I have dedicated this page on my blog to reflect some of the best reading I have come across on the web. None of these have been written by me, but I think they give extraordinary insight to the person who understands it.
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Beginners’ Guide to Financial Statements
(Courtesy: http://www.sec.gov/investor/pubs/begfinstmtguide.htm)
The Basics
If you can read a nutrition label or a baseball box score, you can learn to read basic financial statements. If you can follow a recipe or apply for a loan, you can learn basic accounting. The basics aren’t difficult and they aren’t rocket science.
This brochure is designed to help you gain a basic understanding of how to read financial statements. Just as a CPR class teaches you how to perform the basics of cardiac pulmonary resuscitation, this brochure will explain how to read the basic parts of a financial statement. It will not train you to be an accountant (just as a CPR course will not make you a cardiac doctor), but it should give you the confidence to be able to look at a set of financial statements and make sense of them.
Let’s begin by looking at what financial statements do.
“Show me the money!”
We all remember Cuba Gooding Jr.’s immortal line from the movie Jerry Maguire, “Show me the money!” Well, that’s what financial statements do. They show you the money. They show you where a company’s money came from, where it went, and where it is now.
There are four main financial statements. They are: (1) balance sheets; (2) income statements; (3) cash flow statements; and (4) statements of shareholders’ equity. Balance sheets show what a company owns and what it owes at a fixed point in time. Income statements show how much money a company made and spent over a period of time. Cash flow statements show the exchange of money between a company and the outside world also over a period of time. The fourth financial statement, called a “statement of shareholders’ equity,” shows changes in the interests of the company’s shareholders over time.
Let’s look at each of the first three financial statements in more detail.
Balance Sheets
A balance sheet provides detailed information about a company’s assets, liabilities and shareholders’ equity.
Assets are things that a company owns that have value. This typically means they can either be sold or used by the company to make products or provide services that can be sold. Assets include physical property, such as plants, trucks, equipment and inventory. It also includes things that can’t be touched but nevertheless exist and have value, such as trademarks and patents. And cash itself is an asset. So are investments a company makes.
Liabilities are amounts of money that a company owes to others. This can include all kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of a building, money owed to suppliers for materials, payroll a company owes to its employees, environmental cleanup costs, or taxes owed to the government. Liabilities also include obligations to provide goods or services to customers in the future.
Shareholders’ equity is sometimes called capital or net worth. It’s the money that would be left if a company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company.
The following formula summarizes what a balance sheet shows:
A company’s assets have to equal, or “balance,” the sum of its liabilities and shareholders’ equity. |
A company’s balance sheet is set up like the basic accounting equation shown above. On the left side of the balance sheet, companies list their assets. On the right side, they list their liabilities and shareholders’ equity. Sometimes balance sheets show assets at the top, followed by liabilities, with shareholders’ equity at the bottom.
Assets are generally listed based on how quickly they will be converted into cash. Current assets are things a company expects to convert to cash within one year. A good example is inventory. Most companies expect to sell their inventory for cash within one year. Noncurrent assets are things a company does not expect to convert to cash within one year or that would take longer than one year to sell. Noncurrent assets include fixed assets. Fixed assets are those assets used to operate the business but that are not available for sale, such as trucks, office furniture and other property.
Liabilities are generally listed based on their due dates. Liabilities are said to be either current or long-term. Current liabilities are obligations a company expects to pay off within the year. Long-term liabilities are obligations due more than one year away.
Shareholders’ equity is the amount owners invested in the company’s stock plus or minus the company’s earnings or losses since inception. Sometimes companies distribute earnings, instead of retaining them. These distributions are called dividends.
A balance sheet shows a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the reporting period. It does not show the flows into and out of the accounts during the period.
Income Statements
An income statement is a report that shows how much revenue a company earned over a specific time period (usually for a year or some portion of a year). An income statement also shows the costs and expenses associated with earning that revenue. The literal “bottom line” of the statement usually shows the company’s net earnings or losses. This tells you how much the company earned or lost over the period.
Income statements also report earnings per share (or “EPS”). This calculation tells you how much money shareholders would receive if the company decided to distribute all of the net earnings for the period. (Companies almost never distribute all of their earnings. Usually they reinvest them in the business.)
To understand how income statements are set up, think of them as a set of stairs. You start at the top with the total amount of sales made during the accounting period. Then you go down, one step at a time. At each step, you make a deduction for certain costs or other operating expenses associated with earning the revenue. At the bottom of the stairs, after deducting all of the expenses, you learn how much the company actually earned or lost during the accounting period. People often call this “the bottom line.”
At the top of the income statement is the total amount of money brought in from sales of products or services. This top line is often referred to as gross revenues or sales. It’s called “gross” because expenses have not been deducted from it yet. So the number is “gross” or unrefined.
The next line is money the company doesn’t expect to collect on certain sales. This could be due, for example, to sales discounts or merchandise returns.
When you subtract the returns and allowances from the gross revenues, you arrive at the company’s net revenues. It’s called “net” because, if you can imagine a net, these revenues are left in the net after the deductions for returns and allowances have come out.
Moving down the stairs from the net revenue line, there are several lines that represent various kinds of operating expenses. Although these lines can be reported in various orders, the next line after net revenues typically shows the costs of the sales. This number tells you the amount of money the company spent to produce the goods or services it sold during the accounting period.
The next line subtracts the costs of sales from the net revenues to arrive at a subtotal called “gross profit” or sometimes “gross margin.” It’s considered “gross” because there are certain expenses that haven’t been deducted from it yet.
The next section deals with operating expenses. These are expenses that go toward supporting a company’s operations for a given period – for example, salaries of administrative personnel and costs of researching new products. Marketing expenses are another example. Operating expenses are different from “costs of sales,” which were deducted above, because operating expenses cannot be linked directly to the production of the products or services being sold.
Depreciation is also deducted from gross profit. Depreciation takes into account the wear and tear on some assets, such as machinery, tools and furniture, which are used over the long term. Companies spread the cost of these assets over the periods they are used. This process of spreading these costs is called depreciation or amortization. The “charge” for using these assets during the period is a fraction of the original cost of the assets.
After all operating expenses are deducted from gross profit, you arrive at operating profit before interest and income tax expenses. This is often called “income from operations.”
Next companies must account for interest income and interest expense. Interest income is the money companies make from keeping their cash in interest-bearing savings accounts, money market funds and the like. On the other hand, interest expense is the money companies paid in interest for money they borrow. Some income statements show interest income and interest expense separately. Some income statements combine the two numbers. The interest income and expense are then added or subtracted from the operating profits to arrive at operating profit before income tax.
Finally, income tax is deducted and you arrive at the bottom line: net profit or net losses. (Net profit is also called net income or net earnings.) This tells you how much the company actually earned or lost during the accounting period. Did the company make a profit or did it lose money?
Earnings Per Share or EPS
Most income statements include a calculation of earnings per share or EPS. This calculation tells you how much money shareholders would receive for each share of stock they own if the company distributed all of its net income for the period.
To calculate EPS, you take the total net income and divide it by the number of outstanding shares of the company.
Cash Flow Statements
Cash flow statements report a company’s inflows and outflows of cash. This is important because a company needs to have enough cash on hand to pay its expenses and purchase assets. While an income statement can tell you whether a company made a profit, a cash flow statement can tell you whether the company generated cash.
A cash flow statement shows changes over time rather than absolute dollar amounts at a point in time. It uses and reorders the information from a company’s balance sheet and income statement.
The bottom line of the cash flow statement shows the net increase or decrease in cash for the period. Generally, cash flow statements are divided into three main parts. Each part reviews the cash flow from one of three types of activities: (1) operating activities; (2) investing activities; and (3) financing activities.
Operating Activities
The first part of a cash flow statement analyzes a company’s cash flow from net income or losses. For most companies, this section of the cash flow statement reconciles the net income (as shown on the income statement) to the actual cash the company received from or used in its operating activities. To do this, it adjusts net income for any non-cash items (such as adding back depreciation expenses) and adjusts for any cash that was used or provided by other operating assets and liabilities.
Investing Activities
The second part of a cash flow statement shows the cash flow from all investing activities, which generally include purchases or sales of long-term assets, such as property, plant and equipment, as well as investment securities. If a company buys a piece of machinery, the cash flow statement would reflect this activity as a cash outflow from investing activities because it used cash. If the company decided to sell off some investments from an investment portfolio, the proceeds from the sales would show up as a cash inflow from investing activities because it provided cash.
