Book: The Essays of Warren Buffet: Lessons for Corporate America

I recently finished reading "The Essays of Warren Buffet: Lessons for Coporate America". Given my thin knowledge of corporate finance, corporate governance, and investing, this book was quite useful. Over the next few posts I'll be presenting a few interesting ideas from the book. This first post is based on the first chapter.

Chapter 1 Corporate Governance

The chapter is mainly about Buffet's frustration with the top management of firms not owned by Berkshire and how things are different at Berkshire owned firms.

He starts with talking about the significance of full and fair disclosure of company performance. He doesn't approve of any company that highlights EBITDA (Earnings Before Interest, Taxes, Depreciations, and Amortization). He says that proponents of EBITDA argue that depreciation is not truly an expense, given that it is a "non-cash" charge. He offers a convincing counter-example: imagine that at the beginning of this year a company paid all of its employees for the next 10 years of service. In the following nine years, compensation would be a "non-cash" expense - a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years 2 through 10 would simply be a bookkeeping fomality ? Buffet offers some more views on the significance of clear accounting. He finally sums up his views as follows: "We want our managers to think about what counts, and not how it is counted."

Buffer is quite critical about CEO performance and compensation. He believes that CEOs of many public companies get away with underperformance for two reasons. Fistly, there are no clear standards of CEO performance. And secondly, the system charged with monitoring the CEO - the board of directors - often doesn't do a good job. Buffet provides some interesting insights into who should and should not be in the board. According to him, a director must have 3 qualities: (1) business savvy, (2) interest in the company, and (3) care about the owners. The most important service a director can do is to watch the CEO, ensure that he/she is doing a good job, and fire the CEO asap if not. Regarding the CEO, Buffet says that his message to every CEO is to run the business as if (1) you own 100% of it, (2) it is the only asset in the world that you and your family have or will ever have, and (3) you can't sell or merge it for at least a century.

Even if you have the best management and best board, you can still come out a loser if there are issues with the line of business. Buffet cites the example of a very well managed company, Burlington textiles, that has yielded substantially below average returns over the past few decades. He : "If you want to get a reputation as a good businessman, be sure to get into a good business". He offers another handy quote about working too hard on terrible businesses: "A horseman that can count to ten is a remarkable horse - not a remarkable mathematician". Buffet has a large repository of handy quotes on this topic. For example, in Chapter 2 he cites "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".

In the last section of this chapter, flaws in options based compensation and how that corrupts CEO performance. Buffet argues that if a midly profitable company reinvests its earnings (instead of giving dividends), it can still maintain a pretty decent stock price growth over time assuming a constant PE ratio. Consequently, managers will reap good profits from the fixed-price stock options they received when starting, even though they have merely sustained the company's slow growth. Buffet suggests that cash bonuses have all the same merits as stock options since the managers can use it to buy as much stock as they want from the open market.