Mergers and acquisitions back with a bang

STUART WASHINGTON

April 17, 2010

AFTER sharemarkets plummeted in 2008 and the world was on the precipice of a global economic disaster, US Federal Reserve governors used the word ''panic''.

Fast forward 18 months and the Australian corporate landscape has shifted with a rapidity that has surprised even the most seasoned market watchers.

This week the ASX 200 topped 5000 amid evidence Australia's mergers-and-acquisition market has reignited.

Macarthur Coal juggles three suitors. AXA is being stalked by two camps of would-be buyers. One of those buyers, AMP with $13.4 billion market capitalisation, is frequently named as being in the cross-hairs of a takeover itself.

Thomson Reuters data shows announced takeovers reached $US28.8 billion ($A30.8 billion) for the first quarter of 2010, pushing the year-to-date levels back towards boom-time peaks last experienced through 2007.

''I think it is more likely to be part of a longer wave,'' says David Cassidy, an equity strategist at broking firm UBS.

''Cyclical'' is how Cassidy describes a corporate world that moved from instances of insane levels of debt in 2006 and 2007 to very real questions about survival in 2008 and a slew of desperate capital raisings in 2009.

But a sharp recovery in Australia's economic fortunes has the sharemarket ticking higher. Earlier this month Cassidy lifted his forecast for the ASX 200 to 5550 by year-end.

And in lockstep with a resurgent sharemarket is the prospect of a return to heady levels of mergers-and-acquisitions.

UBS nominates sharemarket operator ASX, financial services business Suncorp Metway, Australian energy-and-power business AWE, Bank of Queensland, media buyer Mitchell Group, technology play Redflex and New Zealand casino Sky City as its top likely targets.

The wave of mergers-and-acquisitions shares common features with the pre-crisis boom (Cassidy singles out the absence of private equity as the most notable difference this time around).

First, many takeovers are now focused on a Chinese-led resources boom that is likely to bring high-level policy issues and low-level rabble rousing as China's interest in Australian assets continues.

''China is now Australia's largest trading partner. Just like the Japanese in the '80s, China is now looking to rapidly integrate vertically across the supply chain,'' says Tony O'Sullivan, an investment banker with boutique advisory firm O'Sullivan Partners.

Second, in common with the pre-crisis boom, retail shareholders will face the significant question - should I stay or should I go? - when they find themselves caught up in a bidding war.

Academic literature points to several indicators retail shareholders can look to as they decide whether the day their company announces its intention to buy another company is as good as it gets.

Third, the resurgence also has in common with the pre-crisis boom the often overlooked reality: it too will end.

First, how did we get back to investment bankers spruiking deals again?

Despite signs of health in the economy, it would be easy to see merger-and-acquisition activity as vultures picking over carcasses that barely survived the crisis.

In laying the foundations for the recovery, the recapitalisations throughout 2009 was a central plank, raising more than $US60 billion in equity to restore overstretched balance sheets across the Australian public market.

In Cassidy's view the recapitalisation was the building block that means merger and acquisition activity is more than a ''dead cat'' bounce.

Cassidy cites interest on loans faced by industrial companies of about 20 per cent of available cash before the capital raisings, falling to about 10 per cent of available cash after the capital raisings.

Just like a home loan, the more cash you have after you have met your interest bill, the more there is to spend.

''The cycle has swung back in the opposite direction very quickly,'' says Cassidy. ''Two things happened; they raised equity … and the second leg, that's the profits kicking up.''

The result is a lot of cash on the balance sheet available for - you guessed it - mergers and acquisitions.

The asperity with which investment bankers are ringing the bell for mergers and acquisitions, after taking at least $1 billion in fees from the wave or recapitalisations, has not gone unremarked. ''So in four financial years the (investment bank) advice has been 'maximise gearing', 'minimise gearing', and now 're-gear for M&A','' Charlie Aitken, an analyst with broker Southern Cross Equities, wrote in his April 7 newsletter.

''The only winner from that series of advice would be the investment banks themselves.''

But he adds: ''Trust me, the investment banks and their new M&A push will get an audience. Many Australian boards will sit around and say, 'Yes, the world is getting better and we have a good balance sheet, we need to do something'.''

O'Sullivan makes a similar point: ''M&A is incredibly sentiment driven. Every time a chairman and chief executive officer opens the paper and sees a bold move, it gives them the confidence and courage to think about their own business.''

