12 Experts Explain The Secret To Buffett’s Success.

12 Experts Explain The Secret To Buffett’s Success. 

If you’re interested in finance, trying to crack the secret of Warren Buffett‘s success is as entertaining as it is maddening — an enticing Rubik’s cube for anyone looking to get rich. Buffett’s success is so elusive — and so far, unreplicated — that it took a team of Yale academics to determine the Oracle of Omaha does not owe his $73 billion fortune to magic.

“Buffett’s returns appear to be neither luck nor magic,” found a 2013 research paper published on Yale’s website, which boiled down Buffett’s actual secret sauce to “reward for use of leverage combined with a focus on cheap, safe, quality stocks.” (Not-so-secret, really: Buffett admitted to this strategy more than 30 years ago.)

Still, if asked to explain the source of his “alpha,” Buffett is as divided as his devotees — at times shmaltzy (“I found what I love to do very early”), other times coy (“You can’t produce a baby in one month by getting nine women pregnant”) and more often than not, completely blunt: “‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

We interviewed some of America’s biggest money experts, and threw them a gauntlet: Tell us the secret to Warren Buffett’s success.

Here’s how they explained the Oracle’s track record.

12 Experts on Why Warren Buffett Is Successful

1. His No. 1 focus is growing his wealth

According to Brandon Turner, real estate investor and co-host of “BiggerPockets Podcast,” Buffett has a single-track mind — and that’s worked well for him.

“I think Warren Buffett succeeded because he focused 100 percent on growing wealth above all other things,” Turner said. “He made it a point to continue his education his entire life and stick to sound business principles.“

2. He invests in businesses that aren’t competitive

“Warren Buffett identifies companies that generally don’t face an enormous amount of competition, and holds them for years — or forever,” said Clark Howard, a consumer expert and host of “The Clark Howard Show.” “His failures have tended to be in businesses that were too competitive.”

3. He doesn’t scare easy

Andrew Horowitz, CFP, author and host of “The Disciplined Investor,” told us Buffett owes his wealth to one factor: “Time. He has a holding period that appears to be infinite so he does not get spooked by market moves. He also knows that the best time to buy is when everyone else is selling.“

4. He doesn’t let his ego get in the way

Journalist Emma Johnson, host of “Like a Mother with Emma Johnson,” mentioned Buffett’s famous penchant for value investing — but said his real X-factor was his personality.

“As an investor, Buffett’s success is well-documented — he buys easy-to-understand companies with reasonable management and an intrinsic value. So easy, anyone can understand it,” Johnson said. “But Buffett’s success as a beloved public character is the real magic. We can attribute that to his humble persona: We love him for his habits that include banjo-playing, cheeseburger devotion and that he has lived in the same, relatively modest house in not-so-glamorous Omaha for 55 years. That he is self-made and earned 99 percent of his wealth after age 50 inspires us to believe that success is possible for all of us, and his adherence to a modest life of family and charity are great lessons on wealth that apply to us all. He’s both fabulous and accessible, and we love him for it.”

5. He takes advantage of a simple and age-old combination

Buffett uses a straightforward formula that pays off for anyone who gives it the time, said John Lee Dumas, founder and host of the podcast “Entrepreneur On Fire“: “Compound interest plus patience .”

6. He sticks to what he knows

“I don’t know much about Warren Buffett other than I’ve heard that he invests in what he ‘knows‘ and/or has ‘learned,'” said Matt Theriault, host of the podcast “Epic Real Estate Investing.” “In my experience, with the right education and information backing investment decisions, most people would be a success.“

7. He’s aggressively anti-stupid

According to Stephen Dubner, co-author of the best-selling “Freakonomics” series and host of “Freakonomics Radio,” Buffett has an unerring sense for what is just plain dumb.

8. He tries to be the best at one thing

Buffett focuses all his energy in one place, according to Laura Adams, a personal finance expert and host of “Money Girl.”

“Buffet’s success seems to come from passion for his work, good mentors early in his career, and striving to be the best at one thing — his consistent knack for identifying undervalued companies to invest in,” she said.

9. He thinks years in the future

Most investors are too short-sighted, Chris Hill, host of “Motley Fool Money,” told us.

