Sunday, May 1, 2011

Observations from Omaha

The annual meeting and "rally" of Berkshire Hathaway is probably the event most covered by the world’s financial press. The following observations are without the benefit of reading other people's impressions. Further, I should disclose that I have been a long-term shareholder of the company and the stock is also held in the private financial services fund that I manage.

Compliance awareness

I came away from the meeting with a concern that in terms of personal behavior, the company’s culture did not sufficiently produce an awareness of the potential violations of good corporate practice. I am pleased that the audit committee did conduct a careful review of the facts and concluded that there were a series of violations. What is not clear to me is whether any changes have been put in place in terms of appropriate conduct with investment bankers. In my judgment, one should not use investment bankers as, in effect, personal investment advisors. That senior operating officers earn very substantial compensation from the success of their specific operations does not appear to be enough of a constraint on their personal investment urges. I do not view what happened in connection with the acquisition of Lubrizol as a fatal flaw, but as an area for improvement.

Succession discount

There are a number of companies that are led by what are viewed as unique individuals, e.g. Apple. Long-term investors are concerned as to who will replace the great leader. This is particularly true with a CEO of eighty years young. The stock price of Berkshire, in my opinion, already reflected a discount for this uncertainty. The publicity around Mr. Sokol for the last two years through this weekend, has added to this discount. From a shareholder's viewpoint, this widening of the discount is a much bigger penalty than any short-term trading profits that have been forgone.

Earnings drivers

Berkshire-Hathaway has more than seventy different operating businesses that are wholly-owned and another one hundred forty that are partially-owned. However, the earnings, book value and thus the stock price, will be principally driven from three operating activities and Berkshire’s investment portfolio.

The largest operating activity is the insurance group. Due to a record amount of severity from natural disasters such as the recent tornadoes in the US, these activities are likely to break-even this year. Next year the severity of losses could very well be materially less. Often after a year such as the present, premiums are raised to restore the industry's balance sheet capacity. The second major earnings driver is likely to be the railroad, whose freight volume will probably increase as the economy rebounds. The railroad has significant operating leverage and because of the way Berkshire bought the company, it has some additional financial leverage. The third major operating driver is the utility group which is another high fixed-cost operation, with both financial and operating leverage. Both rail and utility activities have significant profit guarantees built into their pricing structures. Thus, in terms of certainty, these two drivers are almost like bonds. The combination throws off a prodigious amount of cash which allows and requires the investment portfolio to find attractive places to invest, which may well be overseas. Bottom line, I believe that the long-term value of the company will continue to grow faster than the global economy, as reflected in the S&P500.

Other observations

Often there is more wisdom in Charlie Munger's laconic answers than Warren's longer non-answers. To me, the silence was deafening on BYD, their investment in the Chinese battery maker and auto producer, even though BYD’s vehicles were on display. Finally from a biased point of view, for sometime in the future Berkshire Hathaway will have a significant investment in financials. Berkshire owns shares in Wells Fargo and US Bank and it admires Bob Wilmer of M&T Bank. The new internal investment manager comes from a background in financial services regulation; the last portfolio that I saw contained significant investments in some of the types of names in a typical financial services fund.

Other opinions

Some of our blog community were probably at the meeting and many others will have views of the meeting and the stock. Please share some of these with me via email.


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