A note: we realise the LEX column isn’t free, but it’s worth every cent.

“He has opined on the wonders of modern capitalism but he also has been prescient about its weaknesses. Among these are perverse management incentives, deceptive accounting and a general under-appreciation of risk. More than his folksy wisdom though, the way Mr Buffett has managed Berkshire, a conglomerate in the business of taking large, calculated risks, is instructive. Even at the depth of the crisis, it was never in danger of going under and played the profitable role of backstopping companies such as Goldman Sachs and General Electric.”

(…) “In spite of fame that could send a stock soaring on mere whispers of his involvement, his entreaties on thrift, prudence and governance fell largely on deaf ears.” (…) “Anything Mr Buffett says about risky behaviour on Wednesday will have to wait for another crisis to become conventional wisdom.”

We’ll never get tired of saying this: dump the checklist approach to CG. Actually, dump the checklist approach to anything.

Corporate Governance and alignment of interests is about so much more than the proportion of “independent” directors or separate CEO and Chairman roles and so on… It’s like saying that Berkshire’s governance lacks substance because “Buffett is both Chairman and CEO and keeps family and friends in the Board” without digging deeper – and by the way, many people do say this. The fact that Buffett only takes home US$ 100,000 in annual salary with no stock options and has about 99.7% of his net worth tied to Berkshire stock (all of which he purchased directly in the market) goes unnoticed. The percentage of stock owned by WB, Charlie Munger and Buffett relatives amounts to so much of the company that it’s like having a saber-tooth tiger as a watchdog for minority shareholders.

Back to seriousness: Business Week had a cover article by Alice “Snowball” Schroeder interviewing CEOs who have had Buffett in their boards, as advisor, friend, whatever. Interesting read. There was an entire book on the subject a few years ago, but it focused on Berkshire subsidiaries and frankly wasn’t all that great, although nowadays it does help to evaluate some potential successors.

By the way, the Business Week section included this article by Peter Buffett, Warren’s musician son, about how his father handled money with him. Nothing new, but always interesting.

The videos, as promised:

1) The Business Week video on Warren Buffett:

2) Buffett as Axl Rose (the ballad of customer service)

3) Buffett the hip-hop artist (from GEICO’s sales reps annual meeting, Buffett is on around 4:00)

Highlights:

On accountants: “A majority of the horrors we’ve faced would not have happened if the accounting profession were organized properly.”

On the actions taken in the middle of the crisis: “The problem is so extreme that nothing “un-extreme” has any chance of fixing it. So I basically applaud the people in the government that are doing these extreme things. I’m sure they’re making a lot of decisions that in retrospect will be seen as mistakes, but given human condition where they have to do extreme things under fire, I’m not inclined to criticize them.” (…) “I’m happy to see that the Obama administration has brought in Larry Summers, who is a ferociously smart man and will try to do the right things even if it offends some people.”

On what needs to be done in the US: “Not only do we have to save the financial system, (…) but we also need a huge spending stimulus from the federal government… I don’t regard that as all bad at all, there’s so much that needs to be done in this country. We need a whole electricity distribution system (…) Much can be done in medical care. The hospitals in this country are about to get a vast improvement in its facilities and that’s all for the good. (…) The dangers from what we have to do are less than the dangers that would plainly come if we responded as we did in the 1930′s.”

On the US allowing Lehman to fail: “It was not a mistake. It actually helps to have one or two go (…) You have to have a loud failure.” - he did have to think about it a lot before he actually said it, though...

The numbers that matter: US$ 131Bi in equity, US$ 62Bi in float => ~ US$ 193Bi in “capital”. Book value grew 20%. Float grew 5.8% (from US$ 58.5 to US$ 62Bi). All insurance businesses operated with underwriting profit again. Cash = US$ 30Bi (US$8Bi used in Q1 to pay part of the BNSF deal). Operational assets = US$ 30Bi but generated only US$ 1.1Bi in net profits, which shows insurance/investments did the heavy lifting. The operating units will hopefully make up their fair share of contribution in a recovery.

Bottom line: investors are still paying about capital value at current prices. It has the best governance we ever saw. If they continue to grow float, have underwriting profits and make good investments, it’s a steal. Never mind the recovery.

We don’t have any intention to be the “ultimate source for all things Buffett”, as a lot of people already do a great job at this and we thank them for uncovering these pearls. But this video is special. The parts on “moats” add up to some of his most detailed comments yet on the subject.

We don’t think it’s any exaggeration to say that Buffett has transcended the investment realm and that this is interesting for people in all walks of life. We’re certainly making backup copies.

We’ve recently had the opportunity to do research on Buffett’s letters to shareholders beginning in 1959 (when Buffett managed Partnerships and Berkshire Hathaway was not even in his sights). His consistency and transparency are always impressive – especially in times like these and since we’re talking about more than 50 years of Buffett clearly practicing what he preaches.

