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.


Anonymous said...

Professor Jeff:

If I recall, isn't Berkshire acquiring Burlington Northern both in cash and in stock (60/40 respectively)? I thought I read somewhere where part of the deal was to use approximately $16 billion in cash from bank notes/loans. Wouldn't the cash portion of Berkshire's offer cause a capital gains tax hit despite the portion of Berkshire stock offered as well? Just wondering. And if I'm a BNI shareholder, I'd take the BRK.A stock swap, $100 collar or no $100 collar, pronto!

That's my two cents, of which, I could be wrong!

jason said...

The real reason he wanted to split the stock seems to be to get into the SP 500. You will note that the SP announcement was made just prior to the start of the pricing period-- reducing the number of BRK shares to be issued in the transaction. After the announcement the price has increased ~$65 to ~$74.
That is the real brilliance of Mr. Buffett. In fact this has the effect of hurting those very same BNI holders he mentioned.

Jeff Matthews said...

Aaron, you can bet most shareholders will opt for stock, so as to minimize the tax hit on the cash portion.


ryan said...

Jeff, you gatta keep these series posts coming faster....6 days in between isnt cutting it for me.

Kevin said...

BNSF investors will wait until the last minute to decide whether to elect cash or stock. If the value of a BRK.A share is above the $125K collar, you'd elect all stock and get BRK shares worth more than the cash offered. Conversely, if the value of BRK shares is below $80K, you'd elect cash because you'd get a fixed number of BRK shares that are worth less than the cash offered. When the value of BRK shares is within the collar, it doesn't matter because the exchange ratio floats and you'll get $100 in shares or stock. Of course, if the collars are exceeded, you are going to get 60% in cash and 40% in stock because everybody else will be making the same election as you and you'll be subject to pro-ration. The tax impact is, therefore, much more of a consideration for a BNSF shareholder when you are within the collar.

But I have to take issue with the characterization of Buffett's "maneuvering around the tax code". That is an unkind way to put it. In fact, I'd characterize it as "compliance" with the tax code - which is not one bit different and just as legitimate as if the deal had been structured as an all cash taxable deal. If the IRS wanted to treat all business combinations as taxable events, then they would have written the code to reflect that. They didn't, so how does complying with the tax code become tax avoidance?

Alain said...

Jeff you are such a tease :) Can't wait for your next post.



CrisisMaven said...

While Bernanke and Irving Fisher didn't see the bubble, Warren Buffet amongst others did. They should let him run the economy, audit the Fed, then, like in that insurance takeover, kick out all weapons of financial mass destruction, then close the place down, the building by now probably being the only valuable asset.

Alex said...

Buffett's positions on taxation are quite interesting if you view the man as an admixture of Homo Economicus and Homo Sapien. As Kevin said, Buffett will happily act as a proponent for change whilst exploiting the rules as they stand. It's rather refreshing honest: "Here is what you should do, but until you do..."

On the other hand, his critics are probably conflating his views on taxation and inheritance when they decry his "avoidance" of the inheritance tax. From my understanding of Buffett, admittedly less than Jeff Matthews', he regards the inheritance tax as a means to avoid a system that allocates capital on the basis of fortune rather than merit. We all know how much Buffett loves monopolistic advantages; he is likely sensitive to the 'natural monopoly' characteristics of enormous inherited wealth.

Stevin R. Hoover said...

Dear Jeff:

You left us with a cliff-hanger on Monday, namely the question from an informed meeting attendee as to why it is NOT ok for Kraft to issue undervalued shares to make its acquisition of Cadbury while it IS ok for Berkshire to issue its own (arguably more undervalued than Kraft) shares to make the Burlington Northern acquisition.

The question is especially relevant given how public Warren was in voting "no" on giving Kraft CEO Rosenfeld and team a blank check to issue as many shares as necessary to hit the takeout number and close the Cadbury deal, which ended up being just shy of USD20 billion.

Even if one might justifiably say it's not quite a comparison of apples to apples (e.g., far more dilutive in case of KFT, KFT overpaying v. Berkshire getting reasonable value, etc.) would it be possible for you to post Warren's answer and your assessment of his answer without your loyal readers having to wait too much longer?

Toby Young's answer in the UK Telegraph as to why Kraft REALLY needed to buy Cadbury came down to his taste buds. See, entitled "Why did Kraft Pay 11.7 Billion Pounds For Cadbury? Because Americans Can't Make Chocolate."

Otherwise, you write well on the atmospherics of that mini-meeting and on the substantive questions asked. But please don't keep us hangin' Thank you.
Best wishes,

Lance said...

Nobody saw the bubble coz they were all busy getting their share of the pie...except for Warren of course.

AMH in Missouri said...

I wonder if Buffet idea of dynastic wealth and taxation wouldn't be so extreme if he wasn't so extremly rich...