“While many on Wall Street are thinking about the next quarter, Warren Buffett is thinking about the next five, ten, and twenty years,” he said. “That may seem like a small thing, but it is a radical departure from the short-term mindset that drives so much trading activity. It’s also why Buffett is the greatest investor we will ever see in our lifetimes.“

10. His investments are diversified and long-term

“He has said it many times: He invests only in things he understands (relying on his common sense, which we all have), he doesn’t put too much of his money into any one investment (called diversification), and his holding period is “forever” (called a long-term approach),” said Ric Edelman, chairman and CEO of Edelman Financial Services, and host of “The Truth About Money with Ric Edelman.” “The best part is that anyone can replicate the strategy used by Warren — and since it made him the world’s most successful investor, we all can become financially successful, too!“

11. He plays the No. 1 game for investors

When Robert Kiyosaki — inveterate investor and founder of “Rich Dad Radio Show” — was young, he learned about business and money by playing Monopoly.

Apparently, the Oracle of Omaha invests like he’s played the game a couple times himself. “He, too, plays the game of Monopoly in real life,” Kiyosaki told us.

12. He’s a “go-giver”

Farnoosh Torabi, financial strategist, author, and host of “So Money with Farnoosh Torabi,” told us Buffett’s truly outstanding factor is his largesse.

“He’s a go-giver,” she said. “He’s incredibly philanthropic and I’ve discovered from countless interviews with some of the most successful people on the planet that being a giving person with your money, time, ideas yields abundance in your life. Warren, consistently ranked as one of the world’s wealthiest individuals, has pledged to give away 99 percent of his fortune. That’s outstanding.”

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Trying to crack the secret of Warren Buffett's Success - use of leverage combined with a focus on cheap, safe, quality stocks.

According to Forbes' latest list of worldwide billionaires, Warren Buffett is worth more than $50 billion.

The octogenarian’s massive fortune was built through Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B), the company he’s been a controlling shareholder of since 1965. Since that time, Berkshire’s stock has appreciated nearly 600,000% (no, that’s not a typo!) versus 7,400% for the S&P 500 index.

At that rate of return, a $1,000 investment in Berkshire would have become roughly $6 million.

Much of the success at Berkshire has been driven by Buffett’s uncanny skill as an investor. During his career as CEO, he’s made billions for the company and its investors by buying top-notch companies like American Express (NYSE: AXP) and Coca-Cola (NYSE: KO) and holding the stocks for decades.

There’s a lot we can learn from Buffett

Fortunately, not only has Buffett been one of the most effective CEOs of the modern age, he’s also been one of the most transparent. For Berkshire, each year is capped by a letter to shareholders from Buffett that not only details the company’s results, but teaches readers general investing lessons in Buffett’s down-to-earth, folksy style. Outside of those letters, Buffett is also known for delivering some of the all-time most concise, elucidating quips about investing.


Ref:

Warren Buffett's Greatest Wisdom

Warren Buffett: Why stocks beat gold and bonds

February 9, 2012:

In an adaptation from his upcoming shareholder letter, the Oracle of Omaha explains why equities almost always beat the alternatives over time.

By Warren Buffett

FORTUNE -- Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power -- after taxes have been paid on nominal gains -- in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability -- the reasoned probability -- of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.

Investment possibilities are both many and varied. There are three major categories, however, and it's important to understand the characteristics of each. So let's survey the field.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as "safe." In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as "income."

For taxpaying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor's visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It's noteworthy that the implicit inflation "tax" was more than triple the explicit income tax that our investor probably thought of as his main burden. "In God We Trust" may be imprinted on our currency, but the hand that activates our government's printing press has been all too human.

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments -- and indeed, rates in the early 1980s did that job nicely. Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.

Warren Buffett: Your pick for Businessperson of the Year

Under today's conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.

Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain -- either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we've exploited both opportunities in the past -- and may do so again -- we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: "Bonds promoted as offering risk-free returns are now priced to deliver return-free risk."

The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer's hope that someone else -- who also knows that the assets will be forever unproductive -- will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce -- it will remain lifeless forever -- but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As "bandwagon" investors join any party, they create their own truth -- for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the "proof " delivered by the market, and the pool of buyers -- for a time -- expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: "What the wise man does in the beginning, the fool does in the end."

Today the world's gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce -- gold's price as I write this -- its value would be about $9.6 trillion. Call this cube pile A.

