In his letter to shareholders in 1981, Warren Buffett discussed his ideas on reported non-controlled earnings and acquisition.



Non-controlled ownership earnings



Non-controlled ownership earnings do not reflect in the financial statements of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B). However, Warren Buffett believed those undistributed earnings (or unrecorded earnings) would be translated into tangible value for shareholders just as surely as if the subsidiaries Berkshire controlled had earned, retained and reported earnings.



"This translation of non-controlled ownership earnings into corresponding realized and unrealized capital gains for Berkshire will be extremely irregular as to time of occurrence. While market values track business values quite well over the long periods, in any given year the relationship can gyrate capriciously. Market recognition of retain earnings also will be unevenly realized among companies."



Buffett mentioned that overall, the non-controlled businesses have more favorable underlying economic characteristics than the controlled ones. "Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety rarely, and then almost always at high prices."



Buffett at that time often found values more easily through the stock market by purchasing fractional positions in companies with excellent business characteristics. "We expect that undistributed earnings from such companies will produce full value (subject to tax when realized) for Berkshire and its shareholders. If they don't, we have made mistakes as to either: (1) the management we have elected to join; (2) the future of economics of the business; or (3) the price we have paid."



"For personal as well as more objective reasons, however, we generally have been able to correct such mistakes far more quickly in the case of non-controlled businesses (marketable securities) than in the case of controlled subsidiaries. Lack of control, in effect, often has turned out to be an economic plus."



General Acquisition Behavior



The insurance and trading stamps businesses looked for in major investments were mainly in marketable securities due to their liquidity requirements. Berkshire Hathaway acquisition goals are to maximize real economic benefits, not for either managerial domain or for accounting purposes. "In the long run, managements stressing accounting appearance over economic substance usually achieve little of either."



"Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated rationale for their behaviour."



There were three motivations, usually unspoken for high-premium takeovers:





Leaders seldom are deficient in animal spirits and often relish increased activity and challenge. Most organizations measure themselves, are measured by others, and compensate their managers far more by the yardstick of size than by any other yardstick. Many executives were overexposed, like the story of the imprisoned prince released from a toad's body by a kiss from a beautiful princess. So they hope their managerial kiss will do wonders for the profitability of the target.

About the author:

Anh Hoang Chief investment strategist for the Global Hidden Gems Portfolio (https://ghginvest.com). Searching around the world for stocks that trade below net cash but are still profitable. Chief investment strategist for the Global Hidden Gems Portfolio (https://ghginvest.com). Searching around the world for stocks that trade below net cash but are still profitable. Visit Anh Hoang's Website