Tag Archives: Economics

Buffett’s Split Personality?

“Do I contradict myself? Very well then I contradict myself, (I am large, I contain multitudes.)
Walt Whitman, “Song of Myself” ―   Walt Whitman

Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong. — Ayn Rand

Below is an unusual article (from www.marktier.com) on the split between Buffett’s private and public beliefs.  Interestingly, when Buffett was growing up his father, Howard Buffett, was an advocate for the gold standard, low taxes and extremely limited government.  Thoughts on this article?

6 January 2012     Warren Buffett’s “Split Personality”

How Warren Buffett’s investment and political philosophies just don’t get along with each other.

Economic Franchise

Warren Buffett became the world’s richest investor by following a clear and straightforward investment philosophy. Intriguingly, though, his political convictions contradict the investment principles that made his fortune. For example, he refused to invest in companies which can’t control their prices; he looks for what he calls “an economic franchise.” His definition, from his 1991 Letter to Shareholders:

“An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation.” [emphasis added] This produces what he calls a “moat” — a barrier that hinders competitors who want to invade their turf.

Nebraska Furniture Mart — probably the world’s biggest furniture store located in, of all places, Omaha, Nebraska, and 100% owned by Buffett’s company, Berkshire Hathaway — keeps its costs and prices so low that national furniture chains simply avoid Omaha entirely. Coca-Cola, of which Buffett is the biggest shareholder, has such a powerful brand name that only Pepsi is in the race for second place.

By the same token, Buffett avoids “commodity businesses” like agricultural products, where producers are at the mercy of the market. And (until 1999) he shunned businesses whose retail prices are regulated.

An Energy Czar for California

In 2000-2001, California suffered severe rolling blackouts across the state. Pacific Gas and Electric Company went bankrupt and Southern California Edison almost did as well.

The cause? The state had deregulated wholesale prices, but left retail prices fixed (This is an example of a HAMPERED or price-controlled market). When wholesale prices zoomed 800%, Californian utilities had to buy power out-of-state to resell in California at the lower, regulated prices. A recipe for financial disaster.

Buffett’s reaction to the California energy crisis is an example of the dichotomy between his investment principles and his political views. When asked for his solution, he replied: “California needs an energy czar.”  (More centralized, bureaucratic control? How would Buffett’s company managers like to be micro managed from a person/group without aligned profit motives?)

California already had one — the reason there was an energy crisis!

And…with an energy czar regulating and dictating every aspect of the energy business, how much money do you think Buffett would invest in utilities in California?

Quite clearly, none.

What’s more, in a world where every investor acted like Buffett, nobody would have invested in Californian utilities.

Logically then, it follows from Buffett’s investment principles that the solution to California’s energy crisis was the deregulation of retail prices as well (politically impossible at the time). Only then would Buffett and investors like him be willing to put up the money needed to resuscitate California’s ailing utilities.

By rooting for an energy czar, obviously Buffett hadn’t connected the dots.

Interestingly, when Buffett made this “recommendation,” he’d recently added the gas and electric utility, Mid American (with zero exposure to California at the time), to Berkshire’s portfolio of “outstanding companies.”

Had he changed his spots? No, he’d lowered his standards. He had to. With billions of dollars to invest, gone were the days when a See’s Candies or Nebraska Furniture Mart could make a difference to Berkshire’s net worth. He now needed to find “elephants” where he could sink billions of dollars at a time. When he only had millions at his disposal, he’d never have looked twice at companies like Mid American or Burlington Northern.

To Tax or Not to Tax

Buffett calls taxes a “drag” that Berkshire must overcome to “justify its existence.”

This has been his attitude since he started his first investment partnership in 1956. Indeed, back then, one way he persuaded doctors and other professionals to invest with him was by stressing the tax benefits they’d get.

Today, he says he likes to hold his investments “forever” … so capital gains tax, payable only when an investment is sold, is also delayed “forever.” In his 1989 Letter to Shareholders he gave an example showing how just delaying capital gains could multiply Berkshire’s returns 27-fold, concluding that the government would gain in exactly the same ratio when capital gains taxes were ultimately paid, “though admittedly, it would have to wait for its money.”