O'Sullivan sees the return of the cycle in mergers and acquisitions being spurred by the demand for resources from the emerging middle classes in India and China.

And he predicts continuing demand for Australia's resources will raise profound policy considerations for Australia similar to the period in the 1980s when it was feared Japan would come to control significant assets within Australia.

He said that to date the Chinese had shown sophistication in avoiding Vegemite-style iconic assets, unlike the disproportionate Japanese interest in Gold Coast real estate.

''The fear, if people like Kevin Rudd have any fear at all, would be we wake up one day and a lot of our minerals have been hollowed out and so [affect] our wealth as a nation,'' he said.

And he said it could be a case for the federal government to rethink ownership structures for Australian resources, moving from a leasehold arrangement rather than outright ownership.

HOW investors should think about mergers and acquisitions has been informed by detailed academic research. US research has shown that acquirers, on average, tend to lose out in takeovers.

The most cited research on the negative experience in US takeovers, by Sara Moeller, Frederik Schlingemann and Rene Stulz, studied 12,000 takeovers of more than $US1 million between 1980 and 2001.

The research found, on average, acquiring firms lost $US25 million of value when a takeover was announced, with problems in acquisitions most pronounced in large company takeovers.

These losses on announcement of activity were long-lasting and were not reversed.

The research found large companies were more likely to offer larger premiums than small companies and also enter transactions where there were no synergy gains.

The research supported as the major reason for these failures the hubris, or overconfidence, among managers in large bidding companies.

Dr Ronan Powell, a senior lecturer in banking and finance with the University of New South Wales' Australian School of Business, said research had repeatedly shown the importance of the initial market reaction in assessing the likely success or failure of a takeover.

The US paper notes: ''The market seems fairly efficient in incorporating the information conveyed by acquisition announcements in the stock price.''

Powell says this ability of the market to judge a takeover accurately means a negative reaction for the acquirer should be a warning for both managers and the company's investors to think again.

And he says a management determined to conclude a negatively received deal indicated a willingness of management to act in its own interests, rather than those of shareholders.

''If it's negative [reaction to a takeover], as a manager you should be questioning this deal,'' he says. ''It's a good way to pick out the really entrenched managers, the ones who say they don't care what the market thinks.''

(As an example, investors need only think of the negative market reaction when Allco announced the purchase of Rubicon in October 2007. The acquisition heralded the end of Allco.)

Powell offers an additional checklist of takeover characteristics that lead to positive outcomes for acquirers, based on research.

- A strong rationale for the acquisition as a strategic necessity rather than overconfident empire-building.

- An acquirer using its shares as acquisition ''currency'' can signal that management believes its shares are overvalued. Think of AOL's takeover of Time Warner; AOL's shareholders would have been best off if they sold the moment the deal was announced.

- A takeover of a listed company rather than a private company is much more likely to result in the acquirer paying too much.

Powell and his student Mark Humphery issued an Australian Business School working paper in January that found the overall Australian takeover experience was significantly better than the US experience.

Their study of 1900 Australian acquisitions between 1993 and 2007 found a net gain to acquirers on takeover announcements of an average of $8 million. The Australian research also found, unsurprisingly, strong links between the company's previous operating performance and its operating performance after a takeover.

There was also a strong link showing the higher the premium paid, the better the operating performance after the takeover.

Of course, the maths are much simpler for investors in a target company considering a takeover offer.

''Obviously the general rule is, if I'm a retail investor … give me a control premium,'' Powell says.

Boutique investment advisory firm Greenhill Caliburn chairman Peter Hunt offers a note of caution on the overall return to economic good times, with recent history underlining how participants and investors should scrutinise potential downsides of any acquisition.

''We should have learnt there's a big risk this (crisis) will happen again because of the speed of the markets and the volatility of the markets and the tendency towards greed at the end of the cycle,'' he says.

''While the politicians and the regulators have talked about the need to stop it happening again, it's not clear to me yet that they will actually do anything meaningful to stop it happening again.''

