Sunday, February 15, 2009

The Warren Buffett Way: Part IV

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Today, we look at the management tenets of Warren Buffett

Management Tenets

Is management rational?
Rationality is determined by the manner in which management allocates the company’s capital. Buffett says it is highly irrational for a company to retain earnings for investment in projects which return below-average rates for the company, as this destroys shareholder value. This kind of behaviour will catch up with the company in the form of lower long-term market values. Companies should only retain excess cash and reinvest internally where doing so produces a higher return that the cost of capital. Look for managers that are rational in their asset allocation.

Is management candid with its shareholders?
Managers that provide the least amount of information as required by securities law and GAAP are not being candid, and provide very little opportunity to analyze the company. Look for managers that admit their mistakes just as readily as they trumpet their successes. Buffett’s theory is that managers who confess their mistakes publicly (as Buffett does in his annual reports) are more likely to correct them. Those that mislead the public are likely to mislead themselves in private. You want honest managers who provide lots of information useful for analyzing the company.

Does management resist the institutional imperative?
The institutional imperative is “the lemminglike tendency of corporate management to imitate the behaviour of other managers, no matter how silly or irrational that behaviour may be.” It is human nature to want to follow the group, because it is much easier to blame someone for failure associated with contrarian behaviour than failure associated with group behaviour. Watch out for managers who follow the institutional imperative in buying companies that make little sense, as this kind of empire building almost invariably destroys shareholder wealth.

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