Financing Activities
The third part of a cash flow statement shows the cash flow from all financing activities. Typical sources of cash flow include cash raised by selling stocks and bonds or borrowing from banks. Likewise, paying back a bank loan would show up as a use of cash flow.
Read the Footnotes
A horse called “Read The Footnotes” ran in the 2004 Kentucky Derby. He finished seventh, but if he had won, it would have been a victory for financial literacy proponents everywhere. It’s so important to read the footnotes. The footnotes to financial statements are packed with information. Here are some of the highlights:
- Significant accounting policies and practices – Companies are required to disclose the accounting policies that are most important to the portrayal of the company’s financial condition and results. These often require management’s most difficult, subjective or complex judgments.
- Income taxes – The footnotes provide detailed information about the company’s current and deferred income taxes. The information is broken down by level – federal, state, local and/or foreign, and the main items that affect the company’s effective tax rate are described.
- Pension plans and other retirement programs – The footnotes discuss the company’s pension plans and other retirement or post-employment benefit programs. The notes contain specific information about the assets and costs of these programs, and indicate whether and by how much the plans are over- or under-funded.
- Stock options – The notes also contain information about stock options granted to officers and employees, including the method of accounting for stock-based compensation and the effect of the method on reported results.
Read the MD&A
You can find a narrative explanation of a company’s financial performance in a section of the quarterly or annual report entitled, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” MD&A is management’s opportunity to provide investors with its view of the financial performance and condition of the company. It’s management’s opportunity to tell investors what the financial statements show and do not show, as well as important trends and risks that have shaped the past or are reasonably likely to shape the company’s future.
The SEC’s rules governing MD&A require disclosure about trends, events or uncertainties known to management that would have a material impact on reported financial information. The purpose of MD&A is to provide investors with information that the company’s management believes to be necessary to an understanding of its financial condition, changes in financial condition and results of operations. It is intended to help investors to see the company through the eyes of management. It is also intended to provide context for the financial statements and information about the company’s earnings and cash flows.
Financial Statement Ratios and Calculations
You’ve probably heard people banter around phrases like “P/E ratio,” “current ratio” and “operating margin.” But what do these terms mean and why don’t they show up on financial statements? Listed below are just some of the many ratios that investors calculate from information on financial statements and then use to evaluate a company. As a general rule, desirable ratios vary by industry.
- Debt-to-equity ratio compares a company’s total debt to shareholders’ equity. Both of these numbers can be found on a company’s balance sheet. To calculate debt-to-equity ratio, you divide a company’s total liabilities by its shareholder equity, or
- Inventory turnover ratio compares a company’s cost of sales on its income statement with its average inventory balance for the period. To calculate the average inventory balance for the period, look at the inventory numbers listed on the balance sheet. Take the balance listed for the period of the report and add it to the balance listed for the previous comparable period, and then divide by two. (Remember that balance sheets are snapshots in time. So the inventory balance for the previous period is the beginning balance for the current period, and the inventory balance for the current period is the ending balance.) To calculate the inventory turnover ratio, you divide a company’s cost of sales (just below the net revenues on the income statement) by the average inventory for the period, or
- Operating margin compares a company’s operating income to net revenues. Both of these numbers can be found on a company’s income statement. To calculate operating margin, you divide a company’s income from operations (before interest and income tax expenses) by its net revenues, or
- P/E ratio compares a company’s common stock price with its earnings per share. To calculate a company’s P/E ratio, you divide a company’s stock price by its earnings per share, or
- Working capital is the money leftover if a company paid its current liabilities (that is, its debts due within one-year of the date of the balance sheet) from its current assets.
Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
If a company has a debt-to-equity ratio of 2 to 1, it means that the company has two dollars of debt to every one dollar shareholders invest in the company. In other words, the company is taking on debt at twice the rate that its owners are investing in the company.
Inventory Turnover Ratio = Cost of Sales / Average Inventory for the Period
If a company has an inventory turnover ratio of 2 to 1, it means that the company’s inventory turned over twice in the reporting period.
Operating Margin = Income from Operations / Net Revenues
Operating margin is usually expressed as a percentage. It shows, for each dollar of sales, what percentage was profit.
P/E Ratio = Price per share / Earnings per share
If a company’s stock is selling at $20 per share and the company is earning $2 per share, then the company’s P/E Ratio is 10 to 1. The company’s stock is selling at 10 times its earnings.
Working Capital = Current Assets – Current Liabilities
Bringing It All Together
Although this brochure discusses each financial statement separately, keep in mind that they are all related. The changes in assets and liabilities that you see on the balance sheet are also reflected in the revenues and expenses that you see on the income statement, which result in the company’s gains or losses. Cash flows provide more information about cash assets listed on a balance sheet and are related, but not equivalent, to net income shown on the income statement. And so on. No one financial statement tells the complete story. But combined, they provide very powerful information for investors. And information is the investor’s best tool when it comes to investing wisely.
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Remarks of Bill Gates
Harvard Commencement
(Text as prepared for delivery
Courtsey http://www.news.harvard.edu/gazette/2007/06.14/99-gates.html)
President Bok, former President Rudenstine, incoming President Faust, members of the Harvard Corporation and the Board of Overseers, members of the faculty, parents, and especially, the graduates:
I’ve been waiting more than 30 years to say this: “Dad, I always told you I’d come back and get my degree.”
I want to thank Harvard for this timely honor. I’ll be changing my job next year … and it will be nice to finally have a college degree on my resume.
I applaud the graduates today for taking a much more direct route to your degrees. For my part, I’m just happy that the Crimson has called me “Harvard’s most successful dropout.” I guess that makes me valedictorian of my own special class … I did the best of everyone who failed.
But I also want to be recognized as the guy who got Steve Ballmer to drop out of business school. I’m a bad influence. That’s why I was invited to speak at your graduation. If I had spoken at your orientation, fewer of you might be here today.
Harvard was just a phenomenal experience for me. Academic life was fascinating. I used to sit in on lots of classes I hadn’t even signed up for. And dorm life was terrific. I lived up at Radcliffe, in Currier House. There were always lots of people in my dorm room late at night discussing things, because everyone knew I didn’t worry about getting up in the morning. That’s how I came to be the leader of the anti-social group. We clung to each other as a way of validating our rejection of all those social people.
Radcliffe was a great place to live. There were more women up there, and most of the guys were science-math types. That combination offered me the best odds, if you know what I mean. This is where I learned the sad lesson that improving your odds doesn’t guarantee success.
One of my biggest memories of Harvard came in January 1975, when I made a call from Currier House to a company in Albuquerque that had begun making the world’s first personal computers. I offered to sell them software.
I worried that they would realize I was just a student in a dorm and hang up on me. Instead they said: “We’re not quite ready, come see us in a month,” which was a good thing, because we hadn’t written the software yet. From that moment, I worked day and night on this little extra credit project that marked the end of my college education and the beginning of a remarkable journey with Microsoft.
What I remember above all about Harvard was being in the midst of so much energy and intelligence. It could be exhilarating, intimidating, sometimes even discouraging, but always challenging. It was an amazing privilege – and though I left early, I was transformed by my years at Harvard, the friendships I made, and the ideas I worked on.
But taking a serious look back … I do have one big regret.
I left Harvard with no real awareness of the awful inequities in the world – the appalling disparities of health, and wealth, and opportunity that condemn millions of people to lives of despair.
I learned a lot here at Harvard about new ideas in economics and politics. I got great exposure to the advances being made in the sciences.
But humanity’s greatest advances are not in its discoveries – but in how those discoveries are applied to reduce inequity. Whether through democracy, strong public education, quality health care, or broad economic opportunity – reducing inequity is the highest human achievement.
I left campus knowing little about the millions of young people cheated out of educational opportunities here in this country. And I knew nothing about the millions of people living in unspeakable poverty and disease in developing countries.
It took me decades to find out.
You graduates came to Harvard at a different time. You know more about the world’s inequities than the classes that came before. In your years here, I hope you’ve had a chance to think about how – in this age of accelerating technology – we can finally take on these inequities, and we can solve them.
Imagine, just for the sake of discussion, that you had a few hours a week and a few dollars a month to donate to a cause – and you wanted to spend that time and money where it would have the greatest impact in saving and improving lives. Where would you spend it?