He also prefers companies to distribute money to shareholders by buying back stock rather than paying dividends. Shareholders must pay taxes on dividends, which are paid from profits that have already been taxed at the corporate level. Stock buy-backs, by raising the value of the remaining shares, increase the shareholders’ wealth free of the dividend tax.

That double taxation is one reason Berkshire Hathaway doesn’t pay dividends. It’s also a reason why, when Buffett buys a company, he wants a minimum of 80%. Then, dividends to Berkshire are taxed at a lower rate.

If taxes are a drag on Buffett’s investments, surely they’re a drag on everyone’s? If Buffett and Berkshire are better off with minimal tax rates, wouldn’t everyone else be too? So you’d expect Buffett to support pretty much any proposal to cut taxes, right?

If you did, you’d be wrong.

“Voodoo Economics”

Buffett’s underlying political belief is that the rich should pay more tax than the poor, both absolutely and as a percentage of their income.

Indeed, in an op-ed for the New York Times Buffett complained that the previous year he’d paid only 17.4% of his income in tax, compared to an average of 36% for the 20 staff in his office in Omaha. He recommended the government raise his taxes, and those of the other super-rich.

He does not, however, put this belief into practice by voluntarily making up the difference between the tax he must pay and the amount which, according to his beliefs, he would deem “fair.” Indeed, his personal affairs are arranged the same way as Berkshire’s: to pay the least tax possible.

A case of “do as I say, not as I do.”

Shortly after becoming president, George W. Bush proposed slashing the tax on dividends. Buffett’s reaction? “Voodoo economics” that uses “Enron-style accounting,” saying it further tilts the scales towards the rich.

Maybe. But the widespread ownership of stocks in America today (through mutual funds and pension plans) means that the rich are not the only beneficiaries of a lower dividend tax.

And by opposing such a tax cut, he clearly contradicts a significant element of his investment philosophy, which implies it is iniquitous to tax corporate profits again when they’re paid out to shareholders as dividends. Indeed, if every company followed Berkshire’s lead and paid no dividends, the government wouldn’t collect any taxes on dividends at all.

Buffett also opposes abolishing the estate tax: he believes that you shouldn’t get “a lifetime supply of food stamps just because you came out of the right womb.”

Buffett has arranged his personal affairs accordingly. When he dies, his children certainly won’t be poor. But they will only have enough money so that, as he puts it, they’ll “feel they could do anything, but not so much that they could do nothing.”

Most of his wealth is going to the Bill & Melinda Gates Foundation. As it’s a non-profit organization the bequest will be — guess what? — tax-free!

It is clearly more important to Buffett that Berkshire Hathaway, his creation — his “baby” — survives his death, than remaining true to his political beliefs, no matter how sincerely they are held. After all, Berkshire Hathaway might not live on if a chunk of his controlling shareholdings had to be sold off to pay estate tax.

However, by requiring the Gates foundation to spend his annual donations immediately, he’s practicing what governments do so well: consuming capital, not investing in the future.

And he often ignores the overall context, as he did when he was an advisor to Arnold Schwarzenegger during his campaign to become Governor of California.

Buffett told the Wall Street Journal he thought California’s property taxes were “too low.” He compared the property tax he paid on his home in Laguna Beach, California with the tax on his home in Omaha. He paid twice as much property tax in Nebraska, even though his home there is one-eighth the value of his house in California.

Is that “unfair”? Not when — unlike Buffett — we look at the total context. When you add income tax, sales tax and all the other taxes Californians pay, they’re stung by the state for much more Nebraskans. Californians get a break on property taxes — and absolutely nothing else.

An American Liberal

Politically, Buffett tends to support government action to correct what he sees as society’s inequities.  And he believes that the rich should pay for it.

Yet, he arranges his own affairs to avoid government intervention wherever possible. Indeed, when price controls in New Jersey made it impossible to earn what Buffett considers a decent return of capital, one of his insurance subsidiaries turned in its license and shut down its operations there. With Buffett’s hearty approval.

His comments on business and investing draw on 55 years of proven and tested knowledge and experience.  His political recommendations have no such pedigree.  They are an expression of his beliefs unalloyed by experience.

