Intelligent Investor Club

At the end of Warren Buffett’s 1983 letter, there was an appendix discussing on economic and accounting goodwill.

When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired.

Frequently the sum of the fair values put on the assets (net of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account called “Goodwill”.

This accounting goodwill is then amortized (typically) over a period of 40 years to the earnings account.

For example, Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. See’s was earning about $2 million after tax at the time. This works out to a very impressive 25% returns on assets.

Blue Chip’s purchase of See’s at $17 million over net tangible assets required that a Goodwill account of this amount be established as an asset on Blue Chip’s books and that $425,000 be charged to income annually for 40 years to amortize that asset.

Thus, instead of $2 million, earnings will be reflected as $1.575 million on the accounts.

If See had been bought at a price of $88 million, the amortization of $80 million over 40 years will be reflected by a net earnings of $0 on the accounts.

If you think about it, the economics of See’s business has not really changed even though the two purchase price were different. Yet, the income sheet tells a drastically a different story.

Different purchase dates and prices can give us vastly different asset values and amortization charges for two pieces of the same asset.

Consider another business B that is earning $2 million on assets of $18 million. Earning only 11% on required tangible assets, this mundane business would possess little or no economic Goodwill.

A business like B might been sold for the value of its net tangible assets, or for $18 million. In contrast, $25 million was paid for See’s, even though it had equal earnings and less net tangible assets!

Could less really be more?

The economic goodwill of See is much greater than B. If earnings of $4 million is to be achieved, See would require only an additional $8 million in capital while B would require a good $18 million.

See would now be worth $50 million (if valued on the same basis as originally). It would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.

B would be worth $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested.

Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

On another note, if an overexcited management purchases a business at a silly price, this silliness ends up showing up as Goodwill in the accounts. It remains on the books as an “asset” just as if the acquisition had been a sensible one!

Tags: warren buffett, benjamin graham

In the past year, there was an increase in the number of registered shareholders (due to the merger with Blue Chip Stamps) from 1900 to 2900. As such, Warren started this year’s letter with a summary of his key principles:

1) Shareholders are treated as owner-partners; Warren and Charlie Munger are simply managing partners. The company is simply a conduit through which shareholders own the assets of the business.

2) Company directors are all major shareholders of Berkshire Hathaway.

3) The long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. This is not measured by the size but more on per-share basis.

4) The preference for achieving point three above is by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. The second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by insurance subsidiaries.

5) Consolidated reported earnings may reveal relatively little about the true economic performance due to accounting rules.

6) Warren would rather prefer to purchase $2 of earnings that is not reportable under standard accounting principles than to purchase $1 of earnings that is reportable. Capital-allocation decisions are not influenced by accounting rules.

7) To prevent over-leverage, debt is seldom used.

8) A managerial “wish list” will not be filled at shareholder expense.

9) Common stock will be issued only when business value received is as much as the one given.

10) Regardless of price, Warren has no interest in selling any good businesses that Berkshire owns, and is very reluctant to sell sub-par businesses as long as he expects them to generate at least some cash and as long as he feels good about their managers and labor relations.

11) Investment ideas will normally not be discussed as good ideas are hard to come by.

Nebraska Furniture Mart

The letter goes on to highlight the main point of 1983; the acquisition of a majority interest in Nebraska Furniture Mart and the resulting association with Rose Blumkin and her family.

Rose started the business with $500 of her savings (after having arrived in USA with no money and no knowledge of English many years earlier) and grew it to over $100 million of sales annually out of one 200,000 square-foot store. One question that Warren always ask himself in appraising a business is how he would like, assuming he had ample capital and skilled personnel, to compete with it.

In his own words, “I’d rather wrestle grizzlies than compete with Mrs. B and her progeny.”

Book Value Vs Intrinsic Value

In the past year, the book value of Berkshire increased by 32%. Warren never takes the one-year figure very seriously. Why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Rather, a five year yard stick should be used.

While performance is usually reported in book value, the one that really counts is intrinsic business value. Book value only serves as a conservative but reasonably adequate proxy for growth in intrinsic business value.

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

Using a simple analogy, assume you spend identical amount of money putting two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education.

Similarly, businesses having equal financial input may end up with wide variations in value.

Stock Splits

One of Warren goals is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value. The key to a rational stock price is rational shareholders, both current and future owners.

High quality shareholders can be attracted and maintained if there is consistent communication of the business and ownership philosophy – along with no other conflicting messages.

With a stock split or some other actions focusing on stock price rather than business value, an entering class of buyers inferior to the exiting class of sellers would be attracted.

Would a potential one-share purchaser be better off if the shares were split 100 for 1 so he could buy 100 shares?

Those who think so and who would buy the stock because of the split or in anticipation of one would definitely downgrade the quality of the present shareholder group.

Thus, Warren will avoid policies that attract buyers with a short-term focus on the stock price and try to follow policies that attract informed long-term investors focusing on business values.

Liquidity

Another thing that Warren frowns on is the emphasis on the liquidity of a stock by brokers. A high turnover in shares simply means that the ownership is changing. And the more of this ‘musical chairs’, the higher the commissions will be paid to the stock brokers out of the pockets of investors.

In my next post, I will cover economic and accounting goodwill that was discussed as an appendix to this year’s letter.

Tags: warren buffett, benjamin graham