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Corporate Governance

There are three fundamentally different manager/owner situations that exist in public companies.

The first and most common board situation is where there is no controlling shareholder. Directors should evaluate management’s performance in the long term interest of a “single absentee owner”.

The directors are responsible for changing the management if their performance is poor. A single director would be unable to make such changes on his own. He will need to persuade the other directors to his views.

For this first type of board situation, Warren Buffett believes the number of directors should be little (ten or less) and come mostly from the outside. They should be business savvy, owner-oriented and have interest in the job.

The second board situation is where the controlling owner is also the manager (This situation occurs at Berkshire). In this situation, directors do not act as an agent between owners and management.

There is nothing much a director can do (except object) if the owner/manager is under-performing. If there is no change, the next best thing a director can do is to resign. This will send a signal to outsiders on their doubts about management.

The third situation occurs when there is a controlling owner who is not involved in management (This will be the case at Berkshire after Warren Buffett has passes away).

In this situation, if the directors are unhappy with the competence or intergrity of the management, they can approach the controlling shareholder (who might also be on the board). If the controlling shareholder is intelligent, he can make decisions that are pro-shareholder and fair.

This third scenario is the most effective to ensure first-class management. In the first case, directors often find it difficult to affect change while in the second, a lousy owner is not going to fire himself.

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At Berkshire, after-tax overhead costs are under 1% of their reported operating earnings and less than 0.5% on their look-through earnings. They have no legal, personnel, public relations, investor relations or strategic planning departments. And no need of support personnel such as guards, drivers and messengers.

Some companies spend up to 10% (or even more) of their operating earnings on corporate expenses. Warren Buffett observes no correlation between high corporate costs and good corporate performance.

In actual fact, he feels that the simpler and lower operation is more likely to operate effectively than one saddled with bureauracy.

If the operating earnings of two companies are similar but one spends 10% on corporate costs while the other spends only 1%, then shareholders of the first business lose 9% in the value of their holdings due to this corporate overheads.

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Of CEOs and their soldiers…

Some CEOs clearly do not belong in their jobs; yet their positions are usually quite secure. The irony is that it is easier for an inadequte CEO to keep than it is for an inadequate subordinate.

If a secretary is hired for a job that requires typing ability of at least 80 words a minute and turns out to be capable of only 50 words a minute, she will lose her job in no time. Similarly for sales people that fail to meet their quota.

However, a CEO who doesn’t perform frequently stays on in his role, at least for some time. One reason is that performance standards for his job seldom exist. When they exists, they are usually fuzzy and any shortfall is usually waived or explained away.

At many companies, the bullseye is painted around the spot where the arrow lands.

Another important, but seldom recognized, distinction between the boss and the foot soldier is that the CEO has no immediate superior whose performance is itself getting measured.

It is in the immediate self-interest of a manager to weed out any under- performers in his team. But the CEO’s boss is a Board of Directors that seldom measures itself and is infrequently held to account for substandard corporate performance.

Bearing the above points, they should not be interpreted as a blanket condemnation of CEOs or Boards of Directors: Most are able and hard- working, and a number are truly outstanding.

Holding Period of Securities

When Buffett own portions of outstanding businesses with outstanding managements, his favorite holding period is forever. This is just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint.

Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.

Long Term Bonds

Buffett continues to hold his aversion towards long-term bonds. That will change only if prospects for long-term stability in the purchasing power of money improves. And that kind of stability is unlikely: Both society and elected officials simply have too many higher-ranking priorities that conflict with purchasing-power stability.


The word abitrage used to mean the simultaneous purchase and sale of securities or foreign exchange in two different markets. The goal was to exploit tiny price differentials that might exist between, say, Royal Dutch stock trading in guilders in Amsterdam, pounds in London, and dollars in New York.

Since World War I the definition of arbitrage – or “risk arbitrage”, has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market.

The major risk he usually faces instead is that the announced event won’t happen.

To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire – a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

Berkshire’s arbitrage activities differ from those of many arbitrageurs. First, they participate in only a few, and usually very large, transactions each year. Most practitioners buy into a great many deals perhaps 50 or more per year. Warren Buffett certainly does not want to spend all his time monitoring the progress of so many deals and the market movement of the related stocks!

The other way is that they participate only in transactions that have been publicly announced. No trading on rumors or trying to guess takeover candidates.

Efficient Market Theory (EMT)

The EMT said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices.

While they observed correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient.

In Buffett’s opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp, Buffett Partnership and Berkshire illustrates just how foolish EMT is. Returns have averaged 20% per year compared to the average market returns of 10% per year. That is a significant statistical difference.

All this said, a warning is appropriate. Arbitrage is not a form of investing that guarantees profits of 20% a year or, for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time: For every arbitrage opportunity that Buffet seized in that 63-year period, many more were foregone because they seemed properly-priced.

An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better a strategy than selecting a portfolio by throwing darts.

Listing of Berkshire

Berkshire’s shares were listed on the New York Stock Exchange on November 29, 1988. Berkshire’s goals differ somewhat from most other listed companies.

First, they do not want to maximize the price at which Berkshire shares trade. Rather, they wish for them to trade in a narrow range centered at intrinsic business value.

Significant overvaluation as significant undervaluation will inevitably produce results for many shareholders that will differ sharply from Berkshire’s business

If the stock price instead consistently mirrors business value, each shareholder will receive an investment result that roughly parallels the business results of Berkshire during his holding period.

Second, they wish for very little trading activity. Their goal is to attract long- term owners who, at the time of purchase, have no timetable or price target for sale but plan instead to stay with them indefinitely.

Lots of stock activity can be achieved only if many of the owners are constantly exiting. At what other organization – school, club, church, etc. – do leaders cheer when members leave?

Of course, some Berkshire owners will need or want to sell from time to time, and there needs to exists good replacements who will pay them a fair price. Therefore they will try to attract new shareholders who understand their operations and share their time horizons.

If they can continue to attract this sort of shareholder – and, just as important, can continue to be uninteresting to those with short-term or unrealistic expectations – Berkshire shares should consistently sell at prices reasonably related to business value.

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