One of our favorite investors at The Acquirer’s Multiple is of course Warren Buffett.
As a value investor, one of the most important free investing resources is Buffett’s Berkshire Hathaway shareholder letters. Each contains hidden gems of value investing wisdom.
One of my favorite gems is in the 2014 shareholder letter in which Buffett explains how Charles Munger convinced him to break his habit of investing in cigar-butt companies, it’s a must read for all investors.
Here’s an excerpt for that shareholder letter:
Charlie Straightens Me Out
My cigar-butt strategy worked very well while I was managing small sums. Indeed, the many dozens of free puffs I obtained in the 1950s made that decade by far the best of my life for both relative and absolute investment performance.
Even then, however, I made a few exceptions to cigar butts, the most important being GEICO. Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares. Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique, and it worked.
But a major weakness in this approach gradually became apparent: Cigar-butt investing was scalable only to a point. With large sums, it would never work well.
In addition, though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise. Selecting a marriage partner clearly requires more demanding criteria than does dating. (Berkshire, it should be noted, would have been a highly satisfactory “date”: If we had taken Seabury Stanton’s $11.375 offer for our shares, BPL’s weighted annual return on its Berkshire investment would have been about 40%.)
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It took Charlie Munger to break my cigar-butt habits and set the course for building a business that could combine huge size with satisfactory profits. Charlie had grown up a few hundred feet from where I now live and as a youth had worked, as did I, in my grandfather’s grocery store. Nevertheless, it was 1959 before I met Charlie, long after he had left Omaha to make Los Angeles his home. I was then 28 and he was 35. The Omaha doctor who introduced us predicted that we would hit it off – and we did.
If you’ve attended our annual meetings, you know Charlie has a wide-ranging brilliance, a prodigious memory, and some firm opinions. I’m not exactly wishy-washy myself, and we sometimes don’t agree. In 56 years, however, we’ve never had an argument. When we differ, Charlie usually ends the conversation by saying: “Warren, think it over and you’ll agree with me because you’re smart and I’m right.”
What most of you do not know about Charlie is that architecture is among his passions. Though he began his career as a practicing lawyer (with his time billed at $15 per hour), Charlie made his first real money in his 30s by designing and building five apartment projects near Los Angeles. Concurrently, he designed the house that he lives in today – some 55 years later. (Like me, Charlie can’t be budged if he is happy in his surroundings.) In recent years, Charlie has designed large dorm complexes at Stanford and the University of Michigan and today, at age 91, is working on another major project.
From my perspective, though, Charlie’s most important architectural feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.
Altering my behavior is not an easy task (ask my family). I had enjoyed reasonable success without Charlie’s input, so why should I listen to a lawyer who had never spent a day in business school (when – ahem – I had attended three). But Charlie never tired of repeating his maxims about business and investing to me, and his logic was irrefutable. Consequently, Berkshire has been built to Charlie’s blueprint. My role has been that of general contractor, with the CEOs of Berkshire’s subsidiaries doing the real work as sub-contractors.
The year 1972 was a turning point for Berkshire (though not without occasional backsliding on my part – remember my 1975 purchase of Waumbec). We had the opportunity then to buy See’s Candy for Blue Chip Stamps, a company in which Charlie, I and Berkshire had major stakes, and which was later merged into Berkshire. See’s was a legendary West Coast manufacturer and retailer of boxed chocolates, then annually earning about $4 million pre-tax while utilizing only $8 million of net tangible assets. Moreover, the company had a huge asset that did not appear on its balance sheet: a broad and durable competitive advantage that gave it significant pricing power. That strength was virtually certain to give See’s major gains in earnings over time. Better yet, these would materialize with only minor amounts of incremental investment. In other words, See’s could be expected to gush cash for decades to come.
The family controlling See’s wanted $30 million for the business, and Charlie rightly said it was worth that much. But I didn’t want to pay more than $25 million and wasn’t all that enthusiastic even at that figure. (A price that was three times net tangible assets made me gulp.) My misguided caution could have scuttled a terrific purchase. But, luckily, the sellers decided to take our $25 million bid.
To date, See’s has earned $1.9 billion pre-tax, with its growth having required added investment of only $40 million. See’s has thus been able to distribute huge sums that have helped Berkshire buy other businesses that in turn, have themselves produced large distributable profits. (Envision rabbits breeding.) Additionally, through watching See’s in action, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments.
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Even with Charlie’s blueprint, I have made plenty of mistakes since Waumbec. The most gruesome was Dexter Shoe. When we purchased the company in 1993, it had a terrific record and in no way looked to me like a cigar butt. Its competitive strengths, however, were soon to evaporate because of foreign competition. And I simply didn’t see that coming.
Consequently, Berkshire paid $433 million for Dexter and, rather promptly, its value went to zero. GAAP accounting, however, doesn’t come close to recording the magnitude of my error. The fact is that I gave Berkshire stock to the sellers of Dexter rather than cash, and the shares I used for the purchase are now worth about $5.7 billion. As a financial disaster, this one deserves a spot in the Guinness Book of World Records.
Several of my subsequent errors also involved the use of Berkshire shares to purchase businesses whose earnings were destined to simply limp along. Mistakes of that kind are deadly. Trading shares of a wonderful business – which Berkshire most certainly is – for ownership of a so-so business irreparably destroys value.
We’ve also suffered financially when this mistake has been committed by companies whose shares Berkshire has owned (with the errors sometimes occurring while I was serving as a director). Too often CEOs seem blind to an elementary reality: The intrinsic value of the shares you give in an acquisition must not be greater than the intrinsic value of the business you receive.
I’ve yet to see an investment banker quantify this all-important math when he is presenting a stock-for-stock deal to the board of a potential acquirer. Instead, the banker’s focus will be on describing “customary” premiums-to-market-price that are currently being paid for acquisitions – an absolutely asinine way to evaluate the attractiveness of an acquisition – or whether the deal will increase the acquirer’s earnings-per-share (which in itself should be far from determinative). In striving to achieve the desired per-share number, a panting CEO and his “helpers” will often conjure up fanciful “synergies.” (As a director of 19 companies over the years, I’ve never heard “dis-synergies” mentioned, though I’ve witnessed plenty of these once deals have closed.) Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. They should instead be standard practice.
I can promise you that long after I’m gone, Berkshire’s CEO and Board will carefully make intrinsic value calculations before issuing shares in any acquisitions. You can’t get rich trading a hundred-dollar bill for eight tens (even if your advisor has handed you an expensive “fairness” opinion endorsing that swap).
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Overall, Berkshire’s acquisitions have worked out well – and very well in the case of a few large ones. So, too, have our investments in marketable securities. The latter are always valued on our balance sheet at their market prices so any gains – including those unrealized – are immediately reflected in our net worth. But the businesses we buy outright are never revalued upward on our balance sheet, even when we could sell them for many billions of dollars more than their carrying value. The unrecorded gains in the value of Berkshire’s subsidiaries have become huge, with these growing at a particularly fast pace in the last decade.
Listening to Charlie has paid off.