The Rational Walk
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Book Review: Berkshire Beyond Buffett November 5, 2014

I love running Berkshire, and if enjoying life promotes longevity, Methuselah’s record is in jeopardy.

-Warren Buffett, Berkshire Hathaway Owner’s Manual

Berkshire Hathaway will soon reach an important milestone with the fiftieth anniversary of Warren Buffett’s control of the company.  Nearly forty percent of Mr. Buffett’s tenure at Berkshire has been accomplished as a senior citizen and he is clearly not ready to retire anytime soon.  However, Berkshire shareholders are faced with the fact that an 84 year old man has an life expectancy of approximately six years.  It is prudent to consider succession issues carefully.  Mr. Buffett has assured shareholders that the company is well prepared but how can shareholders be certain?

BerkshireBeyondBuffettWarren Buffett almost certainly has higher name recognition in the United States today than all but a small number of public figures.  Even individuals who have no background in business and investing recognize Mr. Buffett’s name but what is interesting is that he is almost always characterized as an investor rather than as a manager.  In Berkshire Beyond Buffett, George Washington University Professor Lawrence Cunningham paints a compelling portrait of Berkshire’s culture that demonstrates how Mr. Buffett’s skills as a manager have been key to the company’s growth over the past two decades.

Berkshire Hathaway’s portfolio of common stocks attracts a great deal of attention, but the bulk of the value of the company has resided in wholly owned subsidiaries for quite some time.  Mr. Buffett has assembled a diverse group of businesses over the years and has characterized his management approach as delegating “almost to the point of abdication”.  While Mr. Buffett has involved himself in operating decisions in rare cases, his primary role is to allocate free cash flow generated by the non-insurance subsidiaries as well as “float” obtained from the insurance businesses.  Berkshire’s subsidiary managers have generally proven to be very capable with many of the original family owners continuing to run businesses even with no financial need to do so.

The Economist published a skeptical article on Berkshire earlier this year questioning how Mr. Buffett will “play his last hand”.  This article is useful in that it outlines many of the concerns skeptics typically point to when it comes to succession planning.  Specifically, it is alleged that Berkshire’s business model is simply not scalable or sustainable in the absence of the man who built the company.  Would a break-up of Berkshire create more long term value for shareholders after Mr. Buffett leaves the scene?

Professor Cunningham’s book is perhaps the most comprehensive examination of this question that has been published up to this point.  The book examines the origins of today’s Berkshire Hathaway and attempts to paint a picture of how Mr. Buffett has gone about building the conglomerate seemingly “by accident”.  Whether by accident or by design, over the years, Berkshire Hathaway developed a culture that ties together seemingly unrelated business units in a manner that makes Mr. Buffett’s extreme decentralization work.  Charlie Munger likes to describe the culture very succinctly as a “seamless web of deserved trust”, and Professor Cunningham’s work provides insight into how this web has developed and can be sustained.

The core of the book investigates how Mr. Buffett has balanced autonomy and authority through the examination of several Berkshire subsidiaries.  Professor Cunningham conducted numerous interviews with subsidiary CEOs as well as shareholders so the book is based on primary research and unprecedented access.  While some of the businesses have been analyzed in depth elsewhere in the past, the book also covers smaller subsidiaries that have received less attention such as the Pampered Chef.

One of the most interesting chapters goes into detail regarding the evolution of the Marmon Group, one of Berkshire’s wholly owned subsidiaries.  Marmon is a diversified conglomerate that was built by brothers Jay and Robert Pritzker. The company was considered too unwieldy and diverse to be successfully managed after the Pritzkers left the scene, but it turns out that little changed in terms of the company’s decentralized management approach.  John D. Nichols was CEO from 2002 to 2006 and Frank Ptak has been CEO since that time.  Both CEOs spent most of their careers at ITW, a diversified conglomerate with a structure similar to Marmon.  Mr. Nichols did introduce ten division presidents to logically group together Marmon’s subsidiaries but otherwise left the units mostly unchanged.

