Essays of warren buffet (before Common stock)

P The year 2015 marks the fiftieth anniversary of Berkshire Hathaway under Warren Buffett's leadership, a milestone worth commemorating. The tenure sets a record for chief executive not only in duration but in value creation and philosophizing. This fourth edition of The Essays of Warren Buffett: Lessons for Corporate America celebrates its twentieth anniversary. As the book Buffett autographs most, its popularity and longevity attest to the widespread appetite for this unique compilation of Buffett's thoughts that is at once comprehensive, non-repetitive, and digestible. The original edition of The Essays of Warren Buffett was the centerpiece of a symposium held two decades ago at the Benjamin N. Cardozo School of Law under the auspices of its Heyman Center on Corporate Governance. This gathering brought hundreds of students together for a two-day dissection of all the ideas in the compilation, featuring a series of vibrant debates among some 30 distinguished professors, investors, and managers, with Warren and Charles T. Munger, Berkshire's vice chairman, participating throughout from their seats in the front row. In the two decades since initial publication, I have often taught The Essays , as this book has come to be known, in my classes and seminars at four different universities. The book is adopted by scores of professors at other schools for classes such as investment, finance and accounting. Investment firms have distributed copies to their professional employees and clients as part of training programs. I am grateful for the positive feedback from these students, teachers, and other users and delighted to know that the lessons are being taught. As in previous editions of The Essays , this one retains the architecture and philosophy of the original edition but adds selections from Warren's most recent annual shareholder letters, including his fiftieth anniversary retrospective. All the letters are woven together into a fabric that reads as a complete and coherent narrative of a sound business and investment philosophy. As an aid to all readers, and to enable readers of the previous editions to see what is new in this one, a disposition table at the end of the book shows the various places in this collection where selections from each year's letter appear. Footnotes throughout indicate the year of the annual report from which essays are taken. To avoid interrupting the narrative flow, omissions of text within excerpts are not indicated by ellipses or other punctuation. The new edition is called for not because anything has changed about the fundamentals of Warren's sound business and investment philosophy but because articulation of that philosophy is always delivered in the context of contemporary events and business conditions. So periodic updating is warranted to maintain its currency. In preparing the previous editions, I was aided by numerous people, to whom I expressed gratitude in those editions, and I want to thank them again. Among those, I especially thank Warren Buffett. His generosity not only made the symposium possible but his participation enriched it manifold; his willingness to entrust the rearrangement and ongoing republication of his letters to me is a great honor. His partner, Charlie Munger, deserves explicit repeated thanks too, for not only did he participate in the 1996 symposium from the front row he also graciously chaired, on a moment's notice, one of the panels. He also granted me permission to reprint some of his letters in this collection as well, including his fiftieth anniversary retrospective. At Berkshire's 2011 annual meeting, Charlie stressed to me how different Berkshire had become in the fifteen years since our symposium—and yet how much it remained the same. Back then, Berkshire looked more like a mutual fund, with 80 percent of its assets in minority common stock positions and 20 percent in wholly owned businesses; today, the ratio is reversed and Berkshire looks more like a conglomerate. Yet then and now, the company and its constituents are united by a core set of common values, values defined by the tone Warren set at the top and that animate The Essays . I thank the many thousands of devoted fans, followers, and friends who have been avid readers of The Essays over the past 20 years and look forward to continuing our journey. Lawrence A. Cunningham New York City Experienced readers of Warren Buffett's letters to the shareholders of Berkshire Hathaway Inc. have gained an enormously valuable informal education. The letters distill in plain words all the basic principles of sound business practices. On selecting managers and investments, valuing businesses, and using financial information profitably, the writings are broad in scope, and long on wisdom. By arranging these writings as thematic essays, this collection presents a synthesis of the overall business and investment philosophy intended for dissemination to a wide general audience. The central theme uniting Buffett's lucid essays is that the principles of fundamental business analysis, first formulated by his teachers Ben Graham and David Dodd, should guide investment practice. Linked to that theme are management principles that define the proper role of corporate managers as the stewards of invested capital, and the proper role of shareholders as the suppliers and owners of capital. Radiating from these main themes are practical and sensible lessons on the entire range of