Author: BoringBiz_

Translation: Deep Tide TechFlow

Introduction: As Warren Buffett prepares to step down after nearly 60 years at the helm of Berkshire Hathaway, it is particularly important to reflect on the essence of his early thoughts.

This article is a translation of an in-depth review of Buffett's shareholder letters from 1981 to 1982. Even after more than 40 years, Buffett's discussions on "rejecting mediocre acquisitions," "inflation as a termite eroding businesses," and "real economic surplus being superior to accounting profits" still hold significant warning for today's Web3 investors, DAO governors, and business operators.

The full text is as follows:

As Warren Buffett approaches the end of his nearly six-decade tenure as CEO of Berkshire Hathaway, I have revisited and begun studying all of his annual shareholder letters.

If you want to read the lessons from the letters of 1977-1980, please see here: 1977-1980 Letters

Here are some classic lessons for both investors and operators.

1981 Shareholder Letter

On the Standards for Acquisition Decisions

"Our acquisition decisions aim to maximize real economic benefits, not to expand the management's territory or to pursue accounting numbers in a financial statement. (In the long run, those managements that emphasize accounting appearances rather than economic substance usually end up with neither.)"

"Regardless of the immediate impact on financial report earnings, we would prefer to buy 10% of an excellent company T at a price of X per share rather than buy 100% of T at a price of 2X. However, most company managements tend to prefer the latter and never lack reasons to justify their actions."

Why CEOs are willing to pay premiums for mergers and acquisitions (M&A) and leveraged buyouts (LBO)

"We suspect that in most high-premium acquisitions, the following three motivations (often unspoken) are the main drivers, either acting alone or in concert:

1. Leaders in both business and other fields rarely lack 'animal spirits'; they are often eager to increase activity and take on challenges. At Berkshire, the pulse of the company has never raced so vigorously as when there is a prospect of an acquisition.
2. Most organizations, whether in business or other fields, tend to measure themselves by size and are measured by others in the same way. Compensation for management is far more often based on 'size' than on other standards. (Ask a manager at a Fortune 500 company what rank their company holds on that famous list, and the number they blurt out will certainly be the one ranked by sales size; they may not even know where their company ranks in terms of profitability, which is also faithfully recorded by Fortune.)
3. Many managements seem to have been overly influenced during their formative years by the story of 'The Frog Prince'—in which the handsome prince imprisoned in a frog's body is restored to life by a kiss from a beautiful princess. Thus, they are convinced that their 'management kiss' can work miracles for the target company T.

This optimism is essential. Without this delightful illusion, why would the shareholders of acquiring company A support buying T's equity at a price of 2X rather than simply buying it on the secondary market at a price of X?"

Investors Should Seek to Buy 'Princes' at 'Frog Prices'

"Investors can always buy frogs at market prices. If investors fund those 'princesses' willing to pay double the price to kiss frogs, then those kisses had better have some real power.

We have observed many kisses, but miracles are rare. Nevertheless, many management 'princesses' remain confident in the effectiveness of their future kisses—even when their company's backyard is piled high with unresponsive frogs.

We have occasionally tried to buy frogs at low prices, and the results have been detailed in past reports. Clearly, our kisses have utterly failed. We have done well with a few 'princes'—but they were princes at the time of acquisition. At least our kisses didn't turn them into frogs. Ultimately, we can sometimes successfully buy portions of easily identifiable 'princes' at 'frog-like' prices."

What Makes a Successful Acquisition

"We must acknowledge that some acquisition records are indeed very impressive. They can mainly be categorized into two types:

The first type involves companies that, through careful design or coincidence, only purchase businesses that are particularly well-suited to thrive in an inflationary environment. These favored businesses must possess two characteristics:

1. The ability to raise prices easily (even when product demand is mediocre and capacity is not fully utilized), without worrying about losing significant market share or sales;
2. The ability to handle substantial dollar business growth with minimal additional capital investment (this growth is typically driven by inflation rather than actual growth). Even managements with mediocre capabilities can achieve excellent results over the past few decades by focusing on acquisitions that meet these standards. However, very few companies possess both characteristics simultaneously, and competition to buy such companies has now become extraordinarily fierce, even to the point of self-harm.

The second type involves managerial geniuses—those who can identify rare princes disguised as frogs and possess the management ability to tear off the disguise. We salute these managers."

Stable Price Levels Are Like Chastity

"We have explained how inflation makes our seemingly satisfactory long-term performance appear illusory when measuring the true investment results for owners.

