All we can say is WOW.

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)

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.

There was also an interesting (but misguided) issue raised about Buffett’s stance in this deal versus Berkshire’s bid for Burlington – see inside.

Kraft’s management was in a bit of a quandary last month. Because its original offer to buy Cadbury involved issuing stock representing more than 20% of its shares outstanding, the company needed shareholder approval to close the deal as per NYSE’s rule 312.03(c). Warren Buffett, Kraft’s largest shareholder, didn’t like the idea and said that Kraft’s stock was an expensive currency to use at that time. In a very public way, he declared a “no” vote on the issuance and recommended that other shareholders do the same. Given Buffett’s reputation, this was a very credible threat.

To steer away from him, Kraft needed desperately to raise enough cash to be able to cut the share issuance below the 20% threshold, thus avoiding the need for a shareholder vote. That’s where Nestlé came in. Over a weekend the company switched from being a competing bidder for Cadbury, to “helping out” Kraft by acquiring the company’s frozen pizza business. It’s reasonable to suppose that it got a good deal. Not only does it know the ins-and-outs of the food business, but it had the money on hand to act quickly – especially after the sale of Alcon to Novartis. Buffett’s commentary that the pizza sale was badly structured fiscally for Kraft only adds to the impression that the Kraft-Cadbury deal was a “marriage done at gun point”, rushed due to competition or perceived competition for Cadbury, where “minor details” were ignored in view of the bigger objective.

Check out our Q4 2009 report for our take on M&A in the “Merge!” section – this could very well be one example of the “shotgun wedding” we mentioned there.

LINKS:

Does Buffett’s vote on Kraft mean that Berkshire is fully valued? – Bloomberg, Jan. 11th 2010 – If Kraft’s shares are “very expensive currency” and Berkshire is using BRK stock in its bid for Burlington Northern, does it mean that Buffett thinks Berkshire shares are even better valued than Kraft’s? Not necessarily is the obvious answer. Buffett has always said that to pay for an acquisition with shares he must be getting more than what he’s giving away. He is therefore implying that this is happening in his bid for Burlington, while from the press release linked above it’s clear that he thinks that this is not the case in Kraft’s bid for Cadbury. Each deal must be analyzed separately.

LEX on Kraft/ Cadbury – Financial Times, Jan. 19th 2010 – LEX columns are a significant part of the FT.com’s value proposition and we highly recommend ponying up the cash for it. There’s a short video we couldn’t embed here and links to other LEX pieces on the subject.

Buffett’s Lost Vote – NYT’s DealBook blog, Jan. 21st 2010 – For an explanation in layman’s terms of the NYSE rule that would require shareholder approval for Kraft’s original bid for Cadbury.

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.