Why Buffett prefers minority stake to entire company?

Shareholder Letter

Preference for minority stakes

If you are familiar with Buffett’s important shareholding companies and the history of mergers and acquisitions, you should find that Buffett’s investment career has the following commonality when investing in extremely promising large-scale listed companies:

  • Preference for investing in minority stakes rather than buying entire businesses to gain control.
  • The companies bought by Buffett are usually private companies, and there are few large-scale listed companies, because the cost of acquiring large-scale listed companies is too high. I mentioned this part in the section “Type 6″ Past M&A Cases of the Same Industry: Precedent Transaction Analysis Method” on page 353 of the book “The Rules of Super Growth Stocks Investing” 5-1: “If you want to obtain a controlling stake in the company, you have to pay Higher premium. This is also why Buffett, who advocates value investing, prefers to only buy a minority stake in an excellent company he likes unless the seller actively asks for a sale.
  • Concentrated investment, large sums of money bet on promising companies.
  • The most common minority percentage is 5%, and it’s easy to see why, since such a percentage does not require SEC approval.

In his 1981 letter to shareholders, Buffett detailed his preference for acquiring “substantial minority stakes” in good companies rather than “acquiring entire companies.”

As our history indicates, we are comfortable both with total ownership of businesses and with marketable securities representing small portions of businesses. We continually look for ways to employ large sums in each area. (But we try to avoid small commitments – “If something’s not worth doing at all, it’s not worth doing well”.) Indeed, the liquidity requirements of our insurance and trading stamp businesses mandate major investments in marketable securities.

Tax considerations

In his 2000 letter to shareholders, Buffett reiterated his “preference for buying entire companies rather than fractions”:

Many people assume that marketable securities are Berkshire’s first choice when allocating capital, but that’s not true: Ever since we first published our economic principles in 1983, we have consistently stated that we would rather purchase businesses than stocks. (See number 4 on page 60.) One reason for that preference is personal, in that I love working with our managers. They are high-grade, talented and loyal. And, frankly, I find their business behavior to be more rational and owner-oriented than that prevailing at many public companies.

But there’s also a powerful financial reason behind the preference, and that has to do with taxes. The tax code makes Berkshire’s owning 80% or more of a business far more profitable for us, proportionately, than our owning a smaller share. When a company we own all of earns $1 million after tax, the entire amount inures to our benefit. If the $1 million is upstreamed to Berkshire, we owe no tax on the dividend. And, if the earnings are retained and we were to sell the subsidiary ¾ not likely at Berkshire! ¾ for $1 million more than we paid for it, we would owe no capital gains tax. That’s because our “tax cost” upon sale would include both what we paid for the business and all earnings it subsequently retained.

Contrast that situation to what happens when we own an investment in a marketable security. There, if we own a 10% stake in a business earning $10 million after tax, our $1 million share of the earnings is subject to additional state and federal taxes of (1) about $140,000 if it is distributed to us (our tax rate on most dividends is 14%); or (2) no less than $350,000 if the $1 million is retained and subsequently captured by us in the form of a capital gain (on which our tax rate is usually about 35%, though it sometimes approaches 40%). We may defer paying the $350,000 by not immediately realizing our gain, but eventually we must pay the tax. In effect, the government is our “partner” twice when we own part of a business through a stock investment, but only once when we own at least 80%.

Substantive interests

Our acquisition decisions will be aimed at maximizing real economic benefits, not at maximizing either managerial domain or reported numbers for accounting purposes. (In the long run, managements stressing accounting appearance over economic substance usually achieve little of either.)

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

The purpose of mergers and acquisitions

However, we suspect three motivations – usually unspoken – to be, singly or in combination, the important ones in most high-premium takeovers:

  • (1) Leaders, business or otherwise, seldom are deficient in animal spirits and often relish increased activity and challenge. At Berkshire, the corporate pulse never beats faster than when an acquisition is in prospect.
  • (2) Most organizations, business or otherwise, measure themselves, are measured by others, and compensate their managers far more by the yardstick of size than by any other yardstick. (Ask a Fortune 500 manager where his corporation stands on that famous list and, invariably, the number responded will be from the list ranked by size of sales; he may well not even know where his corporation places on the list Fortune just as faithfully compiles ranking the same 500 corporations by profitability.)
  • (3) Many managements apparently were overexposed in impressionable childhood years to the story in which the imprisoned handsome prince is released from a toad’s body by a kiss from a beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the profitability of Company T(arget).

Institutional Imperative

The above three points are actually “bad habits of corporate”, and a more professional term is “undocumented rules of corporate”. In Berkshire’s shareholder letter in 1989, Buffett also listed several typical examples of unspoken corporate rules. For the unspoken rules of corporate, please refer to my previous article “Institutional imperative – the good, bad, and ugly

Price-raising power and inflation-resisted

Such optimism is essential. Absent that rosy view, why else should the shareholders of Company A(cquisitor) want to own an interest in T at the 2X takeover cost rather than at the X market price they would pay if they made direct purchases on their own?

In other words, investors can always buy toads at the going price for toads. If investors instead bankroll princesses who wish to pay double for the right to kiss the toad, those kisses had better pack some real dynamite. We’ve observed many kisses but very few miracles. Nevertheless, many managerial princesses remain serenely confident about the future potency of their kisses – even after their corporate backyards are knee-deep in unresponsive toads.

In fairness, we should acknowledge that some acquisition records have been dazzling. Two major categories stand out.

  • The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.
  • The second category involves the managerial superstars – men who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise. We salute such managers as Ben Heineman at Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at National Service Industries, and especially Tom Murphy at Capital Cities Communications (a real managerial “twofer”, whose acquisition efforts have been properly focused in Category 1 and whose operating talents also make him a leader of Category 2). From both direct and vicarious experience, we recognize the difficulty and rarity of these executives’ achievements. (So do they; these champs have made very few deals in recent years, and often have found repurchase of their own shares to be the most sensible employment of corporate capital.)

People-dependent is too risky

Currently, we find values most easily obtained through the open-market purchase of fractional positions in companies with excellent business franchises and competent, honest managements. We never expect to run these companies, but we do expect to profit from them.

We expect that undistributed earnings from such companies will produce full value (subject to tax when realized) for Berkshire and its shareholders. If they don’t, we have made mistakes as to either:

  • (1) the management we have elected to join;
  • (2) the future economics of the business; or
  • (3) the price we have paid.

We have made plenty of such mistakes – both in the purchase of non-controlling and controlling interests in businesses. Category (2) miscalculations are the most common.

minority stake

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