Let's now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world's most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today's annual production of gold command about $160 billion. Buyers -- whether jewelry and industrial users, frightened individuals, or speculators -- must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops -- and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil (XOM) will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it's likely many will still rush to gold. I'm confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard "cash is king" in late 2008, just when cash should have been deployed rather than held. Similarly, we heard "cash is trash" in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

My own preference -- and you knew this was coming -- is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola (KO), IBM (IBM), and our own See's Candy meet that double-barreled test. Certain other companies -- think of our regulated utilities, for example -- fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See's peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

Our country's businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial "cows" will live for centuries and give ever greater quantities of "milk" to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).

Berkshire's goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety -- but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we've examined. More important, it will be by far the safest.

This article is from the February 27, 2012 issue of Fortune.

http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/

http://warrenbuffettresource.wordpress.com/2012/02/14/warren-buffett-why-stocks-beat-gold-and-bonds-fortune/

WARREN BUFFETT THE BILLIONAIRE NEXT DOOR GOES GLOBAL

Buffett (2002): Three suggestions to help an investor avoid firms with management of dubious intentions.

After enthralling readers with a wonderful treatise on how good corporate governance need to be practiced at firms in his 2002 letter to shareholders, Warren Buffett rounded off the discussion with three suggestions that could go a long way in helping an investor avoid firms with management of dubious intentions. What are these suggestions and what do they imply? Let us find out.

The 3 that count

The master says,  "First, beware of companies displaying weak accounting.There is seldom just one cockroach in the kitchen." If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes.

On the second suggestion he says, "Unintelligible footnotes usually indicate untrustworthy management. If you can't understand a footnote or other managerial explanation, its usually because the CEO doesn't want you to."

And so far the final suggestion is concerned, he concludes, "Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don't advance smoothly (except, of course, in the offering books of investment bankers)."

Attention to detail

From the above suggestions, it is clear that the master is taking the age-old adage,  'Action speak louder than words', rather seriously. And why not! Since it is virtually impossible for a small investor to get access to top management on a regular basis, it becomes important that in order to unravel the latter's conduct of business; its actions need to be scrutinized closely. And what better way to do that than to go through the various filings of the company (annual reports and quarterly results) and get a first hand feel of what the management is saying and what it is doing with the company's accounts. Honest management usually does not play around with words and tries to present a realistic picture of the company. It is the one with dubious intentions that would try to insert complex footnotes and make fanciful assumptions about the company's future.

We would like to draw curtains on the master's 2002 letter to shareholders by putting up the following quote that dispels the myth that manager ought to know the future and hence predict it with great accuracy. Nothing could be further from the truth.

CEOs don't have a crystal ball

The master has said, "Charlie and I not only don't know today what our businesses will earn next year; we don't even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to 'make the numbers' will at some point be tempted to make up the numbers."

Hence, next time you come across a management that continues to give profit guidance year after year and even meets them, it is time for some alarm bells.

http://www.equitymaster.com/p-detail.asp?date=8/20/2008&story=2

Buffett (2002): The primary job of an Audit committee and the four questions the committee should ask auditors.

Buffet explained some key corporate governance policies in his 2002 letter to shareholders. After driving home his views on independent directors and their compensation, he has now turned his attention towards the audit committees that are present at every company.

Audit committees - Substance and not form

The primary job of an audit committee, says Buffett, is to make sure that the auditors divulge what they know. Hence, whenever reforms need to be introduced in this area, they have to be introduced keeping this aspect in mind. He was indeed alarmed by the growing number of accounting malpractices that happened with the firm's numbers. And he believed this would continue as long as auditors take the side of the CEO (Chief Executive Officer) or the CFO (Chief Financial Officer) and not the shareholders. Why not? So long as the auditor gets his fees and other assignments from the management, he is more likely to prepare a book that contains exactly what the management wants to read. Although a lot of the accounting jugglery may well be within the rule of the law, it nevertheless amounts to misleading investor. Hence, in order to stop such practices, it becomes important that the auditors be subject to major monetary penalties if they hide something from the minority shareholders behind the garb of accounting. And what better committee to monitor this than the audit committee itself! Buffett has also laid out four questions that the committee should ask auditors and the answers recorded and reported to shareholders. What are these four questions and what purpose will they serve? Let us find out.

