Buffett's Owner's Manual - Part 2

In 1983 Warren Buffett set down 13 owner related business principles that he believed would help shareholders understand their managerial approach.  Since our approach to investing money is very similar to Buffett's I thought it would be helpful to also share those principles with our clients and friends. These principles are as applicable as they were in 1983.  

Some of them will directly apply to our clients. Some of them will be adapted to our relationship with our clients which is obviously much different than the manager/shareholder relationship that Buffett has with the shareholders of Berkshire Hathaway.  As we go through the principles, I'll relate the principle back to our team so that you can see the parallel.

This is part 2 of a 3 part post, with a discussion of Intrinsic Value as defined by Buffett being the topic of the third post.  To go back and read part one, please click (link to post 1)

Principle 8

A Managerial 'Wish List' will not be fulfilled at shareholder expense.  We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders.  We will only do with your money what we do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market. This comment is a direct criticism of managers who seek to enrich themselves at shareholder's expense by making acquisitions which do not make economic sense, but nevertheless expand the manager's field of influence, as well as their ego.  

Unfortunately this is an all too common practice in business as the manager's money and motivations are often disconnected from those of the shareholders. Our primary responsibility is to provide great service to our clients. We will never engage in a business activity that would compromise that mission.  Similarly we will not take on business if we felt that by doing so it would compromise the service we provide to our existing clients.  Though we are definitely trying to grow our practice, we will never do so at the expense of our clients.

Principle 9

We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.  To date this test has been met.  We will continue to apply it on a five year rolling basis.  As our net worth grows, it is more difficult to use retained earnings widely.

Buffett is speaking here of the very real issue when an investment manager reaches a size as big as Berkshire.  They find it increasingly difficult to find opportunities of a size that will still move the needle for Berkshire shareholders and also pass their stringent investment standards. In addition Buffett is also describing how a practice such as retaining earnings should always be subject to review.  Just because it made sense in 1970 or 1990 for Berkshire to retain all of its earnings doesn't necessarily mean it still makes sense in 2018.

If you fail to review these decisions you risk making a mistake and costing your shareholders money. We consistently review our processes to ensure that they still make sense and they are still in the best interest of the clients. If over time, processes or policies that we use become obsolete then we will either change them or replace them.

Principle 10

We will issue common stock only when we receive as much in business value as we give.  This rule applies to all forms of issuance – not only mergers or public stock offerings, but stock for debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company – and that is what the issuance of shares amounts to – on a basis inconsistent with the value of the entire enterprise.

Many companies have committed the sin of issuing stock at a price which is less than the intrinsic value.  This includes executive stock options or grants or other incentives, stock issued in the takeover of another company, or other activities of questionable value to shareholders.  When a stock is issued, the management is selling a portion of your company.  Managements who have recklessly issued stock have destroyed a great deal of shareholder value.  

Similarly, managements who buy back stock at a price higher than intrinsic value, also destroy shareholder value. When investing our client's money we pay very close attention to the behaviour of management.  We place a premium on management that has been respectful of shareholder value and a severe penalty on management that has been reckless with shareholder value.  This premium becomes more valuable if the management are significant shareholders themselves as they are unlikely to damage their own net worth by diluting their stock ownership or by squandering company resources to buy back shares.

Principle 11

You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns.  We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations.

Buffett is referring to businesses they hold outright here and not marketable securities traded on an exchange.  Were we to own businesses outright I expect we would have a similar viewpoint as there are more considerations with those businesses then ones that are publicly traded.  Berkshire maintains a reputation as a good home for private businesses and that reputation would be severely damaged if they were to sell underperforming businesses after one or two poor years.  Behaviour like that would damage their relations with their existing managers as well as hurt efforts to make future acquisitions.  

Berkshire's policy while potentially harmful to shareholders in the short term, may actually make long term sense.  However I believe the policy is also based on the fundamental values of Buffett that they should treat their managers with decency and respect at all times, a lesson which sadly can go by the wayside in business. However at this point in time, our clients own exclusively publicly traded securities and we would not hesitate to sell them if we felt it was in the client's best interest.  

While I understand completely Berkshire's position on this, their circumstances do not apply to our clients in this case. This does not mean we will sell a holding based on negative news which we believe to be short term.  We take a long term approach in our public holdings.  We would only sell if we felt that something had fundamentally changed for the business in a negative way, or that the price of the stock has risen to a point that we feel is high above intrinsic value.  Any time we are selling a business it's because we believe there is better home for our clients' money at that current time.

Principle 12

We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value.  Our guideline is to tell you the business facts that we would want to know if our positions were reversed.  We owe you no less.  We also believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead themselves in private.

Similar to principles 5 and 6 which were discussed in Part 1, Buffett is really emphasizing that management will be extremely transparent with the shareholders of Berkshire.  Buffett goes on to say how they communicate with shareholders, through the annual report and the quarterly reports, as well as answering questions at the annual meeting. Buffett also makes the point that they will never communicate one-on-one to allow for one shareholder to get an edge over another.

Similar to this we have very structured communications with our clients, through regular newsletters, quarterly statements, as well as one on one meetings, telephone calls and emails.  Part of our role is to make sure we are providing you with the information that you need to know to make proper informed decisions on your financial planning and your investments.  

Another goal of our communications is to help educate you on wealth management and investment topics so that you can have a better understanding of your finances and your progress towards your financial goals. We always speak candidly with our clients because we feel that we owe that to you and that it is in your best interests to speak candidly.

Principle 13

Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required.  Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we will not talk about our investment ideas.  This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumoured to be buying.

A person in Buffett's position obviously has to keep a tight lid on what investments he is looking at purchasing.  Stocks that he has purchased in recent years have been given a 'Buffett boost' in the market price after his endorsement of the stock. This raises the price and makes it more difficult for Berkshire to buy the stock.

We obviously have to disclose what we are investing in to our clients, however we do avoid talking publicly about investments that we are looking to buy.  As Buffett has mentioned, good investment ideas are hard to come by and we would be doing a disservice to our clients if we shared investment ideas to the public. We will on occasion discuss companies we currently own or ones that we have sold to illustrate our process or to educate our clients, however this will never be done if it would detrimentally effect our clients' returns.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

Industrial Alliance Securities Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Securities is a trademark and business name under which Industrial Alliance Securities Inc. operates.

This information has been prepared by Craig White who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.