This is third in the series of articles about my learnings from Warren Buffet’s annual letters to Berkshire Hathaway. Read Part 1 and Part 2 here.
Business Performance
- It is comforting to be a in a business where some mistakes can be made yet satisfactory performance can be achieved as opposed to a few businesses where even good management will suffer
- With a few exceptions, when a management with reputation for brilliance tackles a business with reputation for poor economics, it is the reputation of business that remains intact.
- If there is excess production capacity in an industry, the prices tend to reflect operating costs rather than capital employed
- The primary test of managerial economic performance is the achievement of a high earnings rate on equity economic capital without undue leverage and accounting gimmickry
- be achieved by a business in order to produce real return to individual shareholders- increases dramatically with high rates of inflation, often making much corporate investment unwise.
- The true test of a truly outstanding business :
- business earnings must consistently increase in proportion to the increase in price levels without any addition of new capital
- Ability to effect price increases even when the demand is flat with no fear of loss of market share
- When pace of economic change is great, investors and managers should consistently revisit their historic business valuation yard sticks. When pace of change is slow, the same approach can be counter productive
- Action on the liability side should be taken sometime independent of action on asset side
- The profitability of a business is determined by
- What its assets earn
- What its liabilities cost
- What is its utilization of leverage
- A great economic franchise arises from a product or a service that is
- Needed or desired
- Thought by customers to have no close substitute
- Not subjected to price regulation
- Retailing is a tough business to be in. Retailers need to be smart day after day, when competition is close on heels and shoppers are beckoned by countless choices.
- There are 3 kinds of businesses
- Great Businesses with ever increasing stream of stable earnings with no need for incremental capital
- Good Businesses with sound economics but require significant reinvestment of earnings
- Bad Businesses that grow rapidly, require significant capital and lead to little or no money
- Evaluate ‘Moat’ that a business has – a metaphor for the superiorities they possesses to make life difficult for competition
Management
- Incentive plans should be
- Tailored to the economics of specific business
- Simple in character and easy to measure
- Directly related to the daily activities of plan participants
- Managers should run business as though
- They own 100% of it
- It is the only asset owned by them and their family
- They can’t sell or merge it
- In selecting a new director be guided by
- Board members need to be owner oriented
- Business savvy
- Interested
- Truly Independent
- Rationality of managers is often taken over by institutional dynamics, which can often be misguided
- When investing is new projects, it is important to measure if every $ invested generates more than a $ of value over a horizon. Earnings pressures can sometimes thwart good projects.