Friday, June 19, 2009

‘Woodstock for Capitalists’ Concluded: “The Edge of Death” and Other Matters


Lost Bragging Rights; Credit Default Squeeze Explained; Student Loan Business Unexplained; A Nephew Married and a Suspicion Confirmed; Charlie Munger, Rational to the Last; a Final Breakthrough Foretold


Lost Bragging Rights and a Mystery Explained

Warren Buffett loved his Triple-A credit rating.

He mentioned it frequently, and spoke of its importance as far back as his 2003 shareholder letter:

Among the giants, General Re, rated AAA across-the-board, is now in a class by itself in respect to its financial strength.

No attribute is more important…. When an insurer lays out money today in exchange for a reinsurer’s promise to pay a decade or two later, it’s dangerous – and possibly life-threatening – for the insurer to deal with any but the strongest reinsurer around.


In 2004 he crowed even louder about it:

Gen Re’s financial strength, unmatched among reinsurers even as we started 2003, further improved during the year. Many of the company’s competitors suffered credit downgrades last year, leaving Gen Re, and its sister operation at National Indemnity, as the only AAA-rated companies among the world’s major reinsurers.

So it is no big surprise when a shareholder at the Berkshire Hathaway 2009 shareholders meeting asks about the recent Moody’s downgrade of the Berkshire companies’ debt two levels, from AAA to Aa2, on “the severe decline in equity markets over the past year as well as the protracted economic recession.”

And it is no surprise at all when Buffett promptly admits that losing the Triple-A rating bugged him:

“I very much liked having a triple A. I was disappointed when Moody’s downgraded—we didn’t think that was gonna happen, but it did. It does cause us to lose some bragging rights.”

What is a surprise comes when, in the course of discussing the downgrade, Buffett reveals the answer to a mystery which prevailed for months prior to the meeting: what
caused credit default swaps on Berkshire Hathaway—certainly nobody’s idea of a teetering financial institution on the brink of collapse—to soar to levels associated with companies more like Sears?

Turns out that, as we here at NMTU had ventured to guess (see “Is Buffett Worried? No, but Somebody Is,” from November 20, 2008), the spike had been caused by counterparties to the index put options Buffett had sold—prior to the market collapse—buying protection on Berkshire, driving the price of that protection up to absurd levels.

Here’s how Buffett explained it:

“When we write an equity put option—a billion dollar put—and somebody pays us $150 million, we get the cash and set up a liability. The other guy takes $150 million out of cash and sets up a $150 million receivable.

“Now, as the world has developed, the value of that asset has increased and he reports that through earnings, and we report that as a loss. BUT, we’ve got the cash, and he’s got an asset that’s due in 15 years or something.

“Now, his auditors say, you have to go buy a credit default swap [on Berkshire] to protect yourself against that receivable going bad…”


Hence the spike in credit default swaps on Berkshire Hathaway, which for a period of time made the Oracle of Omaha's 44-year-long accumulation of cash-generating businesses and insurance “float” appear to have no more going for it than Sears Holdings Corp.

Buffett concludes the discussion—by way of making his shareholders feel better about contracts that were, at that point, billions in the hole—with the observation that as the price of the credit default swaps increased, the cost to the counterparty of maintaining that put option soared.


“It explains why people may want to modify their contracts with us,” he adds, smugly.


One Industry Not to Expect Warren Buffett to Buy Into

“The only thing out of bounds,” Buffett likes to say before the questions begin, “is what we’re doing now.” But that doesn’t stop shareholders and money managers from fishing.

And, sometimes, they catch something—but not necessarily what they’re looking for.

Asked by a Montclair New Jersey shareholder to talk about the student loan industry—currently under a cloud given the recent near-death experience of Sallie Mae—Buffett lets Munger handle the question.

It turns out to be the briefest answer the entire day, and no doubt a disappointing one to the shareholder from Montclair:


“We don’t know a lot about it,” Munger says. Period.

For Buffett and Munger not to know a lot about a business…well, that’s one business not to expect Buffett and Munger to buy into any time soon.


Suspicion Confirmed

The clocks in the Qwest Center arena are approaching 3 p.m.


The crowd has thinned out, and the question and answer session is almost over.

The 51st and last question of the day now comes—oddly enough—from a young man with a microphone, standing in the audience near the front of the stage.

I say “oddly enough” because up until now, the meeting has been run entirely differently from years past.

Instead of shareholders asking questions unfettered from one of a dozen microphones placed around the Madison Square Garden-sized Qwest Center arena, Buffett chose three reporters—Carol Loomis of Fortune, Becky Quick of CNBC and Andrew Ross Sorkin of the New York Times—to ask questions submitted via email. In between each reporter’s turn, a shareholder chosen by lottery asked a question.


This new format distinctly limited the kind of “What Would Warren Do?” questions that had come to dominate the proceedings, and made for a much more relevant set of questions.