When Mr. Buffett leaves the scene at Berkshire, it is likely that the next CEO will need to create divisions since it would be very difficult to handle over eighty direct reports.  The Marmon model might offer a potential roadmap for how this can be accomplished in a manner that does not erode the operational autonomy that Berkshire has granted to subsidiaries.

Professor Cunningham concludes his book by conceding that some “slippage” is inevitable at Berkshire:

At Berkshire after Buffett, expect slippage.  Deals may not come Berkshire’s way. Offers Berkshire makes may not be on terms as agreeable as they have been.  Negotiations may be less favorable.  Getting through the screen may be a few more subpar businesses or disappointing managers.  If the big deals do not come or the great managers do not follow, returns will be lower.  But absent some extraordinary disruption, returns will not be so disappointing as to warrant dismembering Berkshire or some other radical change.  Its design for sustainability is more powerful than that.

Indeed, Berkshire Hathaway will not be the same after Warren Buffett leaves the scene.  But that is not really the question that needs to be answered.  The question really boils down to whether Mr. Buffett’s creation is worth preserving over time.  The litmus test is not going to be evaluated based on Berkshire’s stock price in the short run but based on growth of intrinsic value over many years and decades.  Logically, intelligent capital allocation across subsidiaries can remain extremely powerful even if the capital allocator in question is not Mr. Buffett.  If subsidiaries can continue to operate well in the future without significant oversight and capital allocation between subsidiaries remains intelligent, there is no reason for the model to fail anytime soon.   Professor Cunningham’s book provides ample evidence to believe that Berkshire’s business model should outlast Warren Buffett.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. 

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Book Review: The Education of a Value Investor October 2, 2014

I constantly see people rise in life who are not the smartest, sometimes not even the most diligent, but they are learning machines. They go to bed every night a little wiser than they were when they got up and boy does that help, particularly when you have a long run ahead of you.

— Charlie Munger, USC School of Law Commencement, May 13, 2007

The most successful individuals in any field of human endeavor are usually those who have adopted a lifestyle of constantly seeking additional wisdom.  In many cases, this wisdom involves keeping up with new advances in fields such as medicine, engineering, or other hard sciences directly relevant to an individual’s chosen profession.  Without efforts to remain up to date, a doctor or scientist will soon find that his skills have atrophied regardless of the initial level of formal education that was attained.

Professional investors who have adopted a value based approach are certainly not exempt from the need to constantly expand their horizons.  However, once a certain baseline of knowledge specific to value investing has been attained, the main goal does not involve constantly revisiting the fundamental analytical framework but attempting to expand our circles of competence so the analytical framework can be applied to a broader set of opportunities.  Perhaps even more importantly, we must seek to know our own personality and temperament and tailor our desired circle of competence and investment approach accordingly.

The Education of a Value InvestorThe Education of a Value Investor chronicles Guy Spier’s evolution from a self described “Gordon Gekko wannabe” to a highly accomplished fund manager who has found success through a constant effort of attaining worldly wisdom and seeking to understand his own personality more fully.  The core of the book is a very personal reflection of the author’s journey and is unsparing when it comes to self criticism.  In this way, the book is more of a memoir than a road map containing specific actionable investment ideas, although several valuable insights are provided which should improve any investor’s process.

From Gekko to Buffett

Mr. Spier graduated at the top of his class in economics at Oxford University and went on to earn an MBA from Harvard.  However, despite his top notch education, Mr. Spier found himself working at D. H. Blair, an investment bank with a very problematic culture that was fundamentally at odds with how he wished to conduct his professional life.

During this difficult period, Mr. Spier became more thoroughly acquainted with value investing by reading Benjamin Graham’s The Intelligent Investor and Roger Lowenstein’s Buffett:  The Making of an American CapitalistHeavily influenced by the manner in which Mr. Buffett has conducted his life, Mr. Spier made the decision to leave D. H. Blair and eventually founded Aquamarine Fund.  Through Aquamarine, Mr. Spier has posted results far in excess of the S&P 500 and is now a very well known investor.

