Monday, February 22, 2010

What I Learned, Part V: On Expected Returns and Diluting the Berkshire Gene Pool

“What is the expected return on capital from Burlington?” asks the shareholder from Hamburg, Germany. “And if you can’t buy more railroads would you expand into shipping?”

As Warren Buffett launches into his answer, I muse that this is not the first time a German has asked the best question at a Berkshire shareholder meeting.

In “Pilgrimage to Warren Buffett’s Omaha” (McGraw-Hill 2008) I described the one and only question that really challenged Warren Buffett throughout more than five hours on a Saturday morning two years ago—and it was asked by a shareholder from Bonn.

The fact that only one question—out of more than 50 that day—attempted to scratch the surface of the Oracle’s brainy-but-folksy demeanor is not as striking as it might appear to those who have only seen Buffett hold court on CNBC, where he dispatches opinions on everything from the inheritance tax to railcar statistics.

Despite the fact that the centerpiece of the annual “Woodstock for Capitalists” is a five-hour, no-holds-barred question-and-answer session with Warren Buffett and his vice-chairman, Charlie Munger, the fact is that in recent years not many shareholders asked questions even marginally related to Berkshire and its businesses.

All that changed at last year’s meeting, of course, when Buffett eliminated the first-come, first-served lineup at the microphones and instead selected three financial journalists to pose questions submitted in advance by shareholders and anyone else with an internet address.

The new format eliminated the tendency of past meetings to veer towards “What Would Warren Do?”-type queries from awestruck acolytes asking Buffett advice on how to become a great investor, or what issues Buffett would tackle if elected President, or—and I am not making this up—“Do you know and believe in Jesus Christ, and do you have a personal relationship with God?” (The answer to that one is—well, buy the book and find out.)

Indeed, at the May 2008 meeting only one question related to the businesses owned by Berkshire Hathaway. It was also the only question Buffett ducked. (By contrast, he answered the “Jesus Christ” question as he answered most of the rest: straight ahead, with no irony.)

And that was too bad, because it was a great question that indirectly got to the heart of what will likely become the central issue at Berkshire Hathaway: what happens when Warren Buffett—the best capital allocator in the world—is no longer allocating capital at Berkshire.

Using Berkshire’s See’s Candies as an example, the Man from Bonn asked whether Buffett would prefer a slower-growing but higher-margin business, as See’s is, to a global but somewhat lower-margin business, as Swiss chocolate giant Lindt & Spr√ľngli has become.

It is a an excellent observation: when Buffett and Munger bought See’s for $25 million in 1972, it was a small, west-coast candy company. 37 years and $1.5 billion in profits later, See’s remains a small, west-coast candy company.

While that’s good news for Berkshire shareholders—after all, Warren Buffett reinvested that $1.5 billion of cash from See’s into other high-return opportunities, to the benefit of Berkshire and its shareholders—it’s not necessarily good news for See’s Candies in a world gone global. (To see how Buffett ducked the German’s question, read “The Decline and Fall of the Sainted Seven,” Chapter 36 in “Pilgrimage.”)

The question asked today by the shareholder from Hamburg is equally good: “What is the expected return on capital from Burlington,” he has asked, “And if you can’t buy more railroads would you expand into shipping?”

This time, Buffett does not duck it.

“I think the return will be satisfactory but not mouth-watering,” Buffett says. “It’ll be similar to our energy utilities.”

Berkshire’s utilities earn decent, regulated returns on investment—not remotely close to the See’s Candies-kinds of returns that most investors associate with Warren Buffett—but “satisfactory” nonetheless.

The reason “satisfactory but not mouth-watering” returns are appealing to a guy famed for growing Berkshire’s book value at 20% a year for 45 years is simple: the sums involved are so vast ($43 billion, give or take, in total capital for the Burlington Northern deal), that a “satisfactory” return on this elephant-sized investment means a lot of money will be coming in Berkshire’s door every year for many, many years.