We appreciate the efforts of Federal Reserve Chairman Volcker and note that the growth of various price indices has moderated.

However, our view on the long-term trend of inflation remains negative. Like chastity, stable price levels seem maintainable but cannot be repaired."

On Equity Risk Premium

"The economic basis for justifying equity investment is that, overall, applying management and entrepreneurial skills to equity capital will generate excess returns above passive investment returns (i.e., fixed income securities' interest).

Moreover, this basis assumes that because equity capital carries higher risk than passive investments, it 'should' earn higher returns. The 'appreciation' bonus generated by equity capital seems logical and certain.

But is this really the case? Decades ago, a return on equity (ROE) as low as 10% could classify a company as a 'good' business—wherein a reinvestment of $1 could logically be valued by the market at over 100 cents.

Because when long-term taxable bond yields are 5% and long-term tax-exempt bond yields are 3%, a business that can utilize equity capital at a 10% efficiency is clearly more valuable to investors than the equity capital it uses. Even if the combination of dividend taxes and capital gains taxes reduces the company's 10% earnings to 6%-8% in the hands of individual investors, this still holds true.

The investment market at that time recognized this fact. During that period, the average return on equity for American companies was about 11%, and the overall price of stocks was far above their equity capital (book value), averaging over 150 cents for every $1 of book value. Most businesses were 'good' businesses because their earning capacity far exceeded their maintenance costs (the returns on long-term passive funds). The total appreciation generated by equity investment was enormous.

That era is long gone. But the lessons from that time are hard to discard. While investors and management must focus on the future, their memories and nervous systems often remain anchored in the past. For investors, using historical price-to-earnings ratios (P/E Ratio) or for management, using historical business valuation standards is much easier than rethinking premises every day.

When change is slow, constant rethinking is actually undesirable; it is ineffective and slows down response times. But when change is rapid, clinging to yesterday's assumptions can come at a great cost. And the pace of economic change has become breathtaking."

Inflation is a Termite for Businesses

"In an inflationary environment, owners of 'bad' businesses face a particularly ironic punishment. To maintain current operations, these low-return businesses often must retain most of their profits—regardless of how much this policy punishes shareholders.

The rational approach, of course, is exactly the opposite. If a person holds a bond with a 5% interest rate that has many years until maturity, they would not take the interest from that bond to buy more 5% bonds at 100 cents, especially when similar bonds are available for as little as 40 cents. Instead, they would extract interest from that low-return bond and—if they intend to reinvest—look for opportunities that currently offer the highest safe returns. Good money does not follow bad money down the drain.

The logic that applies to creditors also applies to shareholders. Logically, a company with high historical returns and high expected returns should retain most or all profits so that shareholders can earn premium returns through enhanced capital.

Conversely, a low return on equity means that a very high dividend distribution policy should be adopted so that owners can redirect capital to more attractive areas. (The Bible holds the same view. In the parable of the talents, the two high-yield servants received a 100% retention reward and were encouraged to expand. However, the third servant, who had no yield, was not only reprimanded—'wicked and lazy'—but was also required to hand over all his capital to the one who performed best. Matthew 25:14-30)

But inflation is like taking us into the mirror world of 'Alice in Wonderland,' where everything is upside down. When prices are constantly rising, 'bad' businesses must retain every penny they can get. This is not because it is an attractive place for equity capital; rather, it is precisely because it is unattractive that low-return businesses must follow high retention policies. If they hope to continue operating in the future as they did in the past—most entities, including businesses, want to do so—they have no choice.

Because inflation is like a giant 'termite' for businesses. This termite preemptively consumes the investment dollars it needs daily, regardless of the health of the host organism. No matter what the reported profit level is (even if it is zero), to merely maintain last year's business volume, companies continuously need more dollars invested in accounts receivable, inventory, and fixed assets. The worse the business is, the larger the proportion of available nutrients consumed by this termite.

Under current conditions, a business with an 8% or 10% return on equity typically has no remaining funds for expansion, debt repayment, or paying 'real' dividends.

This termite of inflation simply cleans the plate. (The situation where low-return companies cannot pay dividends is often well concealed. American companies are increasingly turning to dividend reinvestment plans, sometimes even including a discount arrangement that almost forces shareholders to reinvest. Other companies are 'robbing Peter to pay Paul,' selling newly issued stock to Peter in order to pay dividends to Paul. Be wary of those 'dividends' that can only be paid if someone promises to replace the capital distributed.)"