Indeed, one would think that his experience in creating, from nothing, a highly successful, almost debt-free Fortune 500 company with outstanding managers and (until recently) one of only eight corporate AAA credit ratings in the United States would lead him to be skeptical of the ability of governments to solve any problem.

After all, in almost every respect governments exhibit qualities 180 degrees opposite to Berkshire Hathaway: they lose money every year; run up more debt every day; hardly ever kill programs that are known failures; and if governments have a higher credit rating than Berkshire Hathaway, it’s not from a gilt-edged reputation but from the knowledge that they can always make repayments by collecting money at the point of a gun — or by printing it.

Something else often missing from government is a principle central to Buffett’s style of doing business: integrity. “In evaluating people [to hire or work with],” Buffett says, “you look for three qualities: integrity, intelligence and energy. And if you don’t have the first, the other two will kill you.”

While Buffett might enjoy playing golf with politicians like Bill Clinton, he’d have to break one of his fundamental principles to ever put one of them on Berkshire’s payroll. Mark Tier

Have a question or a comment?

Well……I never quite bought the howdy doody act, but I respect Mr. Buffett as an investor and human being.  His public proclamations on economics seem Daffy.

Economics and QE2 Explained with Cartoons; A Future Case Study: Amazon

The First Economist

Hayek’s Road to Serfdom

A Reader’s Digest Version–thirty pages–of Hayek’s Road to Serfdom, plus cartoons.  Hayek and Mises both predicted the inevitable collapse of socialism and fascism. http://www.cblpi.org/ftp/Econ/RoadtoSerfdom


Quantitative Easing explained in a cartoon video. http://www.youtube.com/watch?v=PTUY16CkS-k  About five million viewers have watched this video of two bears (dogs?) asking simple questions about monetary policy.  The theory at issue here is Keynesianism  which assumes that stimuli from government, a category that includes QE2 (Quant. Easing for the second time), are beneficial. Really? Why?  If economics can neither be explained in plain English nor understood then it’s probably bunk.

For a Future Case Study on Moats


Amazon Says Long Term And Means It By

In 1997, the year Amazon.com went public, its chief executive, Jeff Bezos, issued a manifesto: “It’s all about the long term,” he said. He warned shareholders “we may make decisions and weigh tradeoffs differently than some companies” and urged them to make sure that a long-term approach “is consistent with your investment policy.” Amazon’s management and employees “are working to build something important, something that matters to our customers, something that we can tell our grandchildren about,” he added.

But shareholders seem never to have gotten the message. In October, when Amazon reported strong third-quarter revenue growth and earnings that were pretty much what the company had predicted, but indicated it would be spending more to support continued growth, investors hammered its stock. Amazon shares dropped nearly $30, or 13 percent, to $198 a share in just one day, Oct. 25. This week they were trading even lower, at $181.

Over the years, Amazon shares have been periodically buffeted by short-term results that seem to have disappointed investors. “The stock has been bumpy,” a Morgan Stanley analyst, Scott Devitt, told me this week. “Investor trust seems to go in cycles.”

The notion that public companies should maximize shareholder value by managing for the long term is pretty much gospel among good-governance proponents and management experts. Jack Welch advanced the concept in a seminal 1981 speech at the Pierre Hotel in New York and elaborated on it in subsequent books and articles while running General Electric, when G.E. was widely lauded as the best-managed company in the country. It has been especially championed in Silicon Valley, where technology companies like Google have openly scorned Wall Street analysts and their obsession with quarterly estimates and results by refusing to issue earnings guidance.

Amazon, in particular, has been true to its word to manage for the long term. It remains one of the world’s leading growth companies and its stock has soared 12,200 percent since its public offering. In late October it reported quarterly revenue growth of 44 percent to almost $11 billion, which came on the heels of 80 percent growth a year ago. “We’re seeing the best growth which we’ve seen since 2000, meaning in 2010 and so far over the past 12 months ending September,” the chief financial officer, Thomas Szkutak, told investors in October. But operating earnings fell sharply to $79 million. While that was in line with most estimates, Amazon offered a forecast for the fourth quarter in which it said it might lose as much as $200 million or earn as much as $250 million, and even the high end would represent a 47 percent drop.