And any money manager—Buffett, especially—will tell you it is far more difficult to grow large amounts of money than small. In Burlington Northern, Buffett has found precisely the kind of “elephant” he has been hunting for years.

That does not mean, however, Buffett thinks the Burlington acquisition is without risk.

By comparing the railroad business to Berkshire’s existing utilities businesses, Buffett makes an important point. For unlike See’s Candies, which sells a discretionary consumer product and therefore may raise prices or introduce new products or enter new markets at will, the railroad business is subject to significant oversight from the Feds—less so than in the past, when pricing was regulated, but still significant—much like a regulated utility.

Indeed, at this very moment, Jay Rockefeller’s Senate Commerce Committee is considering new rail legislation to beef up regulatory oversight and put the screws to railroads—legislation that the CEO of Union Pacific, Burlington’s chief rival in the west, complained about on his company’s recent earnings call.

And so it is that Buffett proceeds to discuss the risk this government interference poses:

“We are counting on society to behave well with us in allowing us a reasonable return on capital IF we do our job of behaving reasonably well,” he says.

Asked next what would happen if government regulation got “more intense” on railroads, Buffett says matter-of-factly:

“The governments could strangle our utilities… They have the ultimate authority…they could raise the corporate tax rate to 80% or something…

Our basic position is that if we behave well, they’ll behave well. Our utility customers oughta feel very sure that when they flick a switch the lights’ll go on,” he says, adding, “They’re gonna need the railroads in this country big time.”

Buffett’s age (he’ll be 80 in August) seems to be catching up with him: despite shielding his eyes from the glare of the spotlights, he can’t discern from which microphone in the crowd the next question is coming from. He looks intently at the unused microphone near us while the shareholder asking the question is at the microphone on the other side of the concert hall:

“How would the stock split affect Berkshire’s ability to be in the S&P 500?”

It is a bit unsettling to see Buffett continue to stare at nobody, but the spotlights are bright and what the hell, this is Warren Buffett, who cares where he’s looking?

Besides, this is a question with big dollars at stake. Berkshire is not in the S&P 500 Index, despite the fact that its market value is larger by far than any other company not already in that index—and bigger than most that are in it.

The reasons Berkshire has been excluded up to now are straightforward: two of the Standard & Poor’s Index Committee’s five ‘admitting criteria’ haven’t been in Berkshire’s favor since the day Buffett took control in 1965—one being trading volume and the second being the amount of stock in public hands.

Before the Burlington deal was announced in early November, a less-than-whopping 40,000 shares of Berkshire “B” shares traded on a good day, not adjusted for today’s proposed 50-for-1 stock split. And the volume in “A” shares, through which Buffett controls Berkshire, barely rounded up to a 1,000 a day prior to the announcement.

Answering the question, Buffett observes:

"We’re by far the largest co that’s not in the S&P 500… the A/B situation creates problems for us, but eventually we’ll be in the S&P 500, we’ll be so large.”

So far, so clear; but it is in discussing the effects of this dramatic change in his shareholder base (over which Buffett was once so obsessed that he used to keep track of how many shareholders lived in his own zip code) that Buffett exhibits the ability to rationalize any particular stance that makes him so remarkable, and, to some investors, so hypocritical:

“If they put us in the S&P, it’s good for shareholders,” he says, because “if 6-7% of funds are in index funds it’s a block of stock that’s essentially there forever, which is EXACTLY what we’re looking for.”

Thus in one easy, plain-spoken sentence the investor who for fifty years has warned against following the herd; has railed against diversification by serious investors (“ass-backwards,” his business partner, Charlie Munger, calls it); and has refused to split his stock for fear of diluting the intellectual gene pool of the “quality shareholders” in the Berkshire Hathaway shareholder base, now blithely claims that index funds—big, stupid, mechanical, massively diversified index funds—are “Forever.”

If, by “Forever,” Buffett means “So long as Berkshire’s market capitalization stays proportional to the index,” then he’s correct.

