Co-founder of BursaMethod, Peter Lim Cheng Teik dissected the best part of Warren Buffet’s letter to 1978 shareholders.
We have here a letter from Warren Buffet in 1978 to the shareholders of Berkshire Hathaway Inc. In this one, he talks about accounting for mergers.
What happened was, in 1978, they merged with DRC (Diversified Retailing Company). When a merger happens, calculating the balance sheet and income statement is different. After their merger with DRC their ownership of Blue Chip Stamps increased to 58%. Owning less than 50% and more than 50% requires different accounting methods.
When one company owns more than 50%, it accounts are consolidated. This means that all the balance sheets and income statements, etc. of the two companies will be combined together. Everything is added up minus the portion of the minority interest. A “minority interest” is everything which is not owned by the parent company.
Previously Berkshire Hathaway owned less than 50%. If one owns less than 50%, the share of the net earnings is included in only one line of the balance sheet. As it says on the letter, “In previous reports, our share of net earnings only included a single item on Berkshire’s Statement of Earnings, now it has included everything.”
Another line mentions that, “In fact, such grouping of Balance Sheet and Earnings items – some wholly owned, some partly tends to obscure economic reality more than illuminate it. In fact, it represents a form of presentation that we never prepared for internal use during the year and which is of no value to us in any management activities.”
In other words, what Buffet was trying to say was that the combined/consolidated statement is of no value. What he wanted to know was how each individual company is performing and how the performance affects the companies’ investors.
So, when investing in to a diversified business like bluechip companies that have many other businesses or other subsidiaries, which are also publicly listed and may be of different natures, the consolidated financial statement might not have a meaning by itself. A better way is to evaluate each and every company by itself, and then do an evaluation on each and every individual company. After that, you can then combine it all together as a whole rather than looking at it as one financial statement.
In that sense, if you want to go for simple businesses, then you should go for businesses that only has one business identity. This is way simpler, you’ll save a lot of time, and it’s far less confusing.
Lastly, he says “For that reason, throughout the report we provide much separate financial information and commentary on the various segments of the business to help you evaluate Berkshire’s performance and prospects.”
For more information go to BursaMethod.