Equity investors should never look kindly upon misconduct in the companies they invest in
09-Mar-2023 •Dhirendra Kumar
On February 25, Berkshire Hathaway released the annual letter to the shareholders from company Chairman Warren Buffett. As usual, all the world's Buffett fans (myself included) rushed to download and read the letter. The release of this letter is an annual landmark. This may sound strange to anyone unfamiliar with Buffett or Berkshire Hathaway. Every company in the world goes through this ritual, that of the Chairperson writing to the shareholders. These letters are dull, dead and boring, and I doubt whether even the supposed writer reads them.
However, Buffett's letters are different. On Berkshire's website, letters from 1977 onwards are available for download. Together, they make a fascinating record of Buffett's career and his witty and incisive comments on the business and economic issues of the day. The letters also contain the standard material about business performance and outlook that has to be there in such letters. However, in everything, Buffett's warm and humane personality shines through, making the letters a great pleasure to read.
This year's letter has an even more personal touch than usual. Towards the end, there is a section titled 'Nothing Beats Having a Great Partner,' a personal note about Charlie Munger. This section contains a series of pithy quotes from Charlie, who has a way of saying the wisest things in one humorous sentence. While the section is full of Charlie's wit, there is an underlying sadness of an era heading to its end. Munger is 99 years and three months old and not in the greatest of health. It makes one wonder what made Buffett include this section in this year's letter.
Anyhow, much else in the current letter makes for interesting reading. In the section 'What We Do,' one passage discusses Buffett and Munger's attitude towards the individuals chosen to run the businesses that Berkshire controls. Buffett says, "We invest in businesses we control, usually buying 100% of each. Berkshire directs capital allocation at these subsidiaries and selects the CEOs who make day-by-day operating decisions. When large enterprises are being managed, both trust and rules are essential. Berkshire emphasises the former to an unusual - some would say extreme - degree. Disappointments are inevitable. We understand business mistakes; our tolerance for personal misconduct is zero."
All equity investors should pay attention to this point that tolerance for personal misconduct should be zero. It touched a chord in my thinking because of my experience as an equity analyst. At Value Research, we basically have the same rule as Buffett does for our stock investing magazine Wealth Insight and our stock recommendation service Value Research Stock Advisor. Suppose there is any evidence of personal misconduct amongst a company's promoters or senior management. In that case, it should never be considered for investment, no matter how compelling it is otherwise.
This is a lesson learned the hard way. As a theoretical position, I had always believed in it, but in earlier years, I would sometimes talk myself into taking a lenient view. When faced with a compellingly good investment prospect, I would say, "This is a great business, so what if the promoter steals a little from shareholders - many do it. We can overlook it this time." However, it never works. Anyone who shortchanges shareholders doesn't know when to stop. Whenever we made such a compromise, it came back to bite us.
Chastened by years of experience, we now have a reverse position. The equity research process at Value Research has a set of no-go 'eliminator' conditions which cannot be violated - and the ethical standards of the business managers are the foremost. One can compromise on the fundamentals if, just as a hypothetical example, a stock has an attractive valuation but never on conduct.
It's a principle that all equity investors should follow - if they wish to avoid disappointment.