If, on the other hand, by “Forever” he means “Whatever happens to Berkshire Hathaway,” he can’t be more wrong.

It is an astonishing piece of rationalization, even for most of the investors seated in this room, yet the prevailing reaction seems to be a shoulder-shrugging 'Warren-will-be-Warren'.

Buffett then rationalizes the effect on the Berkshire gene pool in an equally offhand way:

“By now our identity is pretty well known. I don’t worry about downgrading the quality of our shareholders.”

He concludes the stock-split discussion with one more remarkable statement:

"We should have done it when we bought Gen Re.”

The final question of the day gets to something that’s been on people’s minds since Buffett first announced the Burlington deal: what kind of hidden assets he sees in the Burlington railroad balance sheet.

To be concluded….

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Friday, February 12, 2010

What I Learned Writing a Book, Part IV: Of Colonoscopies, Cash and Cutouts

The question Buffett’s been asked is simple: ‘What’s the difference between Berkshire using undervalued stock to buy Burlington Northern, and Kraft using undervalued stock to buy Cadbury?’

It’s also quite good: Buffett has been beefing to anybody who’ll listen—and CNBC pretty much listens whenever he’s awake—about the price Kraft CEO Irene Rosenfeld is paying for Cadbury PLC, the iconic British chocolate company, and the fact that much of it will be in shares of Kraft.

He’s beefing about it because Berkshire Hathaway happens to be the single largest holder of Kraft stock.

But what really gets Buffett is that Rosenfeld did an end-around the “Oracle”—imagine that!—by cutting back on the stock portion of the deal to less than 20% of shares outstanding precisely so that Buffett wouldn’t have a chance to vote against the deal, as he promised to in a highly public, early January, press release.

(Charlie Munger, seen here looking over Buffett’s shoulder, no doubt feels equally slighted.)

For the record, Rosenfeld’s Kraft is paying roughly $21 billion all-in for Cadbury. This amounts to 24-times Cadbury’s trailing earnings, 14.3-times Cadbury’s trailing cash operating income (what analysts call ‘EBITDA’), and 3.8-times Cadbury’s book value.

(Yes, I know, most deals are priced on forward-looking sales and earnings…but investment bankers and chief financial officers can, and will, come up with whatever they need as far as futures go to justify their salaries and their bonuses. Garbage in, garbage out, as Buffett himself would say.)

For all that money, Kraft is getting a business that by my Bloomberg generates 45-50% gross margins, 12% operating margins, and throws off only enough cash from operations to cover capital expenditures. For a branded consumer business, this lack of “free cash flow” is hard to fathom, and sure to change under Kraft.

Some—including Kraft and its advisors—could argue the company is picking up an irreplaceable consumer franchise at a multiple of sales and operating cash flow that would have looked like a steal during the credit boom’s glory days.

Blackstone Group, after all, paid Cadbury-type multiples of revenue and operating cash flow for Freescale Semiconductor, a business—semiconductors, for goodness sake—that’s as cyclical, unstable and unpredictable as the chocolate company’s is non-cyclical, stable and predictable. Oh, and it’s a low-margin and highly capital-intensive business, to boot.

Nevertheless, Warren Buffett opposes the Kraft-for-Cadbury deal because, as he said during an early morning interview, in a typically Buffettian utterance, that as Kraft’s largest shareholder “I feel poorer.”

So let’s compare what Kraft is willing to pay for Cadbury with the price Warren Buffett is willing to pay—using both cash and a slug of shares of Berkshire Hathaway—for Burlington Northern, a “Class 1” American railroad that was assembled through mergers at the rate of one-per-decade starting in the 1970s.

Berkshire, which already owns 22% of Burlington (most of that purchased for close to $80 a share) is paying $100 a share for the rest of the company. All-in, that amounts to $34 billion for the equity plus about $9 billion in net debt, for a total price of roughly $43 billion, according to my Bloomberg.