Announced mergers and acquisitions

Year ending first quarter Value
2006 $95bn
2007 $221bn
2008 $179bn
2009 $113bn
2010 $144bn

ANNOUNCED DEALS, FIRST QUARTER 2010

 SOURCE: THOMSON REUTERS

Target Acquirer Value
AXA Asia Pacific National Australia Bank $6.6bn
Macarthur Coal Peabody Energy $3.7bn
Arrow Energy Investor Group $3.1bn
AXA Asia Pacific (offshore) AXA SA $2bn
WesTrac Seven Network $1.8bn

Source: The Age

http://www.smh.com.au/business/mergers-and-acquisitions-back-with-a-bang-20100416-skms.html

Director who engaged in insider trading walks free

LEONIE WOOD

April 17, 2010

JOHN Francis O'Reilly, a former director who pleaded guilty to insider trading, has averted jail after a judge said the businessman's judgment was ''clouded'' at the time and the nature and value of the shares he traded did not mark the offence as particularly serious.

In sentencing O'Reilly, Justice Terry Forrest of the Victorian Supreme Court said the former Lion Selection director had obtained only a ''modest'' $29,045 profit from his purchase and sale of 50,000 Indophil Resources shares in mid-2008.

The judge said that while the most troubling aspect of O'Reilly's conduct was that he traded shares as a ''true insider'' - from inside the boardroom - he acknowledged that O'Reilly conducted only one trade and did not embark on a sustained course of trading.

O'Reilly was convicted of one count of insider trading. Justice Forrest imposed a jail sentence of 10 months and then wholly suspended the term, allowing O'Reilly to walk free. Justice Forrest said that but for the guilty plea, O'Reilly would have been sentenced to 13 months' jail and ordered to serve a minimum of five months.

O'Reilly must be of good behaviour for 18 months and pay a $500 bond. The court also imposed a $30,000 pecuniary penalty on top of the $61,600 that O'Reilly must forfeit under the Proceeds of Crime Act. O'Reilly bought $38,880 of Indophil shares in May 2008, when he was privy to confidential information as Lion negotiated to sell its 25 per cent Indophil stake to Xstrata - a move that would trigger a takeover of Indophil and send its shares higher.

''By your conduct you have misled your fellow directors, acted in contravention of Lion's security trading policy, misled your shareholders and the Australian Securities Exchange, and undermined the integrity of the securities market,'' Justice Forrest said yesterday.

He said the ''objective gravity'' of O'Reilly's offence emerged after considering that, as a director, O'Reilly was a ''true insider'', but he did not try to conceal the trading through secret or nominee accounts. This ''relative lack of sophistication'' suggested ''that your judgment was clouded at this time'', the judge said.

''Thirdly, I do not regard the nature of the trade, the amount invested or the anticipated profit as falling into a particularly grave or serious category. You did not seek to multiply your anticipated profit by choosing an exotic method of trading, nor did you invest a really large sum of money.''

Justice Forrest said he considered it a ''mid-range example of a serious offence'' and accepted O'Reilly's conduct was ''an aberration''.

Ian Ramsay, director of Melbourne University's Centre for Corporate Law and Securities Regulation, suggested the sentence appeared ''relatively modest'' considering several earlier insider trading cases had attracted jail or periodical detention sentences.

Professor Ramsay argued that the number of insider enforcement actions in Australia and the penalties tended to be ''relatively light'' compared with overseas.

''I actually think the Australian insider trading law is a mess in some respects,'' he said. In some ways it was too broad, he said, adding: ''You could be an insider by picking up a piece of paper on Collins Street.''

And in other areas, the legislation was too proscriptive.

''What you do come to quickly, though, is the realisation that courts typically do not impose terms of imprisonment for offences under the Corporations Act,'' he said.

Source: The Age

http://www.smh.com.au/business/director-who-engaged-in-insider-trading-walks-free-20100416-skmy.html

The China bubble: don't predict, prepare

GREG HOFFMAN

April 16, 2010 - 9:42AM

Even dyed-in-the-wool, bottom-up stockpickers like me have to accept one inalienable fact; economies and markets are now so interconnected as to be systemically linked; a problem in one area of the system rapidly moves to another.

That fact does not demand predictions as to what will go wrong, when or where. But it does imply preparation for scenarios that would impact your investments. Don't predict, prepare.

For Australian investors, leveraged as we are to the China growth story, that preparation should include an assessment of how your portfolio would stand up were China's growth to slump, if only temporarily.

''Up ahead they's a thousand' lives we might live,'' counselled Ma in John Steinbeck's The Grapes of Wrath, ''but when it comes, it'll only be one.'' And so it is with our portfolios.

It's prudent not to weight your portfolio wholly towards any single possible ''life''. And, several factors are leading The Intelligent Investor's analysts to recommend investors consider building some protection into their portfolios.

