Warren Buffett: Investing Lessons from the ‘Frozen Corporation’: Avoid Value Traps

During the 1998 Berkshire Hathaway Annual Meeting, Warren Buffett discussed Ben Graham’s ‘frozen corporations’ and why they should be avoided. Here’s an excerpt from the meeting:

WARREN BUFFETT: Well, we discount at the long rate just to have a standard of measurement across all businesses. But we would take the company that is spending the money as it comes in, and they don’t get credit for gross cash flow, they get credit for whatever net cash is left every year.

But of course, if they’re spending the money wisely, even though you have to discount it for more years, the growth in cash development should offset that or they weren’t investing it wisely.

The best business is one that gives you more and more money every year without putting up anything to get it, or very little. And we’ve got some businesses like that.

The second-best business is a business that also gives you more and more money. It takes more money, but the rate at which you invest — reinvest — the money to get that growth is a very satisfactory rate.

The worst business of all is the one that grows a lot, and where you’re forced — forced, in effect — forced to grow to stay in the game at all, and where you’re reinvesting the capital at a very low rate of return. And sometimes people are in those businesses without knowing about it.

But in terms of discounting, in terms of calculating intrinsic value, you look at the cash that is expected to be generated and you discount back at — in our case, we use the long-term Treasury rate. That doesn’t mean that you pay the amount that that present value calculation leads to, but it means that you use that as a common yardstick, that Treasury rate.

And that means that if somebody is reinvesting all their cash flow the next five years, they’d better have some very big figures coming in down the road. Because at some day, a financial asset has to give you back cash to justify you laying out cash for it now.

Investing is the art, essentially, of laying out cash now to get a whole lot more cash later on, and something at some point better deliver cash.

Ben Graham in his class, we used to talk about what he called the Frozen Corporation. And the Frozen Corporation was a company whose charter prohibited it from ever paying anything to its owners, or ever being liquidated, or ever being sold and —

CHARLIE MUNGER: Sort of like a Hollywood producer. (Laughter)

WARREN BUFFETT: Yeah. And the question was, what was such an enterprise worth? Well, that’s sort of a theoretical question, but it forces you to think about the realities of what business is all about. And business is all about putting out money today to get back more money later on.

You can watch the entire discussion here: