Monday, June 01, 2009

Part 5: Buffett Declines to Agonize, or Analyze…and the Least Satisfying Answer of the Day


Carol Loomis Goes Three-for-Three; No Post-Mortem on GenRe…or, How GenRe Outfoxed Warren Buffett; Perils That Lurk and the Four Managers Who Failed to Avoid Them.



Agonizing over errors is a mistake. But acknowledging and analyzing them can be useful, though that practice is rare in corporate boardrooms. There, Charlie and I have almost never witnessed a candid post-mortem of a failed decision, particularly one involving an acquisition.


A notable exception to this never-look-back approach is that of The Washington Post Company, which unfailingly and objectively reviews its acquisitions three years after they are made. Elsewhere, triumphs are trumpeted, but dumb decisions either get no follow-up or are rationalized.
—Warren E. Buffett

Warren Buffett wrote those words in the year 2000. He was describing for Berkshire shareholders about how a large advertising budget had failed to produce the desired growth at GEICO that year.

Fortune Editor Carol Loomis, Buffett’s editor for his annual shareholder letters and one of three reporters asking questions at the Berkshire annual meeting, recalled those very words when she asked, on behalf of a Berkshire shareholder, one of the best questions of the day:

“You’ve said management should do a post-mortem on acquisitions. Would you do a post-mortem on Gen Re?”

And although it was one of the best questions of the day, Buffett ducked it.

Now, the deal for General Re, for which Buffett paid what amounted to $16 billion worth of precious Berkshire stock on the closing date, was not a terrible one. After all, Berkshire got $16 billion in “float”—Gen Re's accumulated premiums available for investment—and a billion dollar annual earnings stream.

As things turned out, however, it was not a terrific one.

The terrorist attacks of 9/11 (or are we calling them “expressions of human rights” these days?) exposed a serious lapse in reinsurance underwriting standards at Gen Re that would wipe out more than $8 billion of retained earnings.

Furthermore, the Gen Re derivatives book gave Buffett and Munger less expensive but longer-lasting headaches, costing $400 million to unwind and leading Buffett to deliver his famous “ticking time bomb” early warning against the stuff five years before the explosion went off.

Of course, $400 million is a pittance and rounding error compared to the trillions in damages derivates did to the American economy. But to the rational mind of Warren Buffett—who paid for those derivates, along with the rest of Gen Re, in stock—that was $400 million worth of cherished Berkshire stock vaporized.

In fact, the cost was more than $400 million, since Berkshire stock rose in value over the years after the acquisition—by slightly more than half, at today’s price. Thus a $16 billion purchase price for Gen Re at the time of closing now stands at $25 billion, based on Berkshire’s Friday closing price.

Finally, Berkshire’s ownership of Gen Re also resulted in the biggest black eye ever to hit the close-knit Berkshire family: the Federal prosecution of Gen Re/Berkshire employees for income-ginning insurance transactions to benefit Now-Ward-of-the-State AIG.

On the plus side, Gen Re is these days an entrenched core of an insurance industry giant—what was, until recently, the only AAA-rated reinsurance business in America. It contributed $21 billion in float to Berkshire at the end of 2008, and although pre-tax earnings at Gen Re aren’t even half what they were back when Buffett acquired the business, he likes owning it.

Yet Buffett declined to perform any “post-mortem”—of the kind he once castigated most “corporate boardrooms” for failing to perform—for Berkshire shareholders:

“I don’t think you attract managers by pointing out the shortfalls that may have occurred with the managers that may be doing a very good job trying to overcome problems,” he said. “Gen Re has worked out after a terrible start.”

Instead of analyzing the largest and most important acquisition in Berkshire’s history, Buffett said what he wrote in his most recent shareholder letter: “Gen Re is now the company I thought it was when I bought it in 1998.”

Indeed, he seemed far more concerned with protecting the feelings of existing management at Gen Re in front of 17,000 shareholders sitting in the Qwest Center arena than rationally explaining the positives and negatives of the deal:

“It would really have been a mistake to discuss dumb decisions that might reflect on some of the managers of the businesses…”

Charlie Munger, on the other hand, presented a more frank appraisal of the deal:

“Joe was the steward for the General Re shareholders,” Munger said, referring to Joe Brandon, who was General Re’s chief financial officer for the decade before the Berkshire merger—presumably when the tainted derivates book was being built. “We got a decent result,” Munger said, referring to Berkshire shareholders, “and they got a fabulous result.”

“Post-mortem” avoided, Buffett moved on.