important business issues, from accounting to mergers to valuation. Buffett has applied these traditional principles as chief executive officer of Berkshire Hathaway, a company with roots in a group of textile operations begun in the early 1800s. Buffett took the helm of Berkshire in 1965, when its book value per share was $19.46 and its intrinsic value per share far lower. Today, its book value per share is around $100,000 and its intrinsic value far higher. The growth rate in book value per share during that period is about 20% compounded annually. Berkshire is now a holding company engaged in 80 distinct business lines. Berkshire's most important business is insurance, carried on through various companies including its 100% owned subsidiary, GEICO Corporation, among the largest auto insurers in the United States, and General Re Corporation, one of the largest reinsurers in the world. In 2010, Berkshire acquired Burlington Northern Santa Fe Railway Company, among the largest railroads in North America, and has long owned and operated large energy companies. Some Berkshire subsidiaries are massive: ten would be included in the Fortune 500 if they were stand-alone companies. Its other interests are so vast that, as Buffett writes: “when you are looking at Berkshire, you are looking across corporate America.” Examples: food, clothing, building materials, tools, equipment, newspapers, books, transportation services and financial products. Berkshire also owns large equity interests in major corporations—including American Express, Coca-Cola, International Business Machines (IBM), and Wells Fargo—along with half the equity of Heinz and a valuable option to buy a sizeable stake in Bank of America. Buffett and Berkshire Vice Chairman Charlie Munger built this sprawling enterprise by investing in businesses with excellent economic characteristics and run by outstanding managers. While they prefer negotiated acquisitions of 100% of such a business at a fair price, they take a “double-barreled approach” of buying on the open market less than 100% of some businesses when they can do so at a pro-rata price well below what it would take to buy 100%. The double-barreled approach pays off handsomely. The value of marketable securities in Berkshire's portfolio, on a per share basis, increased from $4 in 1965 to more than $140,000 by 2015, a 19% compound annual gain. Per share operating earnings increased in the same period from just over $4 to nearly $11,000, a compound annual gain of about 20.6%. According to Buffett, these results follow not from any master plan but from focused investing—allocating capital by concentrating on businesses with outstanding economic characteristics and run by first-rate managers. Buffett views Berkshire as a partnership among him, Munger and other shareholders, and virtually all his net worth is in Berkshire stock. His economic goal is long-term—to maximize Berkshire's per share intrinsic value by owning all or part of a diversified group of businesses that generate cash and above-average returns. In achieving this goal, Buffett foregoes expansion for the sake of expansion and foregoes divestment of businesses so long as they generate some cash and have good management. Berkshire retains and reinvests earnings when doing so delivers at least proportional increases in per share market value over time. It uses debt sparingly and sells equity only when it receives as much in value as it gives. Buffett penetrates accounting conventions, especially those that obscure real economic earnings. These owner-related business principles, as Buffett calls them, are the organizing themes of the accompanying essays. As organized, the essays constitute an elegant and instructive manual on management, investment, finance, and accounting. Buffett's basic principles form the framework for a rich range of positions on the wide variety of issues that exist in all aspects of business. They go far beyond mere abstract platitudes. It is true that investors should focus on fundamentals, be patient, and exercise good judgment based on common sense. In Buffett's essays, these advisory tidbits are anchored in the more concrete principles by which Buffett lives and thrives. C G For Buffett, managers are stewards of shareholder capital. The best managers think like owners in making business decisions. They have shareholder interests at heart. But even first-rate managers will sometimes have interests that conflict with those of shareholders. How to ease those conflicts and to nurture managerial stewardship have been constant objectives of Buffett's long career and a prominent theme of his essays. The essays address some of the most important governance problems. The first is the importance of forthrightness and candor in communications by managers to shareholders. Buffett tells it like it is, or at least as he sees it, and laments that he is in the minority. Berkshire's annual report is not glossy; Buffett prepares its contents using words and numbers people of average intelligence can understand; and all investors get the same information at the same time. Buffett and Berkshire avoid making predictions, a bad managerial habit that too often leads other managers to fudge their financial reports. Besides the owner-orientation reflected in Buffett's disclosure practice and the owner-related business principles summarized above, the next management lesson is to dispense with formulas of managerial structure. Contrary to textbook rules on