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Lessons from Warren Buffett - VI

Aug 2, 2007

While the world of stocks seems to be tearing apart on US subprime woes, what could be better than to indulge in some thought provoking lessons that can help you, as an investor, in staying calm in such situations of panic. In a previous write-up, we saw Warren Buffett (the 'master') talk about his policies for making acquisitions and how managers tend to overestimate themselves. In this write-up let us see what the investing genius had to offer in his 1982 letter to shareholders. In what was probably a bull market, Berkshire Hathaway, the master's investment vehicle faced a peculiar problem. By that time, the company had acquired meaningful stakes in a lot of other companies but not meaningful enough for these companies' earnings to be consolidated with that of Berkshire Hathaway's. This is because accounting conventions then allowed only for dividends to be recorded in the earnings statement of the acquiring company if it acquired a stake of less than 20%. This obviously did not go down well with the master as earnings of Berkshire in the 'accounting sense' depended upon the percentage of earnings that were distributed by these companies as dividends.

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"We prefer a concept of 'economic' earnings that includes all undistributed earnings, regardless of ownership percentage. In our view, the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used - and not by the size of one's ownership percentage."

As for some examples in the Indian context, companies like M&M and Tata Chemicals, which hold small stakes in many companies should not be valued based on what dividends these companies pay to M&M and Tata Chemicals but instead one should arrive at the fair value of these companies independently and that value should be attributed on a pro-rata basis to all the shareholders, whether minority or majority.

While the master tackled accounting related issues in the first few portions of the 1982 letter, the next few portions were once again devoted to the excesses that take place in the market time and again. This is what he had to say on corporate acquisitions and price discipline.

"As we look at the major acquisitions that others made during 1982, our reaction is not envy, but relief that we were non-participants. For in many of these acquisitions, managerial intellect wilted in competition with managerial adrenaline. The thrill of the chase blinded the pursuers to the consequences of the catch. Pascal's observation seems apt: 'It has struck me that all men's misfortunes spring from the single cause that they are unable to stay quietly in one room.'"

He further goes on to state, "The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments."

The above comments once again bring to the fore a strict discipline that the master employs when it comes to paying an appropriate price. Infact, as much as his success is built on finding some very good picks like Coca Cola and Gillette, he has never had to sustain huge losses on any of his investment. The math is simple, if you lose say 50% on an investment, to make good these losses, one will have to unearth a stock that will have to rise atleast 100% and that too in quick time. A very difficult task indeed! No wonder the master pays so much attention to maintaining a strict price discipline.

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