Gustavo Ballvé on February 29th, 2012
Corporate Governance, Corporate Strategy, Food for thought, Home, Industries, Insurance, Investment Themes, Mental models, Portfolio Management, Quotes, Risk management

As promised, we dive a little deeper in the annual report – or, at least, the letter to shareholders. As we’ve argued before (check this link for the PDF of the report and for Buffett’s letters since 1959), it’s another chapter in a body of work that can be read strictly with an investing “hat” – or, more usefully, with many such hats (business, corporate governance, communications, recruiting/incentives etc.). This one is interesting in many regards: succession, Berkshire’s strategy and goals, IBM, insurance float, share repurchases, the state of the US economy and more.

We also link throughout to numerous other sites who do a great job of covering all things Buffett, such as ValueWalk.com – through which we got a link to the entire transcript of CNBC’s 3-hour special with Warren Buffett on Feb. 27th. Definitely worth a read as well.

BRK/A’s Performance

The first thing that jumps to mind is the 5-year performance. While it has again beat the S&P 500 in a 5-year period, it isn’t necessarily the stuff of dreams for the small investor with, paradoxically, access to more investment possibilities. Buffett himself has said, many times, that size deters performance and that while Berkshire is looking for home runs, it is also satisfied with investing sizable amounts of money at decent returns. One example of that is MidAmerican’s immense capex spending which earns capped, but decent and monopoly-like, returns.

Then again there’s the “once in a lifetime” opportunities such as the preferred shares/warrants in Goldman Sachs, BofA, GE etc. that only a Gibraltar-like solid company with Berkshire’s reputation can get. Funny how often these “once in a lifetime” events seem to take place…

Share repurchases

To stay in the same realm of performance, but now future performance, Buffett discusses how book value per share is a relatively good proxy for Berkshire’s intrinsic value fluctuations, but not for the actual Berkshire intrinsic value. And in this letter, again, Buffett goes to great lengths to hint at Berkshire being undervalued. He makes a good point about a discount between Berkshire’s book value per share and its intrinsic value.

What is remarkable about his insistence in this subject is the fact that Berkshire has an open share repurchase program, so Buffett talks a lot about repurchases and how he doesn’t want to buy out existing partners at a discount without them fully knowing what he (Buffett) thinks about the share price. After all, he’s not selling and he explains why in the letter. In fact, let’s see the excerpts:

“Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated. (…) Continuing shareholders are hurt unless shares are purchased below intrinsic value. (…)”

“Charlie and I have mixed emotions when Berkshire shares sell well below intrinsic value. We like making money for continuing shareholders, and there is no surer way to do that than by buying an asset – our own stock – that we know to be worth at least x for less than that – for .9x, .8x or even lower. (…) Nevertheless, we don’t enjoy cashing out partners at a discount, even though our doing so may give the selling shareholders a slightly higher price than they would receive if our bid was absent. When we are buying, therefore, we want those exiting partners to be fully informed about the value of the assets they are selling.”

Ask yourself how many companies take the trouble to think – and ACT – on share repurchases with as decent and shareholder-friendly a framework as this one. Buffett notes Jamie Dimon of J.P. Morgan as one CEO who “gets it”. And yet, doesn’t it seem intuitive when he explains it? Culturally and behaviorally, beating the “institutional imperative” requires much more than common sense. In Buffett’s case, the fact that such shrewd investors as Buffett and Munger own a sizable chunk of Berkshire’s stock certainly helps create the right alignment, but in the end it’s about making the right choices.

IBM as core holding

Can’t say I wasn’t hoping to hear his “case” on IBM, and now I can’t say I’ve heard it either. Nothing too deep here and I’m hoping to hear better questions about it during the annual meeting, but here’s what seemed important:

“Counting IBM, we now have large ownership interests in four exceptional companies: 13.0% of American Express, 8.8% of Coca-Cola, 5.5% of IBM and 7.6% of Wells Fargo. (…) We view these holdings as partnership interests in wonderful businesses, not as marketable securities to be bought or sold based on their near-term prospects.” (…)

“CEOs Lou Gerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operational accomplishments were truly extraordinary. But their financial management was equally brilliant, particularly in recent years as the company’s financial flexibility improved. Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.” (…)

“As was the case with Coca-Cola in 1988 and the railroads in 2006, I was late to the IBM party. I have been reading the company’s annual report for more than 50 years, but it wasn’t until a Saturday in March last year that my thinking crystallized. As Thoreau said, ‘It’s not what you look at that matters, it’s what you see.’ “

He uses IBM to say how a net buyer of stocks should actually cheer for stock prices to come down instead of going up, and that’s what he hopes from IBM in the next 5 years as IBM should have up to US$ 50 billion to repurchase its own shares. And the DealBreaker blog had an interesting post about this, which we can summarize using the blogger’s own words:

“(…) the value of the Buffett brand is obtaining capital discipline from the companies where you’re an owner – and capital indiscipline from companies where you’re a net buyer.”