organizational behavior, mapping an abstract chain of command on to a particular business situation, according to Buffett, does little good. What matters is selecting people who are able, honest, and diligent. Having first-rate people on the team is more important than designing hierarchies and clarifying who reports to whom about what and at what times. Special attention must be paid to selecting a chief executive officer (CEO) because of three major differences Buffett identifies between CEOs and other employees. First, standards for measuring a CEO's performance are inadequate or easy to manipulate, so a CEO's performance is harder to measure than that of most workers. Second, no one is senior to the CEO, so no senior person's performance can be measured either. Third, a board of directors cannot serve that senior role since relations between CEOs and boards are conventionally congenial. Major reforms are often directed toward aligning management and shareholder interests or enhancing board oversight of CEO performance. Stock options for management were touted as one method; greater emphasis on board processes was another. Separating the identities and functions of the Chairman of the Board and the CEO or appointment of standing audit, nominating and compensation committees were also heralded as promising reforms. Perhaps the most pervasive prescription is to populate boards with independent directors. None of these innovations has solved governance problems, however, and some have exacerbated them. The best solution, Buffett instructs, is to take great care in identifying CEOs who will perform capably regardless of weak structural restraints. In public companies, large institutional shareholders must exercise their power to oust CEOs that do not measure up to the demands of corporate stewardship. Outstanding CEOs do not need a lot of coaching from owners, although they can benefit from having a similarly outstanding board. Directors therefore must be chosen for their business savvy, their interest, and their owner-orientation. According to Buffett, one of the greatest problems among boards in corporate America is that members are selected for other reasons, such as adding diversity or prominence to a board—or, famously, independence. Most reforms are painted with a broad brush, without noting the major differences among types of board situations that Buffett identifies. For example, director power is weakest in the case where there is a controlling shareholder who is also the manager. When disagreements arise between the directors and management, there is little a director can do other than to object and, in serious circumstances, resign. Director power is strongest at the other extreme, where there is a controlling shareholder who does not participate in management. The directors can take matters directly to the controlling shareholder when disagreement arises. The most common situation, however, is a corporation without a controlling shareholder. This is where management problems are most acute, Buffett says. It would be helpful if directors could supply necessary discipline, but board congeniality usually prevents that. To maximize board effectiveness in this situation, Buffett believes the board should be small in size and composed mostly of outside directors. The strongest weapon a director can wield in these situations remains the threat to resign. All these situations do share a common characteristic: the terrible manager is a lot easier to confront or remove than the mediocre manager. A chief problem in traditional governance structures was that in corporate America evaluation of chief executive officers was never conducted in regular meetings in the absence of that chief executive. Holding regular meetings without the chief executive to review his or her performance can produce a marked improvement in corporate governance. The CEOs at Berkshire's various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their business as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for fifty years. This enables Berkshire CEOs to manage with a long-term horizon ahead of them, something alien to the CEOs of public companies whose short-term oriented shareholders obsess with meeting the latest quarterly earnings estimate. Short-term results matter, of course, but the Berkshire approach avoids any pressure to achieve them at the expense of strengthening longterm competitive advantages. If only short-term results mattered, many managerial decisions would be much easier, particularly those relating to businesses whose economic characteristics have eroded. Consider the time horizon trade-off Buffett faced in managing what he considers the worst investment he ever made, buying Berkshire in the first place. The economic characteristics of Berkshire's old textile business had begun to erode by the late 1970s. Buffett had hoped to devise a reversal of its misfortunes, noting how important Berkshire's textile business was to its employees and local communities in New England, and how able and understanding management and labor had been in addressing the economic difficulties. Buffett kept the ailing plant alive through 1985, but a financial reversal could not be achieved and Buffett eventually closed it. This balancing of short-term results with long-term prospects based on community trust is not easy, but it is intelligent. Kindred lessons carry over to other sectors in which Berkshire invests, such as the newspaper business in the