Tuesday, May 26, 2009

The Best of “Woodstock for Capitalists,” Part 4: Best Questions Not on Our List—Avoided


An Only-in-LA Question about Buffett’s “Partner”; A “Damn Miracle”; Oddball Things That Happen Once every 50 Years; A Sales Pitch for Wells Fargo and a Brief Sermon on Leverage.


As reported previously in these virtual pages, of the “Top Ten Questions for Warren Buffett” selected by readers of NotMakingThisUp prior to this year’s “Woodstock for Capitalists”—the Berkshire Hathaway annual shareholders meeting—fully eight were asked, in one form or another, of Buffett and his long-time business partner, Charlie Munger.

(Note that we refer here to Munger as Buffett’s business partner. A few weeks ago we were in Los Angeles speaking to a somewhat under-informed business school group. After we had referred several times to Munger as “Buffett’s partner,” a hand went up. “This Mr. Munger,” the student asked earnestly, “Is he Mr. Buffett's life partner?”
Only in L.A.)

Now, since a total of 51 questions were asked during the five-plus hours of questions-and-answers, there were plenty of topics not considered “Top Ten” material by our readers that shareholder did think worth hearing Buffett and Munger ruminate on.

And ruminate the two men did.

Topics ranged from BYD, the upstart Chinese car manufacturer championed by Munger (“A damn miracle,” the notoriously skeptical Munger called the company, prompting laughter), to the impact of a hypothetical nationalized healthcare plan on Berkshire’s portfolio (“We’ll see what the national sentiment is as expressed in Congress,” Buffett said, “and act accordingly.”)

Of those questions that did not make our Top Ten list, several were quite good, and deserve to be highlighted here. Of them, Buffett answered one and generally avoided the other two.

The first question avoided was asked by Fortune Editor and long-time Buffett friend and confidant (not to mention early Berkshire investor) Carol Loomis.


It hinged on Buffett’s standard measure of value-creation by company managers: that a public company should create a dollar of market value for each dollar retained in the business, or else give the money to shareholders.

Buffett wrote about it in his now-famous 1983 “Owner’s Manual,” in which he presented 13 astoundingly clear “owner-related business principles”:

We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.

Ten years ago Buffett updated and commented on this (as well as the other 12 principles) for the benefit of thousands of Berkshire shareholders added through the 1998 stock-for-stock purchase of General Re, as follows:

We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we can't create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.

The question posed by Loomis, on behalf of a shareholder from Yardley Pennsylvania—and it’s a great one—was that since Berkshire’s market value had not so increased over the last five years, “Will Berkshire pay a dividend or not?”

Buffett readily admitted that Berkshire has not done this in recent years. “I would say he is right that we have not increased market value for each dollar of retained earnings…”.


Indeed, Berkshire’s large investment portfolio—comprising the Cokes, Wells Fargos and Washington Posts of the world, which was valued at $75 billion at the end of 2007, including net unrealized gains of just over $30 billion—had shrunk to an estimated $65 billion at the end of 2008 (the precise number is unavailable because of a change in accounting for certain equity investments).

Still, Buffett by no means was willing to concede that he and his business partner no longer “pass the test” and it was time to “let our shareholders deploy the funds,” as he wrote back then.

I would also say that we measure our business performance against the S&P,” Buffett added, and by that measure, Berkshire has done “better” than the alternative.

And certainly Berkshire has done better: a 20% compound growth over 44 years compared to slightly over 9% for the S&P 500 in the same time frame, and only a 9.6% decline in 2008 versus a negative 37%, including reinvested dividends, for the broader market.

Still, the percentage loss in Berkshire's equity portfolio last year was closer to the S&P’s negative 37% than to Berkshire’s modest 9.6% drop in book value. In fact, by year-end 2008, Berkshire’s portfolio’s total net unrealized gains were down almost two-thirds, to something north of $10 billion.


Nonetheless, Charlie Munger (Buffett's business partner) was even more blasé than Buffett about what had happened in 2008:

“I don’t get too excited about these oddball things that happen once every 50 years. If you’re reasonably prepared for them other people are suffering a lot more, and other opportunities are coming to you. Take Wells Fargo, I think Wells Fargo is gonna come out of this best, way stronger…”

Buffett picked up on this, and turned his answer into a sales pitch of sorts for Wells Fargo:

“I had a class meeting that day—it’s the only time any of those guys have gotten me to name a stock…somebody with a Blackberry checked the price, it was below $9. I said I’d put all my net worth into it on that day. Wells Fargo is gonna be a lot better off—unless they have to issue a lot of shares, which they shouldn’t…”

And while Buffett was wrong on that—Wells Fargo issued 341 million shares less than a week later—he was right about buying the stock at $9 a share.

The stock sale was priced at $22 a share.

Buffett was also right when he summed up his response with a brief sermon on leverage:

“You can’t let somebody else get you in a position where you have to sell out your position. Leverage is what gets you in trouble in this business.”

Next up: another good question, avoided, by Buffett...and his business partner.


Jeff Matthews
I Am Not Making This Up


© 2009 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.

7 comments:

mattw said...

The S&P was down more like 38% in 2008 than 28%; I'm not sure where you got that number.

Jeff Matthews said...

MattW: Thanks. Sloppy on my part. But the net was -37 including dividends, not -38.

JM

cheyfaith said...

Hi Jeff. The clarification on Munger being Buffet's business partner vs. life partner is priceless. You cannot make this stuff up.

Speaking of who's who...Loomis is Buffet's confidant, not confident.

Thank you for another great post.

Jeff Matthews said...

Faith,
I need a contextual spell-checker!
Thanks,
JM

Anonymous said...

Despite my respect for Buffet, this has always struck me as an apples and oranges comparison. He's comparing the BV of berkshire to the Price of the S&P500. Not really fair.

Derek Pilecki said...

The reason to invest in Berkshire is to have Buffett allocate your capital. The last thing you'd want him to do is return money to you through a taxable dividend. Especially in the current investment environment, with stocks still materially down from their highs and the bond market in disarray, Buffett will make better decisions than most investors.

Historically, investors have wanted management teams to pay dividends because they don't trust management with the free cash flow of the business. They're afraid management will make a poor capital allocation decision like making a stupid acquisition or investing in a money-losing new venture. If this is how an investor feels about Buffett, they should sell Berkshire because access to his capital allocation decisions is the reason to own the stock.

Doug said...

I thought the question on retained earnings was great, but I was disappointed that Charlie missed the best (aka "my") answer.

I say Charlie and not Warren because I thought Charlie was close to giving my proposed answer when he spoke. Yes, no question about it, Berkshire failed the test from Dec 31, 2003 (84K) to Dec 31, 2008 (100K).

But did not the A shares crack 150K in Sep 2008? What if we use Sep 2003 (76K) and Sep 2008 (150K)? I think a double in five years for a 100B+ cap stock is not too bad.

"My" answer is to the reinvested earnings question is that if you can pick different dates that only differ by about 100 days out of 5 years and get such different results, then the market and not the capital allocator is to blame or praise. I think this is why Charlie was so blase on the issue.

Five years is sufficient time for Warren's test in normal times, but not in the middle of a crisis. If you want to indict Warren - pick the flat results from 1998 to 2003 not 2003 to 2008.