For Melinda and for me, the challenge is the same: how can we do the most good for the greatest number with the resources we have.
During our discussions on this question, Melinda and I read an article about the millions of children who were dying every year in poor countries from diseases that we had long ago made harmless in this country. Measles, malaria, pneumonia, hepatitis B, yellow fever. One disease I had never even heard of, rotavirus, was killing half a million kids each year – none of them in the United States.
We were shocked. We had just assumed that if millions of children were dying and they could be saved, the world would make it a priority to discover and deliver the medicines to save them. But it did not. For under a dollar, there were interventions that could save lives that just weren’t being delivered.
If you believe that every life has equal value, it’s revolting to learn that some lives are seen as worth saving and others are not. We said to ourselves: “This can’t be true. But if it is true, it deserves to be the priority of our giving.”
So we began our work in the same way anyone here would begin it. We asked: “How could the world let these children die?”
The answer is simple, and harsh. The market did not reward saving the lives of these children, and governments did not subsidize it. So the children died because their mothers and their fathers had no power in the market and no voice in the system.
But you and I have both.
We can make market forces work better for the poor if we can develop a more creative capitalism – if we can stretch the reach of market forces so that more people can make a profit, or at least make a living, serving people who are suffering from the worst inequities. We also can press governments around the world to spend taxpayer money in ways that better reflect the values of the people who pay the taxes.
If we can find approaches that meet the needs of the poor in ways that generate profits for business and votes for politicians, we will have found a sustainable way to reduce inequity in the world. This task is open-ended. It can never be finished. But a conscious effort to answer this challenge will change the world.
I am optimistic that we can do this, but I talk to skeptics who claim there is no hope. They say: “Inequity has been with us since the beginning, and will be with us till the end – because people just … don’t … care.” I completely disagree.
I believe we have more caring than we know what to do with.
All of us here in this Yard, at one time or another, have seen human tragedies that broke our hearts, and yet we did nothing – not because we didn’t care, but because we didn’t know what to do. If we had known how to help, we would have acted.
The barrier to change is not too little caring; it is too much complexity.
To turn caring into action, we need to see a problem, see a solution, and see the impact. But complexity blocks all three steps.
Even with the advent of the Internet and 24-hour news, it is still a complex enterprise to get people to truly see the problems. When an airplane crashes, officials immediately call a press conference. They promise to investigate, determine the cause, and prevent similar crashes in the future.
But if the officials were brutally honest, they would say: “Of all the people in the world who died today from preventable causes, one half of one percent of them were on this plane. We’re determined to do everything possible to solve the problem that took the lives of the one half of one percent.”
The bigger problem is not the plane crash, but the millions of preventable deaths.
We don’t read much about these deaths. The media covers what’s new – and millions of people dying is nothing new. So it stays in the background, where it’s easier to ignore. But even when we do see it or read about it, it’s difficult to keep our eyes on the problem. It’s hard to look at suffering if the situation is so complex that we don’t know how to help. And so we look away.
If we can really see a problem, which is the first step, we come to the second step: cutting through the complexity to find a solution.
Finding solutions is essential if we want to make the most of our caring. If we have clear and proven answers anytime an organization or individual asks “How can I help?,” then we can get action – and we can make sure that none of the caring in the world is wasted. But complexity makes it hard to mark a path of action for everyone who cares — and that makes it hard for their caring to matter.
Cutting through complexity to find a solution runs through four predictable stages: determine a goal, find the highest-leverage approach, discover the ideal technology for that approach, and in the meantime, make the smartest application of the technology that you already have — whether it’s something sophisticated, like a drug, or something simpler, like a bednet.
The AIDS epidemic offers an example. The broad goal, of course, is to end the disease. The highest-leverage approach is prevention. The ideal technology would be a vaccine that gives lifetime immunity with a single dose. So governments, drug companies, and foundations fund vaccine research. But their work is likely to take more than a decade, so in the meantime, we have to work with what we have in hand – and the best prevention approach we have now is getting people to avoid risky behavior.
Pursuing that goal starts the four-step cycle again. This is the pattern. The crucial thing is to never stop thinking and working – and never do what we did with malaria and tuberculosis in the 20th century – which is to surrender to complexity and quit.
The final step – after seeing the problem and finding an approach – is to measure the impact of your work and share your successes and failures so that others learn from your efforts.
You have to have the statistics, of course. You have to be able to show that a program is vaccinating millions more children. You have to be able to show a decline in the number of children dying from these diseases. This is essential not just to improve the program, but also to help draw more investment from business and government.
But if you want to inspire people to participate, you have to show more than numbers; you have to convey the human impact of the work – so people can feel what saving a life means to the families affected.
I remember going to Davos some years back and sitting on a global health panel that was discussing ways to save millions of lives. Millions! Think of the thrill of saving just one person’s life – then multiply that by millions. … Yet this was the most boring panel I’ve ever been on – ever. So boring even I couldn’t bear it.
What made that experience especially striking was that I had just come from an event where we were introducing version 13 of some piece of software, and we had people jumping and shouting with excitement. I love getting people excited about software – but why can’t we generate even more excitement for saving lives?
You can’t get people excited unless you can help them see and feel the impact. And how you do that – is a complex question.
Still, I’m optimistic. Yes, inequity has been with us forever, but the new tools we have to cut through complexity have not been with us forever. They are new – they can help us make the most of our caring – and that’s why the future can be different from the past.
The defining and ongoing innovations of this age – biotechnology, the computer, the Internet – give us a chance we’ve never had before to end extreme poverty and end death from preventable disease.
Sixty years ago, George Marshall came to this commencement and announced a plan to assist the nations of post-war Europe. He said: “I think one difficulty is that the problem is one of such enormous complexity that the very mass of facts presented to the public by press and radio make it exceedingly difficult for the man in the street to reach a clear appraisement of the situation. It is virtually impossible at this distance to grasp at all the real significance of the situation.”
Thirty years after Marshall made his address, as my class graduated without me, technology was emerging that would make the world smaller, more open, more visible, less distant.
The emergence of low-cost personal computers gave rise to a powerful network that has transformed opportunities for learning and communicating.
The magical thing about this network is not just that it collapses distance and makes everyone your neighbor. It also dramatically increases the number of brilliant minds we can have working together on the same problem – and that scales up the rate of innovation to a staggering degree.
At the same time, for every person in the world who has access to this technology, five people don’t. That means many creative minds are left out of this discussion — smart people with practical intelligence and relevant experience who don’t have the technology to hone their talents or contribute their ideas to the world.
We need as many people as possible to have access to this technology, because these advances are triggering a revolution in what human beings can do for one another. They are making it possible not just for national governments, but for universities, corporations, smaller organizations, and even individuals to see problems, see approaches, and measure the impact of their efforts to address the hunger, poverty, and desperation George Marshall spoke of 60 years ago.
Members of the Harvard Family: Here in the Yard is one of the great collections of intellectual talent in the world.
What for?
There is no question that the faculty, the alumni, the students, and the benefactors of Harvard have used their power to improve the lives of people here and around the world. But can we do more? Can Harvard dedicate its intellect to improving the lives of people who will never even hear its name?
Let me make a request of the deans and the professors – the intellectual leaders here at Harvard: As you hire new faculty, award tenure, review curriculum, and determine degree requirements, please ask yourselves:
Should our best minds be dedicated to solving our biggest problems?
Should Harvard encourage its faculty to take on the world’s worst inequities? Should Harvard students learn about the depth of global poverty … the prevalence of world hunger … the scarcity of clean water …the girls kept out of school … the children who die from diseases we can cure?
Should the world’s most privileged people learn about the lives of the world’s least privileged?
These are not rhetorical questions – you will answer with your policies.
My mother, who was filled with pride the day I was admitted here – never stopped pressing me to do more for others. A few days before my wedding, she hosted a bridal event, at which she read aloud a letter about marriage that she had written to Melinda. My mother was very ill with cancer at the time, but she saw one more opportunity to deliver her message, and at the close of the letter she said: “From those to whom much is given, much is expected.”
When you consider what those of us here in this Yard have been given – in talent, privilege, and opportunity – there is almost no limit to what the world has a right to expect from us.
