Notes from Berkshire Hathaway Shareholder's Meeting

Once again, as became known as "Woodstock for Capitalism", Warren Buffett and his partner Charlie Munger fielded questions from shareholders and journalists from all around the globe. With an audience north of 17,000 people present in the Qwest center in Omaha, Buffett, 80, showed he's still in decent shape and perfect wit by withstanding a grilling session that lasted for about 6 hours.

David Sokol

Buffett started clarifying his mistake at publishing a press release about David Sokol, the Berkshire manager who bought shares of Lubrizol in the days leading Berkshire's offer to purchase the company outright, pocketing an estimated three million dollars. 

Buffett explained why his much criticized press release was too positive on Sokol. Buffett felt like publishing a press release only criticizing David for his "inexcusable" mistake would be diminishing all the great work Mr. Sokol's done for Berkshire. Mr. Sokol did great things and Buffett didn't want them to be lost because of this one mistake. 

Buffett also said he does not believe a man who was paid handsomely over many years (last year his compensation was US$ 14 million) would act in bad faith to earn another 3 million. He believes Mr. Sokol's lack of proper disclosures were an oversight, not an act of bad faith. But that nonetheless, they were inexcusable. 

He then went on to mention Mr. Sokol's altruistic personality.  When Berkshire first bought MidAmerican, Buffett offered a $50 million package to Mr. Sokol and $25 million to Greg Able (another executive at MidAmerican). But Mr. Sokol refused to accept such split and suggested a 50-50 split between the too.

Buffett also clarified that he didn't fire Mr. Sokol on the spot because he wasn't sure of the involvement of Sokol at first, but that when Sokol resigned Buffett decided to accept the resignation which is cheaper than firing an executive and less prone to law suits.

I think deep inside Buffett didn't want to let Mr. Sokol go, but was forced to act this way to keep his image clean and Berkshire's reputation pristine.

Investing in Gold

When asked about investing in gold, Buffett said gold "doesn't do anything". He said people can stare at gold, climb a ladder on top of a pile of gold and sit on it and claim to be the king of the hill. One can even fondle gold and rub it. But it doesn't generate any wealth. 

He then proceeded to tell the same funny story he's told before: suppose Martians were watching the Earth. They would be quite confused by seeing people dig up gold from the ground in South Africa, transport it to New York and then bury it again in vaults.

Buffett simply prefers to invest in things that create economic value and tend to grow over time, such as well-managed companies with competitive advantages that require little re-investment of capital to maintain sales and grow, such as See's Candies.

I very much agree with this. In fact, I wrote about it very recently on my discourse on how to fight inflation.

Investment Vehicles

When answering a question about money, Buffett mentioned that there are three types of investment vehicles: currency-denominated investments, things that only have value because of prices people pay for them and businesses. 

Currency-denominated investments are poor investments over the long run. All fiat currencies tend to go to zero over time. Even shorting currencies is not a great investment because one still needs to know which one will go to zero faster, but in the long run, they all go, because of inflation. So Buffett prefers to stay away from these, which include bonds, loans, IOUs and currencies. He did, however, short the dollar a few years ago for a handsome profit. But he doesn't believe he can consistently predict which currencies will lose value faster.

Things that depend on others to pay up later include gold, oil, and precious metals in general. Even though some metals have utility and oil is a finite resource, he doesn't have any edge on predicting what the demand is for these things. So he doesn't invest in them.

The third category is his favorite: well-managed companies that require little re-investment of capital to function. He cited an example of See's Candies which went from $30 million to $300 million in sales with just a $31 million investment (from $9 million in assets when he purchased it to $40 million now). So, a 10x gain was obtained with less than 10x investment, which is a property of great businesses.

Again, I agree completely with Buffett. I also classified different types of investments recently. Although not exactly like Buffett, my categories are similar.

Investing in Oil

When an investor asked if she should short oil or go long, Buffett answered that instead she should teach us how to do it, because he didn't have any insight. He simply said he has no edge on picking the direction of commodities and as such he doesn't get involved in doing it.

Too Big To Fail

An investor and small business owner asked whether there should exist a business that is "too big to fail", which was the case of many US banks in 2008 and 2009 and also AIG, Freddie and Fanny as well as General Motors.

Buffett said that these businesses do exist and in fact, there are now countries that are too big to fail. This is simply unavoidable, in his view. However, he doesn't believe in free bailouts either. He suggested a policy where shareholders should get wiped and the CEOs and their families should lose all their money, certainly all their money earned when at the helm of such big institutions. Such treatment would protect investors and the population by discouraging CEOs from taking huge risks.

In the case of GM, Buffett said he was on the fance on whether it should have been bailed out, but he said that in hindsight it was a good move by the government. I disagree. GM was not too big to fail and it sucked up resources and market share that could have gone to more efficient players. 

In the case of banks, I'm sympathetic to Buffett's view, since a run on banks and massive unemployment could have destabilized the country and generated massive domino effects elsewhere. However, it's clear more responsibility is necessary on the part of executives. The trick is to achieve this without too much regulation and without stifling innovation and competitiveness -- if other countries can do it, then the US will lose out by not allowing their banks to do it too. Balance is the key.

Expanding the Circle of Competence

A shareholder asked: "if given another 50 years to live, which new circle of competence would you like to develop?" Buffett first answered with "I really like the preamble", and the crowd laughed. He then proceeded to say that he would learn about tech, because it's a very large field and there will certainly be a few big winners in it.

Charlie agreed and also said that energy would be a good area, because with enough energy all problems of civilization are resolved, such as clean water. Charlie mentioned having read "In the Plex", a book about Google, which he certainly enjoyed reading and learned a lot from it.

Best Businesses To Invest

A shareholder asked Buffett whether an asset-heavy business would perform well during periods of inflation versus a business with fewer assets. His theory was that tangible assets such as factories, machinery, power plants, etc would work as a store of value.

Buffett was unequivocal about this: no, the best business is the one that doesn't depend on too much capital invested in it and can generate profits with minimal capital reinvestment. He again  cited the example of See's Candies and compared it with Lubrizol and utilities, which can be lucrative, but are not as good as businesses with moats and low capital requirements.

On Inflation

Buffett dislikes inflation like everyone else. He said that the dollar from when he was born is only worth six cents today. But despite that, he and Charlie did well over time. So inflation is bad, but not as bad as it sounds. 

I suppose he was trying to say that controlled inflation is not a very big deal. But that somehow goes a little against his disdain for cash-denominated investments. I guess what he meant by this all is that inflation is only a problem if one is not invested in great businesses and instead holds cash or cash-denominated investments.

Jamie Dimon

Like two years ago, this year again Buffett praised the CEO of JP Morgan, Jamie Dimon, and said it's worthwhile reading his shareholder's letter. Maybe again this year, like two years ago, yours truly will read it and summarize it here. Stay tuned.

On BRK Dividends

This year again, as is common for several years now, people ask when Berkshire will pay dividends. Buffett thinks it's best not to, as long as a dollar retained produces more than one dollar of economic value for the stock. So far this requirement has been met. 

The day Berkshire pays a dividend, says Buffett, is the day they admit defeat and can no longer invest money profitably. On this day, the stock price should go down, according to him.

Buffett joked that he wishes his friends live until BRK pays a dividend.

Misc

Many other topics were debated, including a charitable giving program that was discontinued several years ago; Charlie's love for Costco; Ajit Jain's workaholic habit of flying to London on Thanksgiving to continue on working; and the one diploma Buffett has on his wall: "Dale Carnegie's Course on how to communicate effectively".

Buffett also commented that the government not raising the debt ceiling would be the biggest asinine thing it could do. That the debt capacity of the US is larger than it was when the ceiling was instated and that, in his opinion, there should be no limit.

All told, it was worthwhile flying to Omaha to see the Sage. (Even better, on a private jet with a couple friends of mine). I expect to repeat this again in the years to come. Long live Buffett.

Disclosures: I own BRK at the time of writing. I do not own an airplane.

You can follow me on Twitter @pinhe1ro.

Why Does Warren Buffett Buy Entire Companies?

This might be obvious to some, but Warren Buffett buys whole companies for different reasons than the average CEO does. The average CEO is concerned about building empires, pleasing their egos, diversifying, expanding market share, etc.

Warren Buffett simply wants to make more efficient use of capital. That's it. By buying companies outright, he's essentially unlocking the free cash flow (what he calls "owners earnings") and making that available to his holding company, so that it can more profitably be employed in other businesses or used to buy shares of public companies.

Free Cash Flow

Let me explain in more details. A portion of earnings that a company retains (retained earnings) is not available (free) to be taken by the owners or paid in the form of dividends. Some of that is needed to re-invest in the business: buy new equipment, hire new people, train the workforce, invest in a brand new computer system, build a necessary office in a foreign country to support the business there, etc. After all re-investment needed to support the business is accounted for is when free cash flow or owners earnings appears.

But most companies don't pay out as dividend their entire free cash flow. They retain more earnings than is necessary, to have reserves for a rainy day.

Warren is after these reserves, which he can more ably allocate within his holding company than any single company could within itself.

But why wouldn't Buffett buy lots of shares, take a board seat and simply force the company to pay out all its free cash flow as dividends? That wouldn't be efficient from a tax perspective due to double taxation in the corporate structure. So, the alternative is to buy at least 80% of companies and consolidate their assets on Berkshire's balance sheet.