The acid test
As per Buffett, these questions are -

1.  If the auditor were solely responsible for preparation of the company's financial statements, would they have in any way been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management's argument and the auditor's response should be disclosed. The audit committee should then evaluate the facts.

2.  If the auditor were an investor, would he have received - in plain English - the information essential to his understanding the company's financial performance during the reporting period?

3.  Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?

4.  Is the auditor aware of any actions - either accounting or operational - that have had the purpose and effect of moving revenues or expenses from one reporting period to another?

Toe the line or else...

Buffett goes on to add that these questions need to be asked in such a manner so that sufficient time is given to auditors and management to resolve any conflicts that arise as a result of these questions. Furthermore, he is also of the opinion that if a firm adopts these questions and makes it a rule to put them before auditors, the composition of the audit committee becomes irrelevant, an issue on which the maximum amount of time is unnecessarily spent. Finally, the purpose that these questions will serve is that it will force the auditors to officially endorse something that they would have otherwise given nod to behind the scenes. In other words, there is a strong chance that they resisting misdoings and give the true information to the shareholder.

 http://www.equitymaster.com/p-detail.asp?date=8/13/2008&story=1

Buffett (2002): Guidelines for choosing independent directors who will think for the shareholders and not against them.

We learnt how independent directors at a lot of investment partnerships have put up disastrous performance through Buffett’s 2002 letter to shareholders. Let us further go down the same letter and see what other investment wisdom he has on offer.

Of practicing and preaching

Ok, we have heard a lot about the failings of independent directors and their apathy towards shareholders. However, preaching is one thing and practicing and offering a solution is completely another. Since Buffett himself runs a company, it will be fascinating to understand the guidelines he has set forth for choosing independent directors on his company's board as well as the compensation he pays them. He has the following views to offer on the kind of 'independent' directors he would like to have on his company's board:

Buffett says, "We will select directors who have huge and true ownership interests (that is, stock that they or their family have purchased, not been given by Berkshire or received via options), expecting those interests to influence their actions to a degree that dwarfs other considerations such as prestige and board fees."

Interesting, isn't it? If a person derives most of his livelihood from a firm and if he is made a director of the firm, he is quite likely to take decisions that result in maximum value creation. While this approach may not be completely foolproof, it is indeed lot better than approaches at other firms where such a criteria is not set forth while looking for independent directors.

Furthermore, on the compensation issue, Buffett has the following to say:

"At Berkshire, wanting our fees to be meaningless to our directors, we pay them only a pittance. Additionally, not wanting to insulate our directors from any corporate disaster we might have, we don't provide them with officers' and directors' liability insurance (an unorthodoxy that, not so incidentally, has saved our shareholders many millions of dollars over the years). Basically, we want the behavior of our directors to be driven by the effect their decisions will have on their family's net worth, not by their compensation. That's the equation for Charlie and me as managers, and we think it's the right one for Berkshire directors as well."

Buffett's superb understanding of human psychology is on full display here. If a person is not behaving rationally, force him to behave rationally by smothering his options.

• First, choose those people that have a large and true ownership in a firm so that they really think of what is good and what is bad for the firm in the long run. 
• Secondly, pay them a pittance so that like other shareholders, they too derive greater portion of their income from the firm's profits and not take a higher proportion of its expense. This is also likely to pressurise them further to take decisions that are in the shareholders' interest. 

Indeed, some great lessons on how an independent director should be chosen and to ensure that he continues to think for the shareholders and not against them.

http://www.equitymaster.com/detail.asp?date=8/6/2008&story=1

Buffett (2002): "Independent" directors: How independent are they?

Warren Buffett complained about failings of independent directors in his letter to shareholders for the year 2002. Let us go further down the same letter and see what other investment wisdom he has on offer.

'Independent' directors: How independent are they?


It is a known fact that Buffett pays a great deal of attention to the management of companies before investing in them. And the reasons behind this obsession may not be difficult to find. Since it is the management that is responsible for making most of the capital allocation decisions in a business, which in turn are central for creating long-term shareholder value, it is imperative that a management allocates capital in the most rational manner possible.

However, as we saw in the last article, the list of managers or CEOs with a 'quick rich' syndrome is swelling to dangerous proportions, thus forcing shareholders to pin all their hopes on the board of a company or more importantly on the independent directors for a bail out. But as mentioned by Buffett, most independent directors (including him) on several occasions have failed in their attempt to protect the interest of shareholders owing to a variety of reasons.