In line with the promise of this age, I want to exhort each of the graduates here to take on an issue – a complex problem, a deep inequity, and become a specialist on it. If you make it the focus of your career, that would be phenomenal. But you don’t have to do that to make an impact. For a few hours every week, you can use the growing power of the Internet to get informed, find others with the same interests, see the barriers, and find ways to cut through them.
Don’t let complexity stop you. Be activists. Take on the big inequities. It will be one of the great experiences of your lives.
You graduates are coming of age in an amazing time. As you leave Harvard, you have technology that members of my class never had. You have awareness of global inequity, which we did not have. And with that awareness, you likely also have an informed conscience that will torment you if you abandon these people whose lives you could change with very little effort. You have more than we had; you must start sooner, and carry on longer.
Knowing what you know, how could you not?
And I hope you will come back here to Harvard 30 years from now and reflect on what you have done with your talent and your energy. I hope you will judge yourselves not on your professional accomplishments alone, but also on how well you have addressed the world’s deepest inequities … on how well you treated people a world away who have nothing in common with you but their humanity.
Good luck.
*****
WARREN BUFFETT ON THE STOCK MARKET
(Abridged, For Educational Use Only.
This is a classic illustration on the stock market trends of the future by Warren Buffett)
(courtesy http://chinese-school.netfirms.com/)
FORTUNE
Thursday, December 6, 2001
By Carol Loomis
From Fortune Magazine:
“Two years ago, following a July 1999 speech by Warren Buffett, chairman of Berkshire Hathaway, on the stock market–a rare subject for him to discuss publicly–FORTUNE ran what he had to say under the title Mr. Buffett on the Stock Market (Nov. 22, 1999). His main points then concerned two consecutive and amazing periods that American investors had experienced, and his belief that returns from stocks were due to fall dramatically. Since the Dow Jones Industrial Average was 11194 when he gave his speech and recently was about 9900, no one yet has the goods to argue with him.
So where do we stand now–with the stock market seeming to reflect a dismal profit outlook, an unfamiliar war, and rattled consumer confidence? Who better to supply perspective on that question than Buffett?
The thoughts that follow come from a second Buffett speech, given last July at the site of the first talk, Allen & Co.’s annual Sun Valley bash for corporate executives. There, the renowned stockpicker returned to the themes he’d discussed before, bringing new data and insights to the subject. Working with FORTUNE’s Carol Loomis, Buffett distilled that speech into this essay, a fitting opening for this year’s Investor’s Guide. Here again is Mr. Buffett on the Stock Market. “
Warren Buffett:
The last time I tackled this subject, in 1999, I broke down the previous 34 years into two 17-year periods, which in the sense of lean years and fat were astonishingly symmetrical. Here’s the first period. As you can see, over 17 years the Dow gained exactly one-tenth of one percent.
Dow Jones Industrial Average
Dec. 31, 1964: 874.12
Dec. 31, 1981: 875.00
And here’s the second, marked by an incredible bull market that, as I laid out my thoughts, was about to end (though I didn’t know that).
Dow Industrials
Dec. 31, 1981: 875.00
Dec. 31, 1998: 9181.43
Now, you couldn’t explain this remarkable divergence in markets by, say, differences in the growth of gross national product. In the first period–that dismal time for the market–GNP actually grew more than twice as fast as it did in the second period.
Gain in Gross National Product
1964-1981: 373%
1981-1998: 177%
So what was the explanation? I concluded that the market’s contrasting moves were caused by extraordinary changes in two critical economic variables–and by a related psychological force that eventually came into play.
Here I need to remind you about the definition of “investing,” which though simple is often forgotten. Investing is laying out money today to receive more money tomorrow.
That gets to the first of the economic variables that affected stock prices in the two periods–interest rates. In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. If interest rates are, say, 13%, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.
So here’s the record on interest rates at key dates in our 34-year span. They moved dramatically up–that was bad for investors–in the first half of that period and dramatically down–a boon for investors–in the second half.
Interest Rates, Long-Term Government Bonds
Dec. 31, 1964: 4.20%
Dec. 31, 1981: 13.65%
Dec. 31, 1998: 5.09%
The other critical variable here is how many dollars investors expected to get from the companies in which they invested. During the first period expectations fell significantly because corporate profits weren’t looking good. By the early 1980s Fed Chairman Paul Volcker’s economic sledgehammer had, in fact, driven corporate profitability to a level that people hadn’t seen since the 1930s.
The upshot is that investors lost their confidence in the American economy: They were looking at a future they believed would be plagued by two negatives. First, they didn’t see much good coming in the way of corporate profits. Second, the sky-high interest rates prevailing caused them to discount those meager profits further. These two factors, working together, caused stagnation in the stock market from 1964 to 1981, even though those years featured huge improvements in GNP. The business of the country grew while investors’ valuation of that business shrank!
And then the reversal of those factors created a period during which much lower GNP gains were accompanied by a bonanza for the market. First, you got a major increase in the rate of profitability. Second, you got an enormous drop in interest rates, which made a dollar of future profit that much more valuable. Both phenomena were real and powerful fuels for a major bull market. And in time the psychological factor I mentioned was added to the equation: Speculative trading exploded, simply because of the market action that people had seen. Later, we’ll look at the pathology of this dangerous and oft-recurring malady.
Two years ago I believed the favorable fundamental trends had largely run their course. For the market to go dramatically up from where it was then would have required long-term interest rates to drop much further (which is always possible) or for there to be a major improvement in corporate profitability (which seemed, at the time, considerably less possible). If you take a look at a 50-year chart of after-tax profits as a percent of gross domestic product, you find that the rate normally falls between 4%–that was its neighborhood in the bad year of 1981, for example–and 6.5%. For the rate to go above 6.5% is rare. In the very good profit years of 1999 and 2000, the rate was under 6% and this year it may well fall below 5%.
So there you have my explanation of those two wildly different 17-year periods. The question is, How much do those periods of the past for the market say about its future?
To suggest an answer, I’d like to look back over the 20th century. As you know, this was really the American century. We had the advent of autos, we had aircraft, we had radio, TV, and computers. It was an incredible period. Indeed, the per capita growth in U.S. output, measured in real dollars (that is, with no impact from inflation), was a breathtaking 702%.
The century included some very tough years, of course–like the Depression years of 1929 to 1933. But a decade-by-decade look at per capita GNP shows something remarkable: As a nation, we made relatively consistent progress throughout the century. So you might think that the economic value of the U.S.–at least as measured by its securities markets–would have grown at a reasonably consistent pace as well.
The U.S. Never Stopped Growing
Per capita GNP gains crept in the 20th century’s early years.
But if you think of the U.S. as a stock, it was overall one helluva mover.
| Year | 20th-Century growth in per capita GNP (constant dollars) |
|---|---|
| 1900-10 | 29% |
| 1910-20 | 1% |
| 1920-30 | 13% |
| 1930-40 | 21% |
| 1940-50 | 50% |
| 1950-60 | 18% |
| 1960-70 | 33% |
| 1970-80 | 24% |
| 1980-90 | 24% |
| 1990-2000 | 24% |
That’s not what happened. We know from our earlier examination of the 1964-98 period that parallelism broke down completely in that era. But the whole century makes this point as well. At its beginning, for example, between 1900 and 1920, the country was chugging ahead, explosively expanding its use of electricity, autos, and the telephone. Yet the market barely moved, recording a 0.4% annual increase that was roughly analogous to the slim pickings between 1964 and 1981.
Dow Industrials
Dec. 31, 1899: 66.08
Dec. 31, 1920: 71.95
In the next period, we had the market boom of the ’20s, when the Dow jumped 430% to 381 in September 1929. Then we go 19 years–19 years–and there is the Dow at 177, half the level where it began. That’s true even though the 1940s displayed by far the largest gain in per capita GDP (50%) of any 20th-century decade. Following that came a 17-year period when stocks finally took off–making a great five-to-one gain. And then the two periods discussed at the start: stagnation until 1981, and the roaring boom that wrapped up this amazing century.
To break things down another way, we had three huge, secular bull markets that covered about 44 years, during which the Dow gained more than 11,000 points. And we had three periods of stagnation, covering some 56 years. During those 56 years the country made major economic progress and yet the Dow actually lost 292 points.
How could this have happened? In a flourishing country in which people are focused on making money, how could you have had three extended and anguishing periods of stagnation that in aggregate–leaving aside dividends–would have lost you money? The answer lies in the mistake that investors repeatedly make–that psychological force I mentioned above: People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them.