It also, however, slowed things down.

After all, when a person stands at a microphone to ask a question of the world’s most successful investor and his equally intelligent (and highly acerbic) business partner, that person doesn’t want to look like an idiot in front of 30,000 people and a worldwide press corps.

Thus, in years past, the questions—though generally off-topic, and sometimes way off-topic—tended to be asked quickly, and to the point.

That same person, however, when emailing a question to one of the three reporters, may write to his or her heart’s content.

And that's why the questions from the reporters today—even the really good questions—have tended to be verbose and sometimes convoluted, none more so than the one about Berkshire’s derivatives exposure, which conjured up “Slim Pickens in 'Dr. Strangelove' riding a nuclear bomb” and much other flowery imagery to make a simple point—i.e. that Berkshire’s derivatives positions had cost a bunch of money, and what did Buffett think of that?

Furthermore, although Buffett himself started the meeting by highlighting the new format—“They’re all Berkshire Hathaway-related questions…. We had a problem where they drifted off the last couple of years: what we should do in school, that sort of thing”—he hasn’t exactly been forthcoming in responding to those Berkshire-related questions.

Buffett has refused to do a post-mortem on the General Re acquisition; failed to address a great question on the difference between the money-center banks that collapsed and one (Wells Fargo) that didn’t; professed ignorance of earnings management at one of the most earnings-managed companies in the world (GE); and dismissed the Index Fund-style 2008 performance of the four money-managers in the running to succeed him at Berkshire with a figurative wave of the hand (“They did not cover themselves in glory, but I did not cover myself in glory so I’m more tolerant,” he said blandly).

Indeed, one of Buffett’s favorite questions the entire day was entirely theoretical: What would Buffett have done had he been in the same position as Bank of America’s Ken Lewis, who felt pressured by Paulson and Bernanke to withhold making public the deterioration of Merrill Lynch during the financial crisis?

Boy that’s a great question,” Buffett says enthusiastically, then turns the question on its head. “If I’d been in Ben Bernanke’s or Paulson’s situation would I do differently? We were in a fragile situation in September, if B of A had rejected Merrill on a material adverse change clause…. I’m gonna ask Charlie what he would do.”

Munger stirs in his seat and says simply:

“You can criticize the original decision to buy Merrill and the contract they signed, and that would be legitimate, but once they signed that contract I believe the Treasury and B of A behaved honorably”

With Buffett wondering out loud what he would do if he’d been Ben Bernanke or Hank Paulson, a suspicion—that he actually prefers answering the “What Would Warren Do?”-style questions to the strictly-business questions in which he might embarrass a member of the extended Berkshire family in front of 30,000 people—takes root.

And it is confirmed when the young man with the microphone standing in the audience asks the 51st question of the day.

The young man’s name is Alex, and he wants to know “how we can improve the economy.”

“We can do what the government wants us to do and spend, and housing formations are important. I don’t know if that gives you any ideas or not.” Buffett says suggestively.

The young man then turns to a young woman beside him: “Mimi, you’re my best friend, would you be my wife?”

It’s a set-up. The couple embraces, the audience applauds, and Buffett concludes the day’s question-and-answer session on a decidedly non-business note:

“I have two comments to make. Alex is my sister Doris’s grandson, my grand-nephew; and Mimi is terrific.”

The meeting is over. The crowd disburses.


Charlie Munger, Rational to the Last

If, by concluding the session with a grand-nephew's marriage proposal in front of 30,000 people, Warren Buffett appears to affirm the transformation of the Berkshire annual meeting into something more pep rally than business meeting, Charlie Munger has changed his own contribution to the proceedings not one bit.

In fact, Munger has added more to the proceedings than in recent years, although always in the same rich, deeply skeptical, highly moral vein that made him sentimental favorite of a good portion of Berkshire’s “quality shareholders.”

Asked how to improve the “financial literacy” of Americans, Munger says dourly,

“I don’t think you can teach people high finance who can’t use a credit card.”

When Buffett is asked whether he uses “a normal free cash flow over the discount rate” calculation in making investments and responds with his standard line—“If you need to use a computer or calculator to make the calculation, you shouldn’t buy it”—Munger adds:

“Some of the WORST business decisions I’ve ever seen is when people do these complex calculations. The worst I’ve ever seen was when Shell did that with Belridge Oil.”

(I still have the Lucite paper-weight with the tombstone ad announcing that deal from almost exactly 30 years ago. Merrill Lynch, my alma mater, helped do some of those “complex calculations” for Shell.)

And when Buffett defends his ownership of Moody’s—the ratings firm that contributed mightily to the subprime crisis by slapping Triple-A ratings on junk assets—Munger says:

“I think the ratings agencies eagerly sought stupid assumptions…it’s an example of being too smart for your own good.”

But Charlie Munger is no grumpy old man. He is, above all things, rational.

