1982: Acquisition, paid with stock
In this letter, Warren Buffett talks about acquisitions and how a company pays for it. Whenever you buy something, the best value you can get is when you pay as close as possible to the intrinsic value of what you are buying.
There are several reasons for a company to make an acquisition which usually depend on the kind of management that intends to make an acquisition. A company may want to expand its empire and may be ready to pay much over the intrinsic value of a company which is being bought just for the sake of mindless expansion. Such expansion is in no way good for the investors of the company.
Another kind of management may just be acting reckless in a euphoric business environment and want to extend into businesses where it has no business to be in. Such companies irrespective of the value it may pay for a company being bought have a high tendency of resulting in heartbreak. Indian corporate throw up examples like Videocon to substantiate this which are on verge of bankruptcy.
Then there may be very sensible businesses who give extensive thought to their long term vision and stick to it despite the short term attractions and accordingly find businesses and may be able to buy businesses at decent valuations close to their intrinsic value. These are the businesses which are much more likely to reward its shareholders with time.
How does these businesses pay for the business to be bought?
One way is to pay in cash and a cash price is easiest to arrive at. It is a completly different ball game if one were to pay with its own stock though.
If the acquirer business is trading close to its intrinsic value then it is fine to pay with its own stock. If the business is trading at a lower valuation than its intrinsic value then it is terrible to pay with its stock since you pay much more than what you should pay for a business and then you loose the future growth potential too.
If the acquirer business is trading at a higher valuation than the intrinsic value then it is beneficial for the investors if the acquirer pays for the company to be acquired with its own stock.
What this means is one has to be utmost careful in using its own stock and a marvelous business can be a terrible buy depending on the price that is paid for it. This extends the fact: A good business can be a terrible investment if it is overpaid for.
In short:
1) be careful and do keen research when acquisitions are made using own stock.
2) be wary of managements that are looking for mindless expansion not sticking to their long term vision.
3) look for companies that buy companies based on their long term vision and make a fair trade in paying for a company being acquisition-ed.
1983: Stock Split and Stock Activity
There are some companies that are immune to splitting their stock. Berkshire doesn't split its stock for a variety of reasons.
First of these is:
1) splitting a stock 1 to 10 doesn't make the value of a stock multiply. it is simply exchanging a Rs 100 note for 10 notes of Rs 10.
2) Berkshire has always wanted its stock price to be 'rationally close' to its intrinsic value. One way they do this is by communicating extensively their beliefs with their shareholders. If they were to split their stock, a lot more investors may flock to the stock who may/may not associate with the beliefs of Berkshire and ultimately leading to increased trading activity on Berkshire ticker resulting in a stock price farther away from intrinsic value.
3) Analysts cry hoarse about amount of trading going on in a stock. The only party benefiting from this activity is the tax authorities who make money out of these transactions. This has a direct impact on the RoE of a company. If they earn a 10% RoE and pay a higher amount of it in taxes than what they otherwise do, the investor just ends up with a lower return despite the hyped high liquidity stock.
Add in inflation and the 10% return may just turn negative for the investor.
In rudimentary terms, if you divide a 6 inch pizza into 12 slices instead of 8, the size of the pizza DOES NOT increase. A child can understand that but the brilliant stock market analysts will not. They crave activity. Activity for the sake of activity does not generate any value.
1984: Dividend Policy
It is extremely important that a company shares its vision about dividends with the shareholders and explains its dividend policy. It is not at all sufficient to just say we are going to give 15% of earnings as dividend come what may.
All earnings are not created equal. In business that have high asset/profit ratio, meaning a lot of money is required to earn small amounts of profits, all or a part of the earnings becomes ersatz OR artificial since inflation may eat up any earnings. For ex. if a company earns 8% and inflation is 6% then 6% of the earnings is ersatz. These earnings are called restricted earnings. If a company continuously distributes its restricted earnings then it is destined to go into oblivion or live under increasing debt forever.
Now when it comes to unrestricted earnings, there should only be one consideration for the business to decide on distribution and that is 'Can the business deploy a rupee of earnings retained and create a market value of more than a rupee'. Also, if the business say generates 5% of value over a rupee while the current safe fixed income returns are 8% then it makes no sense to retain the earnings still. If not, the earnings should be distributed to shareholders.
Earnings must never be retained to feed the ego of a management which only looks for a mindless expansion of its empire and operate from a position of financial comfort.
1985: Earnings and Growth
When analyzing companies' growth in earnings over a period of time, it is of utmost importance to look at the new capital employed by the company and the earnings generated with the capital. A lot of times, an increase in company's earnings over a long period may just be a result of compounding of the retained earnings by the company and there are numerous cases where the management is handsomely rewarded for no brilliance of their own but simply for having sit own shareholders' retained earnings for a long period of time.
1986: talks about taxation rule changes and its impacts on Berkshire businesses.
In this letter, Warren Buffett talks about acquisitions and how a company pays for it. Whenever you buy something, the best value you can get is when you pay as close as possible to the intrinsic value of what you are buying.
There are several reasons for a company to make an acquisition which usually depend on the kind of management that intends to make an acquisition. A company may want to expand its empire and may be ready to pay much over the intrinsic value of a company which is being bought just for the sake of mindless expansion. Such expansion is in no way good for the investors of the company.
Another kind of management may just be acting reckless in a euphoric business environment and want to extend into businesses where it has no business to be in. Such companies irrespective of the value it may pay for a company being bought have a high tendency of resulting in heartbreak. Indian corporate throw up examples like Videocon to substantiate this which are on verge of bankruptcy.
Then there may be very sensible businesses who give extensive thought to their long term vision and stick to it despite the short term attractions and accordingly find businesses and may be able to buy businesses at decent valuations close to their intrinsic value. These are the businesses which are much more likely to reward its shareholders with time.
How does these businesses pay for the business to be bought?
One way is to pay in cash and a cash price is easiest to arrive at. It is a completly different ball game if one were to pay with its own stock though.
If the acquirer business is trading close to its intrinsic value then it is fine to pay with its own stock. If the business is trading at a lower valuation than its intrinsic value then it is terrible to pay with its stock since you pay much more than what you should pay for a business and then you loose the future growth potential too.
If the acquirer business is trading at a higher valuation than the intrinsic value then it is beneficial for the investors if the acquirer pays for the company to be acquired with its own stock.
What this means is one has to be utmost careful in using its own stock and a marvelous business can be a terrible buy depending on the price that is paid for it. This extends the fact: A good business can be a terrible investment if it is overpaid for.
In short:
1) be careful and do keen research when acquisitions are made using own stock.
2) be wary of managements that are looking for mindless expansion not sticking to their long term vision.
3) look for companies that buy companies based on their long term vision and make a fair trade in paying for a company being acquisition-ed.
1983: Stock Split and Stock Activity
There are some companies that are immune to splitting their stock. Berkshire doesn't split its stock for a variety of reasons.
First of these is:
1) splitting a stock 1 to 10 doesn't make the value of a stock multiply. it is simply exchanging a Rs 100 note for 10 notes of Rs 10.
2) Berkshire has always wanted its stock price to be 'rationally close' to its intrinsic value. One way they do this is by communicating extensively their beliefs with their shareholders. If they were to split their stock, a lot more investors may flock to the stock who may/may not associate with the beliefs of Berkshire and ultimately leading to increased trading activity on Berkshire ticker resulting in a stock price farther away from intrinsic value.
3) Analysts cry hoarse about amount of trading going on in a stock. The only party benefiting from this activity is the tax authorities who make money out of these transactions. This has a direct impact on the RoE of a company. If they earn a 10% RoE and pay a higher amount of it in taxes than what they otherwise do, the investor just ends up with a lower return despite the hyped high liquidity stock.
Add in inflation and the 10% return may just turn negative for the investor.
In rudimentary terms, if you divide a 6 inch pizza into 12 slices instead of 8, the size of the pizza DOES NOT increase. A child can understand that but the brilliant stock market analysts will not. They crave activity. Activity for the sake of activity does not generate any value.
1984: Dividend Policy
It is extremely important that a company shares its vision about dividends with the shareholders and explains its dividend policy. It is not at all sufficient to just say we are going to give 15% of earnings as dividend come what may.
All earnings are not created equal. In business that have high asset/profit ratio, meaning a lot of money is required to earn small amounts of profits, all or a part of the earnings becomes ersatz OR artificial since inflation may eat up any earnings. For ex. if a company earns 8% and inflation is 6% then 6% of the earnings is ersatz. These earnings are called restricted earnings. If a company continuously distributes its restricted earnings then it is destined to go into oblivion or live under increasing debt forever.
Now when it comes to unrestricted earnings, there should only be one consideration for the business to decide on distribution and that is 'Can the business deploy a rupee of earnings retained and create a market value of more than a rupee'. Also, if the business say generates 5% of value over a rupee while the current safe fixed income returns are 8% then it makes no sense to retain the earnings still. If not, the earnings should be distributed to shareholders.
Earnings must never be retained to feed the ego of a management which only looks for a mindless expansion of its empire and operate from a position of financial comfort.
1985: Earnings and Growth
When analyzing companies' growth in earnings over a period of time, it is of utmost importance to look at the new capital employed by the company and the earnings generated with the capital. A lot of times, an increase in company's earnings over a long period may just be a result of compounding of the retained earnings by the company and there are numerous cases where the management is handsomely rewarded for no brilliance of their own but simply for having sit own shareholders' retained earnings for a long period of time.
1986: talks about taxation rule changes and its impacts on Berkshire businesses.
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