NOT ONLY DO INVESTORS hang on Warren Buffett's every word, they spend countless hours trying to read between the lines. Over the past three years Lawrence A. Cunningham, 35, a professor at Yeshiva University's Cardozo School of Law in New York City, has gone one step further: He has compiled and distilled 20 years of Buffett's annual letters to Berkshire Hathaway shareholders. The result: The Essays of Warren Buffett: Lessons for Corporate America (Cardozo Law Review, $14.95).
Buffett himself called the book a "superb job." Here, Cunningham tells why he went to the effort.
FORBES: Why is a law professor interested in the letters of Warren Buffett?
I'm a corporate governance scholar. There's an intersection between law and government [which is] where I write and teach. Buffett's essays are full of profound wisdom on governance and related themes.
Most chief executives brush the owners off with a few clichs. Why does Buffett go to all this trouble?
The reason is precisely that he would want this kind of letter written to him. He wants the people who have entrusted their wealth to him to know how he thinks about allocating their capital. He wants them to understand what his choices and tradeoffs are and how he goes about choosing among them.
Why did you, an academic, put this collection together?
I'd like to have finance professors teach students about fundamental valuation analysis again, rather than about modern finance theory.
[Modern finance theory teaches] that you're better off throwing darts rather than spending time thinking about whether investment opportunities make business sense.
Efficient market theorists tell you that price is the same as value.
Buffett thinks markets are somewhat efficient but not perfect. He quots Ben[jamin] Graham [Buffett's teacher and mentor] on that point: That in the short run stock markets are voting machines; in the long run they're weighing machines.
On a daily basis, Graham taught, people are expressing hopes and fears. But over a long period of time, the voting will be corrected and the gap between price and value will narrow.
We've had a bull market for 15 years. This isn't Ben Graham's world, is it?
Graham would say we're just experiencing a phase where there is an extraordinary amount of greed, and a mind-set of endless prosperity.
What Graham wouldn't understand -- what would be totally unrecognizable to him -- is the degree to which fashionable academics think that these emotions have been purged from the market process, that the market is getting it right every day and that price and value are functionally identical.
You went through 20 years of Buffett's essays. Has his thinking changed?
Very, very little. There are a couple of examples of evolution, but it's quite incremental and the foundation is permanent. It's fundamental valuation analysis.
I doubt Ben Graham would have bought and held stocks like Coca-Cola that sell for more than 40 times earnings and a huge premium to book value.
Graham was very rigid in thinking about value and very quantitative in his approach. Over time, in part with the guidance and goading of [Berkshire Hathaway Vice Chairman] Charlie Munger, Buffett has accepted harder-to-measure meanings of value, like management integrity and ownership orientation, product strength and brand recognition, which are harder to quantify.
Munger is a high-powered brain. They help each other -- a productive dialogue that stimulates thought and learning -- but with the same core philosophical base.
Insisting as he does on value, Buffett has almost no tech stocks.
Buffett quots [IBM founder] Thomas Watson: "I'm only smart in spots --
but I stay around those spots." Buffett defines his circle of competence pretty narrowly. He admires and respects [Intel's] Andy Grove and [Microsoft's] Bill Gates, but he says he doesn't understand their products well enough to form a valuation judgment.
Buffett criticizes the practice of granting huge stock options to managements. But isn't this a way to align management interests with those of shareholders?
Options are very different from ownership. The manager becomes an owner if things go well, but if things go badly, he or she suffers not at all. A second criticism is that option granting tends to be unrelated to real business performance.
At Berkshire, they pay bonuses in cash, based on performance of areas under managerial control.
Buffett is scathing on the measurement of Earnings Before Interest, Taxes and Depreciation [EBITD], calling it "an abomination."
[He recognizes that] depreciation is a real economic cost. So when you say: "Let's just look at the cash flows," you're ignoring an important part of the cost of maintaining your competitive position.
EBITD was, in part, a way to approve loans that did not make good economic sense.
Another Buffett peeve is zero coupon bonds.
In the beginning they made sense as a way to lock in a return. The trouble is it becomes easy for weaker credits to load up on debt. That's why he says of zeroes: "What the wise do in the beginning, fools do in the end."
What's it tell us, that he bought zero Treasurys and silver?
That it's hard to find equity investments where there is a margin of safety these days, [but] it's a mistake to wonder why Buffett did this or that. People should concentrate on the core principles of fundamental analysis. Graham's most profound investment insight was the "margin of safety" principle, which said: Never buy a security unless the price is substantially lower than the value.
I guess this explains why he isn't buying many new stocks, even though he doesn't think the market overall is overvalued. He just can't find that margin of safety.
Graham said that the three words that are key to investment success are "margin of safety." Buffett still thinks those are the right three words.