Keep in mind, Burlington is a railroad, not a chocolate maker. While railroad operating margins in the good times can hit 23%, in the bad times they can get down to 15%, or less. Cash flows tend to be healthy, but so do capital expenditures.

Indeed, the Chief Financial Officer of CSX, one of the other three “Class 1” (it means “big”) railroads in the U.S., reflected on just that subject at an investor conference this week:

“Yes, we spend a lot of money. We always have. People are always for some reason I’m perplexed with [asking] why the industry spends between 15 and 17% of our revenue. It is a highly capital intensive business.”

For this cyclical, GDP-dependent railroad operator, Berkshire is paying almost 20-times trailing earnings, 9-times trailing cash operating income (EBITDA), and 2.7-times book value.

None of those numbers look like a steal.

Indeed, as Buffett himself has often pointed out, “book value” for a consumer brand business like Cadbury ought to be far more valuable than an industrial, for the simple reason that the cash generated by a consumer brand doesn’t need to be invested in capital expenditures simply to keep the lights on—as with a railroad.

All in all, Buffett’s Burlington investment, as he has been widely, and memorably, quoted, really does represent an “all-in wager on the economic future of the United States.”

As for using precious Berkshire stock in his deal, while at the same time criticizing Kraft for doing the same in their deal, Buffett’s answer here today is not so memorable:

“I’ve written the annual letter,” he says—Buffett drafts his unique, 20-page annual shareholder letter by hand; ace Fortune Magazine Editor and longtime Buffett confidant Carol Loomis edits it with, I am told, a very light touch—“and I deal with this.”

He continues with a line from his earlier CNBC interview: “Charlie and I like using stock for an acquisition about as much as we like preparing for a colonoscopy.” It’s a great line that generates laughs and will surely be the quote of the day, as Buffett surely knows.

“We are paying $100 a share [for Burlington]…but it costs us somewhat more than that because we are using stock on the low side of its historic range of book value, as a proxy for value.”

Buffett moves his hand up and down to indicate a theoretical price range, and keeps his hand down to reflect the lower end of that range: it is the first time in years he has publicly offered an observation on the current market value of Berkshire Hathaway stock.

“So when we looked at the Burlington deal we regarded it costing us somewhat more than $100 a share because we are using stock we would not like to issue.”

Having admitted to paying with undervalued stock, Buffett rationalizes the price in two ways:

“We already owned 22.5% of Burlington... We’re getting to use $22 billion of cash advantageously, and we will get to use more cash in that business, we think advantageously… So we thought the deal was okay.”

As to why use stock at all, Buffett says, without stating this out loud, that the deal wouldn’t have happened without some stock component to the price:

“If we had to use more [Berkshire] stock, I wouldn’t have done it. They TALKED about us using more stock, but I wouldn’t have done it.”

He then takes a parting shot at Kraft, with Charlie Munger’s input:

“I wish that Kraft, looking at THEIR deal, [had considered the value of the stock consideration]. I hope they considered that when they were making their calculations…”

Charlie Munger’s voice—Buffett has been sitting next to a cutout of his partner the entire meeting—breaks in, and breaks up the shareholders watching:

“I couldn’t agree more.”

In “Pilgrimage to Warren Buffett’s Omaha”—a hedge fund manager’s journey to the heart of Berkshire Hathaway—I noted that a remarkable number of German shareholders manage to line up first at the microphones in order to ask questions of Buffett and Munger during the Saturday question-and-answer session.

And today, the first international shareholder happens to be from—yes—Germany.

Specifically, from Hamburg, which is mainly famous as the port city where the Beatles developed their chops while playing to drunken sailors and other detritus of World War II.

And although this shareholder’s question has nothing to do with the Beatles, the second half of it does relate to Hamburg’s historic role in the Germany economy.

“What is the expected return on capital from Burlington? And if you can’t buy more railroads would you expand into shipping?”

Buffett responds, and the answer is both surprising and entirely expected.