Most successful fund managers who write a book typically devote an introductory chapter to their history and then use the book to provide an investment framework that they have found useful over the years.  Often times, such a book is mostly a marketing document used to attract new clients.  Mr. Spier takes a radically different approach and devotes the bulk of the book to continuing a remarkably honest account of his personal journey.  The fundamental premise behind much of the book is that an investor must understand himself well enough to structure his personal and professional life in a manner that allows for success.  Additionally, there is great value in being generous with others in ways where mutually beneficial associations naturally develop over time.

A Turning Point

Perhaps the most important point in Mr. Spier’s journey was when he took the seemingly trivial step of writing a thank you note to Mohnish Pabrai after attending the annual meeting of Mr. Pabrai’s investment partnership.  This simple gesture of gratitude made without any intent of receiving something in return prompted a meaningful friendship and mutually beneficial collaboration over the years.  The most famous collaboration was when Mr. Spier and Mr. Pabrai pooled their resources to bid on Warren Buffett’s annual charity auction.  They won the auction on their second attempt and met Mr. Buffett for lunch in 2008.  Clearly, this lunch had a lasting impact on Mr. Spier and in many ways changed how he would respond to the financial crisis.

Readers will benefit from a number of insights provided in the book, particularly those related to the importance of one’s environment when it comes to investing success.  Following the lunch with Warren Buffett, Mr. Spier made the decision to leave the New York “vortex” and relocate his business and family to Switzerland.  By removing himself from an environment obsessed with short term results, Mr. Spier was able to better match his environment with his personality, thereby resulting in a setup more conducive to his brand of value investing.  Altering his environment extended well beyond simply choosing to move to a different city.  Everything from the location of his home and office to the setup of his computer monitor and the creation of a “distraction free” library where electronics are banned have contributed to a more productive environment.

This book is an account of one investor’s journey and obviously not all of Mr. Spier’s choices will match any particular reader’s personality.  The important point, however, is that we must all embark on a path of discovering the environment that best suits our own personalities and allows us to achieve the best results that we can.

Checklists and Practical Advice

Toward the end of the book, Mr. Spier shares a number of specific pieces of advice that should be helpful to many investors.  Some of the advice is hardly groundbreaking like the admonition to avoid checking stock prices constantly and avoid people who are blatantly trying to sell you something.  However, two of the suggestions are particularly thought provoking and worthy of consideration.

Meat and Vegetables Before Dessert

Mr. Spier urges investors to gather investment research in the proper order and suggests tacking the primary sources (10K, 10Q, and annual letters) before reading any secondary sources such as news articles or analyst reports.  This is important because our brains are wired to give more influence to information we read first, so it is important to read the most direct sources first.  While it is intellectually less demanding to read an analyst report or a news article than to delve into a 10K report, we should avoid reaching for dessert before consuming the basics.  While most seasoned investors would never allocate capital without reading primary sources, it is common to review news articles and other data prior to more primary sources.  Perhaps this should be avoided.

Avoid Discussing Current Investments

Many value investors are familiar with Robert Cialdini’s book Influence:  The Psychology of Persuasion due to its presence on reading lists recommended by Charlie Munger.  One of the principles discussed in the book is related to “commitment and consistency”.  When we publicly take a position on a topic, we create psychological impediments to changing our views even when facts might change in the future.  For example, if an investor recommends a stock in a speech or interview and then the facts change, it can be excruciating to have to alter one’s views to match reality.  Mr. Spier suggests that we avoid discussing current investments and provides an example of where doing so backfired for his fund.

This particular advice should be particularly relevant to any investor who also writes about his or her investments.  A good example can be taken from The Rational Walk’s series of articles on Contango Oil & Gas.  After taking a bullish stand on Contango in September 2012, we published an update in October 2012 which in retrospect appears to rationalize possible flaws in the original investment case.  By May 2013, it was increasingly clear that the outcome envisioned eight months earlier was not working out, which was discussed in a final article on the subject.  In retrospect, there is no doubt that the “commitment and consistency” principle played a role in the length of time required to overturn the investment thesis.  It is very likely that without a public discussion, this realization would have arrived much sooner (and less expensively).

