Value Investing

The 15 Owner-Related Business Principles Of Warren Buffett

Warren Buffett has amassed a fortune of over $70 billion dollars – thanks to his uncanny investing acumen. Investors can piggyback off Buffett’s remarkable success by looking inside his investment portfolio, which is disclosed through publicly-available documents called “13F filings” that are stored with the Securities & Exchange Commission.

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What has caused Buffett’s amazing track record?

One characteristic that stands out is his owner-related investment mentality. Buffett views owning stocks in the same way as owning entire businesses. He has outlined 15 owner-related business principles in Berkshire Hathaway’s annual reports that can help investors absorb this mindset.

When Buffett talks about how to run a business, you should listen – even if you don’t run a business.  Why?

Because you can apply Warren Buffett’s 15 owner-related principles to your stock investments to decide which businesses are worthy of your investment dollars.

This article analyzes and interprets each of Warren Buffett’s 15 Owner Related Business Principles.  Each of the 15 principles is listed in the table of contents below with links for quick navigation.

Table of Contents

Principle 1:  The Shareholders Own the Business

“We (Warren Buffett & Charlie Munger) do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.”
– Berkshire Hathaway 2013 Annual Report, page 103

The first principle is arguably the most important.

Instead of seeing Berkshire Hathaway as a company that has taken investment money from shareholders, Warren Buffett and Charlie Munger view Berkshire Hathaway as a conduit for holding shareholder assets.  Instead of viewing the corporation as the owner of business assets, they view shareholders as the ultimate owner.  This means they will attempt to maximize shareholder value rather than maximizing corporate size.

A business that follows this principle will do what is best for shareholders rather than what is best for increasing company size.  An example would be repurchasing shares (when below intrinsic value) or paying dividends instead of pursuing acquisitions of overvalued businesses that only serve to grow company size without expanding shareholder value.

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Principle 2:  Managers Own Stake In Business

“Most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.”
– Berkshire Hathaway 2013 Annual Report, page 103

The second principle aligns shareholder returns with management returns.  If the managers of a company have a large stake in the company, they are more likely to maximize shareholder value (since they are major shareholders) rather than pay egregious salaries that benefit only themselves.

Businesses where management has a large stake in the outcome of what happens better align shareholder interests with management interests.  It forces managers to think like shareholders.

Indeed, the shareholder-friendly nature of high insider ownership levels tends to spill over to other areas of corporate management and capital allocation. As an example, we studied insider ownership among the Dividend Kingss – a group of ultra-exclusive dividend stocks with 50+ years of consecutive dividend increases – and found that these businesses had very high levels of insider ownership. This is in-line with their long dividend history streaks, and shows that management’s insider ownership incentivizes them to act in the best interests of shareholders in the long run.

The second owner-related principle of Warren Buffett can be summarized with the following sentence: the higher the percentage of ownership management has in a business, the less likely they are to destroy shareholder value by making selfish decisions.

Principle 3:  Goal Is to Maximize Long-Term Growth In Intrinsic Value Per Share

“We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress”
– Berkshire Hathaway 2013 Annual Report, page 103

The goal of any manager should be to maximize long-term shareholder value on a per share basis.

Growing a business by issuing shares does little for shareholders.  Owning 10% of a $1,00,000 business is exactly the same as owning 1% of a $10,000,000 business.

When companies do not show per share numbers but instead focus on overall business growth, they are likely raising money by issuing shares. This reduces each investors fractional ownership in the overall business, which in turn makes their claim on earnings and assets smaller. The issuance of shares (and the dangerous financial consequences associated with it) is usually called dilution.

It’s hard to overstate exactly how adverse Buffett is to issuing Berkshire stock and diluting the company’s shareholders. The following quote provides some additional insight:

“Unfortunately, I followed the GEICO purchase by foolishly using Berkshire stock – a boatload of stock – to buy General Reinsurance in late 1998. After some early problems, General Re has become a fine insurance operation that we prize. It was, nevertheless, a terrible mistake on my part to issue 272,200 shares of Berkshire in buying General Re, an act that increased our outstanding shares by a whopping 21.8%. My error caused Berkshire shareholders to give far more than they received (a practice that – despite the Biblical endorsement – is far from blessed when you are buying businesses).