To be continued…

Jeff Matthews
I Am Not Making This Up

Photographs and Content © 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Monday, February 08, 2010

What I Learned Writing a Book, Part III: “He Can’t Not Answer A Question.”

Buffett runs the meeting briskly and efficiently—and within minutes of his first appearing on stage we reach the guts of the thing, when he offers a motion to approve the 50-for-1 stock split and elimination of paper certificates for the Berkshire “B” shares.

The motion is quickly seconded by several voices in the small crowd.

After the spectacle of the annual gathering, it is an odd thing to sit in a Berkshire Hathaway meeting and hear Warren Buffett ask for a second to a motion—and odder still to have shareholders respond “Second!” from the floor. Berkshire’s “Woodstock for Capitalists” is a moveable affair, with shareholders coming and going as they see fit during the five-plus hours of Buffett and Munger’s question and answer session: but nobody’s moving from this one.

The motion seconded, we may now discuss it, Buffett says, pointing out two microphones for the purpose—one in each aisle. But, he warns, the discussion is strictly about the motion to split the stock.

This is disappointing.

Nearly everyone in this room braved Chicago airplane connections and sleety weather to ask Warren Buffett some good old-fashioned questions—none of the “What should I do with my life?” type of back-and-forth that permeates the annual meeting for this crew—and every one of the individuals in this room has at least one question they’d like to ask, given the chance.

My seatmates glance at one other. “He can’t not answer a question,” somebody says hopefully.

Despite Buffett’s warning, there is one lone shareholder standing at the microphone placed in the aisle near us, and Buffett calls on him—although he has trouble seeing through the glare of spotlights which microphone the question is coming from: the one in the aisle to his left, or the one in the aisle to his right.

The shareholder, a man, is from Princeton, New Jersey (just like the annual meeting, shareholders state their name and where they’re from) and he begins by pointing out that the proposed stock split will occur whether or not the Burlington Northern acquisition goes through.

So, he asks “what is the benefit to vote for the split even if the deal doesn’t go through?”

It’s a good, reasonable question, and Buffett drops all pretence of keeping things brief by starting a long, rambling answer. “Burlington has 250,000 shareholders,” he says, warming-up to the topic. Paying part of the price with Berkshire stock “enables Burlington shareholders to get a more tax-efficient transaction.”

This is true: shares sold for cash in a takeover trigger capital gains tax, but shares swapped for stock trigger no taxable event. Thus, most individual investors—who monitor their after-tax returns more carefully than mutual fund managers—prefer stock swaps to all-cash tenders, and Buffett wants to accommodate those Burlington shareholders looking to avoid a tax hit.

But it is precisely this kind of matter-of-fact maneuvering around the U.S. tax code that drives a healthy slice of investors crazy when it comes to Warren Buffett.

Buffett is a master of such maneuvers, going back to his early days running a hedge fund (yes, Warren Buffett ran what amounted to a hedge fund: see the chapter titled “Beyond Buffett” in “Pilgrimage to Warren Buffett’s Omaha”.) And for years he benefitted mightily from same the tax-advantaged carried interest provisions of private partnerships which he now criticizes.

(His type-written letters to his limited partners from those years are available on the internet, and are as much worth reading as his annual Berkshire “Chairman’s Letter.” In those letters, Buffett takes pains to delineate the amount of short-term gains versus long-term gains for his partners).

And if there is one thing I have learned writing a book about Warren Buffett and his company—or, more precisely, while giving speeches about the book itself—it is that in almost every crowd there is at least one investor who really despises Warren Buffett.

I’ve learned to spot them quickly. They tend to sit in a very uptight position, with arms and legs crossed and face tight, and when question time comes around they will inevitably raise their hand aggressively and ask in a louder-than-normal voice how it is that Warren Buffett gets off blabbing about taxes when he, Warren Buffett, ran a hedge fund for years or he, Warren Buffett is avoiding the inheritance tax by giving away his stock to his billionaire friend, Bill Gates, or when he, Warren Buffett, could just pay higher taxes if he wanted to…

(When asked in public forums why he doesn’t just pony up higher taxes, Buffett responds, quite rationally but, to his critics, lamely, that the laws are the laws, and he obeys those laws.)

