More Praise for The Warren Buffett Way, First Edition

Part of the problem, Buffett suggests, is the shameful tendency of
boards of directors to blithely rubber-stamp whatever senior manage-
ment asks for. It is a question of independence and guts—the degree to
In the long run, of course, trouble awaits managements that
paper over operating problems with accounting maneuvers.
28
W
ARREN
B
UFFETT
, 1991 [N
OTE THE DATE OF THIS REMARK
.]

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which directors are willing to honor their f iduciary responsibility at the
risk of displeasing the senior executives. That willingness, or lack of it,
is on display in boardrooms across the country.
“True independence—meaning the willingness to challenge a
forceful CEO when something is wrong or foolish—is an enormously
valuable trait in a director,” Buffett writes. “It is also rare. The place to
look for it is among high-grade people whose interests are in line with
those of rank and f ile shareholders.” Buffett illuminates his position by
describing what he looks for in members of the Berkshire Hathaway
board—“very high integrity, business savvy, shareholder orientation
and a genuine interest in the company.”
31
C A N W E R E A L LY P U T A VA L U E O N M A N A G E M E N T ?
Buffett would be the f irst to admit that evaluating managers along his
three dimensions—rationality, candor, and independent thinking—is
more diff icult than measuring f inancial performance, for the simple
reason that human beings are more complex than numbers.
Indeed, many analysts believe that because measuring human activity
is vague and imprecise, we simply cannot value management with any
degree of confidence, and therefore the exercise is futile. Without a dec-
imal point, they seem to suggest, there is nothing to measure. Others
hold the view that the value of management is fully ref lected in the com-
pany’s performance statistics, including sales, profit margins, and return
on equity, and no other measuring stick is necessary.
Both opinions have some validity, but neither is strong enough to
outweigh the original premise. The reason for taking the time to eval-
uate management is that it gives you early warning signs of eventual f i-
nancial performance. If you look closely at the words and actions of a
management team, you will f ind clues that can help you measure the
value of their work long before it shows up in the company’s f inancial
reports or in the stock pages of your daily newspaper. Doing so will
take some digging on your part, and that may be enough to discourage
the weak of heart or the lazy. That is their loss, and your gain.
How to go about gathering the necessary information? Buffett offers
a few tips. He suggests reviewing annual reports from a few years back,
paying special attention to what management said then about strategies
for the future. Then compare those plans to today’s results: How fully

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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
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were they realized? Also compare strategies of a few years ago to this
year’s strategies and ideas: How has the thinking changed? Buffett also
suggests that it can be very valuable to compare annual reports of the
company you are interested in with reports from similar companies in
the same industry. It is not always easy to find exact duplicates, but even
relative performance comparison can yield insights.
Expand your reading horizons. Be alert for articles in newspapers
and financial magazines about the company you are interested in and
about its industry in general. Read what the company’s executives have
to say and what others say about them. If you notice that the chairman
recently made a speech or presentation, get a copy from the investor
relations department and study it carefully. Make use of the company’s
web pages for up-to-the-minute information. In every way you can
think of, raise your antennae. The more you develop the habit of staying
alert for information, the easier the process will become.
It must be said here, with sadness, that it is possible that the docu-
ments you study are f illed with inf lated numbers, half-truths, and de-
liberate obfuscations. We all know the names of the companies charged
with doing this; they are a rogue’s gallery of American businesses, and
some of their leaders are f inding themselves with lots of time in prison
to rethink their actions. Sometimes the manipulations are so skillful
that even forensic accountants are fooled; how then can you, an investor
without any special knowledge, fully understand what you are seeing?
The regrettable answer is, you cannot. You can learn how to read
annual reports and balance sheets—and you should—but if they are
based on f lagrant deception and lies, you might not be able to detect it.
I read annual reports of the company I’m looking at and I read
the annual reports of the competitors. That’s the main source
material.
W
ARREN
B
UFFETT
, 1993
We like to keep things simple, so the chairman can sit around
and read annual reports.
32
C
HARLIE
M
UNGER
, 1993

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I do not mean to say that you should simply give up. Keep doing
your research, and strive to be alert for signs of trouble. It should not
surprise us that Warren Buffett gives us some valuable tips:
33
• “Beware of companies displaying weak accounting.” In particu-
lar, he cautions us to watch out for companies that do not expense
stock options. It’s an obvious red f lag that other less obvious ma-
neuvers are also present.
• Another red f lag: “unintelligible footnotes.” If you can’t under-
stand them, he says, don’t assume it’s your shortcoming; it’s a fa-
vored tool for hiding something management doesn’t want you
to know.
• “Be suspicious of companies that trumpet earnings projections
and growth expectations.” No one can know the future, and any
CEO who claims to do so is not worthy of your trust.
In conclusion, Buffett wants to work with managers who are straight
shooters, who are candid with their shareholders and their employees.
His unshakable insistence on ethical behavior as a condition of doing
business has taken on added signif icance since the outbreak of corporate
scandals. However, he would be the f irst to acknowledge that taking
such a stand will not, in and of itself, insulate investors from losses trig-
gered by fraud.
I must add my own caution: I cannot promise that following the
tenets of the Warren Buffett Way described in this book will protect
you 100 percent. If company off icials are f lat-out lying to investors
through fraudulent accounting or other illegal maneuvers and if they’re
good at it, it can be diff icult, often impossible, to detect in time. Even-
tually the perpetrators end up in jail, but by then the damage to share-
holders is done; the money is gone. What I can say is this: If you adopt
the careful, thoughtful way of looking at investments that Buffett
teaches us and take the time to do your homework, you will be right
more often than you are wrong, and certainly more often than those
who allow themselves to be pushed and pulled willy-nilly by headlines
and rumor.

