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Berkshire Hathaway
My Office Newsletter Principles

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By hartmanbirge
May 20, 2002

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Yesterday I said I would begin to publish a newsletter to help guide my co-workers a bit on my methodology. I thought it best to include a two page manifesto on principles and how I would go about the process so they could place recommendations in context. I have now finished my manifesto with some rough edges to be ironed out. Here it is:
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Before acting on any buy recommendations and the regrettable sell recommendations I think it best to understand how my investment process works. This process is not for everyone and it is hard to implement because it takes time and discipline. I own but a few companies so I can not afford to make many mistakes � this means that risk must be overcome through in-depth understanding and a flight to quality. In a nutshell here's how I approach the investment process. My mission consists of three criteria - to find great business models run by people of the highest integrity selling at a good price. That's it. Accordingly, I divide my choices into a three tiered system. Tier I are the rare businesses of highest quality run by management of the highest integrity selling at a great price. Tier II are opportunities which are selling at a great price but which possess only one of the two remaining qualities. Tier III situations possess only a very low under valued price and are businesses of questionable quality run by management that I either don't like or don't know much about. Notice that finding a great price is my Center of Gravity no matter what the situation. Tier I businesses I would be inclined to hold on for life. Tier II I might sell if the valuation became excessive or a Tier I became available at a good price. Tier III, the least favorable, I am looking to find the high probability of an after-tax return which beats holding cash when Tier I and Tier II are not available � I will always eventually sell Tier III.

WHAT I'M LOOKING FOR

1. Associate with Quality. Owning shares of stock makes you a part owner in that business. There is nothing which forces you into one business over another. As such, small investors have the incredible flexibility to say no thanks when the market offers us choices. I want to only be associated with the best of the best. I want to focus on superior business characteristics run by great people of character which over time will almost surely win out over a portfolio of average to poor businesses. This is why the optimal portfolio would consist of no more than three to ten companies. I'll take my shots with the three best businesses I can find over the top fifty I can find. The rewards of such concentration and quality focus can be immense. The risk of fluctuation and any failure in the narrowed choices is also greater....thus we must strive to understand better than Wall Street what it is we're looking at. Most importantly I am seeking incredible cash generating business models which are run by people of the highest integrity.

2. Superior business models. Our choice of businesses to associate ourselves with should have such characteristics that 1) Allow them to thrive in any economic condition; 2) have limited to no competition; 3) be free of rapid change; 4) generate enormous amounts of free cash flow; 5) have little to no debt; 6) require little capital to run the business. Such businesses are very rare. I have spent over a decade looking for great businesses but have found but a few. All businesses have problems. None are perfect. But some stand head and shoulders above the crowd. Those are the ones we want to buy and be associated with. The all star team of business models. But that's only the first part of the quest.

3. Management Integrity. I look at it this way.....would I want the CEO as a trusted friend? If I had problems would he/she bail on me? If I was in another war and the CEO was my foxhole mate could I rely on them or would they be self-centered and run? Has the CEO stuck it to shareholders in the past? Is the CEO adorning him/herself with lots of stock options which dilute my ownership? If I can not trust the management then I've got to worry that they're doing something behind my back - because there is so much they could hide � legally or illegally. I want to know everything I can about the CEO so I can judge the character. Egomaniacs and control freaks need not apply. I hate them - passionately. The screen for CEO character has helped me avoid some major hits in the past � Jill Barrad (Mattel), Larry Ellison (Oracle), Bernard Ebbers (Worldcom), Michael Eisner (Disney) are but a few examples where the CEO put out subtle red warning flags which kept me from going into business with them. If I buy shares in a company it must be one I am proud to own because it becomes part of my identity. This search for management integrity narrows our search for great business models down even further which makes our available choices even more rare.

4. Value. Once we have identified the rare businesses with the above characteristics we MUST purchase them at an attractive price so that our return approximately matches that of the business. If we overpay then the business could go gangbusters for a decade and we would earn very little. We want to buy them when they're undervalued � not fairly valued or over valued but under valued. This gives us a margin of safety in case our analysis is wrong or some dreadful unforeseen event crushes the business. If even an average business sells at a price where I'm trembling with greed then absent a Tier I situation I will buy the company. For the most part these sorts of situations which are far far more likely (though still not common) than a Tier I situation will dominate the pages of the monthly newsletter. The worse the business or the management then the more extreme the under valuation must be to compensate for the increased risk. It all boils down to probability of success vs. the available alternatives of which holding cash is one.

HOW DO I MANAGE A PORTFOLIO?

1. Probability. I'm looking for certainty. Though we can never achieve 100% certainty we want VERY HIGH certainty that the business will grow during our period of ownership. This reduces costly mistakes. If I find a great business run by great people I ask whether I would feel comfortable putting all my family's fortunes on that business. I've got to be that certain. If I've got a Tier I high probability situation I don't mind putting 80-90% of my entire portfolio into that situation. So in essence we're looking for an almost certain homerun and betting big. Absent those rare occurrences we're seeking to maximize our opportunity and performance so we'll have more to put into the rare Tier I when it presents itself.

2. To sell or not to sell. I prefer to never sell a Tier I. Finding the great businesses run by great people is such a rare find that when I manage to land in one at a great price I am loathe to part with it. Selling generates fees and taxes � the two in combination will destroy your portfolio over time. The ideal is a portfolio consisting of nothing but Tier Is and letting them go for life. Absent that, it becomes extremely difficult to overcome costs on a recurrent basis. The fewer decisions we have to make the better. There are ways to get around never selling and still generate the cash and income you need. If you MUST sell a Tier I then do so with great regret and trepidation as if leaving a friend for life. This is contrary to what financial publications will tell you. They always say "do not become emotionally attached to your stocks." I reject this traitor, gypsy mentality out of hand.

3. Weightings. I think that managing a portfolio by putting certain percentages into asset classes and the like is the height of stupidity. If we allocate capital into attractive situations over time then you can't help but eventually create diversification and some asset class variety. Time will see to it that you arrive at some balance. What won't happen if you do it this way is over paying for diversification which makes no economic sense. Mutual funds constantly make this unforgivable mistake.

4. Friction Costs. The ideal would be to have zero costs in our portfolio. We may never get there but it's a worthy goal. I strive to manage my portfolio in such a way that taxes and fees are negligible. If you're paying more than 0.15% in annual fee costs per year then it's too much. Take a cleaver to costs and whack them. You want to maximize your money working for you � once it's gone to a fee it's gone forever.

5. The market. The market is neither your friend nor your enemy � it just is. Whether it's due to rise or fall is really immaterial � I'm looking for great companies selling at great prices. Whether that happens in a high market, a bubble, a depression, or a war is irrelevant. The market is the football field upon which we play. It's the arena. Nothing more. Our job is to recognize the real opportunities as they present themselves rather than trying to force opportunities which don't exist. People are emotional creatures and their financial lives are emotions on speed. This means by definition that markets and individual stock prices therein are not ALWAYS efficient. We want to find those occurrences where the actions of a great many emotionally unstable people or institutions act in unison giving us our moment to pounce.

6. Discipline. The hardest part last. There is noting wrong in waiting for just the right situation � years if necessary. As you wait your cash will build up. This is a way of hording ammunition for the inevitable opportunity which will certainly come. With a focused base of companies I'm looking at there can not be a decent opportunity each and every month. I may go months or years without finding anything to buy. That is very hard to accept mentally as if one is powerless. Nothing could be further from the truth � to NOT act in unfavorable circumstances gives one enormous power over time. When the right time comes we'll be more than ready.

HB


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