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Lessons from Warren Buffett - XXI

Dec 7, 2007

Through a series of articles over the past few weeks, we discussed Warren Buffett's 1991 letter to the shareholders of his investment vehicle, Berkshire Hathaway. Let us now turn to the letter of the following year and see what investment wisdom the master has to dole out through his 1992 letter to shareholders. Up front is a comment on the change in the number of shares outstanding of Berkshire Hathaway since its inception in 1964 and this we believe, is a very important message for investors who want to know how genuine wealth can be created. Investors these days are virtually fed on a diet of split and bonuses and new shares issuance, in stark contrast to the master's view on the topic. Laid out below are his comments on shares outstanding of Berkshire Hathaway and new shares issuance.

"Berkshire now has 1,152,547 shares outstanding. That compares, you will be interested to know, to 1,137,778 shares outstanding on October 1, 1964, the beginning of the fiscal year during which Buffett Partnership, Ltd. acquired control of the company."

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"We have a firm policy about issuing shares of Berkshire, doing so only when we receive as much value as we give. Equal value, however, has not been easy to obtain, since we have always valued our shares highly. So be it: We wish to increase Berkshire's size only when doing that also increases the wealth of its owners."

"Those two objectives do not necessarily go hand-in-hand as an amusing but value-destroying experience in our past illustrates. On that occasion, we had a significant investment in a bank whose management was hell-bent on expansion. (Aren't they all?) When our bank wooed a smaller bank, its owner demanded a stock swap on a basis that valued the acquiree's net worth and earning power at over twice that of the acquirer's. Our management - visibly in heat - quickly capitulated. The owner of the acquiree then insisted on one other condition: "You must promise me," he said in effect, "that once our merger is done and I have become a major shareholder, you'll never again make a deal this dumb."

It is widely known and documented that Berkshire Hathaway boasts one of the best long-term track records among American corporations in increasing shareholder wealth. However, what is not widely known is the fact that during this nearly three decade long period (1964-1992), the total number of shares outstanding has increased by just over 1%! Put differently, the entire gains have come to the same set of shareholders assuming shares have not changed hands and that too by putting virtually nothing extra other than the original investment. Further, the company has not encouraged unwanted speculation by going in for a stock split or bonus issues, as these measures do nothing to improve the intrinsic values. They merely are tools in the hands of mostly dishonest managements who want to lure naive investors by offering more shares but at a proportionately reduced price, thus leaving the overall equation unchanged.

How is it that Berkshire Hathaway has raked up returns that rank among the best but has needed very little by way of additional equity. The answer lies in the fact that the company has concentrated most of its investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals. Plus, the company has also made sure that it has made purchases at attractive enough prices. Clearly, investors could do themselves a world of good if they adhere to these basic principles and not get caught in companies, which consistently require additional equity for growth or which issue bonuses or stock-splits to artificially shore up the intrinsic value. For as the master says that even a dormant savings account can lead to higher returns if supplied with more money. The idea is to generate more than one can invest for future growth.

We would discuss the remainder of the 1992 letter in the forthcoming articles.

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