A discussion of recent stability in lower-priced housing markets, improved home affordability and the current high rate of absorption—Berkshire owns the second-largest real estate broker in the country, and Buffett notes that household creation is running nearly three times the current construction pace—brings this matter-of-fact observation from Munger:

“If I wanted to buy a house in Omaha, I’d buy a house tomorrow.”

Defending last year’s no-better-than-S&P 500 performance of the four investment managers in the running to succeed Buffett, Munger says:

“I don’t think we would WANT a manger that could think he could just go to cash on a macroeconomic basis and then jump back in…we can’t do it ourselves.”

Dismissing a question about last year’s decline in Berkshire’s stock price, Munger focuses on the future:

“What matters is this, our casualty business is probably the best in the world; our utility business, if there is better utility I don’t know it…and I could go down that list. And if you think it’s easy to get into that position Berkshire occupies, you’re living in a different world than I inhabit.”

Charlie Munger is, as always, thinking big thoughts.

And some that are more philosophical than have ever been expressed at a public shareholder meeting.


A Final Breakthrough

Asked about the potential returns from Berkshire Hathaway by a shareholder who notes that Berkshire’s book value has grown 20% only once since 1995, Buffett focuses on the numbers:

“It’s absolutely impossible that we’ll come close to a figure like 20%...we hope that we achieve a few percentage points better than the S&P 500 a year. If we get a couple points better—I’ll feel better.”

Munger, on the other hand, focuses on the intangibles:

“I think this company will make a big and constructive contribution to its surrounding civilization in the years to come.”

Asked if Berkshire’s “sustainable advantage is largely you,” and what happens to this advantage when he is gone, Buffett first jokes that this focus on his eventual demise is “Defeatism,” then argues the sustainable advantage is the culture “embedded” in the Berkshire businesses—a culture reinforced by this very meeting:

“Our culture, our managers, our shareholders JOINED that culture, it gets reinforced all the time, they see that it works… it’s meaningful because there will be people that want to join up with us and they won’t have a good second choice.”

Munger goes a step further:

“A lot of corporations in America are run stupidly from headquarters as they try and force the divisions to come up with profits every quarter that are better than the last quarter…and a lot of problems creep into that business.”

He finishes that profoundly insightful knife at the heart of American capitalism with a hint of his own brand of fatalism:

“While Warren and I will soon be gone…the stupidity of management in the corporate world will likely remain to give Berkshire a competitive advantage in the future.”

Yet it is when Buffett and Munger are asked about the potential for economic upheaval in these uncertain times that Munger comes through with the most remarkably philosophical answer to a question at any annual meeting:

“Well now that I’m so close to the edge of death,” he says matter-of-factly, “I find myself getting more cheery about the economic future. We are going to harness the direct energy of the sun...

“What I see as a final breakthrough—you can see it coming over the horizon. I think it’s usually a mistake to think only about your probable misfortunes, it’s good to think about what’s good about our situation.”


Charlie Munger, rational to the last.

Good to think about, indeed.


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.







9 comments:

DaleW said...

Thanks for your trenchant observations on perhaps the best Berkshire annual meeting in the last decade and perhaps a top-3 meeting for all time.

Aaron said...

I also echo DaleW's sentiment and want to thank you for letting readers like me have the opportunity to pose questions at this year's Berkshire shareholder meeting. The exercise was both instructive and informative for me, and I've come away with a greater appreciation of how the Oracle of Omaha thinks after reading your posts. I hope you'll consider this format of questioning again when attending next year's Woodstock for Capitalists. Great job, as usual, Professor!

smithycroftman said...

Thanks Jeff,

Great posts, maybe Berkshire won't miss Warren and Charlie when they're gone, but we will.

Anonymous said...

Very nicely done. Charlie Munger is my hero.

Anonymous said...

The Sun. Jeff, you thinking what I'm thinking?

Jeff Matthews said...

Anonymous: "The Sun...."

Sorry, I have no idea what you're thinking. Please elucidate.

JM

Joe said...

FWIW I'm interpreting Munger's comment as a reference to fusion energy, not solar power.

Anonymous said...

Jeff - What was the technical mistake in analysis that caused Shell to overpay for Belridge. Bruce Wasserstein has written that Shell overpaid for Belridge because they had better recovery technology (no surprise on the sentiment considering the source).

Regards

Jeff Matthews said...

At the time Shell bought Belridge they sold the deal to Wall Street on the basis that Wasserstein sells it in his book: Shell had the ability to get more heavy oil out of the ground than Belridge itself.

(Heavy oil is thick--almost like asphault, and costs a lot more to produce and refine than so-called "light" crude oil.)

For a few years Shell did look smart, because oil prices tripled after the Iranian criis. Then oil prices collapsed from the high $30s to the $10 area, and heavy oil was the big loser: at $10 a barrel it's hard to justify pumping the stuff.

JM