How Berkshire Hathaway Got Bigger by Getting Better (Part Seven)
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As one of the greatest investors and wealth creators our country has ever known, Warren Buffett certainly deserves our close study. His “Owner’s Manual” for Berkshire Hathaway (NYSE: BRK-B) shareholders is a great primer to gain insight as to what’s made his company such a great investment. I’ve been looking at each principle laid out in the owner’s manual from the perspective found in a story inspired by Chick-fil-A founder Truett Cathy. If you haven’t heard the story yet, back in the 1980’s when a Boston Chicken (now Boston Market) had just finished raising capital to expand; the management at Chick-fil-A spent a long time discussing how they too could get bigger in order to fend off this threat. After hearing enough talk about getting bigger, Cathy pounded the table and said, “I am sick and tired of listening to you talk about how we can get bigger. If we get better, our customers will demand we get bigger.” As we head into the seventh part of a quasi-tribute to the calculated brilliance of Buffett, we continue to gain insights as to what made him a better manager and thereby grew his company bigger.
“We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance – not only mergers or public stock offerings, but stock-for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company – and that is what the issuance of shares amounts to – on a basis inconsistent with the value of the entire enterprise.”
They call Buffett a value investor, and for good reason. He’s unwilling to trade for something of lessor value than what he already owns. Investors should take note; all too often we are willing to trade a dollar today for the hope of two dollars tomorrow. The problem is we can easily fall prey to a misunderstanding of the fundamental difference between price and value. An asset may look cheap or might have a high yield, but is it something you can put a real value on?
If there is one thing Buffett can value it is his own stock. He’s already stated that if the price drops to 1.1 times book value he’ll be buying back the shares. With that being the case, you know he won’t be selling stock unless by doing so he can add to the book value of the company. Unfortunately, all too often we see companies use their shares as if they were an unlimited source of funds to be used for empire building.
There have been a lot of bad deals where the acquiring company used their company’s stock in an attempt to get bigger quickly. Few deals rival the $350 billion dollar AOL (NYSE: AOL) and Time Warner (NYSE: TWX) deal where AOL valued Time Warner at $165 billion or double the market cap just before the deal was announced. The deal at the time valued the combined company and nearly 10 times revenue. While a variety of other assets have been traded in and out of the portfolio, if you fast forward a decade you’ll find that the merger was a bust and the company has been split into AOL now worth $2.58 billion, Time Warner at $36.66 billion and Time Warner Cable at $26.08 billion.
While obviously this isn’t a deal Buffett would have blessed. The control premium, double the value the market was placing on the firm is not something easily justifiable. It’s not likely the market undervalues a firm by that much and deals with such a value disconnect hardly ever deliver the promised deal day value. Management thought that by becoming bigger they would become better, but that’s simply not how it works.
Compare this deal to the one that created ExxonMobil (NYSE: XOM) the year prior. The $75 billion deal which included a 26% premium has turned out quite well for shareholders. At the time the combined company was worth $279 billion dollars and has now grown into a $400 billion dollar behemoth. Exxon was acquiring a company whose assets fit well with theirs but also one that at the time was seeing a lower return on capital. Exxon was seeing an average return on capital of 16.5% while Mobil was seeing just 13.4%. If they could improve the return of the Mobil assets they’d be getting more for their money. Such has certainly been the case, in fact these days ExxonMobil has seen an average return on investment of 25% over the past five years.
So what’s the takeaway for investors? Have at least some idea of the value of each asset you are purchasing. Think of each dollar in your portfolio as a share that you are trading to acquire a share of something that will have a higher return. Look to see if the management of the firm you are acquiring a stake in has any idea what their firm is worth other than it’s worth more. Otherwise they will squander your capital through empire building all the while paying themselves a salary of stock options rivaling a king’s ransom.
latimerburned has no positions in the stocks mentioned above. The Motley Fool owns shares of Berkshire Hathaway and ExxonMobil. Motley Fool newsletter services recommend Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.