Early in 2000, I atoned for that folly by buying 76% (since grown to 90%) of MidAmerican Energy, a brilliantly-managed utility business that has delivered us many large opportunities to make profitable and socially-useful investments. The MidAmerican cash purchase – I was learning – firmly launched us on our present course of (1) continuing to build our insurance operation; (2) energetically acquiring large and diversified non-insurance businesses and (3) largely making our deals from internally-generated cash. (Today, I would rather prep for a colonoscopy than issue Berkshire shares.) [emphasis ours]

Berkshire Hathaway 2016 Annual Report, page 4

Buffett would rather prepare for a colonoscopy than issue shares of Berkshire Hathaway.

For self-directed investors, the key takeaway is to monitor a business’ performance on a per-share basis, not on a company-wide basis.

So how do investors avoid dilution? I have noticed that dilution is especially prevalent in the world of REITs and MLPs. Avoiding these security classes ensures that you’ll “miss out” on the dilution that accompanies them. Unfortunately, this also means that you’ll miss the appealing investments that sometimes lie in these sectors.

Fortunately, there is another strategy that generalizes to all sectors of the stock market. Mathematically, the easiest way to avoid dilution this is with the following quick analysis: if a company’s overall performance is good and its share count is steady or falling, then each investor’s fractional ownership in the business is becoming more valuable over time.

Principle 4:  Own Cash Generating Businesses with Above Average Returns on Capital

“Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital.”
– Berkshire Hathaway 2013 Annual Report, pages 103 and 104

Warren Buffett is known to look for businesses with a strong competitive advantage. Businesses that generate cash instead of using cash while also having above average returns on capital are more likely to have strong competitive advantages that will protect and grow the company for years (or decades).

In Berkshire Hathaway’s history, there is perhaps no better example of such a business than See’s Candy. See’s capital-light business model allowed it to create tremendous amounts of shareholder value for Berkshire Hathaway over the years. Buffett’s describes the company’s performance as follows:

“See’s sold 16 million pounds of candy in 1972. In 2007, it sold 31 million pounds.  That’s a growth rate of about 2% annually.  Yet the business created tremendous value. How? Because it generated high returns on invested capital and required little incremental investment.  Growth creates value only when a business can invest at incremental returns higher than its cost of capital. The higher return a business can earn on its capital, the more cash it can produce, the more value is created.  Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.”

Buffett also recognizes that such cash-generating businesses are worth paying a higher price for, within reason. The following quote illustrates this belief:

“Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars. Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.”

A diversified portfolio of high quality businesses (like See’s Candy) generate cash for shareholders with which to buy more high quality businesses in a virtuous cycle.

Principle 5:  Give Investors Data That Matters

“We believe in telling you how we think so that you can evaluate not only Berkshire’s businesses but also assess our approach to management and capital allocation.”
– Berkshire Hathaway 2013 Annual Report, page 104 (capital allocation link added)

GAAP accounting standards do not always paint the most accurate picture of business performance and value.  As a result, management should give investors additional data that better demonstrates the company’s progress.

An example of this is Berkshire Hathaway’s portfolio of common stocks. While the company’s holdings are required to be disclosed through a 13F filing with the Securities and Exchange Commission, Buffett includes a supplementary table in Berkshire Hathaway’s annual reports that include the cost basis of the stocks in question. An example of this table from Berkshire Hathaway’s 2016 Annual Report can be seen below.

Berkshire Hathaway Common Stocks Table

Source: Berkshire Hathaway 2016 Annual Report

Yet another example is Berkshire Hathaway’s performance broken down by business segment.

Berkshire is a very complicated business that was built up through decades of sound operations, business acquisitions, and other value-creating capital allocation decisions. Accordingly, understanding each of its moving parts can be difficult.

Buffett makes a great stride in simplifying this task by including segment-by-segment financial performance in the notes to Berkshire’s consolidated financial statements. This segmented performance has the following appearance:

Berkshire Hathaway's Performance By Segment

Source: Berkshire Hathaway 2016 Annual Report

When a company (like Berkshire Hathaway) is willing to provide more than is required when it comes to financial data, it shows the company’s management thinks like owners and shareholders are often rewarded in the process.