The reason Amazon is earning so little while selling so much is that it is spending so much on long-term growth. It’s opening 17 new fulfillment centers — airport hangar-size storage and shipping facilities — this year and aggressively cutting prices. Its profit margin for the quarter was just 2.4 percent, and it said it might be zero for the fourth quarter. (By comparison, Wal-Mart’s margins are 6 percent on revenue of $440 billion. )

Amazon seems to be taking customer focus to new levels, willing to run its ever-bigger global business while earning little or nothing in return. To the dismay of some, Mr. Bezos even takes a long-term view of price cuts. “With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease,” he told shareholders in 2005. But that kind of thinking, he added, is “short term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or 10 years or more.” Selling at low prices may undercut profits, but they create “a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com,” Mr. Bezos said.

Amazon has done little to dampen speculation that it is selling its revamped Kindle e-reader devices and its recently introduced Fire tablet at a loss. Amazon simply doesn’t think like most other companies. When “we think about the economics of the Kindle business, we think about the totality,” Mr. Szkutak said. “We think of the lifetime value of those devices. So we’re not just thinking about the economics of the device and the accessories. We’re thinking about the content.” In other words, profits will come down the road when Kindle users buy content through Amazon.

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people,” Mr. Bezos told reporter Steve Levy last month in an interview in Wired. “But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow—and we’re very stubborn.”

Whatever they might say about long-term shareholder value, this is simply too much for many of today’s investors, many of whom are hedge funds, pension funds and institutions who measure their results — and earn their pay — based on quarterly benchmarks. “If you look at the average length of ownership of a stock, the period is declining,” Mr. Devitt said. “Amazon is marching to a different drumbeat, which is long term. Are they doing the right thing? Absolutely. Amazon is growing at twice the rate of e-commerce as a whole, which is growing five times faster than retail over all. Amazon is bypassing margins and profits for growth.”

For Amazon, long-term growth confers two major benefits: the kind of economies of scale enjoyed by Wal-Mart and eliminating or weakening competitors. The book retailer Borders has been forced out of business and a rival, Barnes & Noble, is struggling. Best Buy, the electronics retailer, reported this week that earnings plunged 29 percent, despite higher revenue and a surge of Black Friday sales, because the chain had to cut prices and offer free shipping to compete with Amazon. Amazon inflamed many competitors this holiday season by offering extra discounts to shoppers who took mobile devices into stores and then used them to compare prices and order from Amazon.

The revamped Kindle line and especially the new Fire tablet illustrate Amazon’s long-term strategy. “Amazon has much greater ambitions than near-term profits or margins,” Ken Sena, an Evercore analyst, said.

“Some people are griping that the Fire is sub-par,” Mr. Sena continued. “It’s not an iPad. And some investors are confused. Why would they give it away, even lose money on it? But getting it into as many hands as possible is important to them. They’ll use it to drive higher physical and digital good sales on their site. And these devices also bring Amazon deeper into the local retail opportunity, not to mention the app marketplace potential that exists. Media sales on the device are just the beginning. I think Amazon understands all these components.”

The Fire “isn’t meant to be another iPad,” Mr. Devitt noted. “It’s a device to sell Amazon content. All indications are it’s a success. It’s the most gifted item on Amazon. It’s too soon to tell, but it seems more promising than it’s getting credit for.” This week Amazon said it had sold more than a million Kindles a week for the last three weeks.

Nearly 15 years after Amazon’s public offering, it’s safe to say that Mr. Bezos and his colleagues have realized their goal of creating a company to tell their grandchildren about. But one of these days Amazon has to deliver on its promise of higher margins and profits, however long term that may turn out to be. “To many investors, long term is a year,” Mr. Devitt said. “For Bezos, he’s looking at a 10- to 20-year time line. When he says long term, he means 2020 or 2030.”

Now from http://ycharts.com/  Amazon: Free Shipping and Low Prices Don’t Add Up To a Moat By Jeff Bailey

The smartest guy in financial journalism, James B. Stewart, earlier this month in his Saturday New York Times column, praised Amazon (AMZN) for taking the long view in building its business and criticized the company’s critics for failing to appreciate the company’s steadfastness. (See above.)