The first part of the century offers a vivid illustration of that myopia. In the century’s first 20 years, stocks normally yielded more than high-grade bonds. That relationship now seems quaint, but it was then almost axiomatic. Stocks were known to be riskier, so why buy them unless you were paid a premium?
And then came along a 1924 book–slim and initially unheralded, but destined to move markets as never before–written by a man named Edgar Lawrence Smith. The book, called Common Stocks as Long Term Investments, chronicled a study Smith had done of security price movements in the 56 years ended in 1922. Smith had started off his study with a hypothesis: Stocks would do better in times of inflation, and bonds would do better in times of deflation. It was a perfectly reasonable hypothesis.
But consider the first words in the book: “These studies are the record of a failure–the failure of facts to sustain a preconceived theory.” Smith went on: “The facts assembled, however, seemed worthy of further examination. If they would not prove what we had hoped to have them prove, it seemed desirable to turn them loose and to follow them to whatever end they might lead.”
Now, there was a smart man, who did just about the hardest thing in the world to do. Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man’s natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience–a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation.
*****
Warren Buffett’s Wild Ride at Salomon
October 27, 1997
(Coutresy http://chinese-school.netfirms.com/)
Warren Buffett’s Wild Ride at Salomon A harrowing, bizarre tale of misdeeds and mistakes that pushed Salomon to the brink and produced the “most important day” in Warren Buffett’s life.
Carol J. Loomis
Reporter Associate: Maria Atanasov
As Sanford I. Weill, 64, the dealmaking CEO of Travelers Group, steps up to his biggest acquisition ever–the purchase of Salomon Inc. for $9 billion–a famous Wall Street figure, Warren E. Buffett, 67, steps out of Salomon. His days there began almost precisely a decade ago, in the early fall of 1987, when his company, Berkshire Hathaway, became Salomon’s largest shareholder and he moved in as a director. But that was training-wheels stuff, nothing to the high-wire unicycle act that came later: Buffett was physically, emotionally, and really at Salomon for nine months in 1991 and 1992, when the firm’s trading illegalities created a giant sucking sound that brought him in to run the place.
Though much has been written about Buffett and Salomon, a lot of what you will read here will be new. I have been a friend of Buffett’s for about 30 years and have long been a shareholder of Berkshire (though never a shareholder of Salomon). As a friend, I do some editing every year on Buffett’s well-known annual report, and we have for eons talked about collaborating on a book about his business life. All this has given me many opportunities to learn Buffett’s thinking. Some of what I’ve gleaned has ended up in Fortune stories that I wrote, most especially in an April 11, 1988, article, “The Inside Story of Warren Buffett,” and in an accompanying box, “The Wisdom of Salomon?” But much of what I learned about Buffett’s experiences at Salomon in 1991 was confidential, embargoed by him because Salomon was both struggling to regain its footing and dealing with big legal problems. Later on, though those emergencies eased and the embargo might have been lifted, there was no immediate reason to print the story. Now, with the Travelers deal, there is. To that reason, add another: This drama of 1991 sends a powerful message about the hazards lurking in a financial system that every day grows more complex.
This tale should begin with the thought that the ten months Buffett spent at Salomon were a profound break in the rhythm of his life. Warren Buffett is an executive accustomed to making maybe one big investment decision a year, but Salomon left him dealing with 25 operating decisions a day. At the center of this experience was a single day–what he has called “the most important day of my life,” Sunday, Aug. 18, 1991–in which the U.S. Treasury first banned Salomon from bidding in government securities auctions and then, because of Buffett’s efforts, rescinded the ban. In the four hours of suspense between the two actions, Buffett struggled passionately to ward off a tragedy he saw threatening to unfold. In Buffett’s opinion, the ban put Salomon, this company now being priced at $9 billion, in sure danger of having immediately to file for bankruptcy. Even more important, he believed on that day, as he does now, that the collapse of Salomon would have shaken the world’s financial system to its core.
How It Began
That Sunday in August was a far cry from the commercialism of another Sunday, Sept. 27, 1987, when Buffett and John Gutfreund, then Salomon’s chairman and CEO, agreed that Berkshire Hathaway would buy $700 million of Salomon convertible preferred stock, which equated to a 12% stake in the company. The deal allowed Gutfreund to stave off takeover artist Ronald Perelman, who seemed poised to buy a large block of Salomon common stock from certain South African investors wanting to sell. With Berkshire’s $700 million, Gutfreund was able to strike a deal that allowed Salomon itself to buy the South African stock–and with that, Perelman was dispatched. It was easy to see why Gutfreund welcomed Warren Buffett, White Knight. It was less easy to see why Buffett wanted to hook up with Salomon, much less trust it with this mint, $700 million–the largest amount he’d ever invested in a single company. Over the years, Buffett had derided investment bankers, deploring their enthusiasm for deals that provided huge fees but that were turkeys for their clients. He has also spoken often of wanting to work only with people he likes. So here he was, handing over mountains of Berkshire’s carefully accumulated and husbanded cash to the high-living, cigar-chomping, corner-cutting crowd soon to be made infamous in Liar’s Poker? Several reasons explain the move, none of them really good enough in the light of what followed. One is that Buffett had been having trouble for a couple of years finding stocks he thought reasonably priced and was looking for fixed-income alternatives. A second is that the Salomon proposal came from John Gutfreund, whom Buffett had seen do principled, non-greedy, client-friendly work for GEICO, in which Berkshire was then a major stockholder (and which is now owned 100% by Berkshire). Buffett liked Gutfreund–still does, in fact.
A third explanation was simply that Buffett thought the terms of the deal worth accepting. In effect, convertible preferreds are fixed-income investments with lottery tickets attached. In this case, the security was to pay 9% and be convertible after three years into Salomon common stock at $38 a share–against the $30 for which the stock had been selling. If Buffett did not convert the stock, it was to be redeemed over five years beginning in 1995. To Buffett, it looked like a decent proposition. “It’s not ‘a triple,’ which is what you’d like to have,” he said to me in 1987, “but it could work out okay.”
To some of the brainy, mathematical types at Salomon, that appraisal would have qualified as the understatement of the year. From Day One, they thought–and let it be known to the press–that Buffett had exploited Gutfreund’s fear of Perelman and had secured a dream security, with a too-high dividend or a too-low conversion price or some combination thereof. Over the next few years, this opinion did not die at Salomon, and more than once executives of the firm (though never Gutfreund) came to Buffett with propositions for deep-sixing the preferred.
It’s fair to say that Buffett might have taken those offers more seriously had he known that ahead lay the business-wrecking, profit-shredding scandal that broke in August 1991–and that turned the world upside down for both Salomon and him.
A little stage setting here: Before the crisis hit, Salomon was on its way to an excellent business year, marred only by a Treasury investigation into a May T-bill auction in which Salomon was thought perhaps to have engineered a short squeeze. Despite that sticky matter, Salomon’s stock had climbed to $37 a share, a price very near Buffett’s conversion point of $38.
The Phone Call
For the story of what then happened, we may begin with Buffett in Reno. Yes, Reno, which was the spot two executives of a Berkshire subsidiary had picked for an annual getaway with Buffett. Arriving in Reno on the afternoon of Thursday, Aug. 8, Buffett checked with his office and found that John Gutfreund, en route at that moment from London to New York, wanted to talk to him that evening. Gutfreund’s office said he’d then be at Salomon’s principal law firm, Wachtell Lipton Rosen & Katz, and Buffett agreed to call him there at 10:30 P.M. New York time. Mulling this over, Buffett concluded that it couldn’t be bad news, because Gutfreund hadn’t been in New York to attend to it. Maybe, he thought, Gutfreund had made a deal to sell Salomon and needed a quick okay from the directors. Heading out to dinner in Lake Tahoe, Buffett actually told his group that he might be hearing “good news” before the evening was out–a characterization indicating Buffett was ready to bail from this supposedly plummy deal he’d got into four years earlier.
At the appointed time, breaking from dinner, Buffett stood at a pay phone to make his call. After a delay, he was put through to Salomon’s president, Tom Strauss, and its inside lawyer, Donald Feuerstein, who told him that because Gutfreund’s plane had been held up, they would instead brief Buffett on “a problem” that had arisen. Speaking calmly, they said that a Wachtell Lipton investigation commissioned by Salomon had discovered that two of its government securities traders, including the top gun, managing director Paul Mozer (a name Buffett didn’t know), had broken the Treasury’s bidding rules on more than one occasion in 1990 and 1991.