Principle 6:  Maximize Intrinsic Value, Not Accounting Value

“Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.”
– Berkshire Hathaway 2013 Annual Report, page 104

As mentioned in principle 5, GAAP accounting rules do not always show the true underlying economics of a business.  Managers should not attempt to maximize earnings per share based on accounting metrics, but rather maximize intrinsic value per share.

With that said, there is danger is making too large of adjustments to earnings in the name of reflecting “true” earnings power. Buffett alluded to this in Berkshire Hathaway’s 2015 Annual Report:

“I suggest that you ignore a portion of GAAP amortization costs. But it is with some trepidation that I do that, knowing that it has become common for managers to tell their owners to ignore certain expense items that are all too real. “Stock-based compensation” is the most egregious example. The very name says it all: “compensation.” If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?

Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by managements. Maybe the offending analysts don’t know any better. Or maybe they fear losing “access” to management. Or maybe they are cynical, telling themselves that since everyone else is playing the game, why shouldn’t they go along with it. Whatever their reasoning, these analysts are guilty of propagating misleading numbers that can deceive investors.

Depreciation charges are a more complicated subject but are almost always true costs. Certainly they are at Berkshire. I wish we could keep our businesses competitive while spending less than our depreciation charge, but in 51 years I’ve yet to figure out how to do so. Indeed, the depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly, a mismatch that leads to GAAP earnings that are higher than true economic earnings. (This overstatement of earnings exists at all railroads.) When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.

Our public reports of earnings will, of course, continue to conform to GAAP. To embrace reality, however, you should remember to add back most of the amortization charges we report. You should also subtract something to reflect BNSF’s inadequate depreciation charge.”

The bottom line is this: seek to invest in businesses that have the largest economic earnings, not the largest accounting earnings in a given reporting period. At the same time, avoid companies that are constantly taking out expenses to report too-different “adjusted earnings.” For more information on how to soundly analyze corporate financial statements, consider our comprehensive course The Investor’s Toolbox: How To Analyze Financial Statements.

Principle 7:  Use Debt Conservatively

“The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return.”
– Berkshire Hathaway 2013 Annual Report, pages 104 and 105

The more debt a business takes on, the greater the odds the business will be forced into bankruptcy.  In fact, bankruptcy are almost impossible without debt (unless a company experiences a prolonged period of large and sustained losses).

Debt takes future earnings and uses them in an attempt to grow faster now.  Berkshire Hathaway has a debt to equity ratio of about 30% – quite low for a large corporation.  Heavily indebted companies face serious problems if they incur even short-term issues with their business operations.  Businesses that are conservatively financed are better prepared to handle recessions and business downturns.

Some of Buffett’s most interesting thoughts on debt and leverage came in Berkshire Hathaway’s 2010 Annual Report, in which he wrote:

“The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.

Charlie and I have no interest in any activity that could pose the slightest threat to Berkshire’s wellbeing. (With our having a combined age of 167, starting over is not on our bucket list.) We are forever conscious of the fact that you, our partners, have entrusted us with what in many cases is a major portion of your savings. In addition, important philanthropy is dependent on our prudence. Finally, many disabled victims of accidents caused by our insureds are counting on us to deliver sums payable decades from now. It would be irresponsible for us to risk what all these constituencies need just to pursue a few points of extra return.”

For investors, buying the stock of companies with reasonable levels of leverage is the best (and only) way to avoid to problems associated with excess debt. Using the debt-to-equity ratio is an excellent way to assess a company’s overall financial position.

Principle 8:  Don’t Grow The Business To Satisfy Your Own Ego

“A managerial ‘wish list’ will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders.”
– Berkshire Hathaway 2013 Annual Report, pages 105

The manager of a large corporation may want to acquire other businesses when it is not in shareholder’s best interest.  The reason is that growing the size of a business (but not necessarily shareholder value) often brings higher pay and a sense of satisfaction that the manager is controlling an ever greater empire.