These factors include the fact that many previously unloved stocks are now back in vogue, the possibilities of China's growth slowing, inflation and the substitution of private for public debt by governments around the world.

I'd encourage you to consider your own exposure to currently fashionable cyclical stocks like One.Steel, Seek and Amcor. If you find you're a bit heavy, then it might be a reasonable time to think about re-weighting your portfolio.

Bolstering your cash balance is a great way to build capital stability and also maximise your flexibility for any future dip or downturn in the market; the proverbial financial ''dry powder''.

We're also looking to build in another layer of protection through careful re-investment. A number of top-class blue chip stocks have been left behind by those rushing back into cyclicals and some of these might make great additions to a long-term portfolio.

Current stock recommendations

Stocks such as Foster's Group, Santos and Insurance Australia Group are on our current shopping list, as are several quality stocks with significant offshore income (such as QBE Insurance and Sonic Healthcare).

These stocks offer the potential for significant gains if the Aussie dollar were to take a tumble for any reason (bear in mind that a little over a year ago, our dollar was fetching less than 70 US cents).

We also have a few carefully-selected infrastructure stocks on our buy list as well as a property developer or two. We expect the latter to provide more cyclical oomph if Australia manages to skirt any major economic setbacks from here. 

By combining a higher cash balance with a re-weighting towards less cyclical stocks, we hope to maintain a sensible equilibrium between offence (should markets continue higher) and defence. But how you react from here will be crucial.

We're now recommending investors begin changing their stance in the expectation that further gains will be much harder fought. A number of commentators seem confident that the Australian business sky is blue as far as the eye can see.

It's an increasingly fashionable idea and we've been around long enough to know that in financial markets, danger can lurk in such trendy consensus views.

Our preference is to begin buttressing our portfolios for any potential bumps in the road. Our weapons of choice are increased cash holdings and a higher weighting to more stable, defensive businesses, which currently strike us as offering better value than the more expensive and volatile cyclicals.

This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investor

http://www.smh.com.au/business/the-china-bubble-dont-predict-prepare-20100416-sif2.html

The China bubble

GREG HOFFMAN

April 12, 2010

Edward Chancellor, a member of the asset allocation team for Boston-based GMO and, interestingly, the author of a recent Financial Times piece on Australian property, is a financial historian and bubble expert.

His 1999 book, Devil Take the Hindmost: A History of Financial Speculation, examined past speculative manias. Perhaps you've read articles comparing the tech boom and 1990s' bull market to tulipmania in 1630s' Holland.

The difference is that Chancellor was making that comparison before the tech bubble burst, some years before Alan Greenspan claimed it was futile trying to predict bubbles at all.

Chancellor's timing may have been fortuitous. To accurately predict something once might mean little. To repeat the feat perhaps means something more.

His next major piece - Crunch time for credit: An enquiry into the state of the credit system in the United States and Great Britain - included this prescient paragraph:

''The growth of credit has created an illusory prosperity while producing profound imbalances in the British and American economies...When credit ceases to grow, the weakened state of these economies will become apparent.''

That report was written in 2005, years before the credit bubble burst. Chalk two up to Chancellor.

Third time lucky?

He's now turned his attention to China, a fertile ground for his fertile mind. Released last week on the GMO website, China's Red Flags is split into two parts.

Crisis checklist

Section one identifies speculative manias and financial crises, offering a checklist for those trying to identify bubbles in advance of their bursting. Chancellor offers 10 criteria for what he calls ''great investment debacles'' over the past 300 years (the report explains each in far more detail);
 1. A compelling growth story;
 2. A blind faith in the competence of authorities;
 3. A general increase in investment;
 4. A surge in corruption;
 5. Strong growth in money supply;
 6. Fixed currency regimes, often producing inappropriately low interest rates;
 7. Rampant credit growth;
 8. Moral hazard;
 9. Precarious financial structures;
 10. Rapidly rising property prices;

Although all these criteria need not be present in order for a bubble to be present, you can see where Chancellor's heading: not-so-subtly steering readers towards his own conclusion. In section two he takes each factor and applies it to the case of China.

Ponzi scheme

His conclusion is alarming; The very factors that have allowed China to grow so rapidly over the past few years despite the global slowdown - an investment boom, a credit boom, massive increases in money supply, moral hazard and risky lending practices - are all factors that investors and the mainstream press feel they can safely ignore because China is growing so rapidly.