Mozer and his colleague, said Strauss and Feuerstein, had been suspended, and the firm was now moving to notify its regulators and put out a press release. Feuerstein then read a draft of the release to Buffett and added that earlier in the day he had talked at some length to Salomon director Charles T. Munger, Berkshire’s vice-chairman and Buffett’s sidekick in everything important.
The release contained only a few details about Mozer’s sins. But a fuller account dribbled out over the next few days, depicting a man at war with the Treasury over bidding rules that he despised. A new rule, promulgated in 1990 to prevent such behemoths as Salomon from cornering the market, said that a single firm could not bid for more than 35% of the Treasury securities being offered in a given auction. In December 1990 and again in February 1991, Mozer simply made hash of this rule by, first, bidding for Salomon’s allowable of 35%; second, submitting, without authorization, separate bids for certain customers; and, third, simply stuffing the securities that these bidders won into Salomon’s own account, never telling the customers a word about the whole exercise. From all this, Salomon emerged with more than 35% of the auctioned securities and with increased power to swing its weight around.
On that Thursday night, with other pay-phoners chattering all around him, Buffett did not hear nearly that much detail nor detect, in Strauss and Feuerstein’s matter-of-fact tones, any reason to be particularly alarmed. So he went back to dinner.
Only on Saturday, when he reached Munger, then vacationing on a northern Minnesota island, did Buffett get a sense of real trouble. Munger, a lawyer by training, had stopped Feuerstein’s recital two days earlier to explore what Feuerstein meant by saying–to use the words that were on a sheet of “talking points” drawn up by lawyers for these calls–that “one part of the problem has been known since late April.” In writer-speak, that is the “passive voice,” and it raises an obvious question: “Who knew?”
Munger bore down on that question and found out that Mozer, believing that he was about to be unmasked, had disclosed the February bidding infractions to his boss, John Meriwether, in late April. Calling Mozer’s behavior “career-threatening,” Meriwether immediately went to Strauss with the news and, days later, met with Strauss, Gutfreund, and Feuerstein to decide what to do. Feuerstein advised the others that Mozer’s act was probably “criminal,” and the group concluded that the New York Federal Reserve must be told what had happened. But then no one did a thing about telling–neither in April nor in May, June, or July. That was the inaction that Buffett later said was “inexplicable and inexcusable,” and that pushed the crisis to its limits.
Talking to Buffett on that Saturday, Munger called management’s extended failure to act “thumb sucking,” which is a term Buffett thinks he heard repeated when he himself was talking to Strauss and Feuerstein. But he does not otherwise think the two men made any effort to clearly inform him about top management’s part in this mess. Some of Salomon’s regulators later voiced a similar complaint, saying they were told about top management’s dereliction, but in soft, shrouded words that failed to get the point across.
Even so, that left them better off than the public, which in the Aug. 9 press release learned absolutely nothing about management’s having known anything, at any time. In his phone conversation with Feuerstein, Munger sharply challenged the omission. But Feuerstein said that management and its lawyers worried that too much disclosure would threaten the firm’s “funding”–its ability to roll over the billions of dollars of short-term debt that became due every day. So Salomon’s plan was to tell its directors and regulators that management had known of Mozer’s misconduct, but to avoid saying this publicly. Munger didn’t like it, finding this behavior neither candid nor smart. But not considering himself an expert on “funding,” he subsided.
When he and Buffett talked on Saturday, however–with the Salomon story played big on the front page of the New York Times–they resolved to insist on prompt disclosure of the full facts. On Monday, Munger delivered their strong opinions to Gutfreund’s close friend and adviser, Martin Lipton of Wachtell Lipton, and was told that the matter would be discussed at a telephone board meeting scheduled for Wednesday afternoon. Buffett, meanwhile, was talking to Gutfreund, who allowed that just about all the affair meant was “a few points on the stock.”
At the Wednesday board meeting, the directors heard a reading of a second press release, which included three pages of details and a straightforward admission that top management had learned of Mozer’s February transgression back in April. But a sentence that followed sent the directors into a telephonic uproar. It said that management had then failed to go to the regulators because of the “press of other business.” Buffett, listening in Omaha, remembers calling this impossibly lame excuse “ridiculous.” The explanation in the press release was later changed to incorporate the words “due to a lack of sufficient attention to the matter, this determination was not implemented promptly,” another passive-voice specimen slightly less lame but unflinching in its refusal to assign any blame.
“The Atom Bomb”
The real offense of that Wednesday directors meeting, though, was not language but a flagrant omission: Gutfreund’s failure to tell the board that he had the day before received a letter from the Federal Reserve Bank of New York that contained some doomsday words. The letter was signed by an executive vice president of the bank, but anyone reading it would have known that behind it stood 6 feet 4 inches of Irish force and temper, Gerald Corrigan, the bank’s president. Corrigan by then knew enough to have become incensed by these doings on his watch. The letter said that Salomon’s bidding “irregularities” called into question its “continuing business relationship” with the Fed and pronounced the Fed “deeply troubled” by the failure of Salomon’s management to make a timely disclosure of what it had learned about Mozer. It asked for a comprehensive report within ten days of all “irregularities, violations, and oversights” Salomon knew to have occurred.
Buffett learned later that Corrigan expected the letter to be promptly given to Salomon’s directors, whom he believed would just as promptly recognize that top management had to be changed. When the directors didn’t act, Corrigan thought they were being defiant–but instead, of course, they were simply in the dark. Buffett did not hear about any Fed letter until later in the week, when he spoke to Corrigan, and even then Buffett assumed the Fed had only sent a request for information. Buffett did not actually see the letter until more than a month later, after he heard Corrigan refer pointedly to it in congressional hearings.
In Buffett’s opinion, the Fed’s belief that its letter had been ignored stoked the fury with which the regulators came down on Salomon a few days later. There is no shortage, Buffett says, of “vital matters” that Gutfreund, Strauss, and Feuerstein kept from the directors in the previous months, all the while acting as if things were perfectly normal. But not conveying the Fed letter to the board was in his thinking “the atom bomb.” Or maybe, he says, a more earthy description fits: “Understandably, the Fed felt at this point that the directors had joined with management in spitting in its face.”
A “Run” on Salomon
You may reasonably ask what was going on in Salomon’s stock while all of this was transpiring. It was emphatically down, from above $36 per share on Friday to under $27 on Thursday, when the second press release rocked the market. But the stock was only the facade for a much graver matter, a corporate financial structure that by Thursday was beginning to crack because confidence in Salomon was eroding. It is not good for any securities firm to lose the world’s confidence. But if the firm is “credit dependent,” as Salomon was to an extreme, it cannot tolerate a negative change in perceptions. Buffett likens Salomon’s need for confidence to a mortal’s need for air: When the required good is present, it’s never noticed. When it’s missing, that’s all that’s noticed.
Unfortunately, the erosion of confidence was occurring in a company grown enormous. Salomon in August of 1991 had bulged up to $150 billion in assets (not counting, of course, huge off-balance-sheet items) and was among the five largest financial institutions in the U.S. Propping the company on the right-hand side of the balance sheet was–are you ready?–only $4 billion in equity capital, and above that was about $16 billion in medium-term notes, bank debt, and commercial paper. This total of about $20 billion was the capital base that supported the remaining $130 billion in liabilities, most of these short-term, due to run off in one day to six months.
The paramount fact about those liabilities is that short-term lenders have their track shoes on at all times: They have absolutely no enthusiasm for earning an extra fraction of a percentage point in interest if they perceive that their capital is even slightly at risk. Just waving a premium rate in front of them is in fact counterproductive, since it makes them suspect there is hidden danger. Moreover, unlike commercial banks, whose creditors can look to the FDIC or to the “too big to fail” doctrine, securities firms have no declared “Big Daddy” whose mere presence is a deterrent to runs.