Recommended for Experienced Investors

Mr. Spier has provided a great service by delivering a remarkably candid and humble book that allows investors to potentially learn from his mistakes.  It is always better to learn vicariously through the mistakes of others when possible.  However, when it comes to the psychological pitfalls of investing, a certain baseline level of personal experience is most likely required before one can profit from the experiences of others.

It would be all too easy for a novice investor to read this book and arrogantly declare that there is no way he or she would fall into the same traps.  Only when one is humbled to a certain degree through one’s own errors is it normally possible to be open to learning from the mistakes of others.  The readers who will gain the most from this book are likely to be those who have made their own share of mistakes and seek to improve themselves going forward.

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Revisiting Berkshire Hathaway’s Valuation September 18, 2014

Berkshire Hathaway

Berkshire Hathaway HeadquartersOver the past five years, Berkshire Hathaway has been a frequent topic on The Rational Walk easily surpassing the coverage of any other company.  In retrospect, there have been many reasons for this lopsided treatment of one company in a universe of thousands of publicly traded businesses.  What motivated this unusual focus on Berkshire Hathaway?

Perhaps the most important reason is the clear fact that Berkshire Hathaway is a unique company driven by a very uncommon management philosophy which has led to extraordinary results for shareholders. The record of Warren Buffett and Charlie Munger’s management of Berkshire Hathaway over the past fifty years is unique in business history and certain to be examined for decades to come.  Both investors and managers naturally seek to better understand this extreme outcome and the approach that was used to achieve it.

However, another important motivation involved the market’s valuation of Berkshire in the aftermath of the tumultuous events of 2008 and early 2009.  For a number of years, it appeared that the market had permanently reassessed Berkshire’s intrinsic value relative to valuation levels that had prevailed for a long period of time.  In recent weeks, Berkshire’s stock price has reached record highs, but more importantly the valuation of the stock has returned to levels that might have been considered within the bounds of “normalcy” prior to late 2008.  In this article, we revisit Berkshire’s current valuation relative to historical ranges and assess whether a return to normalcy is justified.

Berkshire’s Price-to-Book Ratio

There are a number of approaches that analysts have used to estimate Berkshire Hathaway’s intrinsic value, many of which have been discussed in some detail in past articles as well as in more extensive reports published in 2010 and 2011 (both of which are now available at no cost).

Following Berkshire’s price-to-book ratio is one of the more straightforward approaches and does have some important limitations.  However, it does have the advantage of being easily calculated based on market prices and figures published on a quarterly basis in Berkshire’s SEC filings and there is at least rough correlation between valuations derived from the price-to-book ratio and more sophisticated approaches.  Additionally, it is often cited by market participants and analysts and is therefore a good way of looking at investor sentiment with respect to Berkshire shares.  Perhaps most importantly, price-to-book is the criteria upon which Berkshire’s repurchase plan is based indicating that Warren Buffett regards this metric to be an important, albeit understated, measure of Berkshire’s intrinsic value.

The chart below presents the closing price of Berkshire Hathaway Class A shares for each trading day since December 31, 1999 along with the then-current book value per A share which is published on a quarterly basis.  Additionally, Berkshire’s repurchase threshold, which was introduced in September 2011, is charted since the date of its introduction.  The repurchase threshold was initially set at 110 percent of book value in September 2011 and subsequently raised to 120 percent of book value in December 2012.

Berkshire Hathaway 2000-2014

From this simple chart, we can see that Berkshire has almost always traded at a significant premium to reported book value except on a few occasions.  In early 2000, Berkshire was out of favor as the dot-com bubble reached its peak and briefly traded at only a small premium to book value.  This situation prevailed for only a short time before Warren Buffett indicated an interest in repurchasing Berkshire shares at $45,000, which was 118 percent of book value at the time.  During the depths of the panic in the fourth quarter of 2008, Berkshire briefly approached book value as reported at the end of the third quarter;  however, this was during a time when market participants were not only in a state of panic but also correctly anticipated that depreciation in Berkshire’s large portfolio of marketable securities would lead to a drop in book value.  During the third quarter of 2011, Berkshire shares approached book value which prompted the introduction of Berkshire’s repurchase plan.