So if the Burlington Northern Board of Directors wants part of the purchase consideration from Berkshire to be stock instead of cash in order to avoid capital gains taxes on a good portion of their shareholders’ profits (as well to benefit from future growth in Berkshire Hathaway, although Buffett does not mention that rationale here today), well, Buffett is going to accommodate them.

And if this means having to split his own company’s high-priced stock so that small investors in Burlington may get the same tax advantages that come with selling out for stock rather than cash, as large investors will, then Buffett is perfectly willing to do it.

“We want to earn the reputation of treating every shareholder equally and with respect,” he says. “To not offer people with less than $3,000 of Burlington Northern the same as those with more, we felt it was the wrong way to go…”

As far as his own well-known, and long-voiced, opposition to splitting Berkshire’s stock, Buffett explains his change of mind this way: “I worried in the past that people would be enticed by the stock price. I’m less worried about that.” He adds ruefully, “in fact our recent record will help with that.”This generates laughter and is precisely the kind of self-deprecating remark by which Buffett diffuses even mildly contentious questions—and it works here today: he calls for the next question, and it moves gingerly outside the realm of stock splits.

“Why Burlington Northern, and not Union Pacific?” the shareholder at the microphone asks.

“They’re both wonderful railroads,” Buffett responds, in his usually tactful manner. Unless the subject is greedy investment bankers, remorseless mortgage brokers or Greek-alphabet-pushing academics, Buffett follows the Dale Carnegie rule of not to criticize, condemn or complain. “And there’s no way one will do better or worse…their fates are locked,” he says.

Then, getting to the heart of the question, Buffett says, “I like the western railroads a little better. If you look out 10 or 15 or 20 years, the West will grow a little faster.”

Clearly, he is looking to China and India as engines of worldwide growth.

The next shareholder asks how he will handle the annual meeting when its shareholder attendance—already north of 30,000—is inflated by some portion of those 250,000 Burlington Northern shareholders to whom he will be giving stock.

Buffett smiles and says, “Maybe if Charlie stays home we’ll only have a hundred people.”

There are now shareholders at each of the two microphones (one in each aisle), and the questions make no pretense of staying on the subject of the stock split.

In fact, it is the next question, from a local Omaha shareholder, that is most clearly on everyone’s mind.

And while Buffett has already this morning been asked a variation on the same question by the Buffett-friendly CNBC anchor Becky Quick, it is here among his most serious admirers that Buffett won’t be able to glibly toss off an amusing response to his favorite talking head.

Buffett has complained about Kraft using “undervalued stock” to buy Cadbury, the shareholder from Omaha says, yet Buffett is using his owned undervalued stock to buy Burlington Northern—a railroad company.

“What are the differences using undervalued Berkshire stock to buy Burlington Northern?”
Buffett begins to speak, and we listen.

—To be continued...

Jeff Matthews
I Am Not Making This Up

Photograph and Content © 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Tuesday, February 02, 2010

What I Learned Writing a Book, Part II: The Oracle Appears, Alone…Sort Of

There is some gamesmanship going on as we enter the cozy, wood-floored Peter Kiewit concert hall here in downtown Omaha.

Of course, it’s nothing like what goes on at the Berkshire Hathaway annual meeting. At that “Woodstock for Capitalists,” as Buffett likes to call it—held not in a 2,000-seat concert hall but in a 17,000-seat arena within the Qwest Center a few blocks away—draws so many shareholders from around the world that lines begin to form, for hundreds of yards around the glass and steel complex, before the sun rises, just waiting for the doors to open.

If the annual meeting is the equivalent of a musical Woodstock, without the drugs and naked dancers, then today’s special meeting is more like one of Sting’s lute concerts. (If you never went to one of Sting’s lute concerts, you are not alone: only hardcore Sting fans went to those, and only hardcore Buffett fans are here.)