How Can Small Investors Benefit?

The rest of us who can't afford to buy their own conglomerates still has options. It has been shown that following Buffett's move -- even 30 days after the fact -- can still provide enough of a return to beat the market average over long time periods.

Current Opportunities

One current opportunity is to buy out-of-favor Kraft (KFT). Buffett purchased it last year for around $30 per share. It's currently trading for $26. So, if you believe Buffett will be proved right once again, buying below his entry point makes a lot of sense -- you'd be getting an edge over Buffett himself!

Disclosures: I own shares of KFT.

Berhkshire Hathaway Shareholders Meeting

This weekend was Berkshire Hathaway's shareholders meeting. This is one of the few times when Buffett goes out to the public to let his shareholders and fans openly question him. This time the meeting format was a little different: half of the questions were vetted by financial journalists Carol Loomis, of Fortune; Becky Quick, of CNBC; and Andrew Sorkin, of the New York Times.

Warren and his not-so-well-known partner Charlie Munger fielded questions for over 6 hours. The most interesting ones had to do with the economy, Berkshire holdings, value investing, and accounting rules.

Economy and Inflation

On the economy front, Buffett answered to an 11-year-old boy who asked about what to expect for his future. Buffett told him the usual honest answer that he can't predict the future, but he doesn't see how it could be possible for the US to avoid inflation: "we're doing things now that will inevitably lead to inflation in the future", Buffett told the boy (as I recall him saying -- not a verbatim quote). Munger complemented that he still remembers the 2-cent stamp and the 5-cent 6 ounce bottle of Coca-cola and that inflation has always been with us, and it will continue to be, and as long as it's not massive and uncontrolled, we will be okay.

Berkshire holdings and activism from Buffett

A very interesting question and perhaps one that exposed one of Buffett's weaknesses in my opinion was about Moodys, the rating agency he owns 20% of. The question asked why he did interfere with Moodys inflated valuations of housing and mortgage-related securities. The question pondered, if he saw it coming -- which it wasn't clear he did -- why didn't he take an active role in telling Moodys (and perhaps S&P) about it. His answer was disappointing, but nonetheless honest. He said he's not an activist and has never been. He buys companies for their value and net worth and not with the intention of changing them. He thought and still thinks that Moodys is a very good company with good prospects, but his role is to allocate capital, not to manage companies, especially ones he doesn't own 100%.

I was disappointed because being such an honest person and so good in what he does, the normal thing to expect is that he would take a more active role in "fixing" mistakes, wrongdoing and excesses. I think I probably expect him to be a hero too, despite being the most successful investor of all times. Perhaps that's asking too much of him. It could even spoil him. Corporate activists have fame of being raiders and acting in self-interest. I disagree with this simplistic view by the media and I respect the famous activist Carl Icahn's position. But that's subject of another post.

Also, it wasn't clear whether or not Buffett really knew the housing excesses were really about to pop or not, so maybe it wasn't just that he didn't say or do anything, but that he, like most of us and most big banks, didn't see it coming.

Executive compensation and shaming mutual fund managers

Another question touched upon changes in executive compensation, and why he didn't take a more active role there, in the public companies he owns. He mentioned he had been on the board of 19 companies and that he didn't believe he could affect them much. He recalled being vocal about compensation when he was part of the compensation committee at some company I don't recall, but being kicked out of the compensation team ever since. Out of 19 boards, he was on only this one compensation committee and was never invited again.

His solution to exuberant executive compensation is to have large institutional investors -- the big mutual funds managers -- be more vocal about it. And that all it takes is for the public and the media to shame them into taking this active role on compensation. He said it would take only 3 to 4 big mutual funds to synchronize an attack on CEO and executive compensation to kick-start the process.

Fair enough. Here's my part of the bargain. Because of all of you, my four faithful readers, I can be considered part of the media too. So I'm now publicly embarrassing the managers of the top 3 mutual funds (by assets) for not taking a more active role in executive compensation. According to this article and others, the top 3 companies managing equities are American Funds, Fidelity and Vanguard. And according to Marketwatch the top 3 funds by assets are: AGTHX, FCNTX and VTSMX. Their manager's names are: Gordon Crawford and team, of American Funds; Will Danoff, of Fidelity Contrafund; and Gerard C. O Reilly, of Vanguard Total Stock Index. Shame on you!

Value Investing

Regarding value investing, a woman from Omaha asked how Buffett does it and whether it was true he didn't need a calculator or a computer to crunch the numbers. Buffett confirmed that he didn't do spreadsheets nor used calculators and that it doesn't make a difference whether the discount rate is 9.1% or 9.2%: "the numbers should jump at you", Warren said.