After the past few years, we should all understand the potential negative implications of such major imbalances. But there seems to be general agreement that a ``build it and they will come'' approach is warranted in China because it keeps growing rapidly. There's a Ponzi-like element to the circularity.

Chancellor is concerned that China's high GDP growth is no longer a function of impressive natural growth. Instead, growth is being engineered to achieve high GDP numbers. It's producing a system that's unsustainable and prone to collapse.

This, in essence, is Chancellor's argument:
- Investors are adopting an uncritical attitude to China's growth forecasts;
- Because of the way local officials are incentivised, it's likely that migration of the population from country to city is much further along than the official numbers suggest. So when you hear of another 350 million internal migrants arriving in cities by 2025, many of them are actually already there;
- Hence, future productivity growth will be much more reliant on efficiency gains than urbanisation. China's record in this area isn't at all strong;
- Beijing imposes GDP growth targets on local governments. Thus, ``GDP growth is no longer the outcome of an economic process, it has become the object''. `When the allocation of resources, whether at the corporate or national level, becomes all about ``making the numbers'' then poor outcomes are to be expected';
- In 2009, Chinese fixed asset investment contributed 90% of total economic growth (an incredible statistic and a natural consequence of the previous point);
- Significant overinvestment is present in many areas. For example, capital spending in the cement industry increased by two-thirds despite capacity utilisation running at an estimated 78%;
- The efficiency of investment (incremental GDP growth for each additional unit of investment) is trending downwards towards wasteful levels;
- Interest rates have been kept way too low for decades, sparking economic growth but also imbalances and bubbles;
- China's enormous foreign exchange reserves are not necessarily a plus. As Michael Pettis pointed out recently, only two countries have previously accumulated such large foreign reserves relative to global GDP - the United States in 1929 and Japan in 1989. Oh dear;
- The Chinese stockmarket is in bubble territory. Last October, a new Nasdaq-style exchange opened in Shenzhen with 28 new listings. The minimum price rise (the laggard of the 28) rose 76% on the first day. Price/earnings ratios averaged 150;
- The residential property market also appears to be in a bubble. In Beijing, the house price to income ratio has climbed to more than 15 times, versus 9 times in Tokyo in 1990;

Assuming Chancellor is right, what are the implications for Australian investors? That's what we'll look at on Wednesday.

This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investorwhich provides independent advice to sharemarket investors.

http://www.smh.com.au/business/the-china-bubble-20100412-s34b.html

Buffett (1994): Investing can be done successfully even without making an attempt to figure out the unknowables.

Staying within one's circle of competence and investing in simple businesses were some of the key points that were discussed in Warren Buffett's 1993 letter to shareholders. Now let us fast forward to the year 1994 and see what investment wisdom the master has to offer in this letter.

Are you one of those guys who are quite keen on learning the nitty-gritty of the stock market but the sheer size of literature that is on offer on the topic makes you nervous? Further, with the kind of resources that the institutions, the ones that you would compete against, have at their disposal, it is quite normal for you to give up the thought without even having tried. Indeed, things like coming out with quaint economic theories, crunching a mountain of numbers and working on sophisticated spread sheets should be best left to professionals. While it is definitely good to be wary of the competition, in investing, one can still comfortably beat the competition without the aid of the sophisticated tools mentioned above. All it needs is loads of discipline and patience.

Thus, for those of you, who in an attempt to invest successfully, are trying to predict the next move of the Fed chief or trying to outguess fellow investors on which party will come to power in the next national elections, you are well advised to stop in your tracks because investing can be done successfully even without making an attempt to figure out these unknowables. Some words of wisdom along similar lines come straight from the master's 1994 letter to shareholders and this is what he has to say on the topic.

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.

But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results."

Infact, the master is not alone in his thinking on the subject but has an equally successful supporter who goes by the name of 'Peter Lynch', one of the most revered fund managers ever. He had once famously quipped, "If you spend 13 minutes per year trying to predict the economy, you have wasted 10 minutes".

Indeed, if these guys in their extremely long investment career could continue to ignore political and economic factors and focus just on the strength of the underlying business on hand and still come out triumphant, we do not see any reason as to why the same methodology cannot be copied here with equally good results.

http://www.equitymaster.com/detail.asp?date=2/1/2008&story=8

Buffett (1993): Staying within one's circle of competence and investing in simple businesses

A key mistake of investors was they never tried to fathom the relationship between the stock and the underlying business.
One should stick with the ones that can be easily understood and not subject to frequent changes.
"Why search for a needle buried in a haystack when one is sitting in plain sight?"