Case in point: Berkshire Hathaway’s cash has been deployed in the last few years. He had always said that when him and Mr. Munger couldn’t find opportunities, they would rather do nothing than do “something stupid”. Well, it’s no coincidence then that the chart below reflects the crisis in the last 2-3 years. The “fat pitches” are finally coming in. Now Berkshire shareholders can look ahead and dream of what Mr. Buffett’s batting average might mean to future returns.

Source: Berkshire Hathaway annual reports and IP research

That said, in Berkshire’s case this consistency has two sides. Mr. Buffett has always said that Berkshire’s size is a constraint and that shareholders shouldn’t expect that he can replicate the decades of 20-25% annualized gains in book value per share. We should have every reason to believe this! The practical implication is a deal like Burlington Northern: an opportunity to deploy large amounts of cash at decent, if not stellar, returns. Remember 2005 and the PacifiCorp deal, when Berkshire subsidiary MidAmerican then deployed some US$ 9billion at a highly-regulated, stable business returning some 12-15% on equity.

Risking obviousness, consistency is desirable when one follows with discipline superior processes that generate desirable outcomes. We don’t think one can doubt that this is the case at Berkshire Hathaway.

Just a quick note regarding transparency: Buffett’s letters to his partners began as 2-page quick notes and later evolved to the tour-de-force format we read today. But even back in 1959 his objective was to let his partners know what he was thinking – he said that they had a right to know since they were trusting him with their money. We couldn’t agree more. First he talked the talk, and he’s been acting accordingly for over 50 years.

Here’s a story that points out that the percentage of shares sold short has quintupled after the BNI deal. There are many “mainstream”, “make-sense” reasons as to why this might be:

1) Berkshire could lose its AAA credit rating due to reduced cash levels (S&P, Fitch and insurance specialist A.M. Best have placed Berkshire on “watch”);

2) It was an oversized, expensive deal that dilutes shareholders;

3) Buffett and Munger aren’t getting any younger…

Well, here’s another: it’s a simple merger “arbitrage” opportunity created by the deal’s structure.

As described in the official press release and better explained in the conference call (on page 6, question number 4), the deal is a share exchange where each BNI share is worth approximately US$ 100 in Berkshire shares IF Berkshire’s share price at the time of the exchange is set between US$ 80,000 and US$ 125,000. This means that within this range of Berkshire Hathaway prices, a shareholder of BNI would get MORE Berkshire shares as the price approaches US$ 80,000 (below this number it doesn’t matter, since the exchange ratio is fixed). So BNI holders have an incentive to short BRK/B and pocket the difference when the deal closes – at which time they’ll hold an excess of Berkshire at attractive prices…

Of course, there are two things that could go very wrong for shorts:

1) As speculated here and in some research we’ve read, BRK/B shares post-split could be included in the S&P 500 index – with the huge sums of money invested in S&P 500-pegged funds, the buying volume could (and usually does) mean a 3-4% increase when the index change is made public.

2) Buffett could announce a share buyback program if Berskhire approaches the lower limit – while he has never done that, and his available cash is relatively depleted after the deal, Berkshire generates some US$ 10bi per year and his credit is still good…

That’s all beside the point. Much more interestingly: what does this deal say about Berkshire’s sharpness in deal-making? Are they losing their edge? We won’t even judge the deal’s merit (cheap, decent or overpriced). We’re just wondering whether the fact that Buffett appears to have created a less-than-ideal deal structure is reason for concern.

Finally, we’d point out that in the unfortunate case that either Mr. Buffett or Mr. Munger dies any time soon, or if the price formation is really altered by this “arbitrage”, there could be an interesting opportunity to buy Berkshire shares. We’re talking about a company with quality assets whose culture will outlive the two, and a company whose current “bets” on inflation, energy, transportation and USA recovery (and related financial market bets, e.g. the famous S&P 500 put) represent a very interesting long-term play. We wouldn’t bet against this – and certainly not against Buffett.

LINKS:

Has Buffett lost his mind? – Dec. 8th article on the Lonely Value Investor blog pointing to the original article (link below) and to a Bruce Greenwald interview blasting the deal as “insanity” (read his answer to the 2nd question). Bruce Greenwald is the Columbia University value investing dean.

Berkshire + Burlington, a Nov. 4th rant in the Lonely Value Investor blog. Not judging merit in this piece, it does link to 3 bearish pieces in “serious” publications such as Barron’s (subscription required), Bloomberg (by none other than Alice “Snowball” Schroeder) and TheStreet.com.

Buffett says Burlington ‘not a bargain’ – Nov. 14th article on Bloomberg quoting a Charlie Rose interview. The full interview transcript can be found here, and as usual it’s quite interesting. The part on Burlington starts after a bit of an introduction, but it’s near the top.

Here’s the video, all 65 minutes of it: