Buffett's Owner's Manual - Part 3

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 3 of a 3 part post.  To go back and read part one, please click (Link to Article 1) part 2 please click (Linkto Article 2).  In this final post, we talk about 2 additional principles which Buffett has added over the years, and we will also discuss Buffett's definition of Intrinsic Value, which is a very important concept for any investor to understand.

Principle 14

To the extent possible, we would like each Berkshire shareholder to record a gain or loss in market value during their period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded by the company during that holding period.  For this to come about, the relationship between the intrinsic value and the market price of a Berkshire share would need to remain constant, and by our preference 1 to 1.  As that implies we would rather see Berkshire's stock price at a fair level than a high level.

Obviously, Charlie and I can't control Berkshire's price.  But by our policies and communications, we can encourage informed rational behaviour by owners that, in turn, will tend to produce a stock price that is also rational. Our it's-as-bad-to-be-overvalued-as-undervalued approach may disappoint some shareholders.  We believe, however, that it affords Berkshire the best prospect of attracting long term investors who seek to profit from the progress of the company rather than from the investment mistakes of their partners.

This principle is simply about fairness and trust.  Buffett explicitly states that he does not want to profit from the mistakes of his own shareholders.  As an example Berkshire shareholders could profit greatly from stock re-purchases as Berkshire's cash reserves have grown.  But Buffett has really lowered the probability of that happening by stating the floor at which Berkshire would begin to repurchase shares.  This means that there is an implied support price on the shares.  

Buffett has done this because he did not want to prejudice the shareholders who would be selling at a price below intrinsic value (and in his view, making a mistake). While this may seem detrimental to long term shareholders I think Buffett's commitment to fairness and trust pays dividends in other aspects of Berkshire.  The shareholders really do trust Buffett and Munger and that gives them latitude to run the business free from activist shareholders or unwanted media attention.

I think the key lesson I take from this, and one which we try and apply to our clients is that trust and fairness is the foundation to any successful long term relationship.  Those are the types of relationships we want to build with our clients, and therefore we must earn their trust through fair dealings with them.

Principle 15

We regularly compare the gain in Berkshire's per share book value to the performance of the S&P 500.  Over time, we hope to outpace this yardstick.  Otherwise, why do our investors need us?  The measurement, however, has certain shortcomings that are described in the next section.  Moreover, it is now less meaningful on a year-to-year basis than was formerly the case.

That is because our equity holdings, whose value tends to move with the S&P 500, are a far smaller portion of our net worth than they were in earlier years.  Additionally, gains in the S&P stocks are counted in full in calculating that index, whereas gains in Berkshire's equity holdings are counted at 79% because of the federal tax we incur.  We therefore, expect to outperform the S&P in lackluster years for the stock market and underperform when the market has a strong year.

Competing with the S&P 500 is a very tough task to try and accomplish. Berkshire has clearly bested the index over a 50 plus year timeframe, though in recent year Berkshire has struggled to outperform the index.  In addition to the tax considerations noted in Buffett's quote, the size of Berkshire precludes them from growing at the very fast pace of earlier years. Nevertheless Buffett continues to set the S&P 500 index as the goal to beat.  Otherwise, Berkshire wouldn't provide any value over the index.  

The same is true for all investment managers.  If they don't provide value over and above the index they compete with, then what value do they provide? In our investment management, we are no different.  Our goal is to provide superior returns after fees over and above the relevant indexes we compete with.  Over time I fully expect to achieve that goal.

However, just like Buffett qualifies his answer to state that competition against the S&P 500 is less relevant, I will do exactly the same. Investment management is not the only value we provide to our clients, and frankly it's not even the primary value in most cases.  Most of our clients need sound financial planning and advice much more than they need superior investment returns.  As a result most of the value attributed by our fees usually goes to financial planning. We will still add value on the investments alone, but competing against the S&P 500 is not our clients' or our main objective in most cases.

Intrinsic Value

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. The definition of Intrinsic Value used by Buffett is simple: "Intrinsic Value is the discounted value of the cash that can be taken out of a business during its remaining life."

Basically it measures how many dollars will be put in your pocket as an owner of the business. Despite this simple definition however, the calculation of intrinsic value, is not so simple.  Intrinsic value is always an estimate and never a precise figure, and it is also subject to change if the forecasts of future cash flows changes, or if interest rates move.  

Two people looking at the same set of facts, moreover will almost inevitably come up with at least slightly different intrinsic value figures.  It can be tough to quantify and given that there are subjective elements, it's hard to standardize or put into a computer algorithm. I will rarely talk about intrinsic value specifically because it is such an imprecise figure.  

One of the things we do to protect our client's money, is that we will only buy a stock if that stock is trading well below what I think to be intrinsic value. That gives us a margin of safety, where even if I am wrong about my calculation of intrinsic value, it is very unlikely that we will lose money because of our built-in margin of safety.

Here's a simple example to explain this principle.  I am interested in buying a frozen banana stand which is owned by Mr. Bluth.  I calculate the future cashflows of the stand will be worth $1000 based on earnings of $100 per year.  It's important to me that I earn at least 10% a year because that's the amount I need to earn to make my financial planning work.  

Even though I believe the stand is worth $1000, Mr, Bluth has some family squabbles and is motivated to sell the stand.  He is willing to sell it for $500.  This is a 50% margin of safety, which is fantastic.  I decide to purchase the stand from Mr Bluth. Now that I own the banana stand, the value of the shares becomes less important than the actual earnings of the business.  

Unfortunately sales are not going as well as planned.  The weather has been poor and so we haven't sold as many frozen bananas.  Our profits are down from $100 a year to $75 a year.  If I had valued the business at $1000, I would probably have a tough time reselling it for more than $750 based on the new projected earnings.  I would have to take a loss.  

If I continue to own the business instead of selling, my returns will be lower than the 10% I would have originally expected as I'm only earning 7.5% each year.  As a result my financial planning will need to be adjusted, potentially causing me hardship.  However, because I built in a margin of safety, I am still in great shape.  The banana stand is still worth more than what I paid for it, and even if I continue to hold on to it and wait for a better price, I continue to earn returns of 15% a year, which is well above my required 10%.

This is a simplified example but in the real world it plays out in a very similar way.  There are lots of half price banana stands out there to purchase, and that's where we can really have a lot of fun with our investments.  If you have any doubts about that, you only need to look at Berkshire Hathaway's track record.

- 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.