So on that Thursday, Salomon began to experience a run. It materialized out of left field in the form of investors who wished to sell this big-league trader and market maker, Salomon, its own debt securities–specifically, the medium-term notes that the company had outstanding. Salomon had always made a market in these securities, but that was ordinarily a yawn, since nobody wanted to sell. But now the sellers poured in. Salomon’s traders responded by lowering their bids, trying to deter the traffic–dying to do that, in fact, because every repurchase of notes they made melted down the capital base that was holding up the whole Salomon structure. Finally, after the traders had bought about $700 million of the notes, Salomon did the unthinkable: It stopped trading in its own securities. That called a halt on the rest of the Street too. If Salomon wasn’t going to buy its own paper, it’s for sure nobody else would.
Gutfreund Falls
That Thursday evening, as newspapers cranked out their stories of the day’s extraordinary events at Salomon–when the teller’s window slams down, there’s no keeping it secret–John Gutfreund and Tom Strauss talked by phone to Gerry Corrigan. Trouble was all around, and in the conversation Gutfreund and Strauss questioned their ability to keep leading Salomon.
The next morning, at 6:45 A.M. Omaha time, Buffett was awakened by a phone call. On the line were Gutfreund, Strauss, and Marty Lipton. Gutfreund said that he and Strauss were resigning, and the question of who was going to take over sort of hung there. Gutfreund later said he asked Buffett to take the job. Buffett thinks he volunteered. He did not in any case nail down anything while at home, but instead said he would call the New Yorkers when he got to his office, five minutes away. Once there, he looked at a just-arrived fax of that day’s New York Times story, whose front-page headlines said:
Wall Street Sees a Serious Threat to Salomon Bros.; High-Level Resignations and Client Defections Feared
And at 7:45 A.M. Omaha time, he called the Salomon group back and said he would take on the job until things got straightened out.
To this day, newspapers report that he went in to protect Berkshire’s $700 million, but that seems awfully simplistic. Sure, he wished for the safety of that investment. But beyond that, he was a director of a company in deep trouble and, in a way that few directors do, he felt an obligation to all of its shareholders. In addition, he had a job–CEO of Berkshire– that he could for a while run with one hand while picking up trouble in the other, and for the $1 a year he earned at Salomon, he didn’t need to waste time working out an employment contract. Okay, he knew he was changing his life, and not for the better. “But somebody had to take this job,” he said then and has said since, “and I was the logical person.”
On that Friday morning, Buffett made immediate plans to fly to New York. But the group from Salomon had asked him to stay at his office to await a call from Corrigan, and it was slow in coming. While Buffett waited, the stock market opened–but trading in Salomon stock did not. Then came the call from Corrigan. It was short and contained word that he was willing to let up a little on “the ten-day schedule” now that Buffett was entering the picture. Not having seen the Fed’s letter, Buffett didn’t have a clue what Corrigan was talking about, but grasped from the context that the Fed must be asking for information. When the conversation ended, Buffett flew to New York, arriving there around 4 P.M. By that time, Salomon had released the news that he was becoming interim chairman, and the New York Stock Exchange had opened up trading in the stock. In its brief exposure to the light, the stock traded heavily and moved up a dollar, closing just under $28.
Buffett’s own exposure that day included an evening meeting with Corrigan at the Fed’s office. Gutfreund and Strauss went too, and the three men stepped into a session totally devoid of the cordiality that normally greets Buffett. Corrigan said soberly that he hadn’t found that interim chairmanships worked well; warned Buffett that he should not attempt to get around Corrigan by seeking help from “Washington friends”; and, in a dire but mysterious comment, told Buffett to prepare for “any eventuality.”
Then he asked Buffett to step out while he talked privately to Gutfreund and Strauss, two men who had long been–past tense needed here–friends of his. When the two emerged, Gutfreund told Buffett that Corrigan had emotionally expressed his personal regrets about the part he was playing in ending their careers. Gutfreund, iron tough to the end, angrily dismissed the incident when talking to Buffett, saying he wasn’t about to grant Corrigan “absolution.” Today, Buffett, recalling those strange moments, remembers also that George Washington cried as he signed the death warrant of Major Andre, a British spy. But like Corrigan, he signed.
Tough Decisions
For Buffett, the rest of Friday and all of Saturday were given over to crucial operating decisions. One obliged him to address the fate of John Meriwether, who had sped to tell his bosses about Mozer’s misdeeds when he learned of them but then had willingly or unwillingly got caught up in the web of nondisclosure. Marty Lipton, terribly visible in these crisis days, wanted Meriwether fired, and so did a good many members of the management committee, who were clawing for anything that might save the firm.
But Buffett, unclear that it was fair to fire Meriwether, kept searching for more understanding of what had truly happened after April. He gained some knowledge on Saturday, when two Wachtell Lipton lawyers spent more than an hour telling Buffett and the surviving members of Salomon’s management committee what they had learned in their investigation, which had begun in early July. Then, late on Saturday, the Meriwether question became moot, because he himself decided it was best that he resign.
The still bigger decision facing Buffett was determining which member of Salomon Brothers’ executive group would become the new head of the securities operation, now losing its two bosses, Gutfreund and Strauss. So on Saturday, at Wachtell Lipton’s offices, Buffett talked serially to about ten members of Salomon’s management committee, asking each man whom, among this group, he thought most qualified to run the business. The great majority said Deryck Maughan, then 43, who had recently returned from running Salomon’s Tokyo office and been made co-head of investment banking. Maughan himself had a subtle answer: “I think that when you ask many of the others whom they want, you’ll find it’s me.” Buffett knew also that Gutfreund thought the choice should be Maughan. So Buffett identified his man that day. But he held off telling both Maughan and the world because the Salomon board–ready to meet in emergency session at 10 A.M. on Sunday, Aug. 18–needed to ratify the decision and indeed to elect Buffett himself.
A New Crisis
Had the whole regulatory establishment slept through that weekend, the board meeting would still have been a landmark event. But as it was, on Saturday Salomon’s regulators were putting the finishing touches on a guided missile. It hit Salomon’s offices in downtown Manhattan just before 10 A.M. on Sunday, by way of a phone call from the Treasury saying that in a few minutes it would announce that Salomon was to be barred from bidding at Treasury auctions, both for its own account and for customers.
Buffett got the message in a small room where he was talking with a handful of people, including two, Gutfreund and Strauss, who were set to offer their resignations at the meeting. The three men immediately concluded that the news would put Salomon out of business–not because of the economic loss that would be sustained because of the Treasury’s lockout, but because the world would interpret the news as TREASURY TO SALOMON: DROP DEAD. Furthermore, this blow would fall on a company already staggered by credit problems and just barely hanging on.
Nor was there time to maneuver: Word had already gone out that Buffett would appear at a 2:30 P.M. press conference, and a crowd of journalists was expected. Worse than that, the tyranny of a worldwide market was bearing down on the firm. The Japanese market would be opening in the late afternoon, and then London, and then New York. Bad news would cascade from one market to the other and center on just one thought: Salomon’s credit is shot. In a firm dependent on credit, other thoughts didn’t matter anyway. This one alone would destroy the company.
In the small room where they got the news, Buffett and the others huddled to consider their options. They saw three possible courses of action. First, get the Treasury to rescind or at least modify the ban. Second, put on a brave face, spout confident statements, and hope that the world would buy the act–or, in other words, lie. Third, liquidate by declaring bankruptcy, hoping thereby to fail honorably, minimize the damage, and spread its effects equitably among Salomon’s creditors.
The second strategy got ditched almost before it was articulated. The other two lived and were pursued simultaneously. That meant bankruptcy lawyers needed to be called in. A team was summoned from Wachtell Lipton and put to work investigating how a mammoth international securities firm goes bankrupt, on a Sunday, possibly needing some judge, yanked from watching baseball and eating popcorn, who might suspect that a careless typist had added an extra zero to that figure of $150 billion, and who would in any case probably never have heard of a derivative or repos or fails to deliver. In short, the bankruptcy filing, if things came to that end, was going to be a nightmare.
In a personal sense, it would have been that for Buffett also. His job description was on the verge of drastic changes that would leave him no reason for being there: He had come to save Salomon, not to escort it through the endless process of bankruptcy. All manner of people could do that job, he told himself.
So early on that Sunday, Buffett concluded that he would refuse election if bankruptcy ensued. He did not, however, kid himself about the furor that would follow, since he knew that his exit would be viewed as the abandonment of a sinking ship or, worse yet, as the very cause of its going down. Buffett had long told his three children that it takes a lifetime to build a reputation but only five minutes to tear it down. As he moved along through Sunday, he told himself he might be edging up on the five minutes.