The best question of the day that Buffett did answer also happened to be asked by Carol Loomis—Loomis went three-for-three on the best questions—concerned the four investment managers Buffett has chosen to manage funds as a sort of test-drive to select one or more successors to Buffett.

“Can you please tell us, without naming names, how each of the four did in 2008,” Loomis asked. “How would you rate the way these four managers did in managing last year. Are they still on the list?”

This time Buffett answered the question, but it wasn’t what a shareholder might have expected to hear.

“I don’t have precise figures on all of them,” Buffett said. Now, this might sound odd given that most money managers know exactly how they’ve done every day, let alone for the year, at 4:01 p.m. Eastern Standard Time after the close of trading. But Buffett’s candidates reportedly include at least one insurance guy managing a complex portfolio.

In any event, while “all four are still on the list,” according to Buffett, they didn’t knock the cover off the ball in 2008:

“I would say they did no better than match the S&P, which was minus 37…so I would say in terms of 2008 you would not say that they did not cover themselves in glory.” Then, as he does, Buffett disarmed the audience with a self-critical disclaimer: “But I did not cover myself in glory so I’m more tolerant.”

This generated laughter and a light-hearted follow-up from Munger:

“Every investment manager that I know of in America that is intelligent…they ALL got creamed last year.”

This generated more laughter—despite the fact that getting “creamed” in a financial crisis was probably not exactly what Buffett had in mind when he selected his money managers:

Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.—Warren E. Buffett

Buffett himself read those very words, first written in the his 2006 letter to shareholders, to this same audience two years ago, wishing to emphasize the importance of preserving Berkshire’s capital in the face of unimaginable—by most—dangers, far into the future.

And yet the four managers competing for the job of replacing “The Oracle of Omaha” apparently failed to do just that.

It is the least satisfying, and most unnerving, answer of the day.

We wind up later this week with:

· Sharpest Implied Put-Down
· Mystery Revealed!
· One Industry Not to Expect Buffett to Buy Into

And

· The Most Philosophical Start to Any Answer at Any Annual Meeting in History, Since the Beginning of Recorded Time


And then back to business and anything else that strikes our fancy—including The Postman Who Freaked and other matters.


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.


6 comments:

AOP said...

Dear Jeff, Speaking of green things and being a stuffing expert, is GMCR employing accouting chicanery with its purchase of inventory from licensees triggering royalty income as reported in last week's Barrons? Your old landlord, Art

Jeff Matthews said...

Art, I didn't understand the Barron's article.

So GMCR buys stuff from a licensee and triggers royalty income for that licensee? Isn't that the business model?

Unless I don't understand the model--and I don't follow GMCR closely--the licensee provides GMCR with coffee in K-Cups that GMCR sells to distributors.

Unless GMCR is storing these K-cups it buys from Dietrich in a warehouse, this isn't like the old Media-Vision days!

But informed readers may have another point of view.

JM

AOP said...

Jeff, The way I read the article is that GMCR purchases inventory from a licensee and that triggers royalty income for GMCR (not the licensee or seller). So, by buying inventory, GMCR triggers royalty income to itself! From what I understood, a method to increase profits by increasing inventory purchases. A pretty neat accounting trick if I ever saw one. I am glad I am not alone in my confusion. Art

But What do I Know? said...

Gee, Warren is a hypocrite who can't take what he dishes out. Thanks for the fine elucidation of what seems to slide by the MSM.

The adolation of WB has always seemed to me to be a case of confusing brains with a bull market and luck. I understand that he bought some things when they were cheap and if you do that you give yourself a better-than-average chance of making good money. But there were a lot of other guys out there doing the same thing and to some degree he got lucky and had a good run in the beginning. Lately, not so good.

Jeff Matthews said...

Art, I get the idea--GMCR triggers a royalty payment to themselves by ordering product from Dietrich on which Dietrich pays GMCR a royalty.

But GMCR is growing. K-cup sales wwere up 129% in the quarter.

Unless there's channel or warehouse-stuffing going on, I don't see the issue until/unless GMCR's sales start rolling over.

Informed readers can email us on this topic: notmakingthisup@gmail.com.

JM

cheyfaith said...

Apparently, conducting a post-mortem is easier said than done. As someone who works for a company that was in some ways, taken over by another company, I can see why Buffet doesn't want to agozine over the Gen Re deal too much too publicly. It's not really productive in terms of growing the company as an investment. Buffet's invesment style seems to place a high premium on human capital, so why do anything to damage that value now? Those retained in the Gen Re acquisition are likely sensitive to being admonished or regarded as a poor choice. In actual practice, it makes more sense for Buffet to move on and stay focused on creating value with what he's got versus conducting a "candid post-mortem".