Suggested questions to consider for Essays’ of Warren Buffett, 4th Edition

Leo H Chan
Associate Professor of Finance, Woodbury School of Business
Utah Valley University

It has been 13 years since the publication of Using the Essays of Warren Buffett: Lessons
for Corporate America in the Classroom (The Essays). The Essays is currently on the 4th edition
and coverage has extended quite a bit. The reference pages for the questions for discussion is no
longer in their right place. This note is an update for those interested in using the 4th Edition of
The Essays in the classroom.

Chapter I. Corporate Governance

Question I.1. What does Buffet mean when he says that while Berkshire Hathaway (BH) is a
corporation, management’s attitude is one of being in a partnership? (p. 28)

Among other things, the annual reports and letters to stockholders are very
straightforward, and they are written personally by Buffett, not by a PR person. At the
stockholder meetings, both Buffett and Munger are willing to take questions for as long
as there are questions. Buffett: “…we believe in telling you how we think so that you
[the stockholders] can evaluate our approach to management and capital allocation.”
Further, Buffett does not believe in using accounting maneuvers to smooth accounting
results. His guiding principle is that he treats shareholders the way he’d want to be
treated, if their roles were reversed.

Question I.2. Most BH directors have a major portion of their wealth in BH stock, and both
Buffett and Munger have over 90% of their wealth in BH stock. Why is this not a
violation of the diversification principle? (p. 29)

Berkshire Hathaway is a very well diversified company owning many companies as well
as numerous stocks in the GEICO stock portfolio. In essence, owning BH stock is like
owning stock in a diversified mutual fund.

Question I.3. Buffett anticipates that future growth in intrinsic value at BH will be less than it
has been in the past. Why? (p. 30)

It was easier to achieve high growth in BH’s intrinsic value when the company was
smaller, but with the much larger size now it will be nearly impossible to continue the
25% growth previously achieved. Still, the goal is to be “above average.” It should be
noted that Buffett does not measure the performance of Berkshire in terms of total size,
but rather by per share progress.
Question I.4. According to Buffett, BH’s stockholders benefit, in the long run, from a declining
stock market. In what sense is this true? (p. 30)

A declining stock market reduces the prices that BH will have to pay to buy either
portions of businesses or whole businesses. There will be many more bargains for BH to
take advantage of. In addition, companies that BH already owns buy back their own
shares, which will be at cheaper prices.

Question I.5. Berkshire is well known for the fact that the CEOs of their subsidiary companies
are given free reign to manage their companies. Each CEO is given a simple mission.
Discuss. (p. 50-53)

The mission given to Berkshire subsidiary CEOs is to run their company as if:
1. You own 100% of it,
2. It is your only asset, i.e., it effectively represents 100% of your invested wealth,
3. During your life time you will not be able to sell or merge the company, and
4. Decisions should not be driven by accounting considerations.

Chapter II. Corporate Finance and Investing

Question II.1. Buffett calls up the “Mr. Market” metaphor first introduced by the legendary Ben
Graham, Buffett’s teacher and friend. Discuss the concept of Mr. Market and how it
relates to the concept of efficient markets. (p. 85)

Mr. Market is, of course, the financial market in which your company’s stocks trade each
day. Each day Mr. Market sets a price on your securities, and you can take advantage of
it or ignore it. From time to time Mr. Market will seriously undervalue or overvalue
your shares which you can take advantage of.

According to the efficient markets theory, stocks would not be under or over priced,
which Buffett does not agree with. For Buffett the operating results determine whether
an investment is successful, not the market valuation.

Question II.2. What are Buffett’s views on the Efficient Markets Theory (EMT)? (p. 95)

Buffett believes that “the market is reasonably efficient much of the time,” however, he
believes that is a far cry from saying that it is always efficient. He uses the arbitrage
experience of Graham and now Buffett over a 63-year period to demonstrate that it is
quite possible to outperform the market over an extended period of time “by evaluating
facts and continuously exercising discipline.”

Question II.3. Buffett’s views on portfolio diversification are at odds with the conventional
wisdom in this area. Explain. (pp. 98 - 101)
 Buffett believes that portfolio concentration actually reduces risk because it allows the
investor to focus on each investment in an intense manner that would not be possible
with a large diversified portfolio. Being more focused will allow the investor to be more
accurate in the assessment of business opportunities.

