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Lessons from Warren Buffett - XXXII

Mar 13, 2008

In the previous article, we rounded off Warren Buffett's 1994 letter to shareholders by bringing face to face with investors his 'simplicity of business models' and 'to heck with the timing of purchases' approach to investing. Let us now move on to the letter from the succeeding year, 1995, and see what investment wisdom he has to impart through this letter.

In one of our previous discussions, we did highlight the master's discomfort with most of the mergers and acquisitions that take place in the corporate world and also put forth his view of them being value destructive to shareholders. However, this does not mean that he is completely averse to mergers and acquisitions (M&As). In fact, even he has dabbled in a few M&As but believes that his company, Berkshire Hathaway has certain advantages, which put it in a position to do only the most favorable transactions. What are these advantages and how best can others incorporate them into their own decision-making processes? Let us find out in the master's own words.

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"We do have a few advantages, perhaps the greatest being that we don't have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners. In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us, including the purchase of small pieces of the best businesses in the world via the stock market. Our practice of making this comparison - acquisitions against passive investments - is a discipline that managers focused simply on expansion seldom use."

While managers obsessed with expansion do not mull over the fact that there could be a better use of their company's cash flows other than pursuing an M&A, Warren Buffett weighs all his investment decisions against a common gold standard, which is - 'Is this the best possible use of shareholder's money?' If the answer is yes, he will pursue the M&A transaction and if it isn't, then he will look at other passive investments like investing in equities. There is no compulsion on him to pursue an M&A transaction if the price is not right because he can either consider other options or can wait. However, different managers competing to acquire the same asset have no such luxuries and are willing to shell out significantly more than the intrinsic value of that asset. Buffett though, prefers quality to quantity.

Further down, the master talks of another couple of advantages that he can offer to the target companies.

"In making acquisitions, we have a further advantage: As payment, we can offer sellers a stock backed by an extraordinary collection of outstanding businesses. An individual or a family wishing to dispose of a single fine business, but also wishing to defer personal taxes indefinitely, is apt to find Berkshire stock a particularly comfortable holding. I believe, in fact, that this calculus played an important part in the two acquisitions for which we paid shares in 1995."

"Beyond that, sellers sometimes care about placing their companies in a corporate home that will both endure and provide pleasant, productive working conditions for their managers. Here again, Berkshire offers something special. Our managers operate with extraordinary autonomy. Additionally, our ownership structure enables sellers to know that when I say we are buying to keep, the promise means something. For our part, we like dealing with owners who care what happens to their companies and people. A buyer is likely to find fewer unpleasant surprises dealing with that type of seller than with one simply auctioning off his business."

To conclude, while getting involved in an M&A transaction, if managers take into account above mentioned factors like -

  • not having a 'achieve at any cost' attitude towards acquisitions,

  • giving the sellers a safe and growing asset like 'Berkshire Hathaway's' stock in exchange for partial or complete stake in their own company, and

  • giving them complete autonomy to run the company even after consummating the acquisition, ...then barring for some unforeseen circumstances, one is unlikely to go wrong in an M&A transaction.

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