internet age, and highly regulated industries, such as energy and railroads, in which Buffett sees an implicit social compact between private enterprise and regulatory overseers. Sometimes management interests conflict with shareholder interests in subtle or easily disguised ways. Take corporate philanthropy, for example. At most major corporations, management allocates a portion of corporate profit to charitable concerns. The charities are chosen by management, for reasons often unrelated either to corporate interests or shareholder interests. Most state laws permit management to make these decisions, so long as aggregate annual donations are reasonable in amount, usually not greater than 10% of annual net profits. Berkshire does things differently. It makes no contributions at the parent company level and allows its subsidiaries to follow philanthropic policies they had in effect before Berkshire acquired them. For two decades, moreover, Berkshire used an imaginative program through which its shareholders designated the charities to which Berkshire would donate and in what amounts. Nearly all shareholders participated, donating tens of millions of dollars annually to thousands of different charities. Political controversy over the abortion issue, however, interfered with this program. Political activists organized boycotts of Berkshire's products to protest particular charitable donations that were made, destroying this feature of Berkshire's “partnership” approach. The plan to align management and shareholder interests by awarding executives stock options not only was oversold, but also subtly disguised a deeper division between those interests that the options created. Many corporations pay their managers stock options whose value increases simply by retention of earnings, rather than by superior deployment of capital. As Buffett explains, however, simply by retaining and reinvesting earnings, managers can report annual earnings increases without so much as lifting a finger to improve real returns on capital. Stock options thus often rob shareholders of wealth and allocate the booty to executives. Moreover, once granted, stock options are often irrevocable, unconditional, and benefit managers without regard to individual performance. It is possible to use stock options to instill a managerial culture that encourages owner-like thinking, Buffett agrees. But the alignment will not be perfect. Shareholders are exposed to the downside risks of sub-optimal capital deployment in a way that an option holder is not. Buffett therefore cautions shareholders who are reading proxy statements about approving option plans to be aware of the asymmetry in this kind of alignment. Many shareholders rationally ignore proxy statements, but the abuse of stock options should be on the front-burner of shareholders, particularly institutional investors that periodically engage in promoting corporate governance improvements. Buffett emphasizes that performance should be the basis for executive pay decisions. Executive performance should be measured by profitability, after profits are reduced by a charge for the capital employed in the relevant business or earnings retained by it. If stock options are used, they should be related to individual performance, rather than corporate performance, and priced based on business value. Better yet, as at Berkshire, stock options should simply not be part of an executive's compensation. After all, exceptional managers who earn cash bonuses based on the performance of their own business can simply buy stock if they want to; if they do, they “truly walk in the shoes of owners,” Buffett says. And owners' interests are paramount on executive pay as with other corporate governance topics Buffett addresses, such as risk management, corporate compliance and financial reporting. Corporate culture is among the most important yet least quantifiable factors in assessing a business. At Berkshire, culture runs deep. It begins with the tone at the top set at Omaha headquarters by the norms and values that animate this collection. Berkshire's culture also permeates the subsidiaries that call Berkshire home and the managers of the many and varied business units that comprise Berkshire today. Remarkably for a vast conglomerate comprised of a sprawling and diverse group of businesses, Berkshire's culture is uniform and enduring and, Buffett says, will help Berkshire prosper long after he and Munger leave the scene. F I The most revolutionary investing ideas of the past forty years were those called modern finance theory. This is an elaborate set of ideas that boil down to one simple and misleading practical implication: it is a waste of time to study individual investment opportunities in public securities. According to this view, you will do better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense. One of modern finance theory's main tenets is modern portfolio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio—that is, it formalizes the folk slogan “don't put all your eggs in one basket.” The risk that is left over is the only risk for which investors will be compensated, the story goes. This leftover risk can be measured by a simple mathematical term— called beta—that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule. Reverence for these ideas was not limited to ivory tower academics, in colleges, universities, business schools, and law schools, but became standard dogma throughout financial America in the