After narrating his experience as an independent director, the master moves on and gives one more example where independent directors have failed miserably to protect shareholder interest. The companies under consideration are investment companies (mutual funds). The master says that directors in these companies have only two major roles, 

• that of hiring the best possible manager and 
• negotiating with him for the best possible fee. 

However, even while performing these basic duties, the independent directors have failed their shareholders and he goes on to cite a 62-year case study from which he has derived his findings.

Even in an era where shareholdings have gotten concentrated, some institutions find it difficult to make management changes necessary to create long-term shareholder value because these very institutions have been found to be sailing in the same boat i.e., neglecting shareholder value so that only a handful of people benefit. Buffett goes on to add that thankfully there have been some people at some institutions that by virtue of their voting power have forced CEOs to take rational decisions.

Let us hear in Buffett's own words, his take on the issue:

Master's golden words


Buffett says, "So that we may further see the failings of 'independence', let's look at a 62-year case study covering thousands of companies. Since 1940, federal law has mandated that a large proportion of the directors of investment companies (most of these mutual funds) be independent. The requirement was originally 40% and now it is 50%. In any case, the typical fund has long operated with a majority of directors who qualify as independent. These directors and the entire board have many perfunctory duties, but in actuality have only two important responsibilities:

• obtaining the best possible investment manager and 
• negotiating with that manager for the lowest possible fee. 

When you are seeking investment help yourself, these two goals are the only ones that count, and directors acting for other investors should have exactly the same priorities. Yet when it comes to independent directors pursuing either goal, their record has been absolutely pathetic."

On the increased ownership concentration and how certain people are forcing managers to act rational, Buffett has the following to say - "Getting rid of mediocre CEOs and eliminating overreaching by the able ones requires action by owners - big owners. The logistics aren't that tough: The ownership of stock has grown increasingly concentrated in recent decades, and today it would be easy for institutional managers to exert their will on problem situations. Twenty, or even fewer, of the largest institutions, acting together, could effectively reform corporate governance at a given company, simply by withholding their votes for directors who were tolerating odious behavior."

He goes on, in my view, this kind of concerted action is the only way that corporate stewardship can be meaningfully improved. Unfortunately, certain major investing institutions have 'glass house' problems in arguing for better governance elsewhere; they would shudder, for example, at the thought of their own performance and fees being closely inspected by their own boards. But Jack Bogle of Vanguard fame, Chris Davis of Davis Advisors, and Bill Miller of Legg Mason are now offering leadership in getting CEOs to treat their owners properly. Pension funds, as well as other fiduciaries, will reap better investment returns in the future if they support these men."

Buffett (2002): "Independent" directors must be business-savvy, interested and shareholder oriented, and who think and speak "independently".

In Warren Buffett's 2002 letter to shareholders, we got to know the master's views on derivatives and the huge risks associated with them. Let us go further down the same letter and see what other investment wisdom the master has to offer.

The demise of the good CEO?

The great bull run of the 1980s-1990s in the US also brought with it a host of corporate scandals. A lot many CEOs, in their attempt to amass wealth quickly did not think twice to do so at the expense of their shareholders. It is fine for a CEO to take home a hefty pay package if the company he heads has put up an impressive performance. But to rake in millions when the shareholders i.e., the real owners of the business get nothing or only a tiny percentage of what the CEOs earn, amounts to nothing but daylight robbery. This is of course impossible without the complicity of the board of directors, whether voluntary or forced. Sadly, these people are increasingly failing to rise to the responsibilities entrusted to them by the shareholders, allowing CEOs to get away scot-free. It is this very issue of corporate governance that the master has talked about at length in his 2002 letter to shareholders. Alarmed by the rising incidents of CEO misconduct, Buffett argues that in a room filled with well-mannered and intelligent people, it will be 'socially awkward' for any director to stand up and speak against a CEO's policies and hence he fully endorses board meetings without the presence of the CEO. Furthermore, he is also in favour of 'independent' directors provided they have three essential qualities. What are these essential qualities and why he deems them to be so important? Let us find out in the master's own words.

The master's golden words
On the nature of directors, Buffett said, "The current cry is for ‘independent’ directors. It is certainly true that it is desirable to have directors who think and speak independently - but they must also be business-savvy, interested and shareholder oriented."