The following chart represents the same underlying data but in a form that allows a more clear examination of the price-to-book ratio trend over time.  We simply take the closing price of Berkshire’s Class A shares and divide by the last reported book value figure provided by Berkshire’s annual and quarterly SEC filings.  The dark red line represents Berkshire’s repurchase authorization threshold introduced in September 2011 and revised in December 2012.

Price to Trailing Book Value

From just a brief look at the chart, it is quite apparent that the market’s assessment of Berkshire Hathaway changed six years ago.  For most of the decade up to that point, Berkshire traded in a range between 150 and 200 percent of book value.  Following the financial crisis, Berkshire’s range has been between 100 and 150 percent of book value.  The recent appreciation of Berkshire shares has increased the valuation to 147 percent of book value as of September 17.  This is at the top of the post-financial crisis range, but toward the bottom of the range that prevailed prior to the crisis.

Was the Lower Range Justified in late 2008 and early 2009?

It is important to recognize the fact that Berkshire Hathaway was not alone in the market’s valuation adjustment of “financial” companies following the financial crisis.  The level of perceived risk in financials increased dramatically in the aftermath of September 2008 and for the most part, the market was justified in its reaction at the time given the uncertainty that prevailed.  Mr. Buffett himself has commented extensively regarding the importance of government intervention at the time, and it was not clear whether officials were up to the task required.  Regardless of one’s views on the specifics of the various “bailouts”, it is quite clear that the carnage in the financial sector would have been far worse had there been less intervention at the time.

Despite the rationality of the market’s overall aversion to financials in late 2008, it is important to point out that Berkshire itself was in remarkably good shape compared to other companies.  Furthermore, Berkshire was a conglomerate engaged in diverse business activities even though it was perceived and valued as a financial.  Berkshire was in a position to provide financing to others at a time when lack of liquidity threatened to sink firms that were previously seen as rock solid.  One could argue that the market’s failure to differentiate Berkshire from its perceived peers was irrational on the part of Mr. Market.

On the other hand, investors had a wide array of choices as the market hit its lows in early 2009 and Berkshire Hathaway stock is necessarily evaluated against other alternatives.  In short, looking at the situation in retrospect, it is no surprise that Berkshire shares were roughly cut in half in less than six months even though intrinsic value couldn’t have possibly dropped by that much.  Indeed, Berkshire suffered a drop of less than 15 percent in book value per share over the course of Q4 2008 and Q1 2009 while the share price dropped over 50 percent from September 19, 2008 to its low on March 5, 2009.

Is a Lower Range Still Justified?

While hindsight might appear to justify the market’s initial reassessment of Berkshire’s intrinsic value in late 2008 and early 2009, it is much harder to make the same case as the United States economy began to recover from the financial crisis.  Even long after market participants had overcome the shocks of 2008 and early 2009, Berkshire shares continued to trade at very low price-to-book ratios.  The implication was that Berkshire’s many franchises were not collectively worth much more than the carrying value of the businesses despite the fact that Berkshire had proven itself to be resilient throughout the downturn.

The post-recession years also brought major changes to the composition of Berkshire itself with the most notable example being the acquisition of Burlington Northern Santa Fe in early 2010.  While property-casualty insurance remains Berkshire’s most important business today, the acquisition of BNSF significantly transformed Berkshire’s earnings stream.  If we also consider the acquisition of Lubrizol, additions to the Berkshire Hathaway Energy portfolio, purchasing the minority interests of Marmon, and many “tuck-in” acquisitions, Berkshire has become far more diversified over the past five years.

BNSF is an interesting case in point when looking at Berkshire’s price-to-book ratio.  At the time of the acquisition, Berkshire used a combination of cash and stock to acquire BNSF and the purchase price was allocated to various accounts on Berkshire’s balance sheet and included substantial goodwill.  As we revisited the BNSF acquisition in late 2013, it became clear that if BNSF had remained a stand-alone company, the market’s assessment of its intrinsic value would have dramatically increased from 2010 to 2013.

