In one sentence: The last of three episodes on Buffett's 2016 letter covers why insurers and banks sit outside most circles, why Buffett distrusts EBITDA and "adjusted" earnings, and how pressure to hit quarterly numbers pushes managers toward cheating.
Key ideas
- Why read the letters. Phil suggests one a month; they run about 30 pages and are candid, even self-critical. Danielle says the letter is full of opinion, which most CEO letters lack. [02:00–06:00]
- Your choices as an investor. Buffett expects his estate to go into an index fund, because very few professionals have the patience and integrity he has. Phil says growth in assets under management makes beating the market harder, and he counts maybe 40 people who have done it for decades. [03:00–05:30]
- Leave insurers and banks until later. Danielle found the insurance section fascinating. Phil's caution: it is very hard to see what risk an insurer or a bank has taken on (loss reserves, derivatives), so wait unless it's your field. [06:00–09:00]
- A moat should be stated. Buffett says Geico has a low-cost moat. If a company's 10-K and CEO can't point to its moat, there may not be one, so don't invent one. Look for six-inch bars. [09:00–10:30]
- Why Buffett avoids EBITDA. Interest and taxes are real costs, and so is depreciation, because assets need replacing. Burlington Northern writes off about $2.1B a year but spent $8.9B in one year on plant and equipment, per Phil. Treating D&A as unreal flatters the numbers. [10:30–15:00, 19:00–20:30]
- But goodwill amortisation can be artificial. Phil explains that on acquisitions, goodwill (price above book value) must be amortised even if the business gains value, e.g. See's Candies, bought for $25M and now making about $65M of free cash a year (Phil's figures). [16:00–18:30]
- Understand the business to read the numbers. GAAP can mislead either way, so the first Munger filter protects you. [20:00–21:00]
- Adjusted earnings make Buffett nervous. Management should explain unusual items good or bad. Regularly waving away real costs with "adjusted" figures breeds a culture of flattering numbers, and insurers that under-reserve have been wrecked this way (paraphrased from the letter). [22:00–24:00]
- Pressure to make the numbers. Phil's Frame Technology story: a CEO and his team resigned for making up a quarter. Danielle notes that hired CEOs face a fireable offence. Business is unpredictable, so a Wall-Street-focused CEO is tempted to fudge. [24:00–28:00]
- Vote your money. Phil says individuals and pensions own most of the market (he gives 85%) and can refuse to fund firms that behave this way, since regulation won't fix it. [27:00–29:30]
How it maps to RuleOne
- The screen uses owner earnings and free cash flow, not EBITDA, which is Buffett's point in practice. Capex versus depreciation is visible on the stock pages' cash flow data.
- The management filter (m3) uses letters and calls as evidence, and a CEO who leans on adjusted figures is a red flag.
- Banks and insurers are a natural "too hard" pile unless you have a real edge.
Buffett, Munger and Graham links
- Berkshire 2016 letter, on EBITDA and on adjusted per-share earnings. Buffett's long-running objection to EBITDA is also in his 2000 letter ("Does management think the tooth fairy pays for capital expenditures?"). Paraphrased here.
- Buffett and Munger on the "institutional imperative" and on managers who always "make the numbers": 1980s-1990s letters; the 1999 letter on "earnings management" is a good starting point.
- Graham, The Intelligent Investor, on reading accounts sceptically, chapters 11–12.
Words to know
- EBITDA: earnings before interest, taxes, depreciation and amortisation.
- Depreciation / amortisation: spreading the cost of an asset (or an acquired intangible) over its life; non-cash in the year but often a proxy for real replacement spending.
- Goodwill: the premium paid above book value in an acquisition.
- GAAP: the standard US accounting rules.
Try this
On /stock/TICKER/ for any capital-heavy company, compare capex to depreciation across ten years. If capex is far above depreciation, ask whether EBITDA would have hidden that.
Check yourself
- Why does Buffett dislike EBITDA?
Answer
It ignores depreciation, but assets wear out and must be replaced with real spending, so it overstates profit. - Why should a beginner avoid insurers and banks?
Answer
Their risks are hidden in reserves and loans, so they are hard to judge from outside. - What cultural problem does heavy use of "adjusted earnings" suggest?
Answer
A focus on pleasing Wall Street that tempts subordinates to bend the numbers.
Short quotes
"Bad behaviour is contagious." (Phil reading Buffett's letter, ~23:30, auto-transcribed, paraphrased)