A review of Buffett’s commentary on accounting, governance, and investing practices: does he “walk the talk”?
In our fifth article Special Issue on Growth and Innovation the co-authors seek to understand Warren Buffett’s investing philosophy, as he is regarded as one of the greatest investors. Unsurprisingly, Buffett has made his opinions on corporate governance, accounting, valuation methodology, and market trends known through the annual reports of Berkshire Hathaway and particularly its Chairman’s Letters.
Buffett’s extraordinary success alone would make him inherently worthy of scholarly research. His long investment horizon, specific suggestions for improving corporate governance, evident reasoning for his opinions on accounting practice, and generally excellent reputation for integrity make him especially useful to study.
These three professors studied both Buffett’s publicly expressed opinions and his investment decisions to see how well Buffett’s opinions matched the investments he has made. Additionally, they studied whether Buffett’s investments tended to be made in companies that already shared Buffett’s preferences or whether Buffett’s investment tended to cause companies to change the way they were managed subsequently so that their behavior became better aligned with Buffett’s public views. The findings of Bowen, Rajgopal, and Venkatachalam are a bit mixed.
As predicted, the companies Berkshire invests in (investees) tend to follow more transparent and timely accounting and disclosure of both good and bad news, tend to have accruals and cash flows in accord, have been more likely to expense stock option costs before being required to do so, are less likely to meet or beat targets, and make conservative assumptions about their pension obligations. On the other hand, Berkshire has invested in companies that are more likely than their peers to flout Buffett’s public advice about using EBITDA and a performance metric, continuing to provide “earnings guidance,” and publishing poorly written and ambiguous annual reports as measured by the “FOG Index.”
CEOs at Berkshire investees are paid less and their pay is more sensitive to company performance than their peer CEOs. That said, Berkshire investee pay plans do not penalize
CEOs for poor performance more so than for their peers, do not filter out the effect of marketwide increases in stock prices on CEOs’ compensation, still rely on stock options rather than “straight” stock, are not sensitive to earnings adjusted for the cost of capital, and are as likely as peer companies to boost CEO pay if that CEO’s pay falls in the lower half of his industry peers in the previous year.
The pattern with members of boards of directors is somewhat similar to the CEOs. While board members of Berkshire investees own more of the investee’s stock than do board members at peer firms, boards are no smaller than average, tend to have fewer outside directors, and greater ethnic and gender diversity than Buffett seems to recommend.
The multivariate regression analysis shows that investees are consistent with Buffett’s stated investment philosophy on six out of seven characteristics that Buffett prefers. Berkshire investees had higher “owner earnings,” lower volatility of owner earnings, more persistent sales, less competition, lower financial leverage, lower pension and other post-retirement liabilities, and fewer stock splits compared with the average firm in the same industry and year. Berkshire investees also tended to pay dividends more often and were more likely to issue equity when their stock price was greater than its intrinsic value per share.
Buffett clearly walks the talk on investment practices. However, the results on accounting, compensation, and disclosure practices are less clear cut. Overall, the authors found much evidence that Berkshire investees were already well aligned with Buffett’s investing principles (e.g., high return on equity) before being bought by Berkshire but not so well aligned already in terms of accounting and disclosure practices.
They found less evidence that these practices changed after Berkshire became a shareholder however. Investee board size and leverage decreased while the frequency of dividend payouts increased, suggesting that Buffett was drawn to certain companies because of the attributes they already had.
Buffett is well known for a hands-off policy in the operating decisions of Berkshire firms. So, despite Buffett’s commentary suggesting that large investors can improve the business practices of their investees, his passive approach appears to extend to accounting and governance choices as well.
Although not mutually exclusive, the evidence therefore is more consistent with the “selection” hypothesis than the “influence” hypothesis. Even if Buffett does exert some influence over management after purchasing shares he seems to be relatively passive in doing so—more so than the tone and breadth of his public statements would suggest. We believe it is important to note that Buffett’s passive behavior towards investee management is inconsistent with the belief that large investors have the potential to improve corporate governance.
Authored by Robert M. Bowen, University of Washington; Shivaram Rajgopal, Columbia Business School; and Mohan Venkatachalam, Duke University