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7
Investing Guidelines
Financial Tenets
T
he f inancial tenets by which Buffett values both managerial excel-
lence and economic performance are all grounded in some typi-
cally Buffett-like principles. For one thing, he does not take yearly
results too seriously. Instead, he focuses on four- or f ive-year averages.
Often, he notes, prof itable business returns might not coincide with the
time it takes for the planet to circle the sun.
He also has little patience with accounting sleight-of-hand that pro-
duces impressive year-end numbers but little real value. Instead, he re-
lies on a few timeless f inancial principles:
• Focus on return on equity, not earnings per share.
• Calculate “owner earnings” to get a true ref lection of value.
• Look for companies with high prof it margins.
• For every dollar retained, has the company created at least a dol-
lar of market value?
R E T U R N O N E Q U I T Y
Customarily, analysts measure annual company performance by looking
at earnings per share. Did they increase over the preceding year? Are
they high enough to brag about? For his part, Buffett considers earnings

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T H E W A R R E N B U F F E T T W AY
per share a smoke screen. Since most companies retain a portion of their
previous year’s earnings to increase their equity base, he sees no reason
to get excited about record earnings per share. There is nothing spec-
tacular about a company that increases earnings per share by 10 percent
if at the same time it is growing its equity base by 10 percent. That’s no
different, he explains, from putting money in a savings account and let-
ting the interest accumulate and compound.
The test of economic performance, Buffett believes, is whether a
company achieves a high earnings rate on equity capital (“without undue
leverage, accounting gimmickry, etc.”), not whether it has consistent
gains in earnings per share.
1
To measure a company’s annual perfor-
mance, Buffett prefers return on equity—the ratio of operating earnings
to shareholders’ equity.
To use this ratio, though, we need to make several adjustments. First,
all marketable securities should be valued at cost and not at market value,
because values in the stock market as a whole can greatly inf luence the
returns on shareholders’ equity in a particular company. For example, if
the stock market rose dramatically in one year, thereby increasing the net
worth of a company, a truly outstanding operating performance would
be diminished when compared with a larger denominator. Conversely,
falling prices reduce shareholders’ equity, which means that mediocre
operating results appear much better than they really are.
Second, we must also control the effects that unusual items may have
on the numerator of this ratio. Buffett excludes all capital gains and
losses as well as any extraordinary items that may increase or decrease
operating earnings. He is seeking to isolate the specific annual perfor-
mance of a business. He wants to know how well management accom-
plishes its task of generating a return on the operations of the business
given the capital it employs. That, he says, is the single best measure of
management’s economic performance.
Furthermore, Buffett believes that a business should achieve good
returns on equity while employing little or no debt. We know that
companies can increase their return on equity by increasing their debt-
to-equity ratio. Buffett is aware of this, but the idea of adding a couple
of points to Berkshire Hathaway’s return on equity simply by taking on
more debt does not impress him. “Good business or investment deci-
sions,” he says, “will produce quite satisfactory economic results with
no aid from leverage.”
2
Furthermore, highly leveraged companies are
vulnerable during economic slowdowns.

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Buffett does not give us any suggestions as to what debt levels are ap-
propriate or inappropriate for a business. Different companies, depending
on their cash f lows, can manage different levels of debt. What Buffett
does tell us is that a good business should be able to earn a good return on
equity without the aid of leverage. Investors should be wary of companies
that can earn good returns on equity only by employing significant debt.
Coca-Cola
In “Strategy for the 1980s,” his plan for revitalizing the company,
Goizueta pointed out that Coca-Cola would divest any business that no
longer generated acceptable returns on equity. Any new business ven-
ture must have suff icient real growth potential to justify an investment.
Coca-Cola was no longer interested in battling for share in a stagnant
market. “Increasing earnings per share and effecting increased return
on equity are still the name of the game,” Goizueta announced.
3
His
words were followed by actions. Coca-Cola’s wine business was sold to
Seagram’s in 1983.
Although the company earned a respectable 20 percent return on
equity during the 1970s, Goizueta was not impressed. He demanded
better returns and the company obliged. By 1988, Coca-Cola’s return
on equity had increased to 31.8 percent (see Figure 7.1).
Figure 7.1
The Coca-Cola Company return on equity and pretax margins.

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T H E W A R R E N B U F F E T T W AY
By any measurement, Goizueta’s Coca-Cola was doubling and
tripling the financial accomplishments of the previous CEO. The results
could be seen in the market value of the company. In 1980, Coca-Cola
had a market value of $4.1 billion. By the end of 1987, even after the
stock market crash in October, the market value had risen to $14.1 bil-
lion (see Figure 7.2). In seven years, Coca-Cola’s market value rose at an
average annual rate of 19.3 percent.
The Washington Post Company
When Buffett purchased stock in the