This will be, indeed, a very mellow affair.

There no camera crews from China prowling the halls for interviewees, no giant video screens hanging alongside the stage, and no young men in Dockers and button-down oxford shirts bursting inside as soon as the doors open, running down the aisles and claiming seats near the stage.

Instead, there are older couples—retirees with time to spare on a sleety, cold, blustery Wednesday morning—and professional investors (all men, most in suits and ties), all walking casually down the aisles, chatting, spotting friends, and selecting seats.

And this is where the gamesmanship comes in.

For even in this cozy concert hall, and even among these—the most serious observers of Warren Buffett and Berkshire Hathaway—there are people are looking for the best seat possible from which to watch Warren Buffett.

Several new acquaintances and I take seats in what appears to be a prime spot, a few rows from the front. The money manager seated next to me is a 20 year Berkshire veteran who had introduced himself out in the lobby—he had read “Pilgrimage to Warren Buffett’s Omaha”—and I learn he attended the last and only other special meeting in Berkshire Hathaway’s post-Buffett history: the meeting to approve the acquisition of General Re.

We talk about that meeting—made legendary when Buffett put up a life-size cut-out photograph of Charlie Munger in the seat next to his and played tape-recorded bits of Mungerisms at appropriate times—and he observes that there were far more investors at that meeting than this one.

Indeed, by my count, there are only about 150 people are here today. By contrast, there were 500 shareholders at the 1998 special meeting.

What accounts for this loss of interest—aside from the bad weather—is one subtle but distinct difference between the General Re meeting eleven years ago and this one today.

Today’s meeting is merely to approve a stock split that will enable Berkshire’s purchase of Burlington Northern railroad. Buffett’s going to buy Burlington come hell or high water, or, as Buffett once said in reference to another transaction, “even if Ben Bernanke runs off with Paris Hilton.”

The 1998 special meeting, on the other hand, was held for Berkshire shareholders to approve the company’s merger with General Re.

Now, until Burlington Northern came along a few months ago, General Re had been the biggest acquisition in Berkshire’s—and Buffett’s—history, although despite Buffett’s high hopes and effusive cheerleading at the time, it did not prove to be one of the best.

Buffett paid $22 billion for General Re, all of it in shares of Berkshire stock (hence the need for a special meeting to get shareholder approval), meaning the cost of the deal went up along with Berkshire’s stock price, even if General Re’s business did not likewise increase in value.

And for some time afterwards, that prospect did not look good. Indeed, the 1998 press release in which Buffett announced the deal reads embarrassingly wide-eyed, given what was to follow:

“But the main attraction of the merger [with General Re] is synergy, a word that heretofore has never been used in listing the reasons for a Berkshire acquisition. In this transaction, however, there are at least four areas of powerful synergy, which Charles Munger, Berkshire’s Vice Chairman, and I believe justify the premium price that Berkshire is paying…”

Not only did the synergies take longer to appear, but one of them—“removes constraints on earnings volatility”—would come to haunt Berkshire after the 9/11 terrorist attacks on the World Trade Center caused more than $2 billion worth of unanticipated “earnings volatility.”

In addition, and to Buffett’s eternal annoyance, Berkshire would later spend $400 million laboriously unwinding 23,000 derivatives contracts fermenting with General Re at the time of the acquisition.

(On the plus side, the experience of unwinding those contracts during the salad days of the early 2000s would directly lead to Buffett’s stern warnings against derivatives as a market cure-all in his 2002 shareholder letter, and help Berkshire emerge from the 2008 crisis in far better shape than its peers.)

Furthermore, Gen Re would, under Buffett’s watch, become embroiled in a scandal that would eventually entail testimony from Buffett himself; threaten the squeaky-clean image Buffett demands the Berkshire business family to maintain; and result in the conviction of several former Gen Re executives—all for entering into “sham transactions” by which Gen Re helped AIG dress up its reserves to satisfy Wall Street’s Finest.