With that said, this is not a shareholder-friendly activity in general because it fails to grow the business if (1) shares are issued to fund the acquisition or (2) the purchase price of the acquisition is too high. Buffett has insightful quotes to illustrate both dangers. First, he writes about the detrimental effects caused by issuing stock to fund acquisitions:

“Finally, a word should be said about the “double whammy” effect upon owners of the acquiring company when value-diluting stock issuances occur. Under such circumstances, the first blow is the loss of intrinsic business value that occurs through the merger itself. The second is the downward revision in market valuation that, quite rationally, is given to that now-diluted business value. For current and prospective owners understandably will not pay as much for assets lodged in the hands of a management that has a record of wealth-destruction through unintelligent share issuances as they will pay for assets entrusted to a management with precisely equal operating talents, but a known distaste for anti-owner actions. Once management shows itself insensitive to the interests of owners, shareholders will suffer a long time from the price/value ratio afforded their stock (relative to other stocks), no matter what assurances management gives that the value-diluting action taken was a one-of-a-kind event.”

Next, Buffett writes about overpaying for acquisitions:

“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

For investors, the best way to avoid these problems is to carefully analyze the valuation and funding scheme of any acquisitions made by portfolio companies. Stocks that consistently issue stock or overpay for their acquisitions likely have no place in the portfolios of the intelligent investor.

Principle 9:   Only Retain Earnings When You Can Generate Positive Returns

“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.”
– Berkshire Hathaway 2013 Annual Report, page 105

A company should only retain and reinvest earnings if they can generate returns greater than paying out earnings in the form of dividends or repurchasing shares.  Retaining earnings for the sake of building a cash hoard and nothing else does not maximize shareholder value.

To be more specific, there are two cases when it makes a great deal of sense to retain earnings. The first is when a company persistently trades at a premium to its book value. Said another way, it makes sense to retain earnings when a company’s price-to-book ratio is consistently above 1.0.

This is because every $1 in retained cash automatically becomes worth more than $1 on the stock market. Every dollar the company earns creates more than one dollar of shareholder wealth.

The second test that tells a company that it should be retaining earnings is when its annualized gains in book value exceed some easily-accessible investment benchmark like the S&P 500. The logic here is shareholders can easily invest in the S&P 500 through a passive ETF, so if the company cannot match this performance then it should deliver capital to shareholders and allow them to do just that.

These two tests should not be applied over short periods of time. Instead, Buffett recommends a five-year test:

“The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.”

If a company passes these tests and retains earnings (or, conversely, fails these tests and distributes earnings) then it is operating with its shareholders best interests in mind and stockholders should be rewarded accordingly.

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Principle 10:  Only Issue New Shares if they Are Fairly Valued Or Overvalued

“We will issue common stock only when we receive as much in business value as we give.”
Berkshire Hathaway 2013 Annual Report, page 105

Earlier in this analysis, we speak about the perils of shareholder dilution. An increasing number of shares outstanding reduces each investor’s fractional share of business profits and assets unless the rising share count is met with an even faster increase in earnings and book value.

It’s important to understand that the impact of dilution is price-dependent. If a company issues shares when they are undervalued, it is actively destroying shareholder value.  Issuing shares when a company’s stock is overvalued is an excellent way to build shareholder value as management can reinvest proceeds into fairly valued or undervalued investment options. Essentially, management can play on the arbitrage between intrinsic value and market value, creating value in the process.

Principle 11:  Never Sell Good A Good Business

“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.”
Berkshire Hathaway 2013 Annual Report, pages 105 and 106

Warren Buffett is famous for his ability to buy a stock and hold it for decades without selling.  When a company is generating positive cash flows for you, it is often better to take the cash flows you are getting than selling and buying a different stock or business.

Here are a few other Warren Buffett quotes that illustrate this belief nicely:

“Inactivity strikes us as intelligent behavior. Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve’s discount rate was predicted or because some Wall Street pundit had reversed his views on the market.”

Berkshire Hathaway 1996 Annual Report

Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings.

Berkshire Hathaway 1990 Annual Report

Buffett’s business partner Charlie Munger (who is also an excellent investor in his own right) echoes these beliefs. Here are three quotes from Munger on long-term investing:

“The big money is not in the buying and the selling…but in the waiting.”

