Warren Buffett’s Five Most Dangerous Words in Business

“Everybody else is doing it.”

Inspired by recent option backdating scandals, and the criminal leak investigation at Hewlett Packard(HPQ), Warren Buffett sent out a memo to his top managers at Berkshire Hathaway(BRKA), reminding them of the importance of ethical behavior. Buffett said that while bad behavior is inevitable,

we can have a huge effect in minimising such activities by jumping on anything immediately when there is the slightest odour of impropriety… Berkshire’s reputation is in your hands

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A lot of banks and insurance companies have suffered earnings disasters after relying on that rationale. Even worse have been the consequences from using that phrase to justify the morality of proposed actions

Buffett acknowledged that “everybody else is doing it” is a “seductive argument”, but said use of the phrase should be a “huge red flag”.

Despite some bad press resulting from General Re’s sale of “earnings smoothing” reinsurance products that didn’t invlove a real transfer of risk, Buffett has a well-deserved reputation as an ethical businessman, and one whose track record doesn’t seem to have been hurt by his unwillingness to do anything he wouldn’t feel “comfortable about being printed on the front page of our local paper.”

Buffett made use of a similar policy when he briefly became CEO of Salomon Brothers in the wake of a scandal that threatened to sink the firm. Unfortunately, too many others base their behavior on what they feel they can get away with. The Hewlett Packard board is a case in point. Even after details of the scandal came to light, they allowed Patricia Dunn to remain on the board. Though Dunn finally resigned, the board members who showed such terrible judgement are still there.

Investors should follow Mr. Buffett’s lead. Companies that behave well should be assigned a valuation premium; those that don’t get it, like Hewlett Packard, should be trading at a discount to compensate for the risk of future scandals.