It’s an interesting, if narrow, frame of mind: you need some source of price decrease if you’re a net buyer, and one possible source is poor capital allocation. But it’s definitely not the only thing that drives down a share price, so it can’t be the only thing Buffett of all people relies on.

Succession

There was some clarification on succession. He mentioned there’s now ONE Board-approved name for CEO, and that while Todd Combs and Ted Weschler will soon be managing “just” US$ 3.5 billion of BRK’s stock portfolio, they’re both able to run the entire investment show if anything should happen to Buffett and Munger. Both are important clarifications. Some have said they need the “Chosen One’s” name right now to be calmer about this CEO issue, but I have to agree with Whitney Tilson that, in the scenario where Buffett stays on for 5-10 years:

“Things can change over five to ten years and if he anoints someone today and then that person makes a terrible mistake, like David Sokol did, or someone better comes along,” Tilson said. “Can you imagine if he tries to change horses?…It would be a media circus.”

Another interesting thing regards Todd and Ted’s compensation: 80% of their performance compensation comes from “his own results and 20% from his partner’s.” It’s an interesting and balanced way to foster teamwork. Again: nothing necessarily new, but always simple and straightforward. Given the company’s culture, Buffett’s close eye on them for now, and the very fact that these guys chose Berkshire as much as Berkshire chose them, it doesn’t seem to matter whether 80-20 is “enough” or “right”: the idea probably has a better chance of working at Berkshire than at most investment firms.

Berkshire’s operating businesses

They can be seen as the future of Berkshire Hathaway’s growth, a thermometer measuring the US economy’s activity and as a continuous source of pain. In a way, they’re all right. What is interesting about this letter, specifically, is not how non-housing businesses have rebounded pretty well since 2009 (page 13 – and 2 years ago we wrote about how we didn’t even need a recovery if float kept growing at a profit with decent investments getting made). It also is not how Buffett explains once more why he won’t sell businesses that are performing poorly and likely to continue to do so in the future (he claims the benefits of being the “buyer of choice” for the right types of business owners offsets the costs of his insistence with poor businesses). What’s really interesting is the line about the Fortune 500, which says a lot about how Berkshire envisions its growth going forward:

“Charlie and I like to see gains in both areas (Note: the two areas are 1- per-share investments, and 2- pre-tax earnings from businesses other than insurance and investments), but our primary focus is on building operating earnings. Over time, the businesses we currently own should increase their aggregate earnings, and we hope also to purchase some large operations that will give us a further boost. We now have eight subsidiaries that would each be included in the Fortune 500 were they stand-alone companies. That leaves only 492 to go. My task is clear, and I’m on the prowl.”

Not news, but this part combined with several mentions of tuck-in/ bolt-on acquisitions the many Berkshire subsidiaries are doing in the early 2012 makes it seem like there’s some acceleration going on.

Float as the TURBO/ AFTERBURNER of the company’s business model

It still impresses me how little press coverage this gets. It’s a huge part of the Berkshire success story: the company’s extremely well-run, extremely conservative insurance operations actually end up raising long-term “capital” sometimes at a low cost, often for free and, for the last nine years, for a FEE (yes, Berkshire actually got paid to hold such funds in this period) – for one of the world’s best investors to play with. Let the man himself explain it.

“Our insurance operations continued their delivery of costless capital that funds a myriad of other opportunities. This business produces “float” – money that doesn’t belong to us, but that we get to invest for Berkshire’s benefit. And if we pay out less in losses and expenses than we receive in premiums, we additionally earn an underwriting profit, meaning the float costs us less than nothing. Though we are sure to have underwriting losses from time to time, we’ve now had nine consecutive years of underwriting profits, totaling about $17 billion. Over the same nine years our float increased from $41 billion to its current record of $70 billion. Insurance has been good to us.”

“Good”? Want to trade me that “good” for my “excellent”, “superb” and I’ll even throw in my “incredible”? …Please?

Interesting addition to the annual meeting Q&A

I’m actually optimistic about this one. Having attended 3 Berkshire meetings, the advent of the 3 top-notch journalists receiving, selecting and asking “best questions” really helped move things along and add some meat to the meeting’s analysis bone, so to speak. Still the questions asked by the audience tended to go from the entry-level to the bizarre, with one or two good ones. Now they’re adding a panel of 3 sell-side analysts who’ll ask their own questions, as we can see below.

“This year we are adding a second panel of three financial analysts who follow Berkshire. They are Cliff Gallant of KBW, Jay Gelb of Barclays Capital and Gary Ransom of Dowling and Partners. These analysts will bring their own Berkshire-specific questions and alternate with the journalists and the audience.”

I’m hoping the analyst selection must reflect some respect on Buffett’s part, so there should be interesting questions emanating from them, or at least better questions than those of the audience. Even the journalists sometime focus too much on macro, politics or some other recent occurrence (last year it was Dave Sokol’s sudden “departure”).

On bonds…

“Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: ‘Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.’ “

…and gold

Actually the whole section is interesting and kind of funny, unless you’ve already read our post last year about Buffett fondling a gold cube. But I’m taking just the serious part.

“True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: ‘What the wise man does in the beginning, the fool does in the end.’ “

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