In 1962, Warren Buffett penned a letter to the editor of financial magazine Barron’s Following an article the paper had recently run on publicly traded real estate companies. In the letter, Buffett attacks these businesses for their “Advanced accounting techniques,” which were being used to boost income and justify higher valuations.
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“An item fully as important as the lack of quantitative coverage of dividends may well turn out to be the dubious quality of the income of many of these companies,” Buffett writes. “Where it is somewhat difficult in many cases to determine this quality” he continues, “there are certain known instances which literally shout for disclosure, and I think there is a reason to believe that continued probing would develop still more instances.”
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He goes on to give the example of one real estate company, Kratter Corp, which came to the market in 1961 and had some dubious items on its balance sheet and income statement. For example, Buffett highlights one transaction with a Brewing Company whereby the real estate company purchased 140,000 containers for $2.8 million and then leased these containers back to the brewery at an annual rate of $710,000 per annum for five years. “What this really amounted to, of course, was a financing transaction for the brewing company,” Buffett writes.
However, when blended with other operating income, this income appears to be the same quality of that received from property, although it's not. "Therefore, if the Casual stockholder takes $710,000 and capitalizes it at 9%, he immediately attributes a value of almost $8 million to something which initially only had a value of $2.8 million.” A similar transaction involving "various machines" was producing $153,000 of income on a $660,000 asset, an unsustainably high rate of return:
“This Sort of transaction is very similar to buying a royalty on a short-lived oil well. If the gross receipts are spent each year, one soon finds out that the capital is not self-replacing. To ignore the Amortisation or depreciation on such transactions is dubious, if not fraudulent.”
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