PDF Summary: The Essays of Warren Buffett , by Warren Buffett and Lawrence A. Cunningham
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Warren Buffett is the world’s most successful investor, but he also thinks of himself as a teacher in the field of investing and economics. Compiled from Buffett’s annual reports to Berkshire Hathaway shareholders, The Essays of Warren Buffett provides a glimpse into the mind of a man whose ideas contrast with those of the typical Wall Street mogul. His insights on investing are simple yet difficult to put into practice, while his thoughts on the culture of the wider business world shine a light on the values that shape modern finance.
In this guide, we’ll cover Buffett’s writings on investment, his recommended approaches, and some widely accepted economic practices that he considers to be wrong. We’ll also look at the opinions of other financial experts, both those who agree with Buffett and those who present an alternate view. We’ll place Buffett’s essays in their historical context and look at how well his ideas hold up in the modern world of high finance.
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Independent Financial Planners If you’re uncomfortable investing without professional assistance, one option is to hire an independent certified financial planner . Instead of being incentivized to sell one institution’s financial products and to encourage frequent trading, independent planners create a tailored financial plan that the client is able to follow or disregard. Many independent planners make no direct transactions on behalf of their clients, and therefore don’t incur the steady stream of fees that Buffett disdains. Independent planners’ earnings are not tied directly to the success of their clients, but neither do they suffer from the conflicts of interest of advisers whose first priority is meeting their firms’ target investment goals. A list of independent financial planners in the US can be found at the National Association of Personal Financial Advisors website.
What to Avoid
From his discussion of his choices, Buffett clearly prefers equities (stocks and bonds) over other forms of investment. Nevertheless, he spends time explaining several other forms of investment and the reasons that they’re problematic. He discusses unproductive assets, junk bonds, financial derivatives, and the worst sin of all, using debt to finance acquisitions.
Some bad investments are made out of fear—people want to keep their money safe in case of a financial crisis. Money market funds and bonds appear safe, but Buffett points out that their interest doesn’t keep pace with inflation. Money in those investments loses value, even as the total dollar figure slowly rises. (Shortform note: Money market funds are not the same as money market accounts , a type of savings account. A money market fund is a mutual fund that invests in short-term, low-risk financial instruments. Bonds, on the other hand, are fixed-interest loans made by you, the investor, to a company or the government. The most famous of these may be the US War Bonds used to finance the United States’ participation in the second World War.)
More foolish, though, is to invest in assets that are completely unproductive, such as jewelry, collectibles, or gold. Unlike a business, these investments create nothing. These items only have value at all as long as people believe that they do. People who invest in unproductive assets hope that someone else will pay a higher price for them in the future, a hope based more in fantasy than fact. (Shortform note: The most popular current types of unproductive assets are gold and other precious metals , but the classic example of unproductive investment speculation is the Dutch tulip craze of 1636 when, for a short while, tulips became a hot investment commodity in the Netherlands before prices fell back to rational levels.)
Fantasy also drives the market for junk bonds . These are bonds issued by companies that are already saddled with more debt than they can bear. Junk bonds are a way to refinance that debt, but the issuing companies are in such poor financial straits that they still pose a very high risk of default. Nevertheless, there are investment firms that funnel lots of money into the junk bond market, believing once again that diversification minimizes risk. In the case of junk bonds, this is much the same as buying a lot of lottery tickets in order to increase your chance of winning. Buffett writes that junk bonds exacerbate financial crises on a regular basis.
(Shortform note: Junk bonds are often marketed more enticingly as “ high-yield bonds ” because of their promised high rate of return. The market for junk bonds was particularly active in the 1980s until a series of defaults in 1989 sent the stock market into a downturn that led to the bankruptcy of the investment firm Drexel Burnham , one of the chief underwriters of junk bonds. There were fears of a similar crisis in 2015 , but the junk bond market stabilized itself. Despite the risk involved with high-yield bonds, in A Random Walk Down Wall Street , Burton G. Malkiel doesn’t discount them as an option for young investors with diversified portfolios .)
