Tuesday, 8th December 2009

Warren Buffett Investment Lessons, part 4

Written by George Traganidas Topics: Stock Investing

Management

Making the most of an existing strong business franchise is what usually produces exceptional economics. Managers need to protect their franchise, control costs, search for new products and markets that build on their existing strengths and do not get diverted. They need to work exceptionally hard at the details of the business. He advocates leaving management alone to do their job.

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

Only do business with people that you like, trust and admire.

What a manager must do is handle the basics well and not get diverted. He must establish the right goals and never forget what he is set out to do. When managers make capital allocation decisions, it is vital that they act in ways that increases per-share intrinsic value.

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.

It is both deceptive and dangerous for CEOs to predict growth rates for their companies.

Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Corporate Boards

Warren Buffett’s advice on selecting board members is that they should be business savvy, interested in the job and owner-oriented. They should have true ownership interest (that is, stock that they or their family have purchased not be given by the company or received via options).

The director’s job is to faithfully represent owners.

Audit committees

The key job of the audit committee is simply to get the auditors to divulge what they know. In my opinion, audit committees can accomplish this goal by asking four questions of auditors, the answers to which should be recorded and reported to shareholders. These questions are:

1. If the auditor were solely responsible for preparation of the company’s financial statements, would they have in any way been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed. The audit committee should then evaluate the facts.

2. If the auditor were an investor, would he have received – in plain English – the information essential to his understanding the company’s financial performance during the reporting period?

3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?

4. Is the auditor aware of any actions – either accounting or operational – that have had the purpose and effect of moving revenues or expenses from one reporting period to another?

The questions we have enumerated should be asked at least a week before an earnings report is released to the public. That timing will allow differences between the auditors and management to be aired with the committee and resolved. If the timing is tighter – if an earnings release is imminent when the auditors and committee interact – the committee will feel pressure to rubberstamp the prepared figures. Haste is the enemy of accuracy.

Shareholder Responsibilities

Large shareholders of any corporation should focus on the following 3 questions:

  • Does the company have the right CEO
  • Is he/she overreaching in terms of compensation
  • Are proposed acquisitions more likely to create or destroy per-share value

Follow the practical way,
George

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