He goes on to add, "In my 1993 commentary, those are the three qualities I described as essential. Over a span of 40 years, I have been on 19 public-company boards (excluding Berkshire's) and have interacted with perhaps 250 directors. Most of them were ‘independent’ as defined by today's rules. But the great majority of these directors lacked at least one of the three qualities I value. As a result, their contribution to shareholder well-being was minimal at best and, too often, negative. These people, decent and intelligent though they were, simply did not know enough about business and/or care enough about shareholders to question foolish acquisitions or egregious compensation. My own behavior, I must ruefully add, frequently fell short as well: Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders. In those cases, collegiality trumped independence."

Buffett (2000): Derivatives - Weapons of Mass Destruction

Buffett's letter for the year 2000 discussed his views on tendencies of certain CEOs to make lofty projections of their companies' future earnings potential and the risks associated with such projections. Let us now move on to accumulating wisdom from the letter for the year 2002*.

In his 2002 letter, the master has devoted a fair deal of time and space to the topic of derivatives. Infact, the master's prognosis on the risks associated with derivatives come so perilously close to describing the current US sub-prime crisis that one would be forgiven for assuming that Mr. Buffett has access to a crystal ball.

Derivatives: Devious or delightful?

Much like most of the other inventions, derivatives too, were created for the benefit of mankind in general and commerce and trade in particular. It was especially helpful to smaller firms that did not have the capacity to bear big risks. Derivatives enabled such firms to transfer some of these risks to stronger, more mature hands. But again, like most of the other inventions, derivatives can also be put to misuse. Abuse of the same, as has become more frequent these days, could lead to dire consequences. Furthermore, the very nature of a derivatives contract makes it risky to the users. This is because unless accompanied by collaterals or guarantees, the final value in a contract depends on the payment ability of the parties involved.

The master is also of the opinion that since a lot of derivatives contract don't expire for years and since they have to be provided for in a company's accounts, manipulation could become a serious threat. For e.g., incorporating overly optimistic projections into a contract that does not expire until say 2018 could lead to inflated earnings currently. However, if the projections fail to materialize, they could lead to potential losses in the future. In an era of short-term profit targets and incentives, such measures result in higher CEO salaries. But they hurt long-term shareholder value creation.

This is what the master has to say on the issue:

"Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on "earnings" calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and "mark-to-model" is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions."

He further goes on to add "The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth."

Highlighting other dangers of derivatives, the master finally goes on to say something that if central banks around the world, importantly the US Fed, would have paid proper heed to, it could have been probably able to avert or maybe minimize the enormous damage that is being caused by the US sub-prime crisis.

We conclude the article with the reproduction of that comment.

Weapons of mass destruction

The master says, "The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts."

Buffett (2000): The risks associated with the twin issues of CEO's lofty projections and sustainable long-term profit growth.

Warren Buffett talked about wealth transfers to greedy promoters during IPOs in the letter for the year 2000. Let us go further down the same letter and see what other investment wisdom the master has to offer.

The master's macro bet

Usually, Buffett refrains from making precise comments about the future especially at the macro level. But if he is willing to bet a large sum on the likeliness of an event happening, then indeed we must sit up and take notice. In the letter for the year 2000, the master has made one such prediction and was willing to bet a large sum on it. The prediction was about the magnitude of growth in profits that would take place among the 200 most profitable companies in the US at that time. Since the master does not believe in short term predictions, the time horizon that was assumed was ten years.

The CEO with a crystal ball

The letter for the year 2000 came out at a time when the practice of a CEO predicting the growth rate of his company publicly was becoming commonplace. Although Buffett did not have an issue with a CEO setting internal goals and even making public some broad assumptions with proper warnings thrown in, it did annoy him when CEOs started making lofty assumptions about future profit growth.

This is because the likelihood of the CEO meeting his aggressive targets year after year on a consistent basis and well into the future was very low and hence this amounted to misleading the investors. After having spent decades researching and analyzing companies, the master had come to the conclusion that there are indeed a very small number of large businesses that could grow its per share earnings by 15% annually over a period of 10 years. Infact, as mentioned in the above paragraph, the master was even willing a bet a large sum on it.