“It is occasionally possible for a tortoise, content to assimilate proven insights of his best predecessors, to outrun hares that seek originality or don’t wish to be left out of some crowd folly that ignores the best work of the past. This happens as the tortoise stumbles on some particularly effective way to apply the best previous work, or simply avoids standard calamities. We try more to profit from always remembering the obvious than from grasping the esoteric. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” [emphasis ours]

“We’re partial to putting out large amounts of money where we won’t have to make another decision. If you buy something because it’s undervalued, then you have to think about selling it when it approaches your calculation of its intrinsic value. That’s hard. But if you buy a few great companies, then you can sit on your ass. That’s a good thing.”

It’s not hard to see why a long-term investing strategy is practiced by both of these super-investors. There are many benefits to being a long-term investor.

When you buy and sell, you incur frictional costs including brokerage fees, price slippage, and taxes, not to mention lost time and wasted emerging fretting over which holdings to sell and which to buy.  A simple buy and hold strategy leads to lower costs and much less second-guessing and worrying.

Principle 12:  Inform Your Shareholders, Don’t Mislead Them

“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.”
Berkshire Hathaway 2013 Annual Report, page 106

Principle 12 is similar to Principle 6.

The corporate officers of publicly traded companies should not mislead their shareholders.  Rather, they should inform shareholders of both positive and negative events in the business in order to paint the most accurate picture possible.  A management that deliberately misleads its shareholders wastes time and effort on ‘bending the truth’; energy that should be focused on maximizing shareholder value.  If a top executive has proven to be less than truthful, there is no telling what other skeletons there are in the corporate closet (hopefully not literal skeletons) that have not yet come to light.

rinciple 13:  Don’t Give Competitors Your Best Ideas

“Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas.”
Berkshire Hathaway 2013 Annual Report, page 106

Principles 6 and 12 discuss being candid with shareholders.  Principle 13 explains the limits of this candor.

Managers should tell shareholders the philosophy and guiding rules that will dictate future company growth, but not the exact and specific details.  Otherwise, competitors may copy a company’s unique competitive edge.

Principle 14:  It’s As Bad For Your Stock  Be Overvalued As It Is To Be Undervalued

“Our it’s-as-bad-to-be-overvalued-as-to-be-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.”
– Berkshire Hathaway 2013 Annual Report, page 106

An overvalued stock attracts the wrong kind of investors. Warren Buffett looks for shareholders that share his long-term approach to investing; shareholders that will buy when the stock is at fair value or better and hold to realize the long-term intrinsic growth in the company.  A stock that is highly overvalued entices shareholders looking for quick gains, or who do not act rationally.  Neither shareholder is likely to stick around for the long-run.

Principle 15:  Long-Term Value Growth Should Outpace the S&P 500

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?
– Berkshire Hathaway 2013 Annual Report, page 106

The long-term per share intrinsic value of a business should grow faster than the S&P 500 over a several year period.  If not, investors are better off putting their money into low-cost index funds rather than investing within a specific corporation.

Distilling the 15 Principles

I believe the core of Warren Buffett’s 15 owner related principles can be expressed succinctly in the following sentence:

Look for a management team that seeks to maximize long-term per share intrinsic value that is operating a high-quality business that treats shareholders as business owners.

Rational long-term investors should look for the following when purchasing fractional ownership in a business (stock investing):

  1. High-quality business with strong competitive advantage
  2. Management that does not take excessive risks
  3. Management that places emphasis on shareholder value
  4. Management skilled in capital allocation
  5. Management that seeks to maximize per share intrinsic value

Final Thoughts

These characteristics are actually quite difficult to find.  There are very few truly high-quality businesses that can withstand the test of time and grow per-share intrinsic value for decades.  Finding a management team that places shareholder interests first is also not easy.

When an investor does find the rare combination of a great business and a great management team, all that is left to do is buy and hold.  The business and management team will compound investor wealth as it grows intrinsic value on a per-share basis year after year.

Additional Resources & Sources

If you enjoyed this article, the following Sure Dividend articles will also prove beneficial:

You can also access more information from Warren Buffett himself by using the following resources:

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