In part I of this post, I talked at a basic level about the factors that seem to me to have enabled the financial success of Warren Buffett and Berkshire Hathaway, and the value of his annual letters to stockholders, and their amalgamation in Larry Cunningham’s The Essays of Warren Buffett, now in its third edition. In examining Buffettonian business principles through those letters, however, it is good to remember that among his many talents has always been an uncanny ability to recognize how his comments will be perceived by different audiences, combined with an acute sensitivity to those audiences (in this regard, he has sometimes been regarded as differing somewhat from his partner, Charlie Munger).
The audience for the letters of Warren Buffett (as he is well aware) is not limited to the stockholders of Berkshire Hathaway. The audience also includes other investors and market participants, the managers and other employees of Berkshire and its many subsidiaries, the owners of businesses who might one day want to sell to Berkshire, the regulators and other government officials who can affect the business, its competitors, the news media and others. Inevitably, then, some part of the content of the letters is intended for those non-stockholder audiences.
To take a simple example, the letters have at times referred to a given operation’s return on book value, in the process of praising the operation’s management for above-market returns. (Always naming the managers involved: “Praise by name, criticize by category.” A maxim breached only, to my recollection, by a reference to Ivan Boesky.) It is fairly apparent that Warren Buffett would not seriously suggest that an appropriate measure of an entity’s worth is book value. There are simply too many ways and too many circumstances in which book value will understate, and often substantially understate, actual worth. (Where is the value of the moat to be found on a balance sheet, except in the case of goodwill for a recently-acquired enterprise? Warren himself notes this—see page 224 in the Essays, for example—whenever he talks about the more rational, if less precise, intrinsic value of an enterprise.) And by virtue of the necessity of recognizing impairment charges book value should be far more likely to understate than to overstate intrinsic value. In consequence, an organization’s return, as measured by return on book value, will often overstate the performance of its managers, but in the pattern of Berkshire Hathaway, to overstate the contribution of managers does little or no harm to stockholders, and may provide a little more job satisfaction, a little more incentive, etc., to the managers involved.
I do not mean to suggest that Warren Buffett would mislead his partner-stockholders—far from it. That he would avoid like the plague. In the first place, it’s simply not in his nature. In the second place (as if a second place were needed) he would immediately realize that misrepresentations would likely be discovered and the reputation he has worked so assiduously to maintain and enhance would be undermined. But he would, and does, introduce relatively harmless error from time to time when doing so is in one way or another to the longer term benefit of Berkshire Hathaway. I rather think he expects his stockholders to be able to recognize such excursions and treat them accordingly. It’s worth recognizing, though, that if in the course of reading the letters, or the Essays, there comes a point when one finds oneself scratching one’s head and saying “that can’t be right,” there is at least a possibility that it isn’t quite right, and was written for a different audience. Of course, it’s also possible that it is right, and that one just didn’t understand. It is quite unlikely to be the case that Warren didn’t understand.
It’s an interesting question whether the change in Berkshire’s stockholder body over the last several years has changed the nature of the annual letters (I would guess not—they have always been written to be understood by everyman). If there have been such changes, that is the kind of nuance that is necessarily lost in the deconstruct-and-reconstruct process of putting together the Essays. Read More