The reasons may not be difficult to find. In free markets, the intensity of competition is so high that it is very difficult for profitable players to maintain high growth rates for consistently long periods of time. Unless the business is endowed with some extremely strong competitive advantages, competition is likely to nibble away at its market share and cut into its profit margins, thus making high growth rates difficult.

Let us hear in the master's own words his take on the twin issues of

• CEO's lofty projections and 
• sustainable long-term profit growth.

The golden words

"Charlie and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble."

He further adds, "It's fine for a CEO to have his own internal goals and, in our view, it's even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble."

The master reasons, "That's true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here's a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years."

Adding further, the master says, "The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to "make the numbers." These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more "heroic." These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)"

Buffett (2000): IPOs usually result in transfer of wealth and that too on a massive scale from the ignorant shareholders to greedy promoters.

In Warren Buffett's letter for the year 2000, he talked about how investors, in their irrational exuberance, tend to gravitate more and more towards speculation rather than investment. Let us go further down the same letter and see what other investment wisdom he has to offer.

IPO – It’s Probably Overpriced

If it is out there in the corporate world, it has to be in the master's annual letters. Over the years, Mr. Buffett has done an excellent job of giving his own unique perspective of the happenings in the business world. Whatever be the flavour of the season, you can rest assured that it will be covered in the master's letters. Since the letter for the year 2000 was preceded by the famous 'dotcom bubble' and the flurry of IPOs associated with it, the master has spent a fair deal of time in trying to give his opinion on the same. And as with other gems from his larder of wisdom, strict adherence here too could do investors a world of good.

On IPOs, the master goes on to say that while he has no issues with the ones that create wealth for shareholders, unfortunately that was not the case with quite a few of them that hit the markets during the dotcom boom. Unlike trading in the stock markets, IPOs usually result in transfer of wealth and that too on a massive scale from the ignorant shareholders to greedy promoters. The master feels so because taking advantage of the good sentiments prevailing in the markets, a lot of owners put their company on the blocks not only at expensive valuations that leave little upside for shareholders but most of these companies end up destroying shareholder wealth.

Hence, while investing in IPOs, two things need to be closely tracked. 

• One, the issue is not priced at exorbitant valuation and 
• second, the company under consideration does have a good track record of creating shareholder wealth over a sustained period of time. 

Thus, if an IPO is only trying to sell you promises and nothing else, chances are that you are playing a small role in making the promoter, Mr. Money Bags.

Master's golden words

Let us hear in the master's own words his take on the issue. He says, "We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get."

He further adds, "What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company's promoters. At bottom, the ‘business model’ for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen."

To conclude, the master says, "But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: 

• First, many in Wall Street - a community in which quality control is not prized - will sell investors anything they will buy. 
• Second, speculation is most dangerous when it looks easiest."

Buffett (2000): Discounted cash flow approach to valuations is the single most important tool in valuing assets of any kind. 'A bird in the hand is worth two in the bush.'

Warren Buffett described his reluctance to invest in tech stocks and the key reasons behind the same (in his 1999 letter to shareholders). Let us move further to the next year and see what the master has to offer in terms of investment wisdom at the turn of the millennium i.e., in his letter from the year 2000.

Buffett's acquisition spree

The year 2000 was the year that could easily go down in Berkshire's history as the ‘year of acquisitions’. Sensing favorable market conditions, the master completed two transactions that were initiated in 1999 and bought another six businesses during 2000, taking the total to eight. This steady stream of acquisitions is perhaps what inspired him to once again bring his theory of valuations out from the closet and present it before his shareholders. However, while the underlying principles of his theory remained the same, it came cloaked in a different analogy.

What Aesop taught Buffett?

This time, the master has turned to Aesop for help and likens the process of performing valuations to his famous saying - 'a bird in the hand is worth two in the bush'. Without getting too much into details, suffice to say that the master reaffirms his faith in the discounted cash flow approach to valuations and believes it to be the single most important tool in valuing assets of any kind, right from stocks to as exotic assets as royalties and lottery tickets.

Let us read the master's own words on his thoughts -

"The formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.)."

"The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush’. To flesh out this principle, you must answer only three questions. 

• How certain are you that there are indeed birds in the bush? 
• When will they emerge and how many will there be? 
• What is the risk-free interest rate (which we consider to be the yield on long-term US bonds)? 

If you can answer these three questions, you will know the maximum value of the bush 3/4 and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars."

"Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota 3/4 nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe."