Tuesday, November 4, 2008

The Warren Buffett Way: Chp 4 Part 2: Buying a Business

Management Tenets:

Judgement of how effective management has behaved, is an important part of the analysis that Buffett performs before deciding to invest in a company. However, it's important to note that for Buffett, excellent management capabilities do not trump poor business economics. The following are the management tenets the author believes are critical factors in Buffett's assessment of management.

1. Is management rational?
2. Is management candid with shareholders?
3. Does management resist the institutional imperative?

One fruitful place to examine if management is behaving in a rational manner, is in their allocation of capital. How well management allocates capital is extremely important for investors because capital allocation over time will determine shareholder value. It's rational to invest a company's retained earnings if it will earn more than the company's cost of capital. Unfortunately, many managers are found lacking when judged on their capital allocation decisions against this standard.

If a rational investment for retained earnings cannot be found, management should return the earnings to shareholders, either in the form of dividenda or with share buybacks. Share buybacks can be particularly rewarding for shareholders if shares in the company are bought back at a price less than its intrinsic value.

Another test for management is whether they can be open and forthcoming about problems and mistakes with their shareholders. All too often, management only emphasizes successes and does not appropriately disclose company problems. Buffett states that whether by GAAP, non-GAAP or extra-GAAP, management needs to report information that will allow answers to the following questions: 1)what is the company approximately worth 2) how likely can the company meets its financial obligations and 3) how well have managers acted?

The institutional imperative refers to the tendency of management to imitate the behaviour of other management, regardless of how illogical those actions may be. Most managers try not to look foolish and so they tend to resist change. A good example of resisting the institutional imperative is the way that Bershire's insurance companies do not write policies when they are expected to produce a poor return for shareholders.

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