Investing between the lines

In an interview Warren Buffett said

Charlie, I’d been reading IBM’s annual report, literally, every year for 50 years. And then this year, I saw something that sort a clicked in terms of adding to my feeling of confidence. And so we spent $10+ billion.

You can learn a lot about the company by reading its annual report. But how many of us read the annual report?

In some cases the CEO of the company also writes the shareholders letter. Buffett grades a company higher if he finds the CEO actually wrote the shareholder letter. When asked why he replied

I look for someone who talks to me frankly and honestly about the business, the way a partner would. That’s a significant plus. If the CEO doesn’t write, it’s a black mark against them for one reason – they may not know their business very well. Plenty of CEOs don’t understand their business as well as a lot of people outside their business, or even the people who work for them. They do not want to be seen as they really are.

Buffett spends a lot of time writing the shareholder letters. He explains Berkshire’s complex business in a simple way so that a person with an average IQ can understand. His letters have more than 10,000 words and are five times longer than the average shareholder letter. I always wonder why can’t every CEO write this kind of a letter.

Some of the shareholder letters written by CEOs contains a lot of facts about the business. But many contain just fluff. You need to read the shareholder letter critically to separate facts from the fluff. In the book Investing Between the Lines, Rittenhouse shows us how. Buffett recommended this book in his 2012 letter . I enjoyed reading the book and in this post I am sharing some of them.

On Cultural Value

One shareholder asked Buffett why he targets a minimum of $20 billion in cash in Berkshire’s balance sheet. Buffett replied

There is no magic number. We think of the worst case and then add an extra margin for safety. We have 600,000 shareholders and members of my family have 80 percent of their net worth in BRK. We do not want to go broke because we took a chance and risked what they have and need for what they do not have and do not need. Accordingly, Berkshire’s returns 99 out of 100 years will be less than they would otherwise have been. But we will survive that one year when no one else does. Life in financial markets has nothing to do with sigmas and standard errors.

On Perils of Leverage

In the 2010 shareholders letter Buffett wrote about the perils of leverage.

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.

Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.

On Questioning the Authority

Read the following passage from Goldman Sachs 2009 shareholder letter

As we do with most other counter party relationships, we limited our overall credit exposure to AIG through a combination of collateral and market hedges in order to protect ourselves against the potential inability of AIG to make good on its commitments. We established a pre-determined hedging program, which provided that if aggregate exposure moved above a certain threshold, credit default swaps (CDS) and other credit hedges would be obtained. This hedging was designed to keep our overall risk to manageable levels.

As part of our trading with AIG, we purchased from them protection on super-senior collateralized debt obligation (CDO) risk. This protection was designed to hedge equivalent transactions executed with clients taking the other side of the same trades. In so doing, we served as an intermediary in assisting our clients to express a defined view on the market. The net risk we were exposed to was consistent with our role as a market intermediary rather than a proprietary market participant.

There is nothing objective in the above passage. But most of the readers will assume they are not smart enough to understand. Why? The person writing this letter is a CEO, an authority figure and we assume that he cannot be wrong and we blame ourselves for not understanding. We fall for the authority bias. We should never do that. We should question the authority.

On Enduring Moats

In 2007 shareholders letter Buffet wrote about businesses with enduring moats.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

On Long-term Thinking

In 2003 letter to shareholders, Jeff Bezos – CEO of Amazon critiqued about the short-term, portfolio-churning practices of Wall Street investors

Long-term thinking is both a requirement and an outcome of true ownership. Owners are different from tenants. I know of a couple who rented out their house, and the family who moved in nailed their Christmas tree to the hardwood floors instead of using a tree stand. Expedient, I suppose, and admittedly these were particularly bad tenants, but no owner would be so short-sighted. Similarly, many investors are effectively short-term tenants, turning their portfolios so quickly they are really just renting the stocks that they temporarily “own.”

In 2002 letter to shareholders he explains how Amazon.com was not a normal store in a way anyone can understand.

In many ways, Amazon.com is not a normal store. We have deep selection that is unconstrained by shelf space. We turn our inventory 19 times in a year. We personalize the store for each and every customer. We trade real estate for technology (which gets cheaper and more capable every year). We display customer reviews critical of our products. You can make a purchase with a few seconds and one click. We put used products next to new ones so you can choose. We share our prime real estate—our product detail pages—with third parties, and, if they can offer better value, we let them.

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