Friday, January 7, 2011

Buffett: Turning Gold Into Lead - Berkshire Shareholder Letter Highlights

Warren Buffett wrote the following in the 1984 Berkshire Hathaway (BRKashareholder letter:

"The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings 'restricted' - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company’s stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Meanwhile, at construction and maintenance sites throughout New York, signs proudly proclaimed the corporate slogan, 'Dig We Must'.)"

Businesses with relatively more "restricted earnings" generally require a higher margin of safety (all other things being equal) to account for the potential gold-into-lead folly. From the 1997 Berkshire shareholder meeting:

"If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety..."

Also, those businesses with fewer "restricted earnings" are intrinsically more valuable as they have greater flexibility to invest earnings in a manner producing a high return on capital for investors.

The problem is, of course, financial statements alone don't explicitly reveal how much of a businesses earnings is restricted. I mean, it would be nice if "restricted earnings" could be found somewhere on an income statement. Still, it's fairly simple to figure out. Any business that has a high ratio of assets on the balance sheet relative to the profits it generates on average over the entire business cycle is a likely candidate.

The bottom line is it makes sense to pay less for companies with a lot of "restricted earnings" both because the intrinsic value of the earnings is lower and a larger margin of safety is required.

It'd be a lot easier if more businesses were like Coca-Cola (KO) but unfortunately most are not.


Long BRKb and KO
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