Amazon revenue continues to rise spectacularly. Its profits, however, have fallen, as margins are squeezed by aggressive product pricing and surging use of the company’s popular free-shipping option. So, the question seems to be, will those strategies help Amazon build what Warren Buffett would call a moat – a protective fortress around its business that long-term allows it to reap substantial profits and build value?

Stewart, author of several fabulous business books, including “Den of Thieves,” about the late-1980s Wall Street scandals, and a Pulitzer Prize winner for his work at the Wall Street Journal, is such a well-regarded thinker about companies that we at YCharts were forced to stop and consider his point of view; he’s not just another pro-Amazon tout.

We have regularly written that we view Amazon as overvalued and have marveled at how its recent growth has made it less profitable, not more so.

The critics have certainly influenced Amazon’s share price in recent months.

Amazon.com Stock Chart by YCharts

Yet the PE remains in the 90s, and this for a company with a plunging and razor-thin profit margin.

Amazon.com PE Ratio Chart by YCharts

Stewart’s admiration of Amazon certainly makes sense if you’re an Amazon customer. The service is wonderful, and like so many American shoppers during this holiday season we have ventured into actual stores very few times because shopping online – from Amazon and its many imitators – is so much easier. That change in consumer behavior seems to suggest a moat is forming. But does the moat encircle Amazon protectively, or is it instead a moat encircling bricks-and-mortar retailers into a market-share-losing ghetto?

The brutal price-comparison ethic Amazon unleashed on the book business years ago helped it take huge market share. But it also rendered the book business less profitable for all players. And as that ethic unfolds across product categories – aided most recently by Amazon’s Price Check app – results at Amazon and Best Buy (BBY) would suggest the greater transparency on pricing is helping consumers, but not so much retailers.

Running Borders out of business, sadly for Amazon and other booksellers, didn’t make the book business more profitable again. Rather, the pricing model Amazon brought to the market seems to have rendered book retailing a crummier business. And it’s also unlikely that consumer electronics and the other categories Amazon is transforming will, once a few large competitors go bust, miraculously become more profitable. There isn’t a shortage of players in any of these markets and the consumer behavior Amazon helped spur – constant price shopping, demanding free or reduced-priced shipping – would seem impossible to reverse.

The Wall Street Journal recently noted the toll free shipping is taking on retailers’ profits. The Journal, noting Amazon’s shrinking margins, said, “Free shipping has likely played a meaningful role in this, although the company hasn’t detailed the cost.”

Actually, Amazon does detail the cost in its 10-K filings (page 26). Its net shipping costs – total shipping costs minus what Amazon collects from customers for shipping – totaled $1.39 billion in 2010, up 63% from $849 million the prior year. Total sales were only growing by 40%. So net shipping costs were equal to 4% of sales in 2010, versus 3.4% in 2009. That trend may have accelerated during 2011, and could largely explain why profits have fallen.

The strategy Stewart lauds is doing a bang-up job of boosting revenue. And consumers love Amazon’s service. But it’s hard to see how the company is going to fatten its margins when competition remains fierce; consumers have been taught to demand low-low prices (and free shipping); and beyond elegant technology, Amazon’s main tools for attracting consumers are both margin killers — low-low prices and free shipping.

Certainly the Kindle is an attempt to build a moat around Amazon’s book business. Selling the devices at what has been reported as a loss suggests the company sees future payoff from Kindle-owning consumers downloading their reading (no shipping expense here) exclusively from Amazon. But in the more general merchandise categories that increasingly make up Amazon’s sales, it’s hard to see how to insert such a loyalty device.

Stewart’s argument seems in part based on the notion that, forgoing current profits, Amazon must be managing for the long term. But if your very pricey stock is reliant on spectacular revenue growth, a cynic might reason that a strategy of adding sales — even if they’re increasingly less profitable (or money-losing) – appears short-term and somewhat desperate.

Amazon management is smart, as is Jim Stewart, and investors could be inviting ruin by shorting Amazon shares. But to us, the company hasn’t made a persuasive case that it’s building a moat – just that it’s delivering great service and selling stuff cheaper than the next guy.   End.

Let’s revisit our study of whether Amazon has a competitive advantage or not after we finish our study of Competition Demystified (in the VALUE VAULT).