job either, according to Warren.
If things get so bad that the government has to step in and save the company, Warren thinks there should be actual consequences for the people who were responsible for allowing it to happen.
“In evaluating a stock-for-stock offer, shareholders of the target company quite understandably focus on the market price of the acquirer’s shares that are to be given them. But they also expect the transaction to deliver them the intrinsic value of their own shares - the ones they are giving up. If shares of a prospective acquirer are selling below their intrinsic value, it’s impossible for that buyer to make a sensible deal in an all-stock deal. You simply can’t exchange an undervalued stock for a fully-valued one without hurting your shareholders.”
This is what makes stock a difficult currency when it comes to acquisitions. You have to consider the intrinsic value of both the acquirer’s shares and the shares of the company being acquired.
The shareholders of the acquired company want to know that they’re receiving the full intrinsic value of the shares they’re giving up, which is sensible.
But the shareholders of the acquiring company also need to know that the shares being used as currency in the acquisition aren’t undervalued. Otherwise, the company would have to give away more of itself than the acquisition is actually worth, which would be a detriment to the existing shareholders.
For example, if you’re buying a business worth $1 billion using stock that you believe is trading at half of its intrinsic value, you would essentially have to give away $2 billion worth of your own company to make a $1 billion acquisition. That obviously wouldn’t make much sense for your existing shareholders.
So in an all-stock transaction, the ideal situation would be for the acquiring company to use fairly valued (or even better, overvalued) shares to purchase another company at a reasonable price.
At the end of the day, the more undervalued your own stock is, the worse of a currency it becomes for making acquisitions.
“When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent this drastic remedy, our recommendation in respect to the use of advisors remains: “Don’t ask the barber whether you need a haircut.”
What Buffett is saying here, when you get to the root of it, is that it all comes down to incentives. Human beings tend to behave in the way they’re incentivized to behave.
If you hire an advisory team to consult on a potential acquisition, and their compensation is dependent on the acquisition going through, then of course they’re going to steer you in the direction of following through with the acquisition. No matter how objective they might try to be, their incentives push them toward one particular outcome.
This is why Buffett says that if you really want a balanced perspective, you should hire a second set of advisors with the exact opposite incentives — to try and talk you out of the acquisition, and be paid based on the deal not going through.
Memorable quotes and key takeaways from the 2009 Berkshire Hathaway shareholder letter.