past forty years, from Wall Street to Main Street. Many professionals still believe that stock market prices always accurately reflect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks. Being part of a distinguished line of investors stretching back to Graham and Dodd which debunks standard dogma by logic and experience, Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion. Accordingly, Buffett worried that a whole generation of MBAs and JDs, under the influence of modern finance theory, was at risk of learning the wrong lessons and missing the important ones. A particularly costly lesson of modern finance theory came from the proliferation of portfolio insurance—a computerized technique for readjusting a portfolio in declining markets. The promiscuous use of portfolio insurance helped precipitate the stock market crash of October 1987, as well as the market break of October 1989. It nevertheless had a silver lining: it shattered the modern finance story being told in business and law schools and faithfully being followed by many on Wall Street. Ensuing market volatility could not be explained by modern finance theory, nor could mountainous other phenomena relating to the behavior of small capitalization stocks, high dividend-yield stocks, and stocks with low price-earnings ratios. The piece de resistance of market inefficiency was the technology and Internet stock bubble that blew up in the late 1990s and early 2000s, marked by stock price gyrations that spasmodically bounced between euphoria and gloom without the remotest nexus to business value. Growing numbers of skeptics emerged to say that beta does not really measure the investment risk that matters, and that capital markets are really not efficient enough to make beta meaningful anyway. In stirring up the discussion, people started noticing Buffett's record of successful investing and calling for a return to the Graham-Dodd approach to investing and business. After all, for more than forty years Buffett has generated average annual returns of 20% or better, which double the market average. For more than twenty years before that, Ben Graham's Graham-Newman Corp. had done the same thing. As Buffett emphasizes, the stunning performances at Graham-Newman and at Berkshire deserve respect: the sample sizes were significant; they were conducted over an extensive time period, and were not skewed by a few fortunate experiences; no data-mining was involved; and the performances were longitudinal, not selected by hindsight. Threatened by Buffett's performance, stubborn devotees of modern finance theory resorted to strange explanations for his success. Maybe he is just lucky—the monkey who typed out Hamlet —or maybe he has inside access to information that other investors do not. In dismissing Buffett, modern finance enthusiasts still insist that an investor's best strategy is to diversify based on betas or dart throwing, and constantly reconfigure one's portfolio of investments. Buffett responds with a quip and some advice: the quip is that devotees of his investment philosophy should probably endow chaired professorships at colleges and universities to ensure the perpetual teaching of efficient market dogma; the advice is to ignore modern finance theory and other quasi-sophisticated views of the market and stick to investment knitting. That can best be done for many people through long-term investment in an index fund. Or it can be done by conducting hard-headed analyses of businesses within an investor's competence to evaluate. In that kind of thinking, the risk that matters is not beta or volatility, but the possibility of loss or injury from an investment. Assessing that kind of investment risk requires thinking about a company's management, products, competitors, and debt levels. The inquiry is whether after-tax returns on an investment are at least equal to the purchasing power of the initial investment plus a fair rate of return. The primary relevant factors are the long-term economic characteristics of a business, the quality and integrity of its management, and future levels of taxation and inflation. Maybe these factors are vague, particularly compared with the seductive precision of beta, but the point is that judgments about such matters cannot be avoided, except to an investor's disadvantage. Buffett points out the absurdity of beta by observing that “a stock that has dropped very sharply compared to the market . . . becomes ‘riskier’ at the lower price than it was at the higher price”—that is how beta measures risk. Equally unhelpful, beta cannot distinguish the risk inherent in “a single-product toy company selling pet rocks or hula hoops from another toy company whose sole product is Monopoly or Barbie.” But ordinary investors can make those distinctions by thinking about consumer behavior and the way consumer products companies compete, and can also figure out when a huge stock-price drop signals a buying opportunity. Contrary to modern finance theory, Buffett's investment knitting does not prescribe diversification. It may even call for concentration, if not of one's portfolio, then at least of its owner's mind. As to concentration of the portfolio, Buffett reminds us that Keynes, who was not only a brilliant economist but also an astute investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy. On that view, risk rises when investments and investment thinking are spread too thin. A strategy of financial and mental concentration may reduce risk by