1982 Shareholder Letter

Setting Preset Yardsticks

"As long as the results are good, yardsticks are rarely discarded. But when performance deteriorates, most managers tend to discard the yardsticks rather than the manager."

For managers facing deteriorating performance, a more flexible measurement system often comes to mind: first, shoot arrows of business performance at a blank canvas, then carefully draw a target around where the arrows land. We generally trust preset, long-term effective, and smaller target measurement standards more.

Accounting is the Starting Point of Business Valuation, Not the Endpoint

"We prefer the concept of 'economic' surplus, which includes all undistributed profits, regardless of ownership percentage. In our view, the value of retained earnings to owners depends on the efficiency with which those earnings are used, not on the size of your ownership stake. If you held 0.01% of Berkshire over the past decade, regardless of how your accounting system records it, you have economically shared in our retained earnings. Proportionally, the benefits you received are the same as if you held that enticing 20% stake. However, if you held 100% of many capital-intensive companies over the past decade, those retained earnings that were fully and accurately accounted for under standard accounting methods may ultimately yield negligible economic value, or even zero.

This is not a criticism of accounting procedures. We do not wish to take on the task of designing a better system. This is merely to illustrate that both managers and investors must understand that accounting numbers are the starting point of business valuation, not the endpoint."

Retained Earnings and Market Valuation

"While total retained earnings have transformed over the years into at least equivalent market value returned to shareholders, this transformation is highly uneven across different companies and exhibits irregularity and unpredictability over time.

However, it is this very unevenness and irregularity that provides opportunities for value-oriented buyers who purchase fractional portions of businesses.

These investors can choose from almost all major American companies, many of which far outperform those that can be negotiated for a complete acquisition. Additionally, purchasing fractional ownership can occur in auction markets, where prices are set by participants whose behavior patterns sometimes resemble a group of manic-depressive lemmings.

In this vast auction arena, our task is to select businesses with excellent economic characteristics, ensuring that every dollar of retained earnings ultimately converts into at least one dollar of market value. Despite making many mistakes, we have achieved this goal so far. In this process, we have received tremendous help from the economist's guardian—St. Offset.

That is to say, in some cases, the impact of retained earnings attributable to our ownership position on market value is negligible or even negative; while in other major holdings, the dollar retained by the invested company has already transformed into two dollars or more of market value. So far, our outstanding companies have more than compensated for the underperformers. If we can continue to maintain this record, we will prove that our strategy of maximizing 'economic' surplus is correct, regardless of its impact on 'accounting' earnings."

On Mergers and Acquisitions (M&A)

"When we look back at the significant acquisitions made by other companies in 1982, our reaction is not one of jealousy, but rather relief that we did not participate.

Because in many of these acquisitions, the rationality of management has shriveled in competition with the adrenaline of management; the thrill of the chase blinds pursuers to the consequences of capture. Pascal's observation seems apt: 'I find that all of humanity's misfortunes stem from a single cause: their inability to stay quietly in their own rooms.'"

What Affects a Company's Profitability?

"If an industry exhibits both 'severe overcapacity' and 'commoditized' products (where there is no differentiation in performance, appearance, service support, or other dimensions of customer concern), it is a prime candidate for profitability challenges. Indeed, if prices or costs are somehow administratively managed, thus at least partially detached from normal market forces, these issues might be avoided.

Such management can be implemented in the following ways: (a) legally through government intervention (until recently, this included pricing for truck freight and deposit costs for financial institutions); (b) illegally through collusion; or (c) through 'extralegal' foreign cartels similar to OPEC (domestic non-cartel operators can also benefit).

However, if costs and prices are determined by comprehensive competition, and there is overcapacity, and buyers do not care whose products or delivery services they use, then the economic condition of that industry is almost destined to be mediocre, if not catastrophic.

Thus, every supplier is constantly striving to establish and emphasize the unique qualities of their products or services. This works for candy bars (customers buy by brand rather than asking for 'a two-ounce candy bar'), but does not work for sugar (how often do you hear, 'Please give me a cup of coffee with cream and C & H sugar'?).

In many industries, differentiation simply cannot produce substantial meaning. If a few producers have broad and sustainable cost advantages, they may continue to perform well. By definition, such exceptions are rare and may not exist at all in many industries. For the vast majority of companies selling 'commoditized' products, a frustrating business economic equation prevails: persistent overcapacity + lack of administrative pricing (or cost management) = poor profitability.

Of course, overcapacity may eventually self-correct, either through a reduction in capacity or through demand expansion. Unfortunately, for participants, this correction is often long delayed. When it finally occurs, the general enthusiasm for returning to prosperity often creates overcapacity again within a few years, leading to a new unprofitable environment. In other words, nothing leads to failure more easily than success.

