Triumph of Hope over Experience. Become a Complete Fool
Hope and Experience were guests for Thanksgiving dinner at the Fardo household. Mrs. Fardo produced turkey, dressing, gravy, sweet potatoes, three-bean salad and pumpkin pie. Elias, in his customary Thanksgiving pout, decried the pumpkin pie, "nobody actually likes pumpkin pie, and they just eat it because it is Thanksgiving. Where is the blackberry cobbler?"
Despite the whining, a splendid feast it was. And, after shamelessly congratulating Mrs. Fardo on the excellence of the meal (and for the record, it was), Hope and Experience joined Elias on the back porch for Hazelnut coffee and cigars.
Elias: I know that you guys have been following my ill-advised argument over the 27 words. What do you think?
Experience: Let is rest, Elias.
Hope: I agree with Experience here, you should let it go. But, maybe I could make a go of it.
Elias: And why do you think you can do a better job than I did?
Hope: Because I am smarter than you are.
Experience: Agreed. But even so, Hope, you would get the same reaction.
Hope: Which is?
Experience: People are going to say that they are amazed that you have such a hard time interpreting a few simple sentences. They are going to bemoan your incessant, futile, compulsive dissecting of those 27 words. That is what is going to happen; it always does.
Hope: Maybe so. But I have a plan. I have an example that is so clear, so conclusive, so devastating in its delivery, that all opposition will be silenced forever.
Experience: You should have been a comedian.
Hope: I am serious. Here is how it will go.
Experience: First, let me put something stronger into my coffee. I think I will need it.
Hope: Here are the 27 words in the Berkshire Owners' Manual: We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. As you both know, Buffett is saying that the retained earnings themselves must produce a $1 worth of value for every $1 retained, not that Berkshire as a whole must produce a $1 worth of additional value for every $1 retained. But, that interpretation is not universal.
Elias: And even though I have constantly failed, you are going to be successful in explaining that?
Elias: And the number of amazed people will soar.
Experience: You are a fool. But let the incessant, futile dissecting begin!
I am going to reorganize Berkshire into three publicly traded companies. One company, Berkshire Financial Holdings (Financial), will contain all the insurance and other financial businesses of Berkshire Hathaway. The other, Berkshire Industrial Holdings (Industrial), will contain everything else; all the manufacturing, service and retailing operations. Each of these two companies will sell 20% of their equity to the public, leaving the present Berkshire Hathaway (Parent) with 80% of two publicly traded corporations and a home office, with no other assets or liabilities.
The only income that Parent will receive is dividends from Financial and Industrial, and earnings from the reinvestment of those dividends. Since there will not be any need to provide any additional capital to Financial or Industrial, it will be very simple to identify the results of the reinvestment of Parent's income.
For sake of this example, we will assume that at the time Financial and Industrial went public, the market price of Parent represented 90% of the market value of its positions in those two companies. Call this a conglomerate, or closed end fund discount. Let us also assume that Parent does not pay a dividend, does not issue or purchases any of its own shares, does not issue any debt, nor issues or purchases any shares in Industrial or Financial; just reinvests all its dividends in short term government securities.
Experience: What about people who say that the earnings of Industrial and Financial will still be consolidated into Parent's financials, and what you are really just talking about here is an accounting treatment?
Hope: I am actually surprised that you came up with such a good question. In Parent's financials it will also present an unconsolidated balance sheet and income statement, so we can follow its accounts. Plus, the earnings of Industrial and Financial will not be available to Parent for dividend payments to its shareholders except to the extent that they are paid out in cash dividends to Parent. When I talk about Parent and its earnings, I am only talking about Parent's earnings in an unconsolidated manner, the earnings it actually receives in cash, not its share of the earnings of subsidiaries. So, your concern doesn't matter. But, if it makes you feel better, assume that Industrial and Financial dividend 100% of their earnings, so Parent actually receives its 80% share of their earnings in cash.
Experience: But this whole arrangement doesn't make any sense. Buffett wouldn't do this.
Hope: I know that. I am just creating an example that provides a clean way of separating the operations that exist at the beginning of a dividend test period, from the earnings that are retained during the test period. This could also be done just by thinking of all the assets held at the beginning of the test period, and understanding that they can appreciate in value while using only capital that is on hand at that time. I just want to get a legal and clear separation.
Now, back to the infamous 27 words. What some people claim they say is that five years after the reorganization, if the market price of Parent has appreciated by more than Parent's net earnings, which in this example would be represented by its portfolio of short term government securities, Buffett's dividend test would be met. Buffett also said he will apply this test prospectively, but we will leave that aside just to keep the example simple.
But that that can't be right. Either the stock price of Financial or Industrial, or both, could appreciate by much more than the earnings retained by Parent during that period of time. Or, the conglomerate discount could close. Any of those things could cause an increase in Parent's stock price. And since we have completely separated both Financial and Industrial from Parent, there is no chance that any appreciation in their share prices could result from reinvestment of Parent's retained earnings in their operations.
Remember, Buffett said: We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. If he had wanted the test to be interpreted as some do, he would have said: We test the wisdom of retaining earnings by assessing whether Berkshire, over time, delivers shareholders at least $1 of market value for each $1 retained. I only changed one word in Buffett's quote. I replaced "retention" with "Berkshire." Buffett is a smart man. If he had wanted to say "Berkshire," he would have said: "Berkshire." But he didn't; he said: "retention." The difference between "Berkshire" and "retention" is the difference in the interpretation that I am making here.
So, in my example, the test would be whether each $1 of retained earnings now being held by the Parent in the form of short term government securities, delivered $1 worth of market value to Parent's shareholders, regardless of how Financial and Industrial affected Parent's stock price.
Experience: But, if what you are saying is true, one more distinction needs to be made.
Hope: Which is?
Experience: Since there is no quoted market value for Parent's retained earnings, when Buffett says market value in the quote in question, he cannot mean market "price," but must mean some other kind of independent appraisal of market value.
Hope: Yes, you are right. But one thing at a time.
So. Did I trump Experience? Do I win a cigar?
Elias: You already have one. But, I think you have done it! No one will argue with this!
Experience: Elias, if you believe that, you are an idiot.
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Triumph of Hope over Experience.
Become a Complete Fool