raising both the intensity of an investor's thinking about a business and the comfort level he must have with its fundamental characteristics before buying it. The fashion of beta, according to Buffett, suffers from inattention to “a fundamental principle: It is better to be approximately right than precisely wrong.” Long-term investment success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats longterm investment success. Such “flitting from flower to flower” imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes. Buffett jokes that calling someone who trades actively in the market an investor “is like calling someone who repeatedly engages in onenight stands a romantic.” Investment knitting turns modern finance theory's folk wisdom on its head: instead of “don't put all your eggs in one basket,” we get Mark Twain's advice from Pudd'nhead Wilson : “Put all your eggs in one basket—and watch that basket.” Buffett learned the art of investing from Ben Graham as a graduate student at Columbia Business School in the 1950s and later working at Graham-Newman. In a number of classic works, including The Intelligent Investor , Graham introduced some of the most profound investment wisdom in history. It rejects a prevalent but mistaken mind-set that equates price with value. On the contrary, Graham held that price is what you pay and value is what you get. These two things are rarely identical, but most people rarely notice any difference. One of Graham's most profound contributions is a character who lives on Wall Street, Mr. Market. He is your hypothetical business partner who is daily willing to buy your interest in a business or sell you his at prevailing market prices. Mr. Market is moody, prone to manic swings from joy to despair. Sometimes he offers prices way higher than value; sometimes he offers prices way lower than value. The more manic-depressive he is, the greater the spread between price and value, and therefore the greater the investment opportunities he offers. Buffett reintroduces Mr. Market, emphasizing how valuable Graham's allegory of the overall market is for disciplined investment knitting—even though Mr. Market would be unrecognizable to modern finance theorists. Another leading prudential legacy from Graham is his margin-of-safety principle. This principle holds that one should not make an investment in a security unless there is a sufficient basis for believing that the price being paid is substantially lower than the value being delivered. Buffett follows the principle devotedly, noting that Graham had said that if forced to distill the secret of sound investment into three words, they would be: margin of safety. Over forty years after first reading that, Buffett still thinks those are the right words. While modern finance theory enthusiasts cite market efficiency to deny there is a difference between price (what you pay) and value (what you get), Buffett and Graham regard it as all the difference in the world. That difference also shows that the term “value investing” is a redundancy. All true investing must be based on an assessment of the relationship between price and value. Strategies that do not employ this comparison of price and value do not amount to investing at all, but to speculation—the hope that price will rise, rather than the conviction that the price being paid is lower than the value being obtained. Many professionals make another common mistake, Buffett notes, by distinguishing between “growth investing” and “value investing.” Growth and value, Buffett says, are not distinct. They are integrally linked since growth must be treated as a component of value. Nor does the phrase “relational investing” resonate with Buffett. The term became popular in the mid-1990s, describing a style of investing that is designed to reduce the costs of the separation of shareholder ownership from managerial control by emphasizing shareholder involvement and monitoring of management. Many people incorrectly identified Buffett and Berkshire as exemplars of this descriptive label. It is true that Buffett buys big blocks in a few companies and sticks around a long time. He also only invests in businesses run by people he trusts. But that is about as far as the similarity goes. If Buffett were pressed to use an adjective to describe his investment style, it would be something like “focused” or “intelligent” investing. Yet even these words ring redundant; the unadorned term investor best describes Buffett. Other misuses of terms include blurring the difference between speculation and arbitrage as methods of sound cash management; the latter being very important for companies like Berkshire that generate substantial excess cash. Both speculation and arbitrage are ways to use excess cash rather than hold it in short-term cash equivalents such as commercial paper. Speculation describes the use of cash to bet on lots of corporate events based on rumors of unannounced coming transactions. Arbitrage, traditionally understood to mean exploiting different prices for the same thing on two different markets, for Buffett describes the use of cash to take short-term positions in a few opportunities that have been publicly announced. It exploits different prices for the same thing at different times. Deciding whether to employ cash this way requires evaluating four commonsense questions based on information rather than rumor: the probability of the event occurring, the time the funds will be tied up, the opportunity