In fact, I’ve been told—while preparing for an early-morning interview with Bloomberg TV—that a final settlement on that sordid chapter was coming, with Gen Re paying $92 million to both settle investor claims and put an end to Federal investigations into the matter.

Thus, as Berkshire closes out the final, downbeat chapter to that last previous record-setting acquisition, we Berkshire shareholders are being asked not to approve the acquisition of Burlington Northern railroad, but merely to allow a 50-for-1 stock split and the elimination of paper stock certificates for the Berkshire “B” shares.

The Berkshire “B” shares—and I’ll keep it light so our readers’ eyes don’t roll back into their heads—are simply cheaper versions of the regular Berkshire “A” shares. The “A” shares trade around $100,000 a share—yes, $100,000 per share—and most people can’t afford to buy them. So Buffett created the “B” shares at 1/30th the value of the “A” shares.

One more difference, and it’s huge: the “B” shares have fewer voting rights than the “A” shares—like 1/200th of the voting rights. This might seem to be a glaring incongruity at a company whose CEO is highly vocal about the rights of shareholders, and also highly outspoken about the irresponsibility of “lapdog” Boards of Directors, but readers of “Pilgrimage to Warren Buffett’s Omaha” know this is only one of several incongruities when it comes to the greatest investor in the world.

Before today’s meeting, the vote-deprived “B” shares sell for around $3,500 each. After the meeting, assuming we’ve approved a 50-for-1 split, they’ll sell for $70-something a piece…and they’ll be even more vote-deprived.

Instead of having 1/200th of the voting rights of an “A” share, they’ll have 1/10,000th of an “A” share vote.

We are seated, as I said, a few rows back from the stage. Our seats are, technically, “Stage Left”—i.e. to the left of center stage when facing the audience—and this is where the gamesmanship comes in.

“The speech is on the other side,” somebody says, pointing to the table onstage where Buffett will sit. It has two microphones, just like the annual meeting, and a stack of papers has been placed at the seat which is to our left as we look at the table, but which is, technically, Stage Right.

Someone else observes, “Well that’s where he always sits at the annual meeting.”

So we get up and walk through an empty row to the other side of the concert hall, and pick seats a few rows back that will presumably give us a better look at Buffett when he sits down at the microphone with the speech in front of it.

Others notice and follow our example; others notice but sit pat. After all, almost any seat in the room will provide a good view of the “Oracle of Omaha.”

I am introduced to a farmer from Iowa. He is a longtime Berkshire shareholder, and we begin talking about the harvest and the outlook for corn prices. Business has been good, he tells us, what with demand from ethanol plants and the wet November that interrupted the harvest. “I was out there yesterday and there’s a lot of corn to be harvested.”

“Isn’t this kind of late in the season?” we ask.

“It is,” he says, “it is, but—”

Our focus turns to the stage, where a woman has crossed from the wings and is arranging things on the table. She moves the speech from one microphone to the other, raising speculation of a shift in Buffett’s preferred seat.

“Maybe Charlie’s coming,” somebody says hopefully.

This bit of Kremlinology ends when Buffett himself strides in from Stage Left, smiling as the crowd begins to applaud.

He sits down on our side of the table, Stage Right—“where he always sits”—and fiddles with the microphone. There is no bowl of See’s candy, as at the annual meeting, but there are two cans of Cherry Coke within arm’s reach.

“This is a little embarrassing,” Buffett begins, in his husky, folksy voice. “When Charlie’s here we usually get about 35,000 people.”

While we’re laughing, Buffett lifts up a life-size cut-out of a youthful Charlie Munger—the same one it would appear he used at the special meeting in 1998—and places it in the other seat.

He presses a button and Charlie’s familiar, higher-pitched voice says, “I have nothing more to add.”

“It’s as good as having him here and we don’t pay him,” Buffett says.

After dispensing with the preliminaries, Buffett announces he will accept questions on the motions before us.

And there are questions.

—to be continued.

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.