Sunday, May 6, 2012

Lessons from Omaha and Louisville


On Saturday there were two iconic events occurring in the heartland of America. In Louisville there was the 138th running of the Kentucky Derby, America's most famous horse race for three year olds. As regular readers of these blogs may remember, despite graduating from Columbia University, I count my two most important learning experiences the analysis of thoroughbred horses and my experience in the U.S. Marine Corps. One of the things that I learned from handicapping races was to select races that I could assess the critical elements of picking winning bets with some confidence. In terms of this year's Derby, the appropriate statement is, “I did not have a horse in that race.” There were 19 horses running. That the first two horses to finish had the smallest odds of 5 to 1 and 2 to 1, indicates that the betting crowds lacked confidence in their choices. (Often winning favorites have odds of 1 to 1 or lower.) The inability to pick winners and the lack of confidence shown by the crowd (or if you prefer, the market) are similar to the lessons learned at Berkshire Hathaway's (BRK-A),(BRK-B)annual meeting celebration.

The warm up

My wife Ruth and I were privileged to attend the Friday night dinner hosted by Charlie Munger for his large family and his friends, (mostly from his days of living in Omaha) and other well wishers. For those who don't know Munger, he has been Warren Buffett's business partner for at least 47 years. His training as a leading attorney combined with a wonderful laconic delivery of encapsulated logic has been something of a control rod to Warren Buffett's natural enthusiasm. Keeping with his tradition of few words, his remarks were brief and to the point and can be summarized as follows:

  1. The decision as to the successor to Buffett is probably the most important decision of Warren’s life and probably will be one of his best.

  2. For Berkshire-Hathaway, making the second $200 billion will be easier than making the first $200 billion.

  3. The managers of BRK’s subsidiaries are an unusual circle of trusted associates unlikely to be found at any other company.

The main event

What one takes out of the six hours of questions and answers is very much dependent on what one expected. The media used the estimate that 35,000 attended the meeting, which is possible including the exhibition space with its closed circuit television. However, I am told that the main arena has only 18,300 seats. Early in the day almost every seat was filled. As the day wore on, particularly after the lunch break, there were many empty seats. Either the lack of significant news or the distraction of buying, at a discount, merchandise from Berkshire’s subsidiaries, partially emptied the main arena. Nevertheless, my son Steve and I found some of the afternoon answers to the questions of interest. In summarizing the lessons of the day, it may be useful to respond to particular types of attendees. For example:

  • Those primarily interested in valuing the stock

  • Analysts trying to model near-term results

  • People who are interested in business principles

  • Those who have political considerations

Valuing Berkshire Hathaway's stock price

There is a belief that the stock should sell at a price equal to an unidentified intrinsic value. A poor substitute for this would be book value. Currently the company has announced a policy of buying back the stock at 110% of book value, (it believes the stock is undervalued by book value). For instance, BRK’s auto insurance company, GEICO, is being valued at $1 billion over its historic cost. The intrinsic value for that company is the firm's current book value plus the size of its float. Management stated that it would not accept a bid with a $15 billion premium over GEICO’s carrying value .

Analysts trying to model near-term results

With the exception of the housing-related operations, operating earnings are up at Berkshire-Hathaway. The current level of float is approximately $70 billion. Buffett and Munger are warning that the float is unlikely to rise further. Over the next ten years, it is possible that Berkshire’s utility operations and probably the railroad (Burlington Northern) will need additional capital of $100 billion combined. Creation and management of float has been one of the keys to the firm's success. These concerns led to a decision not to go forward with a possible $22 billion acquisition. If they did do this particular deal, the transaction would have forced Berkshire to sell some securities, either owned or to be issued, which management did not want to do. There is a desire to maintain a reserve of at least $20 billion for all possible opportunities and contingencies.

Todd Combs and Ted Weschler, the two internal investment managers had $2.75 billion each to manage as of the end of March. Each has a base salary of $1 million and an incentive on the excess return in which he would get 10%; 80% based on his own performance and 20% based on the other manager's results. This is similar to the arrangement BRK had with the former CIO of GEICO. (The company does not use compensation consultants or have a standard compensation plan for their operating executives.)

Business principles

There is a recognized risk of getting too big to manage effectively. Buffett and Munger believe they are pioneering with an uncoordinated holding company approach. Even with their various insurance companies, they do not attempt to coordinate their risks. The use of mathematical measures of market price risks is not believed to be prudent or realistic. Barriers to entry are critical for them in their acquisition and business planning. They do not believe in erecting barriers, but buying them. In their mind, a brand is a promise.

National (political) policies

Judging by the sound of applause, a large number of the audience were opposed to the popular understanding of the so-called "Buffet Rule." Some believed that his pronouncements have hurt the stock and are causing the stock's price to be below where it would normally trade.

Because of the current US interest rate repression that is likely to lead to inflation and higher interest rates, it was suggested that investing in medium and long-term bonds should be avoided. Instead of investing in developing more US-based oil and gas, the United States should import as much as possible, just the opposite of energy independence.

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