The following chart shows the stock price performance of Union Pacific, BNSF’s closest comparable company, from the date of Berkshire’s acquisition of BNSF to September 18, 2014 (click for larger image):

Union Pacific Stock ChartClearly, if Berkshire Hathaway had waited until today to acquire BNSF, a much higher purchase price would have been required.  Yet, Berkshire’s book value continues to reflect the acquisition cost of BNSF in February 2010 unadjusted for any subsequent reassessment in the eyes of Mr. Market.  If we were to adjust BNSF’s carrying value on Berkshire’s balance sheet to reflect the same level of appreciation as Union Pacific shares, Berkshire’s book value would increase by over $50 billion, or in excess of $30,000 per A share.  However, none of that hypothetical increase in value is reflected in Berkshire’s reported book value.


The example of BNSF discussed above is illustrative not merely because of the rather extreme nature of the potential valuation discrepancy between its carrying value on Berkshire’s balance sheet and its likely market value.  It also alludes to the fact that many of Berkshire’s other businesses have similarly appreciated over time.  The most extreme examples involve companies like See’s Candies that were purchased decades ago at a cost that is a tiny fraction of today’s true market value.  Over long periods of time, one can expect the difference between fair value and carrying value of wholly owned subsidiaries to rise rather than fall, implying that Berkshire’s price-to-book ratio might be expected to increase over time rather than decline.

This article focuses on Berkshire’s price-to-book ratio rather than utilizing a broader set of tools such as the float based, “two column”, or sum-of-the-parts approaches that have been discussed on this site and elsewhere over the years.  Although the price-to-book ratio has its important limitations, enough evidence exists to believe that Berkshire’s valuation based on this measure should not be appreciably lower than it was prior to the financial crisis.  Furthermore, one could reasonably expect Berkshire’s price-to-book ratio to increase at a slow pace over a period of several years.

It appears that Berkshire’s stock price has finally returned to the lower end of a “range of normalcy” in recent weeks.  While no longer as severely undervalued as it was for most of the past six years, there is no evidence to suggest that Berkshire’s share price has reached irrational levels even though it is at a record high.  Given today’s share price, Berkshire shareholders are likely to achieve returns commensurate with the growth of intrinsic value plus perhaps some additional increase in the market’s assessment of the stock.  Fortunately, Berkshire has prospects for intrinsic value growth that are quite attractive in today’s investment environment.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. 

Correction to Article

September 20, 2014

A reader brought up an error in the article related to Burlington Northern Santa Fe.  The article, which remains as originally posted, stated that BNSF remains on Berkshire’s balance sheet at the approximate valuation paid for by Berkshire in February 2010.  While this is technically accurate, the statement ignores the fact that BNSF has remitted dividends to Berkshire on a consistent basis over the years.  BNSF had aggregate net income of $14,012 million from the date of Berkshire’s acquisition through the end of the second quarter of 2014.  During that same period, BNSF paid $14,250 million in cash dividends to Berkshire.  So while BNSF’s book value has remained roughly the same, Berkshire’s overall book value has grown due to cash dividends remitted to the parent company.

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Coca Cola Misfires on Share Repurchase Rationale March 29, 2014

“Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.”

— Warren Buffett, 2005 Letter to Shareholders

Coca Cola’s Compensation Controversy

The Coca Cola Company is in the midst of a major controversy prompted by shareholder objections to the company’s equity compensation plan which is outlined in the company’s 2014 proxy statement.  David Winters, managing member of Wintergreen Advisors which controls 2.5 million shares of Coca Cola, has sent two letters (dated March 21 and March 27) to Coca Cola’s board of directors in which he strongly objects to the design and magnitude of the equity compensation program.  Mr. Winters has also posted a YouTube video in which he presents his case against the compensation plan.

Mr. Winters makes some strong points in his presentation regarding the economics of stock based compensation and the magnitude of the proposed grants at Coca Cola in particular.  In recent days, there have been a number of news stories and related commentary regarding the merits of stock option plans as well as the question of whether executive compensation is excessive in general.