Ultimately, the long-term profitability of such industries is determined by the ratio of 'tight supply years' to 'ample supply years.' Typically, this ratio is dismal. (It seems that the last period of tight supply in our textile business—occurring a few years ago—lasted only half a morning.)

However, in certain industries, conditions of tight supply can persist for a long time. Sometimes, actual demand growth can exceed forecasted growth for an extended period. In other cases, increasing capacity requires a long preparation period, as complex manufacturing facilities must be planned and constructed."

Using Equity as a Means of Payment in M&A Transactions

"Our stock issuance follows a simple fundamental rule: we will not issue stock unless the intrinsic business value we receive is equal to what we pay. This policy seems self-evident. You might ask, why would anyone exchange a dollar bill for fifty cents in coins? Unfortunately, many company managers have been willing to do just that.

These managers may prefer to use cash or debt when making acquisitions. But the CEO's desires often exceed cash and credit resources (of course, my desires are always the same). Moreover, these desires often arise when the price of their own stock is far below its intrinsic business value. This situation creates a moment of truth. As Yogi Berra said, 'You can observe a lot just by watching.' Because shareholders will discover which target management truly prefers—expanding the territory or preserving the wealth of the owners.

The reason for needing to choose between these goals is simple. A company's stock market price is often lower than its intrinsic business value. But when a company wishes to negotiate a complete sale, it inevitably wants—and often can—obtain the full business value in any form of currency.

If cash is used for payment, the seller's calculation of the value received is straightforward. If the buyer's stock is used as currency, the seller's calculation remains relatively easy: simply calculate the market cash value of the assets received through the stock.

At the same time, a buyer wishing to use their own stock as currency for purchase has no issues if their stock is priced at its full intrinsic value.

But suppose its price is only half of its intrinsic value. In this case, the buyer faces the painful prospect of purchasing with significantly undervalued currency.

Ironically, if the buyer turns around and becomes the seller of their entire business, they can negotiate and potentially receive the full intrinsic business value. But when the buyer engages in a 'partial sale'—issuing stock for acquisition is essentially this act—they typically cannot set a higher value for their stock than what the market assigns.

Even so, the acquirer who pushes forward despite this ultimately uses undervalued (by market value) currency to pay for an asset valued at full value (by negotiated value). In reality, the acquirer must give up $2 of value to receive $1 of value in return. In such cases, an excellent business bought at a fair price becomes a poor deal. Because gold valued as gold cannot be smartly purchased using gold—even silver valued as lead."

How CEOs Justify Value-Destroying Acquisitions

"If the desire for scale and action is strong enough, the acquiring manager can always find ample reasons to justify this value-destroying stock issuance. Friendly investment bankers will assure them of the rationality of their actions. (Never ask a barber if you need a haircut.)

Here are some common excuses used by management for issuing stock:

1. 'The company we are acquiring will be worth more in the future.' (Presumably, the equity of the original business being traded away is also included; the future prospects are already factored into the business valuation process. If you issue at 2X to exchange for X, when both parts of the business double in value, the imbalance still exists.)
2. 'We must grow.' (One might ask, who is 'we' here? For existing shareholders, the reality is that as long as stock is issued, all existing businesses will shrink. If Berkshire were to issue stock tomorrow for an acquisition, it would have everything it currently owns plus the new business, but your equity in hard-to-match businesses like See’s Candy Shops and National Indemnity would automatically decrease. If (1) your family owns a 120-acre farm, (2) you invite a neighbor with 60 acres of similar land to merge into an equal partnership—where you serve as the managing partner—then (3) your management territory will grow to 180 acres, but your family's ownership stake in the land and crops will permanently shrink by 25%. Managers who wish to expand their territory at the expense of owner interests would do better to consider a position in government.)
3. 'Our stock is undervalued, and we have tried to minimize its use in the transaction—but we need to give the seller's shareholders 51% stock and 49% cash so that some of those shareholders can achieve the tax-free exchange they want.' (This argument acknowledges that reducing stock issuance is beneficial for the acquirer, which we like. But if 100% stock usage would harm existing shareholders, then using 51% is likely to cause harm as well. After all, if a cocker spaniel dirties someone's lawn, they won't feel better about it just because it's a cocker spaniel and not a St. Bernard. The seller's willingness cannot become the determining factor for the buyer's best interests—God knows what would happen if the seller insisted on replacing the acquirer's CEO as a condition of the merger.)"

