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Buffett on hiring, accounting, cash hoarding, and the avoidance of corporate excess

Warren Buffett | Buffett on hiring, accounting, cash hoarding, and the avoidance of corporate excess Ian Fraser

This is the first part of Ian Fraser's blog on Warren Buffett’s letter to shareholders in insurance conglomerate Berkshire Hathaway.

Warren Buffett’s annual letter to shareholders in his Berkshire Hathaway Inc insurance-based conglomerate is eagerly awaited - largely because it tends to contain some useful pearls of management thinking.

Some of the 80-year-old billionaire investor's past letters, such as that of 2002 have genuinely broken new ground. In that one, Buffett, also known as the “Sage of Omaha”, labeled derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

While the letter this year is not quite up to that very high standard, and even though Buffett's 2008 decision to invest $5bn in Goldman Sachs has tarnished the value investor's reputation as a stickler for business ethics, the latest letter is well worth dissecting.

In the section labeled "performance", Buffett warns investors that:

"The bountiful years .. will never return. The huge sums of capital we currently manage eliminate any chance of exceptional performance. We will strive, however, for better-than-average results and feel it fair for you to hold us to that standard.

(Veteran investment commentator Robert Lenzner analyses these candid remarks in his Forbes blog.)

However, Buffett did talk up Berkshire’s $26.4 billion acquisition of US railroad company Burlington Northern Santa Fe, describing it as the highlight of 2010, adding that the deal has dramatically increased earnings power at the same time as being good for the environment (rail freight helps remove trucks from the road).

For me some of the more interesting points come further down the letter, such as where Buffett highlights the critical importance of recruitment to any enterprise.

He says that Berkshire is very careful to hire the right sort of people, and not to hire those who have the wrong motivation (especially those who put short-term desire for self-enrichment ahead of a desire to build an enduring enterprise). Instead he wants to attract individuals who believe in nurturing their businesses for the long term:

"In many cases, [our managers] have sought out Berkshire as an acquirer for a business that they and their families have long owned. They came to us with an owner’s mindset, and we provide an environment that encourages them to retain it. Having managers who love their businesses is no small advantage."

Buffett is especially critical of managers who construct “imperial corporate palaces”, arguing that such edifices “induce imperious behavior” - which could almost have been a reference to Sir Fred Goodwin, ex-boss of Royal Bank of Scotland, who notoriously built a shiny new corporate palace on the western fringes of Edinburgh before driving his bank off a cliff.

Unlike those corporate executives who use their corporations as personal piggybanks, Buffett said he and Berkshire vice-chairman Charlie Munger are extremely frugal with company money. Buffett said annual rent at Berkshire’s “world headquarters” in Omaha is just $270,212 and the total investment in fixtures and fittings is just $301,363.

"Our compensation programs, our annual meeting and even our annual reports are all designed with an eye to reinforcing the Berkshire culture, and making it one that will repel and expel managers of a different bent."

Commenting on the subprime crisis, whose aftershocks are still being felt across the global economy, Buffett said that politicians and bankers should never have built a financial market based on the notion that Americans had some God-given right to live in houses they could not afford.

"A house can be a nightmare if the buyer’s eyes are bigger than his wallet and if a lender – often protected by a government guarantee – facilitates his fantasy."

Turning to accountancy and the media, Buffett slams the media for its obsession with 'net income', a yardstick he said is flawed in that it is easily manipulated by unscrupulous managements. Buffett said he and Munger have a “deep disgust for 'game playing' with numbers", a practice that he claims was “rampant throughout corporate America in the 1990s and still persists.”

This brought to mind an extraordinary interview that Munger gave to Stanford University professor Joseph A. Grundfest in 2008, in which Munger accused the accountancy profession of being spineless and of having caused the global financial crisis.

Buffett added that even though operating earnings do have some shortcomings, when coupled with book value - which takes into account realized and unrealized gains - they are an infinitely more useful way of gauging corporate performance than net income.

Buffett concluded by providing a little personal history to help explain Berkshire’s “extreme aversion to financial adventurism” - which includes overpaying for assets in bull markets.

He told a tale about his grandfather Ernest, born in 1877, who ran a grocery store in Omaha, Nebraska. Basically his grandfather believed that any business, or indeed any individual, should always keep a wadge of cash on the balance sheet to tide it over in hard times. (The Berkshire Hathaway annual report incorporated a facsimile of a 1939 letter from Ernest to Warren’s uncle Fred explaining why this makes sense.) Buffett concluded:

“Ernest never went to business school … but he understood the importance of liquidity as a condition for assured survival.

“At Berkshire, we have taken his $1,000 solution a bit further and have pledged that we will hold at least $10 billion of cash, excluding that held at our regulated utility and railroad businesses.

"Because of that commitment, we customarily keep at least $20 billion on hand so that we can both withstand unprecedented insurance losses (our largest to date having been about $3 billion from Katrina, the insurance industry’s most expensive catastrophe) and quickly seize acquisition or investment opportunities, even during times of financial turmoil…. By being so cautious in respect to leverage, we penalize our returns by a minor amount. Having loads of liquidity, though, lets us sleep well.”

A second blog based on Buffett’s letter to shareholders will cover Ian Fraser's thoughts on Black-Scholes derivatives pricing, charlatanism among economists, the dangers of leverage and lack of ethics among hedge funds.

Further reading on Warren Buffett and value investing:

Tags: accountancy , Accounting , auditors , derivatives , Mergers and Acquisitions , US , value investing
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  1. QFINANCEEditor says:
    Fri Mar 11 09:28:40 GMT 2011

    alexlobov - we're happy to post to anywhere in the world.
  2. Andrea Swainson says:
    Thu Mar 10 12:44:15 GMT 2011

    Buffett'€™s annual letters never fail to impress me. To me, the real gem to be found in this year'€™s letter is the advice to hire managers who love their businesses in the long term, instead of focussing on short-term advantages. Please send me Buffett's biography!
  3. alexlobov says:
    Wed Mar 09 18:01:16 GMT 2011

    Well I have little of note to add to your post, Ian, but I sure wouldn't mind a copy of that book if Bloomsbury doesn't mind sending it to Hong Kong!

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