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Buffett 2.0 – ” buying good businesses at fair prices rather than fair businesses at good prices”.

Value investing is not low multiples.. And high multiples could also be value investing.

Warren Buffett noted that investments in the secondary market have generally performed better due to periodic market inefficiencies offering bargains, unlike the new-issue market, where sellers rarely underprice their offerings.

There was an important change to accounting – companies must now recognize the present value of liabilities for post-retirement health benefits, increasing balance-sheet liabilities and reducing net worth.

Another important reminder – stock options are real expenses.

An important classification of enterprises: businesses and franchises.

An economic franchise arises from a product or service that:
(1) is needed or desired; (2) is thought by its customers to have
no close substitute and; (3) is not subject to price regulation.
The existence of all three conditions will be demonstrated by a
company’s ability to regularly price its product or service
aggressively and thereby to earn high rates of return on capital.
Moreover, franchises can tolerate mis-management. Inept managers
may diminish a franchise’s profitability, but they cannot inflict
mortal damage.

In contrast, “a business” earns exceptional profits only if it
is the low-cost operator or if supply of its product or service is
tight. Tightness in supply usually does not last long. With
superior management, a company may maintain its status as a low-
cost operator for a much longer time, but even then unceasingly
faces the possibility of competitive attack. And a business, unlike
a franchise, can be killed by poor management.

Buffett identified the weakness of (media) franchises, which can’t be told by earnings immediately.

Buffet said they would continue to hold Cap Cities and Washington Pos.

For See’ Candy, California introduced a sales tax of 7%-8% on “snack food” including candies.

One secrete of low cost of funds is underwriting loss vs. float available.

Buffett also talked about the mistake in not making more money – omission.

“Margin of Safety” is important.

Berkshire’s insurance operations leverage float (funds temporarily held before claims are paid) to generate low-cost capital.

Buffett values market downturns as opportunities to acquire quality investments at discounted prices – “fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990.”

Buffett did more old-fashioned “fallen angels” investment with RJR Nabisco bonds. But “angels” only – “as we survey the field, most low-grade bonds still look unattractive. The handiwork of the Wall Street of the 1980s is even worse than we had thought: Many important businesses have been mortally wounded.”

Again, Buffett invested in an industry with fierce competition and is asset heavy – airlines (instead of textile). ” In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor”

Buffett talked about a high level arbitrage: 1) borrowing with zero-coupon bonds with x% effective interest rate, 2) buying preferred shares with x+y% coupon w/ a conversion option in the future.

Buffett also criticized the prevalence of zero coupon bonds, which can easily let borrowers overborrow, and lenders may book unrealistic “profits”.

There is also an interesting discussion of “deferred tax liabilities”, which is essentially an interest-free loan by gov.

Buffett believes efficient market exists most of the time, but not always, given his long term history of arbitrage returns of over 20% vs market of 10%.

It’s such an amazing fact that for quality businesses like See’s Candy, the profit relied a lot on December (90% of its 1988 annual profit).

Again, Buffett cautioned against the ever larger capital base, which needed more additional profits to continue to compound.

Berkshire’s business model was hit by tax reforms:

1. Corporate capital gains tax rates have been increased from
   28% to 34%, effective in 1987.
2. all corporations will be taxed on 20% of the dividends
   they receive from other domestic corporations, up from 15% under
   the old law; additional 15% tax on the residual 80% for property/casualty companies if the stocks were purchased after August 7, 1986.
3. interest on bonds purchased by only to property/casualty companies after August 7, 1986 will only be 85% tax-exempt

There was little Buffett can do, but to accept the marginally lower after-tax result. Oh the company bought a jet!

In terms of philosophy, Buffett emphasized it as – “we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful”.

One important lesson learned and shared by Buffett this year, with the shutdown of the textile business, is that capital allocation can be smart on a stand alone basis but lackluster collectively – “just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes”.

Competition destroys ROE on investment.

Another lesson – when liquidating businesses, sale price of equipments can be much lower than the book value of assets, even lower than removal costs.

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Buffett also commented that the high valuation in stock market, although makes Berkshire look very profitable, left little opportunity for asset allocation in the future.

Berkshire’s growth in bvps slowed down in 1984 to 13.6% vs. previously over 20% compounding growth.

Buffett loves the idea of stock repurchases for his portfolio companies. He could then sell some shares, but he liked to retain the % of ownership so that his proportion of any dividend income won’t drop.

Buffett viewed this kind of transactions as a synthetic “dividend” and wanted to be taxed as dividend. Although from accounting perspective this would be treated as “sales of stock”, those “transactions were
dividends for IRS purposes”.

Buffett loved newspapers – “the economics of a dominant newspaper are excellent”. And he considered some local newspaper as locally “dominant”.

Buffett bought “risky” bonds, and viewed them as businesses that can generate cash – 16.3% after tax yield! They also acknowledged that “ceiling on upside potential is an important minus”.

Again, Buffett talked about the weakness of capital-heavy business w/ competition – reinvestment shall be hurt by inflation (e.g. if high inflation, new store opening will cost more), and thus previous profits is not representing the future. Those earnings are “restricted”, as the business needs to invest to maintain its economic position.

This limits a company’s dividend policy.

Another common problem is reinvesting in “economically unattractive, even disastrous” adventures.

No wonder Buffett liked to invest and receive dividends: “the effective Federal income tax rate on dividends is 6.9% versus 28% on capital gains”.

Buffett also discussed the “goodwill”, and amortization as an expense. He thinks amortization costs doesn’t change the quality of the businesses being acquired, which is true.

He also seemed to be arguing that paying high p/b is good, as additional investments would result in more economic gains. This is true, as long as the business would continued to be valued at a similar p/b.

He also indicated the unwillingness to sell a business – “regardless of price,
we have no interest at all in selling any good businesses that Berkshire owns, and are very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations.”