Financial Derivatives
The most troublesome of all complex financial products are derivatives , such as those that drove the subprime mortgage crisis. Buffett explains that derivatives are contracts between two parties in which one pays the other if some other financial instrument (for example, a stock or a bond) reaches a certain price, up or down. In the simplest terms, derivatives are bets that a portion of the market will behave a certain way. They are instruments of pure speculation, and unless there’s some form of collateral involved, a derivative’s value rests entirely on the financial strength of the parties involved in the gamble.
(Shortform note: The specific types of derivatives that precipitated the 2008 financial crisis were Credit Default Swaps based on subprime mortgages. In a Credit Default Swap , Bank A exchanges a variable-rate loan for a fixed-rate loan held by Bank B. Bank A hopes to protect itself from the possibility of rising interest rates, while Bank B is betting that interest rates will stay low. By 2008, the number of Credit Default Swaps had grown exponentially , making them extremely vulnerable to a sudden decline in the real estate market.)
Buffett argues that derivatives are also instruments of fraud. Until the derivative actually comes due, both parties to the bet can use fictitious projections to claim that their derivatives produce actual earnings, and then get paid by their investors based on those supposed earnings (like receiving a cut from a race horse’s winnings before the race is even run). It’s only when one of the parties tries to cash in on their derivative contract that any fictitious claims about its value are revealed, and if the “loser” of the derivative bet defaults, then both sides' projected earnings disappear. Before that time comes, however, derivative contracts are designed to be so complex that their true risks and false earnings claims are hard for portfolio auditors to spot.
(Shortform note: A striking case of derivatives fraud was perpetrated in 1995 by Nick Leeson, a derivatives trader for the United Kingdom’s Barings Bank . Leeson gambled a vast amount of money using derivatives to bet on Japan’s Nikkei 225 stock index, then manipulated accounting records to hide the scope of his losses, which led to Barings Bank going bankrupt. However, most cases of derivatives fraud rise from dealers misrepresenting the amount of risk to investors, as with mortgage derivatives in 2008 or currency derivatives in 2009 . It’s been proposed that creating a Market Manipulation Index would give regulators a tool to zero in on markets being targeted by derivatives fraud.)
Even more than avoiding such toxic financial products, Buffett wants to impress upon his readers that you should never borrow money to invest. This has always been the curse of Wall Street, and it's led many individuals, companies, and banks straight down the road to financial ruin. Brokers, advisers, and money managers sugar-coat debt by calling it “leverage,” which fueled the corporate takeover craze of the 1980s. Easy access to debt can be like a drug, especially when tied to the thrill of investing. Eventually, though, all debts come due, and if your investments have dropped in value, you won’t be able to pay your debts off. However, if you only invest with cash, you’ll be well-prepared for any hiccups in the market.
(Shortform note: Financial experts agree with Buffett that being debt-free is of paramount importance to your financial health. In Rich Dad’s Cashflow Quadrant , Robert Kiyosaki says getting out of debt first is a prerequisite for smart investing , especially if your debt is tied up in high-interest credit cards that drain your financial resources faster than returns on investment can replace them. However, if your debt carries a low interest rate, it might be wise to start investing anyway. In I Will Teach You to Be Rich , Sethi identifies student loans as one such low-interest form of debt. Because he emphasizes the importance of starting to invest at a young age, he says that you should do so even if your student loans aren’t fully paid off.)
How to Run an Investment Business
Though much of Buffett’s writing contains lessons for any investor, a great deal of his work is devoted to the inner workings of Berkshire Hathaway as it compares to other large investment groups. Buffett believes that the Berkshire system stands above others in terms of transparency, rational investing, and creating value for its shareholders. In this section, we’ll contrast Buffett’s depiction of the less-than-ideal practices he sees as the norm in corporate America with Berkshire Hathaway’s values and culture. For each, we’ll look at issues of corporate governance, accountability, acquisitions principles, and commitment to shareholder interests.