He repeated Ben Graham's words that too much IQ can actually interfere with good financial results in the markets. He pointed out examples of Long-Term Capital Management (LTCM), a hedge fund that blew up a few years back due to manager's exaggerated confidence in their abilities, given their 150 IQ, PhD and sophisticated computers (here's a video of Buffett commenting on this at a meeting with students).

Buffett repeated what he's said many times before, that investing is simple and one should only focus on their circle of competence and when in doubt throw wild ideas and complex companies in the "too hard" file and forget about them.

Voodoo Accounting

As part of a question I don't recall now, Munger made a bold remark about some Generally Accepted Accounting Principles (GAAP) having some rules that are bogus. The one he cited is a company being able to increase its equity because the price of their bonds went down and the company being able to report buying their debt at a discount as a "profit". Citibank recently did just that and the difference between the market value of their bonds and par was recorded as a profit. Of course, this is just a paper profit, since no cash flows to the company. In fact, there's an outlay of cash by the company, to purchase its debt back. So, if anything, this should be an expense, not a gain.

But the debt reduction is real, and hence why GAAP indicates this should be recorded as income. I don't know how to reconcile this fact with what Munger pointed out, that there was no cash being generated to the company. How should this be treated under a proper accounting system? Perhaps it should be booked now as an expense (the outlay of cash to repurchase the debt) and when the debt formally matures it should be treated as a capital gain. But if the entire amount of debt was repurchased, then it's hard to justify waiting many years for the now nonexistent debt to mature.

I've commented on other voodoo accounting practices being adopted by closed-end mutual funds for apparently no good reason.

Dividend Policy

An elaborate question given to the journalists asked whether Berkshire had changed the rules of the game. Its owner manual states that a dividend shall only be paid if for each dollar of earnings retained Berkshire does not accrue at least a dollar in share price over time. The manual says that so far that test has been met. The question points out that for the last 5 years, the retained earnings were not reflected in the share price nor in the book value of the company and that perhaps it would be time for Berkshire to pay a dividend after all.

Buffett answer poorly in my opinion. It was mostly a non-answer about 2008 being a bad, one-off year and that Berkshire did better than the S&P 500. I would have been satisfied if he had said he prefers to exclude 2008 and that he would re-think his decision by end of 2009. That would have been decent. But the comparison with the S&P 500 has nothing to do with whether or not $1 of retained earnings are reflected in the stock price or not. This seems to me like a change in the rules of the game.

I personally think that Buffett will face this question again and again and more strongly every time, given that the amount of growth everyone, including himself, expects from Berkshire is diminishing dramatically, given its size. I wouldn't be surprised if BRK paid a special dividend in the next 5 years and instated a permanent dividend policy within 10-15 years.

Other Things

Berkshire is not immune to corporate activism. This year some shareholder brought to our attention possible employee mistreatment in Fruit of the Loom's factories in Honduras. A former employee, speaking in Spanish, commented on inhumane treatment, threats and other allegedly excesses of management in Honduras. A Fruit of the Loom manager spoke about the third party investigations, actions taken and firing of the people responsible. He said how things have improved since then, commented on some exaggeration by the woman reporting the facts and the closing of the factory since then, due to the downturn in the economy.

On the succession front, Buffett fielded questions about who would take over upon his death. This has become a trite subject by now and is not very interesting, since Buffett won't comment who the candidates are. The same 3 internal candidate remain for the CEO position and the same 4 internal/external candidates also remain for the position of Chief Investment Officer (CIO). When asked how the possible future CIOs did this year, Buffett said they did a little worse than the S&P, but that this didn't bother him, as over the long run, they should outperform the S&P.

Judging from Buffett's voice and some coughing, and Charlie falling asleep a few times during the meeting, their health is not what it used to be (whose is?). Despite that, if Buffett stops drinking five cans of Cherry Coke per day and eating burgers, he might live another 20 years.

Buffett also mentioned a few times about the 2008 letter to shareholders of JP Morgan Chase, by Jamie Dimon. I have not read it yet, but I will. Perhaps I'll have something to say about it here. Stay tuned.

Celebrities

Among the celebrities present, I saw Pat Dorsey, from Morningstar, author of books I highly recommend for the beginner investor: The Five Rules for Successful Stock Investing (the very first book on stock investing I bought) and The Little Book that Builds Wealth (next year I'll be sure to bring my copies of these books for Pat to sign and I'll hope he brings along his colleague Josh Peters, author of another book I like, The Ultimate Dividend Playbook).

Also present who I believe was Monish Pabrai, author of The Dhandho Investor (a popular book I have not read myself yet, except for a few excerpts). Of course, Bill Gates as a Berkshire director was there too as was Susan Decker, ex-Yahoo.


Pat Dorsey, from Morningstar.