---

In the darkest days in the stock market history, there is no better time than this to imbibe the lessons being imparted by the master in value investing, a discipline or a form of investing that we think is one of the safest around.

One of the key mistakes the investors who suffered the most in the recent decline made was they never tried to fathom the relationship between the stock and the underlying business. Instead, they bought what was popular and hoping that there will still be a greater fool out there who would in turn buy from them. We believe that no matter how good the underlying business is, there is always an intrinsic value attached to it and one should not pay even a dime more for the same. Alas, this was not to be the case in the stock markets in recent times for many 'investors', where no effort was being made to evaluate the business model and the sustainability or longevity of the business.

In his 1993 letter to shareholders, the master has a very important point to say on why it is important to know the company or the industry that one invests in. This is what he has to offer on the topic.

"In many industries, of course, Charlie and I can't determine whether we are dealing with a "pet rock" or a "Barbie." We couldn't solve this problem, moreover, even if we were to spend years intensely studying those industries. Sometimes our own intellectual shortcomings would stand in the way of understanding, and in other cases the nature of the industry would be the roadblock. For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee thirty years ago what would transpire in the television-manufacturing or computer industries? Of course not. (Nor did most of the investors and corporate managers who enthusiastically entered those industries.) Why, then, should Charlie and I now think we can predict the future of other rapidly evolving businesses? We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?"

As is evident from the above paragraph, an investor does himself no good in the long-run if he keeps on investing without understanding the economics of the underlying business. Infact, even when one is close to cracking the industry economics, some industries are best left alone because they are so dynamic that rapid technological changes might put their very existence at risk. Instead, one should stick with the ones that can be easily understood and not subject to frequent changes.

http://www.equitymaster.com/detail.asp?date=1/24/2008&story=3

Buffett (1993): His views on real risk and how 'beta" fails to spot competitive strengths inherent in certain companies

Concentration over excessive diversification and the futility of using a stock's beta were the two key concepts that were discussed in Warren Buffett's 1993 letters to shareholders. However, the master does not stop here and, in the follow up paragraphs, puts forth his views on what is the real risk that an investor should evaluate and how the 'beta' as defined by the academicians fails to spot competitive strengths inherent in certain companies.

First up, the master explains what is the real risk that an investor should assess and goes on to suggest that the first thing that needs to be looked at is whether the aggregate after tax returns from an investment over the holding period keeps the purchasing power of the investor intact and gives him a modest rate of interest on that initial stake. He is of the opinion that though this risk cannot be measured with engineering precision, in a few cases it can be judged with a degree of accuracy. The master then lists out a few primary factors for evaluation. These would be:

• 
  
  The certainty with which the long-term economic characteristics of the business can be evaluated;

  ---

• 
  
  The certainty with which management can be evaluated, both as to its ability to realise the full potential of the business and to wisely employ its cash flows;

  ---

• 
  
  The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

  ---

• 
  
  The purchase price of the business; and

  ---

• 
  
  The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.

Indeed, the above qualitative parameters are not likely to go down well with analysts who are married to their spreadsheets and sophisticated models. But this in no way reduces their importance. These parameters, the master says, may go a long way in helping an investor see the risks inherent in certain investments without reference to complex equations or price histories.

Buffett further goes on to add that for a person who is brought up on the concept of beta will have difficulties in separating companies with strong competitive advantages from the ones with mundane businesses and this he believes is one of the most ridiculous things to do in stock investing. This is what he has to say in his own inimitable style.

"The competitive strengths of a Coke or Gillette are obvious to even the casual observer of business. Yet the beta of their stocks is similar to that of a great many run-of-the-mill companies who possess little or no competitive advantage. 

• Should we conclude from this similarity that the competitive strength of Coke and Gillette gains them nothing when business risk is being measured? 
• Or should we conclude that the risk in owning a piece of a company - its stock - is somehow divorced from the long-term risk inherent in its business operations? 

We believe neither conclusion makes sense and that equating beta with investment risk also makes no sense."

He further states, "The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy company-selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie. But it is quite possible for ordinary investors to make such distinctions if they have a reasonable understanding of consumer behavior and the factors that create long-term competitive strength or weakness. Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy."

http://www.equitymaster.com/detail.asp?date=1/17/2008&story=2

Buffett (1993): He believes in making infrequent large bets. "We'll now settle for one good idea a year."

Warren Buffett's 1992 letter to shareholders shared his views on healthcare accounting and ESOPs. Let us now see what insight the master has to offer in his 1993 letter to shareholders.

Ardent followers of the master might not be immune to the fact that whenever an extremely attractive opportunity has presented itself, Buffett has not hesitated to put huge sums in it. In sharp contrast to the current lot of fund manager who use fancy statistical tools to justify diversification, the master has been a believer in making infrequent bets but at the same time making large bets. In other words, he believes that a concentrated portfolio is much better than a diversified portfolio. This is what he has to say on the issue.

"Charlie and I decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire's capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart - and not too smart at that - only a very few times. Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)

The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."

The master does not stop here. Like his previous letters, he once again takes potshots at academicians who define risk as the relative volatility of a stock price with respect to the market or what is now widely known as 'beta'. He very rightly contests that a stock which has been battered by the markets should as per the conventional wisdom bought in ever larger quantities because lower the price, higher the returns in the future. However, followers of beta are very likely to shun the stock for its perceived higher volatility. This is what he has to say on the issue.

"In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don't need a daily quote on our 100% position in See's or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?"

http://www.equitymaster.com/detail.asp?date=1/10/2008&story=5

Buffett (1992): "How many legs does a dog have if you call his tail a leg?"

The master has taken potshots at every accounting convention that understates liabilities and overstates profits and asks investors to guard against such measures. Things like ESOPs and post retirement health benefits should be appropriately accounted for and considered as costs.



In his 1992 letter to shareholders, Warren Buffett's discoursed on valuations and intrinsic value.  In the same letter, let us see what he has to speak on employee compensation accounting and stock options.

In the year 1992, two new accounting rules came into being out of which one mandated companies to create a liability on the balance sheet to account for present value of employees' post retirement health benefits. The master used the occasion to turn the tables on managers and chieftains who under the pretext of the old method avoided huge dents on their P&Ls and balance sheets. The earlier method required accounting for such benefits only when they are cashed but did not take into account the future liabilities that would arise thus overstating the net worth as well as profits by way of inadequate provisioning. This is what the master had to say on the issue.

"Managers thinking about accounting issues should never forget one of Abraham Lincoln's favorite riddles: "How many legs does a dog have if you call his tail a leg?" The answer: "Four, because calling a tail a leg does not make it a leg." It behooves managers to remember that Abe's right even if an auditor is willing to certify that the tail is a leg."

By quoting the above statements, the master has taken potshots at every accounting convention that understates liabilities and overstates profits and asks investors to guard against such measures. Next he criticizes accounting standard for ESOPs prevailing in the US at that time and this is what he has to say on the topic.

"Typically, executives have argued that options are hard to value and that therefore their costs should be ignored. At other times, managers have said that assigning a cost to options would injure small start-up businesses. Sometimes they have even solemnly declared that "out-of-the-money" options (those with an exercise price equal to or above the current market price) have no value when they are issued.

Oddly, the Council of Institutional Investors has chimed in with a variation on that theme, opining that options should not be viewed as a cost because they "aren't dollars out of a company's coffers." I see this line of reasoning as offering exciting possibilities to American corporations for instantly improving their reported profits. For example, they could eliminate the cost of insurance by paying for it with options. So if you're a CEO and subscribe to this "no cash-no cost" theory of accounting, I'll make you an offer you can't refuse: Give us a call at Berkshire and we will happily sell you insurance in exchange for a bundle of long-term options on your company's stock."

The master has hit the nail on the head when he has further gone on to mention that something of value that is delivered to another party always has costs associated with it and these costs come out of the shareholders' pockets. Thus, things like ESOPs and post retirement health benefits should be appropriately accounted for and should not be hidden under the garb of fuzzy accounting standards and ingenious rationales.

Before we round off the 1992 letter, let us see how the master in a way that he only can so strongly puts up the case for ESOPs to be considered as costs.

• "If options aren't a form of compensation, what are they? 

• If compensation isn't an expense, what is it? 

• And, if expenses shouldn't go into the calculation of earnings, where in the world should they go?"

http://www.equitymaster.com/detail.asp?date=12/27/2007&story=4