cost, and the downside if the event does not occur. The circle of competence principle is the third leg of the Graham/Buffett stool of intelligent investing, along with Mr. Market and the margin of safety. This commonsense rule instructs investors to consider investments only concerning businesses they are capable of understanding with a modicum of effort. It is this commitment to stick with what he knows that enables Buffett to avoid the mistakes others repeatedly make, particularly those who feast on the fantasies of fast riches promised by technological fads and new era rhetoric that have recurrently infested speculative markets over the centuries. In all investment thinking, one must guard against what Buffett calls the “institutional imperative.” It is a pervasive force in which institutional dynamics produce resistance to change, absorption of available corporate funds, and reflexive approval of sub-optimal CEO strategies by subordinates. Contrary to what is often taught in business and law schools, this powerful force often interferes with rational business decision-making. The ultimate result of the institutional imperative is a follow-the-pack mentality producing industry imitators, rather than industry leaders—what Buffett calls a lemming-like approach to business. Every reader of this collection will savor, and want to share with family and friends, Buffett's compelling essays on the use of debt. Aptly dubbed “Life and Debt,” these exquisitely explain both the temptation and perils of leverage in personal and corporate finance. I A All these investment principles are animated in Buffett's lively essays concerning investment opportunities. After explaining his preference for investing in productive assets, and defining what this means, a series of essays addresses a wide range of alternatives, starting with junk and zerocoupon bonds and preferred stock. Challenging both Wall Street and the academy, Buffett again draws on Graham's ideas to reject the “dagger thesis” advanced to defend junk bonds. The dagger thesis, using the metaphor of the intensified care an automobile driver would take facing a dagger mounted on the steering wheel, overemphasizes the disciplining effect that enormous amounts of debt in a capital structure exerts on management. Buffett points to the large numbers of corporations that failed in the early 1990s recession under crushing debt burdens to dispute academic research showing that higher interest rates on junk bonds more than compensated for their higher default rates. He attributes this error to a flawed assumption recognizable to any first-year statistics student: that historical conditions prevalent during the study period would be identical in the future. They would not. Further illuminating the folly of junk bonds is an essay in this collection by Charlie Munger that discusses Michael Milken's approach to finance. Wall Street tends to embrace ideas based on revenue-generating power, rather than on financial sense, a tendency that often perverts good ideas to bad ones. In a history of zero-coupon bonds, for example, Buffett shows that they can enable a purchaser to lock in a compound rate of return equal to a coupon rate that a normal bond paying periodic interest would not provide. Using zero-coupons thus for a time enabled a borrower to borrow more without need of additional free cash flow to pay the interest expense. Problems arose, however, when zero-coupon bonds started to be issued by weaker and weaker credits whose free cash flow could not sustain increasing debt obligations. Buffett laments, “as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end.” Many culprits contributed to the financial crisis of 2008, among them the proliferation of derivative financial instruments, which Buffett's essays written several years earlier had warned about. Contemporary financial engineering has produced an explosion of complex instruments known as derivatives, because their fluctuating value is derived from movements in a contractually designated benchmark. Proponents believe that these devices are useful to manage risk—and Berkshire from time to time takes modest positions in derivatives contracts that Buffett judges as mis-priced. But while proponents also believe that derivatives tend to reduce overall systemic risk, Buffett presciently observed that they may have the opposite effect. They are hard to value, valuations can change rapidly and they create linkages and interdependencies among financial institutions. Buffett cautioned that the combination of these factors could mean that, should a single event cause challenges in one sector, that could spread rapidly to others with a domino effect bringing devastating systemic consequences. Such was the case with the crisis of 2008. Buffett acknowledges that his view on derivative risks may be influenced by his aversion to any kind of mega-catastrophe risk that would jeopardize Berkshire's status as a fortress of financial strength. But this is no arm-chair opinion, for Buffett endured several years of direct experience in managing a derivatives dealership that came along with Berkshire's acquisition of the Gen Re reinsurance company. Buffett explains the unpleasant consequences of not dumping the business immediately but notes how it could not be sold and contained a maze of long term liabilities that took several painful years to unwind. Buffett offers extensive meditation on this experience so that others can learn from the Berkshire trials