US 'investment genius' Warren Buffett has made his mint and his reputation by doing the last thing companies expect - investing for the long term and backing their boards to the hilt.
As eyes for a good business go, one of the few who can justly claim to have near perfect vision is the American investor Warren Buffett. A legend among the stock market fraternity in the US, his talent for spotting undervalued and well-managed companies to invest in has put this 64-year-old businessman, born in Omaha, Nebraska, among the country's wealthiest individuals.
According to Forbes magazine's latest rankings of the super-rich, Buffett is number two on the list, behind Bill Gates of Microsoft. Buffett's 42% shareholding in Berkshire Hathaway, the holding company for his family's investments, is now worth more than $9 billion.
Buffett is a stock market investor. But one of many remarkable things about his career is that he has made his money from doing the last thing which most corporate executives expect from stock-market operators - namely, investing for the long term and backing managements to the hilt. He stands out among investors as a man who has made his mint from giving long-term backing to the boardroom, not from trading in and out of stocks like 'a Whirling Dervish' (his own description of the behaviour of the average institutional fund manager).
Buffett still lives in Omaha, the heart of America's Mid-West cattle country. A student of Ben Graham, a Columbia University professor who is usually dubbed the father of modern security analysis for his pioneering work in developing techniques for analysing company's shares, he started out in 1959 as a one-man investment adviser to a group of well-off Nebraskans. The initial capital of his investment fund, $105,000, has since mushroomed into a quoted company with a stock-market valuation (at the end of September) of more than $21,508 million.
Anyone who invested $1,000 in the original partnership in 1959 would today have shares worth $204 million. In the past 29 years, there has not been one in which the value of the company has not grown, and only three in which it has failed to outperform the total return on the Standard and Poor's 500 index. This track record for consistent above-average performance is virtually unparalleled in the investment management business. (Many others have made as much or more money over a period of a few years but none has maintained the record over such a long period of time.) The annual compound growth in the per share book value of Berkshire Hathaway since 1965 has been 23%, roughly double the equivalent increase in the stock market as a whole. Shares in Berkshire Hathaway have risen 47-fold in the past 15 years.
Virtually all of Buffett's wealth and all his business activities are channelled through Berkshire Hathaway, his holding company. The bulk of its assets are equity and fixed-interest holdings in large US corporations, but he also owns outright a significant number of successful smaller businesses, including several in his home state of Nebraska.These operating businesses are mostly profitable and cash-generative, but the bulk of the value of the company comes from its investments in the stock market. The company reported a net profit last year of $688 million on sales of $3,650 million, generated cash flow of $726 million and had assets of $19,500 million, of which $14,600 million (75%) was in the form of investments (stocks and bonds).
Despite such success it is hard for Britons to appreciate fully the awe in which Buffett is held both on Wall Street and in the boardrooms of corporate America. According to Paul Samuelson, the Nobel Prize-winning professor of economics, Buffett is the nearest thing to 'an investment genius' that the modern world has seen. Peter Lynch, who managed the largest mutual fund in the United States, Fidelity's Magellan Fund, describes him simply as 'the greatest investor of all time'.
His stock is equally high in the boardroom. About the highest accolade that the CEO of a large US corporation can achieve is to be told that Buffett wants to take a stake in his company. When General Dynamics disclosed that he had acquired a 14% shareholding in the company, the shares rose sharply on the news. If Buffett rates a company's management sufficiently to entrust his money to it, the market's view tends to be that he must have seen something that they have missed - even if, as often as not, they are not sure what it is.
The strength of Buffett's reputation was most clearly illustrated when, in 1991 Salomon Brothers, the Wall Street investment bank, was discovered making false bids in two auctions for US Treasury notes (government bonds). Buffett had invested $700 million in Salomon bonds four years earlier - in a move that had effectively saved Salomon's from the threat of an unwelcome takeover - and sits on the board as a non-executive director. (He also sits on five other boards, including Coca-Cola, Gillette and Capital Cities/ABC).
When the scandal broke, Buffett was drafted in as an emergency chairman to try and save the firm from going under (and not least, in the process, to protect his own investment). Buffett's patent integrity and public determination to put Salomon's house in order is widely acknowledged to have been a key factor in seeing off the threat to the firm's solvency posed by a combination of Congressional threats to its privileged market position as a primary dealer in Treasury stock and the real possibility of its balance sheet unwinding. Buffett himself emerged from the scandal with both his investment secured and his reputation unimpaired. Nobody doubts that he was ignorant of the malpractice that took place. Yet it underlined how even the most savvy of investors with a seat on the board of a publicly quoted company can still find himself misled by a management that is prepared to turn a blind eye to irregularities inside the business.
This is just one of many hard lessons that has made Buffett an outspoken champion of investor interests over the years. His views on such things as what makes a good company and how to spot an owner-oriented management merit a wider hearing on this side of the Atlantic, where there is no seasoned investor of equivalent stature.
The key to Buffett's success undoubtedly lies in his distinctive investment philosophy. Unlike most other professional investors, his style is to invest in just a few securities - but when he does invest, he does so in large volumes and holds them for long periods of time. Typically, Buffett likes to buy 10-15% of the shares of a company and hold that investment for a long time - 10 years or more. The biggest elements of his portfolio of quoted companies were all acquired in large chunks in this way (see table). His largest single investment was the $1billion he invested in Coca-Cola in 1989. Since then Berkshire Hathaway has received dividends of $230 million and the shareholding has increased in value to $4 billion. Buffett himself has noted that he has become more rather than less selective as his company has grown. He now has fewer holdings and makes fewer decisions each year, with several billion dollars a year to invest, than he did when he was managing $20 million of money.