The Wall Street Way
In discussing the proper management of investment firms, Buffett puts forth many negative examples as lessons to learn from. Wall Street’s business-as-usual practices highlight many areas in which most investment companies don’t serve the interests of the people whose money they steward. Buffett describes the failings of CEO culture, shady accounting, overpriced acquisitions, and the systemic dangers of financial derivatives.
The chief problem Buffett sees with many CEOs is their lack of any true accountability. In theory, CEOs must answer to a board of directors, but in practice that relationship is overly chummy. Directors themselves have little accountability, don’t pay attention to their companies’ business practices, and rarely put themselves on the line to call out poor management. As a result, many CEOs are rewarded for simple mediocrity. Boards and CEOs often do nothing but ride on the wave of their underlings’ efforts, inflate earnings reports by holding back money from investors, then safely escape with their “golden parachutes” if the company fails or is bought out.
(Shortform note: In theory, a company’s CEO and board of directors are answerable to the shareholders, who have the power to vote the board out of office. However, this rarely happens without instigation from the top . In Basic Economics , Thomas Sowell points out that for the most part, shareholders want to reap the benefits of investing without going through the hassle of managing a business . Many board elections are uncontested— directors must simply receive more votes “for” than “against” them in order to retain their positions. However, there’s been a trend in recent years of shareholders taking a more active interest in who sits on corporate boards and how they steer their companies in regard to social and environmental issues.)
Buffett’s ire is particularly strong in regard to awarding stock options as a form of CEO compensation. Managers often negotiate for these, because once awarded, the stock options’ value isn’t tied in any way to CEO performance. A CEO could do nothing for 10 years, cash in his options and receive as much pay as if he’d been effectively running his company. Businesses, in turn, like to award stock options as pay because certain accounting rules let them not be recorded as an expense. However, Buffett argues their expense is very real.
(Shortform note: A stock option is a contractual agreement that allows someone the option to buy or sell a stock at a predetermined price at a future date. When that date arrives, the stock option price and the stock’s actual price may be wildly divergent. For example, if you hold a stock option to buy Company A stock at $100 per share, and the actual stock price shoots up to $200, you can call in your option, buy the stock at the lower $100 price, and immediately double the value of your holdings. However, if the stock price drops instead, you don’t have to buy it at all—you’ve lost nothing. Some employee stock options plans require you to vest over time , but many CEOs are awarded stock options as a form of “free money” bonus when they are hired.)
The theory behind stock options is that they align the CEO with the shareholders. If the CEO adds value to the company, his stock options will be worth more over time. However, an investor must pay the going market price for his stock, whereas the CEO often receives a locked-in rate with the option not to make the purchase. The CEO with stock options, therefore, can reap the same rewards as shareholders but carries none of the risk. Buffett lobbied for a change in accounting rules that would force businesses to list stock options as an expense, but he lost.
The Trouble With Stock Options A different argument against stock options than the one Buffett makes is that stock options incentivize CEOs to make risky decisions on behalf of their company in order to make the stock’s value spike above its true value. Risky behavior could just as likely make the stock price plummet, in which case shareholders lose value, but the CEO loses nothing. Many corporations still award stock options as a way to boost CEO compensation, despite the fact that there’s no correlation between CEO pay and a company’s prosperity . A 2021 study by Harvard Business Review showed that stock options are only effective in situations where CEOs might otherwise misuse company resources for personal gain . A recent study of CEO pay shows that over 70% comes from stock awards and options , 20% from bonuses, and less than 10% from their actual salary.
Takeovers, Debt, and Danger
Though Buffett has made a career of buying interests in companies he admires, many corporate firms do the same in ways that are foolhardy at best and actively harm shareholders at worst. A lot of buyouts and takeovers are driven by CEOs and acquisitions managers who see corporate growth as an end in itself, regardless of whether it adds meaningful value. When one business pays too high a price for another, it will sometimes have to issue stock as a way to fund the purchase. Issuing new stock provides an influx of cash without taking on debt, but it reduces the value of the stock already in shareholders’ hands—they now own a smaller slice of the pie, while management gets to reward itself for expanding the reach of its corporate domain.