But that did not short-circuit a ton of energy he was putting into Plan A: getting a reversal of the ban. Buffett assigned himself to calling the Treasury and also talked once that day to Fed Chairman Alan Greenspan. Gutfreund and Strauss were put on the job of finding Corrigan, who proved hard to reach. Meriwether, lending help, was told to track down Richard Breeden, chairman of the SEC. That thrust turned out to be a total nonwinner. Breeden, once Meriwether got him, said he had participated in the Treasury’s decision, pronounced Salomon “rotten to the core,” and said it would get no help from him.
On the Treasury front, logistics dealt an early blow. When Buffett tried almost immediately to call back the Treasury official who had delivered the awful message, the line was busy. The phone company agreed to interrupt the call, but there was confusion and error and delay. By the time Buffett actually got through to the Treasury spokesman, the announcement of the Treasury ban had hit the wires and gone flashing around the world.
The Most Important Day
The Treasury spokesman then got Secretary of the Treasury Nicholas Brady, at that moment visiting Saratoga Springs, N.Y., for the horseraces, to call Buffett. The two men had been friendly acquaintances over the years but could hardly have imagined they would be facing off on this Sunday morning. His voice cracking with emotion and strain, Buffett made his case, telling the Secretary that Salomon could not cope with the Treasury ban and that it was bringing in bankruptcy experts to prepare for a possible filing. Buffett stressed Salomon’s gargantuan size and the worldwide nature of its business. He predicted that a Salomon bankruptcy would be calamitous, having domino effects that would reach worldwide and play havoc with a financial system that subsists on the idea of prompt payments.
Doomsday scenarios are not easy to get across. Responding, Brady was friendly and empathetic but inclined to think this talk of bankruptcy and financial meltdowns was far-fetched. He could not imagine Buffett refusing to take the job or failing in its execution. Brady was also highly aware of where things stood: The announcement had gone out, and reversing it would be an enormous problem.
But to Buffett’s enormous relief, Brady did not cut off the dialogue. Instead, he went off to make some calls and then kept getting back to Buffett. In one of the stranger details of the day, Buffett talked on Salomon phones that had been programmed not to ring but instead flashed a tiny green light when someone was calling. For longer than he cares to remember, Buffett stared at the telephone, waiting for the Secretary of the Treasury to create light. With each call, Buffett tried to make Brady realize the seriousness of the situation and his sense that they were rocketing along on a train that had to be stopped–but that could be, once everybody realized that this was an accident that mustn’t be allowed to happen. At one point in the Brady conversations, all of Buffett’s anguish and sense of futility got jammed into a single sentence: “Nick, this is the most important day of my life.” Brady said, “Don’t worry, Warren, we’ll get through this.” But that didn’t mean at all that he had changed his opinions.
It took Corrigan’s entrance into the telephone calls in the afternoon to make a difference. This was the man who told Buffett to prepare for “any eventuality” and defined his term by endorsing the ban. But Corrigan now listened hard and seemed to assign credence to Buffett’s talk of bankruptcy and of his personal plans to leave were a filing to come. Said Corrigan to Brady and another regulator on the phone with them: “We better talk among ourselves.” Buffett went back into the boardroom and waited with the other directors. Six floors below, over 100 reporters and photographers, this author among them, were gathering for the 2:30 press conference. Directly outside the boardroom, some of the managing directors that Buffett had interviewed on Saturday were milling around, summoned because one of their number was to be named operating head of Salomon.
And then, just at 2:30, Jerome Powell, an Assistant Secretary of the Treasury, called Buffett to read a statement the Treasury was ready to go with. It was effectively half a loaf, or maybe two-thirds, saying that the ban on Salomon’s bidding for its own account was lifted while the ban on bidding for customers’ accounts remained. “Will that do?” asked Powell. “I think it will,” answered Buffett. The board then raced through electing Buffett as interim chairman of Salomon Inc. and Deryck Maughan as a director and operating head of Salomon Brothers. Buffett found Maughan and said, “You’re tapped,” and the two went down to the press conference, entering at 2:45.
The start was abrupt: “I’m Warren Buffett, and I was this afternoon elected interim chairman of Salomon Inc.” A few minutes later he was into the just-released Treasury announcement, which he read aloud. When he finished, there were muffled cheers from the back of the auditorium and a scrambling of feet as employees ran with the lifesaving news. Buffett then moved into more than two hours of questions. “How will you handle needing to be both here and in Omaha?” he was asked, and the answer popped right back: “My mother has sewn my name in my underwear, so it’ll be okay.”
A Final Payoff
On Monday, the headlines didn’t say DROP DEAD; they took in the reversal as well as the ban. Salomon’s stock opened on time and traded in orderly fashion, falling about a point and a half.
Pointing out a paradox, Buffett says today that the whole Treasury episode, excruciating though it was at the time, probably gave Salomon a boost that it could not have got any other way. The reversal, coming along at 2:30 P.M., sent a message to the market that this almighty regulator, the Treasury, thought Salomon was okay. Had not that endorsement materialized, Monday’s debt markets would have been forced to make their own determination about Salomon’s creditworthiness, and who knows what kind of thoughts they would have pulled from the ether.
As it was, Salomon emerged from that weekend with just enough stamina to limp through some exceedingly tough months, in which the interim CEO reduced leverage by vastly shrinking the balance sheet, haggled with banks about money Salomon badly needed, and hoped above all else that Mozer’s wrongdoing (which cost him nearly four months in prison after he pleaded guilty to lying to the Fed) would not entrap Salomon itself in criminal charges. In the end, the company settled for $290 million, an outcome mainly reflecting the extraordinary cooperation Buffett decreed should be given both regulators and the law in getting things cleaned up.
A big broom in this cleanup was a California lawyer who had worked often for Berkshire, Robert Denham, and whom Buffett pulled into Salomon full-time. When May of 1992 rolled around, with many of Salomon’s biggest problems under control, Buffett went back to Omaha, and Denham stepped into his place as chairman of Salomon Inc. and overseer of the shareholders’ interests. Having now overseen these folk into $9 billion of Travelers stock, Denham will be stepping on to something else.
And Berkshire’s part of the $9 billion? It’s about $1.7 billion, though some of the Travelers stock Berkshire will receive is committed to holders of a Berkshire convertible bond. About that complication you do not wish to know more, nor do you wish to deeply analyze other acrobatics that Buffett has carried out with Salomon stock. Just note this: a share of Salomon is right now worth about $81 in Travelers stock. Against that, Berkshire owns some Salomon stock that it bought in 1987 at an effective price of $38, and it owns other Salomon shares purchased later at an average price of about $48.
In short, Buffett said in 1987 that Salomon wouldn’t be “a triple,” and it hasn’t been. On the other hand, this record hardly equates to a strikeout. “I’d say we hit a scratch single,” says Buffett, “but not before the count got to 0 and 2.”
And then inching oh-so-slightly toward a philosophical summary of Salomon, he hauls out one of his favorite expressions: All’s well that ends.
Two Views; Zero Pay
In Salomon’s chaotic weekend of Aug. 16-18, 1991, outgoing CEO John Gutfreund was unstintingly helpful in trying to ease the transfer of power and combat the dangers of Sunday. But he was also worried about his economic future. So on Saturday, his lawyer, Philip Howard, tried to get some sort of assurances out of Buffett and Munger as to what Gutfreund’s severance package would be. Buffett and Munger had no real stomach for this discussion on that incredibly tense and busy day, but they thought Gutfreund deserved the courtesy of a hearing. Later, though, it turned out that the two sides disagreed on what, if anything, was decided that night. The point is important not only because of what eventually was decided about Gutfreund’s compensation but also because it illustrates how memories and perceptions differ when events are dramatic and strung out, as they were at Salomon in 1991. You can say this in other words: This article that you have been reading mainly describes how Buffett saw events; a Gutfreund account of the same period would be different.
In the compensation talks on that Saturday, Howard says he and Munger came to an understanding that Munger and Buffett would support severance of $10 million to $15 million. Munger and Buffett say they refused to commit to any figures at that point. Ultimately they agreed with the board’s determination to offer $8.6 million. Gutfreund was offended by this amount, and refused. The dispute then became a New York Stock Exchange arbitration case, put before a panel of three experienced Wall Streeters. Gutfreund asked for $55 million. The arbitrators decided to give him nothing–not a cent.
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