Only a handful of companies pass the rigorous criteria that Buffett demands must be met before he will invest his money in a company. Buying stocks and bonds, in his view, is no more and no less than buying a share in the ownership of a business. Consequently he will only invest if he understands how the business works and why its shares are undervalued. This immediately rules out more than half the quoted companies on the stock market: Buffett does not invest in high-technology companies, for example, since he says he does not understand them. In fact, the hardest lesson to learn about investing, he once said, is resisting the impulse to invest without a good reason. 'Masterly inactivity' and 'hopelessly comatose' are how he summed up his own investment style in his report to stockholders earlier this year. Analysis of Buffett's investments since 1969 shows that, unlike some other well-known investors, he does indeed practise what he preaches. For example, there are 17 out of the 24 sectors that make up the Fortune 500 list of companies in which he has never invested in any significant amount. Two-thirds of the value of his equity holdings are accounted for by just four stocks. Most of his investments have deliberately been concentrated in a few sectors - including food and drink (Coca-Cola, Guinness, and earlier General Foods), insurance, and the media (newspapers and advertising). Many of these he has owned for many years. For example, he bought his shares in the Washington Post as long ago as 1973, paying $9 million for a shareholding that is now worth more than $440 million.
The companies that Buffett likes to invest in tend to have one or all of the following features: a strong business franchise (ie, a degree of monopoly or pricing power); strong cash flow; low capital requirements; and what Buffett calls 'owner-oriented' management. He believes that good management can only do so much if the underlying economics of the business are not good. In the words of one of his favourite aphorisms: 'When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.' His large investments in Gillette and Coca-Cola are typical of Buffett's style. Coca-Cola sells about 44% of all soft drinks worldwide and Gillette has more than 60% of the global razor-blade market. Apart from Wrigley's chewing gum, he says he knows of few other businesses of that size that have sustained such global power for so long. They have demonstrated the strength of their brand names, their products and their distribution systems over many years. These provide the companies with 'a protective moat around their economic castles'. Provided you invest in companies of this kind at the right price, he believes the downside risk in these investments is low. They have what his mentor Graham called a 'margin of safety' about them: in other words, limited downside risk and potentially long-lasting favourable economic characteristics. The only snag, of course, is that opportunities of this sort tend to be rare - and you have to be able to spot the hidden intrinsic value where others cannot. Despite the occasional failure (namely his recent investment in USAir and his so far unsuccessful investment in Guinness) Buffett's expertise has lain in finding businesses that are capable of achieving reliable growth over long periods of time. Looking back on his long career as an investor, his view is that 'Successful long-term businesses don't change much. Severe change and exceptional returns usually don't mix. Experience indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or10 years ago.
'That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.' Buffett also notes that successful, long-term businesses usually employ little debt relative to their debt capacity. 'Really good businesses usually don't need to borrow,' he says. Analysis of the best and most consistent performers among large companies over the past 25 years demonstrates that 'making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics'.
One of Buffett's key complaints about managements is that they are so often poor at capital allocation which, along with motivating employees he regards as one of the two key jobs of the CEO. 'Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration - or sometimes, institutional politics.' They have limited experience at capital allocation - and demonstrating the fact can prove very costly for shareholders. After 10 years in the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been 'responsible for the deployment of more than 60% of all the capital at work in the business during the period.' Dividend policy, says Buffett, is often reported to shareholders, but seldom explained. 'A company will say some-thing like "our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in CPI (the inflation index)". And that's it - no analysis will be supplied as to why that particular policy is best for the owners of the business.' He thinks managers and shareholders need to think harder about when earnings should be retained or distributed. Buffett's starting principle is this: 'Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence, or when appropriate by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners.
'Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level, the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here, managers frequently have trouble putting themselves in the shoes of their shareholder owners.' A CEO, he adds, 'will seldom supply his owners with a similar analysis pertaining to the whole company'.
Cash-cow businesses are very effective in achieving high returns on equity while masking much worse performers, he says. 'Many corporations that consistently show good returns both on equity and on overall incremental capital have indeed employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvellous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics).' Buffett is a believer in incentive pay for managers, but argues that it should be linked to the return on new capital invested in the business, not simply to the performance of the shares. Most share option schemes involve no risk for managers, and allow them to benefit from what may merely be the impact of inflation or the return on accumulated cash resources. 'At too many companies,' says Buffett, 'the boss shoots the arrow of management performance and then hastily paints the bull's-eye around the spot where it lands.' Buffett's own salary for doubling up as chairman and CEO of Berkshire Hathaway has been fixed at $100,000 a year for as long as anyone can remember. At this rate, he undoubtedly represents the best value for money in the entire US CEO class - but then, of course, as one who has practised owner-management successfully for so many years, and lives modestly in the same house he bought in the 1950s, he hardly needs the money.
UK boardrooms, please note.
Equity Portfolio of a long-term investor.
% of As % of
% Present Buffrett total
Date stock Cost value equity invest-
brought owned ($m) ($m) holdings ment
Washington Post 1973 14.8 9.7 440.1 3.5 3.0
GEICO 1976-80 48.4 45.8 1,739.6 13.9 11.9
Capital Cities ABC 1984-85 13.0 345.0 1,239.0 9.9 8.4
Coca-Cola 1988-89 13.0 1,023.9 4,167.9 33.2 28.4
Wells Fargo 1989-90 12.2 423.7 878.6 7.0 6.0
Freddie Mac 1989 6.8 307.5 681.0 5.4 4.6
Gillette 1991 10.9 600.0 1,431.0 11.4 9.8
Guinness 1991 1.9 333.0 270.8 2.1 1.8
General Dynamics 1992 13.9 94.9 401.3 3.2 2.7
Other 1,134.8 1,290.9 10.3 8.8
Total 4,317.7 12,540.2 100.0 85.4.