(Shortform note: When raising quick capital is in a company’s interest but you don’t want to impact the value of shares in the way that Buffett describes above, a case can be made for issuing bonds instead of new stock . Bonds are a form of debt that must eventually be repaid to investors, but the interest rates on bonds are generally lower than the interest companies pay when borrowing money from a bank—and bonds come with fewer strings attached than bank loans. Investors should be wary, however, of bonds issued by companies that are in financial trouble. These are the “junk bonds” mentioned earlier in this guide.)
The relentless drive for corporate growth has also given birth to the leveraged buyout , in which Company A takes on debt in order to buy Company B. The buyers then carve up Company B, sell off parts to other businesses, and generate “earnings” by laying off employees. Buffett explains that takeover companies bend accounting rules to make their acquisitions seem profitable while deferring payment on their debt as long as possible. Buffett asks what the cost to society will be to have so many companies saddled with debt. Many peoples’ livelihoods depend on the health of large corporations, and corporate debt puts all of them at risk.
(Shortform note: Leveraged buyouts were the hallmark of many notorious “corporate raiders” in the 1980s, who used them to practice so-called hostile takeovers . Businessman Carl Icahn is remembered for his hostile takeover of the airline TWA , from which he made nearly $500 million while saddling the airline with a staggering amount of debt. Another famous corporate raider, Ron Perelman, is best known for his takeover of Revlon . The negative public image of the hostile takeover magnate was solidified by Michael Douglas’s portrayal of the fictional Gordon Gekko in the 1987 movie Wall Street .)
While leveraged buyouts harm the health of whole companies, the bankers who facilitate them ride into the sunset with the earnings from their fees. Here, Buffett returns to the topic of derivatives. The firms that take part in costly acquisitions use derivatives to hedge against the risk their debt incurs. Buffett argues that derivative contracts can act as insurance on smaller scales but pose a danger to the larger economy. A vast web of derivatives should minimize risk by spreading it around, but in practice the bulk of the risk has gravitated toward a handful of giant, interlinked firms. Any serious shock to the system that triggers a wave of derivative defaults could bring these firms and the whole economy crumbling down like an avalanche.
The Financial and Social Cost of Leveraged Buyouts A counterintuitive aspect of leveraged buyouts that Buffett doesn’t fully explain is that they transfer the burden of debt onto the company being bought , not the company making the acquisition. For example, when Company A takes out a loan to purchase Company B, it uses Company B’s assets as collateral, so that if the loan defaults, Company B goes bankrupt, but not Company A. This is why Elon Musk’s purchase of Twitter saddled Twitter with $13 billion in debt . However, unlike other buyouts that avoid putting the acquiring party at risk, Musk put $33 billion of his own money into the purchase . Therefore, because Twitter wasn’t able to shoulder its new debt, its drop in value resulted in Musk setting the Guinness World Record for greatest loss of personal net worth in history . The potential consequences of the Twitter debacle shine a light on Buffett’s point about the societal impact of corporate insolvency. In this case, it’s because Twitter has a wider scope of impact than other social media outlets in fields such as politics and journalism . In addition to costing over 4,000 people their jobs , the platform’s potential collapse could alter the information landscape in ways we can’t predict , affecting how its users share information and build brands, all for the sake of a leveraged buyout.
The Berkshire Way
As a positive counterexample to standard Wall Street business practices, Buffett holds up his own holding company, Berkshire Hathaway. He takes the time to explain the reasoning and philosophies behind everything he does as Berkshire’s CEO so that his shareholders can fully understand the company that they all own. Buffett spells out Berkshire Hathaway’s goals, his approach to management accountability, his process for folding new companies into the Berkshire conglomerate, and his company’s prospects (not predictions) for the future.