Even a cursory glance at Coca Cola’s proxy statement shows that the named executive officers are paid extremely well through a variety of cash and equity programs.  However, anyone who has been reading proxy statements of Fortune 500 companies knows that Coca Cola is far from unique.  While serving as an executive officer for a large enterprise is no doubt a major responsibility, we have reached the point where anyone serving in such a position for more than a few years is assured of an eight figure net worth providing financial independence for life, in most cases regardless of the company’s performance.

The debate over the level of executive pay and the design of compensation packages occurs during proxy season every year and represents a long term problem for American shareholders.  However, we will leave that larger debate for another day and instead focus on Coca Cola’s highly problematic response to Mr. Winters.  We find the response to be not only patronizing but highly intellectually suspect when it comes to the company’s understanding of capital allocation.

Lemonade Stands and Capital Allocation

Coca Cola’s latest response to Mr. Winters was written by Gloria Bowden who serves as the company’s associate general counsel and secretary.  The title of the response is What Lemonade Stands Can Teach Us About Ownership which is an interesting way to begin a response to a concerned long term shareholder who controls approximately $100 million of the company’s stock.

Once one gets over the patronizing tone, it initially appears that Ms. Bowden is simply reiterating the justification for stock compensation plans that have been put forward countless times in the past.  However, Ms. Bowden does not stop there.  She attempts to justify how shareholders are “protected” by the fact that Coca Cola has a stock repurchase plan in place:

First, we regularly repurchase shares in the stock market.  This reduces the amount of shares on the market which offsets the potential dilutive impact.  In 2013, we repurchased $4.8 billion of our stock. That far exceeded the $1.3 billion repurchased related to employee stock options exercises.

One can fairly debate the pros and cons of providing management with equity compensation and whether the much hoped for “alignment of incentives” is actually created through grants of stock options and restricted stock.  However, the idea that shareholders are “protected” in any way merely because the company has a stock repurchase program that “offsets dilution” makes no sense whatsoever.

Conflating Operating and Capital Allocation Decisions

The act of granting stock options or restricted stock to employees is an operating decision to effectively sell additional pieces of the company to use as currency for compensation rather than using cash.  The act of repurchasing stock is a capital allocation decision that is entirely separate from the decision to grant stock based compensation.

If a company is using equity to pay employees, it is obvious that the effects of the decision are magnified to the extent that the shares are undervalued and dampened if the shares are overvalued.  In other words, the company’s owners should be less inclined to use equity to pay employees at times when shares are trading below intrinsic value.  If the stock is trading well above intrinsic value, the effect of using stock for compensation is less harmful.  Effectively, small pieces of the company are being transferred from owners to employees when stock is used as compensation.  As with any “sale” of the business, owners should hope to sell at high levels rather than low levels.

The economics of repurchases are exactly the opposite:  Shareholders should cheer when repurchases occur below intrinsic value and hold management to account when repurchases occur above intrinsic value.  The idea that repurchases at any price will “protect” shareholders from the impact of stock option dilution reveals a complete misunderstanding of capital allocation.  Repurchases, whether motivated by reducing the dilution of a stock option program or for other reasons, will only make shareholders richer if executed below intrinsic value.

Coca Cola and all other companies must make a decision regarding how to deploy free cash flow.  Cash can be reinvested in the business, used for acquisitions, paid to shareholders as dividends, or used for repurchases.  The fact that Coca Cola directed $4.8 billion toward repurchases in 2013 and that this amount more than offset the dilution from equity compensation is completely beside the point.  These funds belong to shareholders, not to management, and it is not through some form of corporate benevolence that the shares were retired.

Corporate Governance at Coca Cola

We do not necessarily expect Ms. Bowden, who is presumably trained as a lawyer, to be well versed in the finer points of capital allocation but we hope that Coca Cola’s senior management and board of directors would immediately recognize the fallacy of her logic with respect to repurchases categorically “protecting” shareholders from dilution.  It also seems more appropriate for Muhtar Kent, Coca Cola’s Chairman and CEO, to take the responsibility of responding to a major shareholder’s concern rather than delegating the task to a lower level official.

