Thursday, June 16, 2011

Buffett: An Ordinary Horse Sold As Secretariat - Berkshire Shareholder Letter Highlights

From Warren Buffett's 1995 Berkshire Hathaway (BRKa) shareholder letter:

...sellers and their representatives invariably present financial projections having more entertainment value than educational value. In the production of rosy scenarios, Wall Street can hold its own against Washington.

In any case, why potential buyers even look at projections prepared by sellers baffles me. Charlie and I never give them a glance, but instead keep in mind the story of the man with an ailing horse. Visiting the vet, he said: "Can you help me? Sometimes my horse walks just fine and sometimes he limps." The vet's reply was pointed: "No problem - when he's walking fine, sell him." In the world of mergers and acquisitions, that horse would be peddled as Secretariat.

A business run by management in the habit of paying Secretariat prices for so-called strategic acquisitions is a sell.

In most cases, that so-called strategic deal is just a cloak around the reality that a wealth transfer from acquirer to acquiree shareholders is taking place. A company with entrenched management that behaves this way materially reduces the growth in intrinsic value of a business (in fact may shrink it) and, of course, shareholder wealth.

Imagine Berkshire Hathaway without all the smart deals done over the years. Intrinsic value today would be an awful lot less.

Any use of the words like strategic or synergistic to justify a deal warrants skepticism. Consider those words as code for "we are getting bigger at shareholder expense". When these terms are employed, it's almost guaranteed that management overpaid and is selling the rich price to shareholders on the basis of some mysterious hidden value. The likely reality is that animal spirits kicked in during the acquisition process and management began buying the kind of "rosy scenarios" that Buffett refers to above.

So the pitch to shareholders on the merits of the deal will often be under the guise that value not yet revealed will, out of thin air, somehow emerge. Naturally, once the deal is done if that value does not appear down the road there is no recourse. The wealth transfer will have happened with acquiring shareholders feeling (in fact being) a bit poorer.

The bottom line is that management should, in most cases, pay only for the proven economics of a business...not promise.

If not a rule it's the next best thing.

The intrinsic value of a business is raised by having a management team in place that consistently makes smart acquisitions at fair, or better yet, limping horse prices.

Adam

Long BRKb
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