To begin with, Berkshire Hathaway’s long-term goal is to increase its overall value per share, not the size of its holdings. It does this by owning and acquiring companies in good financial standing that produce respectable returns on capital investment. Buffett also wants the company’s shareholders to fully understand Berkshire’s financial position and the value added by its subsidiary companies (what Buffett refers to as “look-through earnings”). To do this, Berkshire goes beyond standard financial reporting practices to give shareholders the same information any owner would want about their business’s financial and managerial standing.
(Shortform note: The generally accepted accounting principles (GAAP) that Buffett frequently takes issue with are established by the Financial Accounting Standards Board, a nonprofit organization recognized by the US Securities and Exchange Commission as being the arbiters of what constitutes fair and transparent financial reporting. The FASB has been criticized for not responding quickly enough to changing accounting practices and the creation of increasingly complex financial instruments. Nevertheless, the FASB releases updates to GAAP throughout the year, sometimes on a near-monthly basis.)
Even though Berkshire’s stock price is already very high, Buffett doesn’t necessarily want it to shoot up even higher. Instead, he wants the stock price to reflect the company’s true value as closely as it can. This, he says, will attract investors who share Berkshire Hathaway’s values and culture of rational investing and long-term commitment. Berkshire isn’t a place for day traders, and it doesn’t pay out dividends to investors. Instead, it uses its massive earnings to allocate capital where it can have the most impact on the corporation’s overall worth.
(Shortform note: Though Buffett’s essays were written over a period of decades, they remain consistent in reflecting that he'd rather Berkshire’s stock be fairly priced than overvalued. Nevertheless, Berkshire Hathaway’s “Class A” stock is by far the most expensive in the world , trading at almost $500,000 per share, five times the amount of its closest stock price rival , the Swiss candy company Lindt and Sprüngli. Berkshire’s “Class B” shares, which represent smaller ownership and voting rights, are more within the reach of the everyday investor . Berkshire’s Class A stock price grew so high that it caused computer problems for the Nasdaq’s online stock exchange .)
Buffett says he views his investors as partners, and it’s important that he, as CEO, be open and accountable for his decisions. Therefore, he reports to a board of directors who are all required to be owners as well. In order to hold a place on Berkshire’s board, each director must own at least $4 million in Berkshire stock that was purchased outright, not through options or grants. That way, the directors’ earnings rise or fall along with all other shareholders’, and they won’t make decisions that benefit themselves at other shareholders’ expense.
(Shortform note: Buffett’s “partnership mindset” toward investors has roots far deeper than Berkshire Hathaway. As Alice Schroeder recounts in Buffett’s biography, The Snowball , Buffett’s first business venture after leaving Wall Street was the formation of Buffett Associates Ltd. in 1956—an investment partnership between himself, friends, and family. Buffett would invest his partners’ seed money and take his own share from a percentage of their earnings. In order to ethically share his partners’ risk, the terms of the business would penalize Buffett if the value of the partnership’s investments went down. He dissolved Buffett Associates in 1969 when he felt he’d no longer be able to match the returns he’d provided his partners in the previous decade.)
As for the managers of Berkshire’s subsidiaries, Buffett awards bonuses based on performance, which he makes clear are not dependent on Berkshire’s stock price going up. Instead, CEO compensation is judged on the nature of their businesses, the challenges they face, and the real returns they generate. Berkshire’s managers are, of course, welcome to buy the company’s stock at market price just like everyone else. If they do, then unlike CEOs with stock options, their interests will truly be aligned with the owners.
(Shortform note: In Built to Last , Jim Collins and Jerry Porras go beyond issues of CEO pay to debunk the basic premise that a charismatic, high-powered CEO is beneficial to a company’s standing. Instead, good management focuses on building the organization and its products rather than increasing managers’ own personal wealth and recognition. More than merely being aligned with shareholders, Collins and Porras suggest that a good CEO will be aligned with the company’s core philosophies and principles , which reach beyond shareholder interests to increase the benefit the company provides to the world.)