He gives a hint as to why Berkshire was not an investor in the tech boom of the late 90s
by saying that “…a business that must deal with fast-moving technology is not going to
lend itself to reliable evaluations of its long-term economics.”

Question II.4. How does Buffett’s approach to investing in a controlling interest in a company
differ from investing a small amount in a company? (pp. 104 - 106)

Actually the approaches are the same. At Berkshire the same types of analyses are
conducted whether it is for the purchase of all of company’s stocks or simply a minority
interest in the company. “We want the business to be one (a) that we can understand;
(b) with favorable long-term prospects; (c) operated by honest and competent people;
and (d) at a very attractive price.”

Question II.5. Buffett says that his most surprising discovery in the business world was an
invisible force he calls the “institutional imperative.” Discuss. (pp. 117 -120)

Essentially, Buffett is speaking about a momentum that develops within a business to do

certain deals despite their irrationality. To name a few (p. 99): businesses resist
changes to their current direction, corporate projects and acquisitions will always
materialize to soak up available corporate funds, projects favored by the business leader
will be supported by the staff, and peer companies will be mindlessly imitated.
“Institutional dynamics, not venality or stupidity, set businesses on these courses, which
are too often misguided.”

Chapter III. Investment Alternatives

Question III.1. Discuss Buffett’s analysis of the junk bond failures of the 1980s. (p. 127)

Originally, junk bonds were the bonds that had been issued by “fallen angels,” i.e.,
companies that at one time were financially strong but had fallen on hard times causing
their previously investment grade bonds to become “junk.” These companies were
looking for a way to get back to financial respectability and restore the quality of their
bonds.

The new junk bonds being offered in the 1980s were junk bonds from their date of issue,
i.e., they were issued by companies that for various reasons were financially weak. The
bonds never were investment grade. The theory was that the heavy load of debt incurred
by these junk bond issuing companies would cause their management to be very focused.

Buffett likened this approach to a dagger being mounted on a car’s steering wheel to
cause the driver to be more focused. Continuing the analogy, unfortunately the road that
 businesses must travel is full of potholes, and in this situation even the smallest of
potholes could produce a disaster. By the end of the 80s, the business road was littered
with disasters. “As the decade progressed, new offerings of manufactured junk became
even junkier and ultimately the predictable outcome occurred: Junk bonds lived up to
their name.”

Question III.2. What is Buffett’s view of the role to be played by investment bankers? (pp. 134
- 140)

Buffett believes that investment bankers have played a role in the misuses of both junk
bonds and zero coupon bonds. Further, he believes that investment bankers should be a
gatekeeper of sorts, “guarding investors against the promoter’s propensity to indulge in
excess.” His criticism of the investment community is best captured by the following
Buffett statement: “Lately, those who have traveled the high road in Wall Street have not
encountered heavy traffic.”

Chapter IV. Common Stock

Question IV.1. What was the motivation for getting Berkshire listed on the New York Stock
Exchange? (p. 172)

According to Buffett the motivation had nothing to do with improving Berkshire’s stock
price. Rather this move was made to reduce the transaction costs incurred by Berkshire
stockholders by reducing the market maker’s spread. Reduced transaction costs for the
shareholders was the motivating factor, however, this could possibly lead to more
trading activity in Berkshire, an outcome that would not please Buffett.

Question IV.2. Buffet maintains that he and Charlie Munger do not want to (1) maximize
Berkshire’s share price, and (2) they wish to keep the trading activity low in Berkshire
stock. Both of these positions are at odds with the prevailing wisdom in corporate
finance. Discuss. (pp. 174 - 175)

Maximizing share price: they are concerned that Berkshire’s price reflect the intrinsic
business value of Berkshire so that their shareholders will in the long run receive a rate
of return that is consistent with Berkshire’s business results. Over-pricing or under-
pricing of Berkshire’s share will not produce such a result.

Trading activity in Berkshire stock: Buffett wants to attract long term investors, and
high trading volume would indicate high turnover in the owners and would indicate that
they are attracting short term investors.

Question IV.3. Berkshire stock sells for a very high price compared to other stocks, and hence it
is often suggested that they should do as other companies do when the stock price
becomes very high and split their stock, so as to drive the price down. Buffett believes
that this is not a pro-shareholder move. Explain. (pp. 185 - 188)
 Buffett believes that splitting the stock will attract shareholders who are more focused on
the stock price than the business results at Berkshire. These types of shareholders,
according to Buffett tend to make emotional or irrational decisions about buying/selling
the stock; hence leading to wild fluctuations in the stock price producing what Buffett
refers to as “manic-depressive valuations.” “People who buy for non-value reasons are
likely to sell for non-value reasons.”

Chapter V. Mergers and Acquisitions

Question V.1. What are the three motives Buffett ascribes to many, if not most of the high
premium takeovers? Contrast these with Berkshire’s philosophy regarding acquisitions.
(pp. 199-202)
The three motives for high premium takeovers:
1. Increased activity and challenge, i.e., “animal spirits.”
2. Measuring success by the yardstick, i.e., size.
3. Belief that their managerial skill will turn around an unprofitable company.

Berkshire philosophy:
For Berkshire issuing shares to acquire a company is driven by receiving as much
intrinsic value in the purchase as Berkshire gives up in shares for the purchase. Further,
Berkshire considers the intrinsic value of its own shares to be the determining criterion,
not Berkshire’s current market price—which might be over- or under-priced.

Buffett believes that most acquisitions are good for the acquiree’s shareholders, the
acquirer’s management, and the investment bankers. The acquirer’s shareholders,
however, usually see their wealth reduced by the acquisition.

Question V.2. Buffett maintains that Berkshire is a good company for a family to sell its
business to. Why? (pp. 216 - 219)

Berkshire purchases companies as much for the current management’s expertise as for
the business itself. As a result, Berkshire’s policy is to allow the current managers to
continue running the business as they always have with minimal interference from the
Berkshire management. The family does not need to worry about Berkshire deciding at a
later date to take over the management of the family business, displacing the family
management. Buffett invites prospective business sellers to contact Berkshire’s previous
acquisitions to determine how Berkshire treated them.

Chapter VI. Accounting and Valuations

Question VI.1. Explain “look-through earnings” as used by Berkshire? (p. 232)

Berkshire makes many stock purchases through its insurance subsidiary that represent
less than 20% interest in the stock of the acquired company. As such, under generally
 accepted accounting practices (GAAP) Berkshire can only report as income the
dividends paid to Berkshire from the acquired stock.

Buffett believes that more important to Berkshire than just the dividends received is the
total earnings of the company. The retained earnings are reinvested in the business and
benefit Berkshire but are not reported by Berkshire. The “look-through” earnings are
calculated by taking Berkshire’s share of all the retained earnings in their investees,
subtract out the taxes that would have been paid had they received these retained
earnings as dividends, and add this amount to Berkshire’s stated earnings.

The example given in the last paragraph on p. 182 demonstrates the effect. To
summarize: Berkshire’s reported 1990 earnings were $371 million, and their share of
their investees’ retained earnings was approximately $250 million minus $30 million in
taxes that would have been paid had these retained earnings instead been received as
dividends, for a net of $220 million. Adding this to the reported earnings gives Berkshire
1990 “look-through” earnings of $591 million ($371 mil. plus $220 mil).

Question VI.2. How does “economic” goodwill differ from “accounting” goodwill? (p. 237)

Accounting goodwill occurs when more is paid for a business than its fair value. The
excess is considered “accounting” goodwill. This accounting goodwill is carried as an
asset on the balance sheet as an intangible asset, and for purchases made after 1970 this
amount must be amortized over no more than 40 years in equal amounts each year.
Therefore accounting goodwill will decline over time.

Economic goodwill occurs when the assets of a business are expected to produce higher
than market rates of return. The capitalized (discounted) value of these excess returns is
economic goodwill. This economic goodwill is, of course, not carried on the balance
sheet as an asset, but for Buffett it is every bit as real as accounting goodwill and
probably more important. Moreover, economic goodwill exists because the business has
some form of consumer monopoly (e.g. brand loyalty for products such as See’s Candy
and Coke), and, therefore, is likely to increase over time.

Question VI.3. Many of the valuation processes that Buffett uses in valuing acquisitions differ
significantly from GAAP, hence, it could be taken to mean that Buffett has no confidence
in GAAP and would discard much of what GAAP provides. Yet, he does not come to
such a conclusion. Discuss. (p. 251)

Buffett believes that GAAP is a good starting point for valuation, but managers and
owners need to understand “that accounting is but an aid to business thinking, never a
substitute for it.” Further, accountants record, not evaluate—that is the role of investors
and managers.

Question VI.4. Discuss Buffett’s views on the three different business valuation numbers that a
business might have—market price, book value, and intrinsic value. (p. 253)
 For Buffett the appropriate value to consider is a business’s intrinsic value, which is
quite simply the discounted future earning power of a business. Of the three measures, it
is the least precise because of the necessity to forecast future earnings and changing
interest rates, hence Buffett states it is simply an estimate—not a precise figure.

Book value is, of course, a GAAP convention, and as such is very precise. Using
Berkshire as an example Buffett shows that different accounting rules apply to various of
Berkshire’s holdings which results in some of the companies being valued using book
values and others using market values.

Finally, as to market price, Buffett states that the market will often value stocks
“foolishly,” and hence cannot be taken at any moment as being accurate. Sometimes it
will overstate a company’s intrinsic or business value, and at other times the market will
undervalue a company.

Chapter VII. Accounting Shenanigans

Question VII.1. Warren Buffett has been a consistent major critic of stock options as a form of
executive compensation. Discuss the problems he has with using stock options in this
manner. (p. 267)

First, because the market price of a stock can be subject to unrealistic valuations, Buffett
believes that cash bonuses are a better way to provide incentives. Further, these bonuses
should be tied to the performance of the unit over which the manager has control, not the
performance of the company’s stock, which presumably represents the overall
performance of the firm. Hence, a stock option bestows its benefits capriciously, often
times on managers for something over which they had no control or impact.

Second, Buffett has a major argument with how options are accounted for. In particular,
they are not included as a corporate expense, and yet the managers who receive these
options clearly view them as having value. For Buffett, “Shareholders should
understand that companies incur costs when they deliver something of value to another
party and not just when cash changes hands.” Unfortunately, cash bonuses appear on
the income statement as an expense, while stock options are not expenses. This is a bias
in the accounting system that favors stock options, and for Buffett this largely accounts
for why stock options have been so popular at corporations. They don’t show up as a
cost.

Third, the argument is made that because options are so difficult to value you can’t
realistically include them as a cost. As Buffett points out there are many things in
accounting that are difficult to calculate, but that doesn’t stop us from accounting for
them. For example, he points out that it is impossible to know exactly what a bank’s loan
losses will be, but nevertheless we do estimate the losses.

Question VII.2. Buffett recognizes that “restructuring” charges can be legitimate, however, he
views them as problematic from an ethical point of view. Explain. (p. 271)
 In recent years, Buffett maintains that CEOs have increasingly given into the pressure of
maintaining a steady earnings stream at their corporation. The justification is often
given that if earnings aren’t stable and/or steadily increasing, their shareholders will be
hurt by the market, or more directly they argue that “everyone does it.” In either case,
because of the flexibility in accounting rules, CEOs have found ways to manipulate their
earnings through the use of one time “restructuring” charges. While the accounting may
be “legal,” the effect is to manipulate the earnings stream of the company giving
investors a false view of what actually occurred at the corporation.

CEOs ultimately view this manipulation as being justified because it helps their
stockholders. For Buffett what is worse is that often times the company’s auditing firm
suggests these manipulative techniques.

Reference

Chan, L, K Chan and E Wolfe, 2005. “Using Essays of Warren Buffett: Lessons for Corporate
America in the Classroom,” Journal of Financial Education, 34, pp. 30 – 41

Buffett, Warren The Essays of Warren Buffett: Lessons for Corporate America, selected,
arranged, and introduced by Lawrence A. Cunningham, Columbia Business School, 4th Edition,
2017.