More Praise for The Warren Buffett Way, First Edition

(Continued)

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8 8
He explained his thinking to Berkshire shareholders: “John
Holland was responsible for Fruit’s operations in its most boun-
tiful years. . . . [After the bankruptcy] John was rehired, and he
undertook a major reworking of operations. Before John’s re-
turn, deliveries were chaotic, costs soared, and relations with key
customers deteriorated. . . . He’s been restoring the old Fruit of
the Loom, albeit in a much more competitive environment. [In
our purchase offer] we insisted on a very unusual proviso: John
had to be available to continue serving as CEO after we took
over. To us, John and the brand are Fruit’s key assets.”
7
Since Holland took the reins, Fruit of the Loom has under-
gone a massive restructuring to lower its costs. It slashed its
freight costs, reduced overtime, and trimmed inventory levels. It
disposed of sideline businesses, eliminated unprofitable product
lines, found new efficiencies in manufacturing process, and
worked to restore customer satisfaction by filling orders on time.
Almost immediately, improvement was apparent. Earnings
increased, operating expenses decreased. In 2000, gross earnings
rose by $160.3 million—a 222 percent increase—compared to
1999, and gross margin increased 11 percentage points. The
company reported an operating loss in 2000 of $44.2 million,
compared to the 1999 loss of $292.3 million. Even more reveal-
ing of improvement are the fourth-quarter results—an operating
loss of $13.5 million (which included one-time consolidation
costs related to the closure of four U.S. plants) in 2000, com-
pared to $218.6 million—more than sixteen times greater—just
one year earlier.
In 2001, the positive trend continued. Gross earnings grew
another $72.5 million, a 31 percent increase over 2000, and gross
margin increased 7.7 percentage points to 22.7 percent for the
year. That means the company ended 2001 with operating earn-
ings of $70.1 million, compared to 2000’s $44.2 million loss.
Of course monumental problems such as the company faced
are not fully corrected overnight, and Fruit of the Loom must
still operate in a ferociously competitive industry environment,
but so far Buffett is pleased with the company’s performance.

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I n v e s t i n g G u i d e l i n e s : M a n a g e m e n t Te n e t s
8 9
another, a company that must integrate and manage a new business is apt
to make mistakes that could be costly to shareholders.
In Buffett’s mind, the only reasonable and responsible course for
companies that have a growing pile of cash that cannot be reinvested at
above-average rates is to return that money to the shareholders. For that,
two methods are available: raising the dividend or buying back shares.
With cash in hand from their dividends, shareholders have the oppor-
tunity to look elsewhere for higher returns. On the surface, this seems to
be a good deal, and therefore many people view increased dividends as a
sign of companies that are doing well. Buffett believes that this is so only
if investors can get more for their cash than the company could generate
if it retained the earnings and reinvested in the company.
Over the years, Berkshire Hathaway has earned very high returns
from its capital and has retained all its earnings. With such high returns,
shareholders would have been ill served if they were paid a dividend.
Not surprisingly, Berkshire does not pay a dividend. And that’s just f ine
Lest anyone still consider buying a debt-ridden bankrupt
company a surprising move, there was also a third reason for
Buffett’s decision, which should come as no surprise whatso-
ever: He was able to acquire the company on very favorable f i-
nancial terms. For details, see Chapter 8.
Buying an underwear maker creates lots of opportunities
for corny jokes, and Buffett, an accomplished punster, made the
most of it. At the 2002 shareholders meeting, when asked the
obvious question, he teased the audience with a half answer:
“When I wear underwear at all, which I rarely do . . .” Leaving
the crowd to decide for themselves whether it’s boxers or briefs
for Buffett. He pointed out why there’s “a favorable bottom
line” in underwear: “It’s an elastic market.” Finally, he dead-
panned, Charlie Munger had given him an additional reason to
buy the company: “For years Charlie has been telling me,
‘Warren, we have to get into women’s underwear.’ Charlie is
78. It’s now or never.”
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9 0
T H E W A R R E N B U F F E T T W AY
with the shareholders. The ultimate test of owners’ faith is allowing
management to reinvest 100 percent of earnings; Berkshire’s owners’
faith in Buffett is high.
If the real value of dividends is sometimes misunderstood, the second
mechanism for returning earnings to the shareholders—stock repur-
chase—is even more so. The benefit to the owners is in many respects
less direct, less tangible, and less immediate.
When management repurchases stock, Buffett feels that the reward is
twofold. If the stock is selling below its intrinsic value, then purchasing
shares makes good business sense. If a company’s stock price is $50 and its
intrinsic value is $100, then each time management buys its stock, they
are acquiring $2 of intrinsic value for every $1 spent. Such transactions
can be highly profitable for the remaining shareholders.
Furthermore, says Buffett, when executives actively buy the com-
pany’s stock in the market, they are demonstrating that they have the
best interests of their owners at hand rather than a careless need to ex-
pand the corporate structure. That kind of stance sends good signals to
the market, attracting other investors looking for a well-managed com-
pany that increases shareholders’ wealth. Frequently, shareholders are re-
warded twice; f irst from the initial open market purchase and then
subsequently from the positive effect of investor interest on price.
Coca-Cola
Growth in net cash f low has allowed Coca-Cola to increase its dividend
to shareholders and also repurchase its shares in the open market. In
1984, the company authorized its first-ever buyback, announcing it
would repurchase 6 million shares of stock. Since then, the company has
repurchased more than 1 billion shares. This represented 32 percent of
the shares outstanding as of January 1, 1984, at an average price per share
of $12.46. In other words, the company spent approximately $12.4 bil-
lion to buy in shares that only ten years later would have a market value
of approximately $60 billion.
In July 1992, the company announced that through the year 2000, it
would buy back 100 million shares of its stock, representing 7.6 percent
of the company’s outstanding shares. Remarkably, because of its strong
cash-generating abilities, the company was able to accomplish this while
it continued its aggressive investment in overseas markets.

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I n v e s t i n g G u i d e l i n e s : M a n a g e m e n t Te n e t s
9 1
American Express
Buffett’s association with American Express dates back some forty
years, to his bold purchase of its distressed stock in 1963, and the astro-
nomical prof its he quickly earned for his investment partners (see
Chapter 1 for the full story). Buffett’s faith in the company has not di-
minished, and he has continued to purchase its stock. A big buy in 1994
can be traced to management decisions, both good and bad, about the
use of excess cash.
The division of the company that issues the charge card and travel-
ers’ checks, American Express Travel Related Services, contributes the
lion’s share of prof its. It has always generated substantial owner earn-
ings and has easily funded its own growth. In the early 1990s, it was
generating more cash than it needed for operations—the very point at
which management actions collide with Buffett’s acid test. In this case,
American Express management did not do well.
Then-CEO James Robinson decided to use excess cash to build the
company into a f inancial services powerhouse by buying other related
businesses. His f irst acquisition, IDS Financial Services, proved prof-
itable. But then he bought Shearson Lehman, which did not. Over
time, Shearson needed more and more cash to carry its operations.
When Shearson had swallowed up $4 billion, Robinson contacted Buf-
fett, who agreed to buy $300 million worth of preferred shares. Until
the company got back on track, he was not at all interested in buying
common stock.
In 1992, Robinson abruptly resigned and was replaced by Harvey
Golub. He set himself the immediate task of strengthening brand
awareness. Striking a familiar tone with Buffett, he began using terms
such as