Coca Cola’s Board of Directors is comprised of seventeen members who are paid well in excess of $200,000 per year and most of whom have substantial business experience.  Until recently, Warren Buffett was on the board and Howard Buffett currently represents Berkshire Hathaway’s substantial ownership interest in Coca Cola.  It is inconceivable that the board of directors fails to recognize the simple economics behind repurchase decisions outlined in this article and it should be an embarrassment to see a corporate general counsel post such an illogical rationale as part of a poorly thought out and tone deaf response to a major shareholder’s concerns.  Whatever justification Ms. Bowden provided regarding the alignment of incentives through ownership (or quasi ownership) by management is far overshadowed by flimsy and alarming logic with respect to capital allocation.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of The Coca Cola Company directly and indirectly by virtue of ownership of Berkshire Hathaway common stock. 

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Book Review: A Manual on Common Stock Investing March 28, 2014

“It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all.  It’s like an inoculation.  If it doesn’t grab a person right away, I find that you can talk to him for years and show him the records, and it doesn’t make any difference.  They just don’t seem to grasp the concept, simple as it is.”

— Warren Buffett, The Superinvestors of Graham-and-Doddsville, 1984

It has been thirty years since Warren Buffett referred to value investing as an “inoculation” and his sentiment appears to be just as valid today.  The ease of access to high quality information is far greater for investors today but so is the constant noise from the hopelessly short term oriented financial media.  If a new investor is to stand a chance against the risk of becoming a speculator, he or she needs to have a firm grounding in value investing concepts and a road map for obtaining further knowledge and avoiding the noise.

A Manual on Common Stock InvestingJohn Rotonti presents beginning investors with an easily understandable guide to value investing in A Manual on Common Stock Investing.  All writers who attempt to explain investing to beginners must strike the right balance between conveying the basic principles in a manner that stresses the fact that these concepts might appear simple but are not simplistic.  Otherwise, it is all too easy for new investors to get lulled into overconfidence.  Mr. Rotonti succeeds in presenting the basic formulation required for success while stressing the need for further reading to develop an aspiring investor’s circle of competence.

The book is divided into seventeen brief chapters outlining the basic concepts a beginning investor must learn before allocating any capital.  For example, Chapter 13 covers the topic of compound interest which is one of the most powerful but least understood concepts among the general population.  It is very likely that if high school graduation required mastery of compound interest, millions of Americans would be far more prudent when it comes to savings as well as debt.  Mr. Rotonti covers this subject well using examples that should resonate with readers who were previously unfamiliar with the concept.  Since the pursuit of compounding at attractive rates of return is the driving force behind all enterprising investing, it is critical for readers to understand the massive difference in the end result of a lifetime of 10% returns compared to 7% returns.

While the book does encourage readers to pursue investing if they have a passion for the process, Mr. Rotonti urges readers who do not have the time or inclination to direct their money into index funds so they at least earn the returns offered by the overall market.  One of the most significant risks facing investors with only a passing interest in the process is that overconfidence could lead to a concentrated portfolio that performs very poorly or even results in the permanent loss of a material amount of capital.  Mr. Rotonti devotes a brief chapter to the importance of avoiding permanent losses of capital and reminds readers of the less than intuitive math required to recover from significant losses.  Diversification via broad indexing is nothing to be ashamed of for the non-enterprising investor and, over an investing lifetime, should provide attractive results while minimizing the risk of permanent losses.

Writing a book with the intent of being one of the first exposures for readers into the world of investing is not an easy task.  The balance between encouragement and caution is not necessarily easy to achieve.  Many of the concepts advocated by value investors like Warren Buffett seem so “obvious” to novices that overconfidence can quickly develop.  Mr. Rotonti provides a recommended reading list for those who would like to pursue the subject further.

After finishing this book, most readers should have a good sense of the importance of avoiding losses, the power of compounding, and the basic language and concepts used by value investors.  Based on this knowledge, the reader can determine whether to proceed with an “enterprising” strategy or opt for indexing.  We would recommend this book for beginning investors curious about whether an active role suits their interests, skills, and temperament.

Disclosure:  The Rational Walk received a complimentary review copy of the book from the author.

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