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Archive for April, 2006

Share Repurchases

When a company with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, repurchases of the shares by the company provide sure benefits to shareholders.

One benefit involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. Corporate acquisition seldom do as well.

Another less obvious benefit is that when management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, shareholders and potential shareholders usually increase their estimates of future returns from the business. This upward revision, produces market prices more in line with intrinsic business value.

Buffalo Evening News

A point that I managed to pick out was that the economics of a dominant newspaper are excellent, among the very best in the business world. Once dominant, the newspaper itself and not the marketplace determines just how good or how bad the paper will be. And either way, it will prosper. Do you have a dominant newspaper?

Errors in Loss Reserving (Insurance)

The determination of costs is a main problem in the insurance industry. Most of an insurer’s costs result from losses on claims, and many of the losses that should be charged against the current year’s revenue are exceptionally difficult to estimate.

In some cases, dishonest companies that would be out of business if they realistically appraised their loss costs have, in some cases, simply preferred to take an extraordinarily optimistic view about these yet-to-be-paid sums. Others have engaged in various transactions to hide true current loss costs.

In other businesses, insolvent companies will run out of cash. Insurance is different: you can be broke but flush. Since cash comes in at the start of an insurance policy and losses are paid much later, insolvent insurers don’t run out of cash until long after they have run out of net worth.

Washington Public Power Supply System (Bonds)

In the past year, there was a purchase of large quantities of Projects 1, 2, and 3 of Washington Public Power Supply System (“WPPSS”).

When Warren buys marketable stocks, he would apply the same criteria that he would use for the purchase of the entire business. This business-valuation approach applies even to bond purchases such as WPPSS.

The interest earned by the bond is treated as operating profits earned by the ‘business’. Such a valuation method means that he will never buy a bond giving a 1% yield! As Benjamin Graham quoted in his book “The Intelligent Investor”, Investment is most intelligent when it is most businesslike.

Dividend Policy

Even though allocation of capital is crucial to business and investment management, dividend policy is seldom explained. It’s often simply stated as a percentage of net earnings.

Inflation causes some or all of the reported earnings to become “restricted” – i.e. if the business is to retain its economic position, cannot be distributed as dividends.

For the rest of the unrestricted earnings, they can either be distributed or retained.

There should only be ONE reason for retention: Unrestricted earnings should be retained only when there is a reasonable prospect that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This means that returns are higher than market rate returns.

Many companies that show good returns both on equity and on overall incremental capital have employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, help to camouflage repeated failures in capital allocation elsewhere.

In Berkshire’s case, no dividend is given out for the simple reason that Warren can generate higher than market returns on those capital!

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