Buffett Answers 5 Basic Investing Questions

In the annual letter (this year was the 50th) sent February 28 to Berkshire Hathaway (BRK.A) shareholders, Chairman Warren Buffett relates how the company performed in the prior year, explains the company's strategies, provides some advice to investors in general (we pulled out some of those prescriptions in Warren Buffett's 8 Warnings for Investors) and this year even addresses the succession plan at Berkshire (which long-time Buffett partner and Berkshire Vice Chairman Charlie Munger explored in this article).

Along the way, Buffett often provides pithy comments about what constitutes a good investment and what doesn't, yielding definitions of key investing principles in his homespun way. He also shares his unvarnished thoughts about the difference between Berkshire's business philosophy and that of much of Wall Street.

Below we pulled out five investing definitions—some with clear implications for advisors—that were tucked away in this year's letter to Berkshire Hathaway shareholders.

Definition 1: What Makes a Good Investment?

At both BPL [Buffett Partnership Ltd.] and Berkshire, we have never invested in companies that are hell-bent on issuing shares. That behavior is one of the surest indicators of a promotion-minded management, weak accounting, a stock that is overpriced and – all too often – outright dishonesty.

Definition 2: What Makes a Company an Attractive Acquisition (and What Doesn't)?

…Marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise. Selecting a marriage partner clearly requires more demanding criteria than does dating.

Too often CEOs seem blind to an elementary reality: The intrinsic value of the shares you give in an acquisition must not be greater than the intrinsic value of the business you receive.

I've yet to see an investment banker quantify this all-important math when he is presenting a stock-for- stock deal to the board of a potential acquirer. Instead, the banker's focus will be on describing "customary" premiums-to-market-price that are currently being paid for acquisitions – an absolutely asinine way to evaluate the attractiveness of an acquisition – or whether the deal will increase the acquirer's earnings-per-share (which in itself should be far from determinative). In striving to achieve the desired per-share number, a panting CEO and his "helpers" will often conjure up fanciful "synergies." (As a director of 19 companies over the years, I've never heard "dis-synergies" mentioned, though I've witnessed plenty of these once deals have closed.) Post mortems of acquisitions, in which reality is honestly compared to the original projections, are rare in American boardrooms. They should instead be standard practice.

I can promise you that long after I'm gone, Berkshire's CEO and Board will carefully make intrinsic value calculations before issuing shares in any acquisitions. You can't get rich trading a hundred-dollar bill for eight tens (even if your advisor has handed you an expensive "fairness" opinion endorsing that swap).

Definition 3: What Is Investing?

Think back to our 2011 annual report, in which we defined 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."

Definition 4: What Business Owners Should Consider When Pondering Their Exit Strategies

Berkshire has one further advantage that has become increasingly important over the years: We are now the home of choice for the owners and managers of many outstanding businesses.

Families that own successful businesses have multiple options when they contemplate sale. Frequently, the best decision is to do nothing. There are worse things in life than having a prosperous business that one understands well. But sitting tight is seldom recommended by Wall Street. (Don't ask the barber whether you need a haircut.)

When one part of a family wishes to sell while others wish to continue, a public offering often makes sense. But, when owners wish to cash out entirely, they usually consider one of two paths.

The first is sale to a competitor who is salivating at the possibility of wringing "synergies" from the combining of the two companies. This buyer invariably contemplates getting rid of large numbers of the seller's associates, the very people who have helped the owner build his business. A caring owner, however – and there are plenty of them – usually does not want to leave his longtime associates sadly singing the old country song: "She got the goldmine, I got the shaft."

The second choice for sellers is the Wall Street buyer.

Definition 5: What Is Private Equity; Why Business Owners Should Avoid It; Why Berkshire Is a Good Home for Those Companies

Buffett continues his discussion of the options that business owners have when considering what to do with the family business. Regarding the "Wall Street buyer" referenced above, he writes:

For some years, these purchasers accurately called themselves "leveraged buyout firms." When that term got a bad name in the early 1990s – remember RJR and Barbarians at the Gate? – these buyers hastily relabeled themselves "private-equity."

The name may have changed but that was all: Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases. Indeed, the amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company.

Later, if things go well and equity begins to build, leveraged buyout shops will often seek to re-leverage with new borrowings. They then typically use part of the proceeds to pay a huge dividend that drives equity sharply downward, sometimes even to a negative figure.

In truth, "equity" is a dirty word for many private-equity buyers; what they love is debt. And, because debt is currently so inexpensive, these buyers can frequently pay top dollar. Later, the business will be resold, often to another leveraged buyer. In effect, the business becomes a piece of merchandise.

Berkshire offers a third choice to the business owner who wishes to sell: a permanent home, in which the company's people and culture will be retained (though, occasionally, management changes will be needed). Beyond that, any business we acquire dramatically increases its financial strength and ability to grow. Its days of dealing with banks and Wall Street analysts are also forever ended.

Some sellers don't care about these matters. But, when sellers do, Berkshire does not have a lot of competition.

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