Growing the Berkshire Family of Businesses
Buffett happily admits that acquiring new businesses is his favorite part of his job. While in his youth he looked for mid-range businesses available for cheap, with Berkshire he seeks out high-quality companies that he can buy for fair prices. Such good deals are rare today, so he doesn’t set any acquisition targets. Instead, for every opportunity that arises, he compares the potential value of an acquisition to other, more conservative ways to invest. This removes the pressure for growth that drives many CEOs to rush into acquisitions based on arbitrary goals.
(Shortform note: A 2018 study identified several irrational factors that drive corporate acquisitions . Among these are greed, a desire for more power, antagonism between competing companies, and the hubris that companies making acquisitions feel when they believe they can perform better than others. The authors of the study recommend that companies involved in corporate acquisitions examine their motives from an emotional perspective to avoid any unintended consequences that may result from irrational decision-making.)
Though Buffett views each acquisition with a critical eye, once Berkshire buys a controlling share, Buffett lets his new acquisitions conduct their business with minimal interference. It’s not Berkshire’s policy to buy up smaller companies only to tear them apart and sell them off. Instead, Buffett portrays himself as the ideal buyer for companies whose owners want the businesses they built to carry on without them. For this reason, Berkshire never sells off an acquisition so long as it can produce even a modest return on investment, recognizing that a mid-tier business is still a vital source of income for its employees and their families.
(Shortform note: In The Snowball , Schroeder gives several examples of businesses that Buffett absorbed into the Berkshire conglomerate while keeping their essential character intact. One that exemplifies Buffett’s preferred type of acquisitions was Omaha’s landmark Nebraska Furniture Mart , founded by Rose Blumkin , a Russian immigrant who was 40 years Buffett’s senior and whom he looked up to greatly . When Blumkin decided to sell, Buffett arranged to keep her family on as partners so that the store would continue to run as it always had with Buffett merely providing the capital it needed in order to keep turning a profit.)
In keeping with Buffett’s philosophy of investing, Berkshire never leverages debt to buy new businesses. Instead, it maintains a ready supply of cash from its various subsidiaries to be used for acquisitions. In times when there aren’t any businesses to buy, that cash can be used to buy back shares of Berkshire stock. This is only done if Berkshire’s stock is trading below the company’s actual value, and Buffett explains how such buybacks serve the interests of Berkshire shareholders. After all, if Buffett reduces the number of slices in the Berkshire pie, the shares that remain increase in value without their owners having spent a dime.
(Shortform note: One other benefit of stock buybacks is that they can result in larger dividend payouts for those who remain as shareholders . Buffett doesn’t bring this up because unlike most profitable companies, Berkshire doesn’t pay dividends at all, instead choosing to reinvest all of its profits to increase share value in other ways. However, some CEOs use buybacks as a tool to push stock prices up. While this may result in higher earnings per share, those earnings are an artificial product of accounting and don’t reflect actual growth in a company’s productivity, and may in fact be harmful in the long run because buybacks spend capital that might otherwise be used to invest in more productive assets for the corporation.)
That owner-centric mindset is at the heart of Berkshire Hathaway’s culture, one which Buffett says he’s carefully cultivated so that it will last even after he’s gone. While describing what makes Berkshire work, he admits that its model would be difficult to replicate. His wealth and Berkshire’s grew over decades in which much changed in the financial world. Though he doubts it’s possible for Berkshire’s gains in the next 50 years to match its first half-century, he has full confidence in the business he created to thrive and endure in the decades to come.
(Shortform note: Because the practices and rules of high finance have changed so much in Buffett’s lifetime, it’s impossible to copy his road to riches exactly. However, Buffett encourages the wealthy to copy him in other ways, especially when it comes to philanthropy. In 2010, Buffett joined with Bill and Melinda Gates to challenge the richest people in the world to leave the majority of their wealth to charity . From 40 original signatories, the Giving Pledge has now been taken by over 200 billionaires .)
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