How to Avoid Value-Destroying Acquisitions

"There are three ways to avoid destroying the value of existing shareholders when issuing stock for acquisitions:

The first method is to conduct a true "business value for business value" merger. This type of merger attempts to be fair to both sets of shareholders, with each party contributing and receiving exactly equal intrinsic business value. It is not that the acquirer wants to avoid such transactions; rather, they are extremely difficult to achieve.

The second path arises when the acquirer's stock price is equal to or greater than its intrinsic business value. In this case, using stock as currency can actually increase the wealth of the acquirer's owners. Many mergers during the period from 1965 to 1969 were completed on this basis. The results were starkly opposite to most activities since 1970: shareholders of the acquired companies received highly inflated currency (often a bubble inflated by questionable accounting and promotional tactics), and they were the true losers of wealth in these transactions.

In recent years, the second option has been effective for a very small number of large companies. The exceptions are primarily those in charming or promotional industries, where the market temporarily assigns them valuations equal to or above their intrinsic business value.

The third option is for the acquirer to continue with the acquisition but then repurchase an amount of stock equivalent to the number of shares issued in the merger. In this way, the original "stock-for-stock" merger can effectively be transformed into a "cash-for-stock" acquisition. Such repurchases are "damage repair" measures. Regular readers of my letters will correctly guess that we prefer repurchases that can directly increase owner wealth rather than merely patching up previous damage. Scoring a touchdown is more exciting than recovering your own fumble. However, when a fumble occurs, recovering possession is crucial, and we sincerely recommend this damage-repairing repurchase that transforms a poor stock transaction into a fair cash transaction.

Traps to Watch Out for in M&A Language

"The language used in mergers and acquisitions often obscures issues and encourages managers to take irrational actions. For example, 'dilution' is typically based on pro forma calculations of book value and current earnings per share (EPS), with particular emphasis on the latter.

When this calculation appears negative (dilutive) from the acquirer's perspective, management will provide a justification (internally, even if not externally) claiming that these curves will favorably intersect at some point in the future. (While transactions often fail in practice, they never fail in predictions—if a CEO is clearly salivating over a potential acquisition, subordinates and advisors will provide the necessary forecasts to rationalize any price.) If the calculated number is immediately positive for the acquirer—i.e., 'anti-dilutive'—then no explanation is deemed necessary.

The attention given to this form of dilution is excessive: current earnings per share (even for the next few years) is an important variable in most business valuations, but far from a decisive factor.

Many mergers are non-dilutive in this limited sense but are instant value destroyers for the acquirer. Conversely, some mergers that dilute current and short-term earnings per share are, in fact, value-enhancing. What truly matters is whether a merger is dilutive or accretive in terms of 'intrinsic business value' (a judgment that involves considering many variables). We believe it is crucial to calculate dilution from this perspective (though few do).

The second language issue relates to the exchange equation. If Company A announces it will issue stock to merge with Company B, this process is often described as 'Company A acquiring Company B' or 'B selling to A.' If a somewhat clumsy but more accurate description is used, the thinking becomes clearer: 'A is partially sold in exchange for B' or 'the owners of B receive a portion of A in exchange for their assets.' In trade, what you give and what you receive are equally important. Even if the settlement of what you give is delayed, this remains true.

Subsequent common stock issuances or convertible bond issuances to finance the transaction or restore balance sheet strength must be fully accounted for when evaluating the original acquisition's basic mathematical model. (If the result of corporate mating is destined to be corporate pregnancy, the timing of facing this fact should be before the moment of ecstasy.)

Managers and directors can sharpen their thinking by asking themselves this question: would they be willing to sell 100% of the business on the basis of being asked to sell a portion of it? If selling the entire business on this basis is not wise, they should ask themselves why selling a portion is smart. A pile of small managerial foolishness can accumulate into a massive folly—rather than a great victory. (Las Vegas is built on the wealth transfer that occurs when people engage in seemingly minor adverse capital transactions.)"

Value Dilution in M&A ("Double Whammy" Effect)

"Finally, it should be noted that when a value-dilutive stock issuance occurs, it produces a 'double whammy' effect on the acquirer's owners. In this case, the first hit is the loss of intrinsic business value caused by the merger itself.

The second hit is the downward adjustment of market valuation, which is rationally assigned to the now-diluted business value. Because current and potential owners will understandably be unwilling to pay such a high price for assets that fall into the hands of management with a record of 'destroying wealth through acquisitions'…"

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