Sunday, June 05, 2011

Munger’s Revenge Part III: “Inexplicable and Inexcusable”


(With excerpts from “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”  Available now at Amazon.com)

Prelude: From $100 to $62 Billion in 56 Years
 In May 1956, seven of Warren Buffett’s friends and family members invested in a partnership that would be managed by that self-assured, 25-year-old Omaha investor. They would pay him no fee or salary, but he would keep a quarter of the profits he earned for them, provided they made at least a nominal 6 percent annual return.
 The seven friends and family members invested $105,000. Warren Buffett himself put in a nominal $100.  That’s right: one hundred dollars.
 Over the next 13 years, Warren Buffett grew Buffett Partnership Ltd. into a $100 million fund. Thanks mainly to his incentive fee, $25 million of the fund belonged to him.
 In1969 Buffett disbanded Buffett Partnership Ltd. and focused on managing its largest investment: a troublesome textile company called Berkshire Hathaway. By 2002, that company was worth nearly $200 billion, and Buffett’s one-third ownership had put him on the top of the Forbes 400 list of richest human beings in the world, with a net worth of $62 billion.
 From $100 to $62 billion, Warren Buffett’s investment legacy was secure around the world.

Mixed Messages
On Wall Street, however, it has been a bit more mixed. Buffett’s influence among investment professionals ranges from “value” investors who have studied him for decades and run their own funds very much in line with Buffett’s methods, to money managers who think the technology-phobic Buffett is brilliant but old-fashioned and out of step with the times.
 There are even some downright cynics who regard Warren Buffett’s eye-popping career as a statistical fluke, consider Berkshire Hathaway to be something of a cult, and view Buffett himself as a kind of Teflon-coated master of public relations.
 Call the cynics jealous, if you like—there is, in fact, no person alive who can match Buffett’s professional track record, and none who likely ever will. But there are some interesting contradictions between what Buffett says publicly and what he does as CEO of Berkshire Hathaway.

Do as I Say, Not as I Do?
 During the hostile takeover boom of the 1980s, for example, such companies as International Paper and Salomon Brothers sold a special class of stock to Berkshire, solely to protect themselves from unfriendly takeovers. Warren Buffett, the implacable foe of clubby corporate boardroom behavior, was helping underperforming managers keep their companies intact and their jobs safe.
 And after the collapse of junk-bond king Drexel Burnham Lambert in the early 1990s, Berkshire purchased billions of dollars worth of junk bonds despite Buffett’s own warnings that junk bonds were dangerous. “The only time to buy these is on a day with no ‘y’ in it,” he liked to say.
 More recently, just before the crisis hit in 2008, Berkshire announced it had taken in nearly $8 billion of premiums on 94 derivative contracts, similar to those “financial weapons of mass destruction” Buffett had been warning about for years.  The derivatives included puts on various stock market indices with a nominal exposure of more than $40 billion.
 Of course, these activities proved to be quite profitable (very profitable, in the case of the RJR bonds) for Berkshire’s shareholders. Just because Buffett casts a dim view on a particular investment class doesn’t mean he shouldn’t take advantage of a profitable opportunity when it appears within his “circle of competence.”

The Lucky Sperm Club...at Berkshire
More grating, and harder to rationalize, might be the sharper moral edge Buffett’s always blunt voice has taken on recently—especially considering his own history.
 Buffett criticizes hedge fund managers because they charge big incentive fees and receive favorable tax treatment compared to common folk. Yet, Buffett Partnership Ltd was structured like a hedge fund, providing Buffett with very large incentive fees and very favorable tax treatment.
 Buffett also criticizes efforts to reduce the inheritance tax on rich families—“the lucky sperm club,” he sniffs. Yet Buffett has, quite deliberately, made Berkshire a haven for family companies that want to keep their business and their own management intact, while avoiding the very estate taxes he wants others to pay. In fact, Buffett has advertised the tax advantage of selling to Berkshire in his own Chairman’s Letter:
 In making acquisitions, we have a further advantage: As payment, we can offer sellers [Berkshire] stock. …. An individual or a family wishing to dispose of a single fine business, but also wishing to defer personal taxes indefinitely is apt to find Berkshire stock a particularly comfortable holding.
 Finally, Warren Buffett himself is dodging what must surely be the biggest estate tax bill of them all by giving away all his Berkshire stock instead of selling it.

Race against Time
These contradictions rankle in the quieter corners of Wall Street, although certainly not on Main Street, where Buffett has, in recent years, become a very public figure known around the world.
 His higher public profile, of course, has a rational impetus: Buffett is engaged in a race against time to create a brand name for Berkshire that not only will attract family-owned businesses to become part of the Berkshire “family” but also will survive his death. The more exposure Buffett gets on CNBC and elsewhere—superficial as it may be—the better it is for Berkshire in the post-Buffett era.
 And yet, while Buffett’s passing is a certainty—he’s now in his eighties—the answer to the question of whether Berkshire Hathaway will thrive without him is not.  
 Indeed, Berkshire shareholders got a harsh reminder of that fact thanks to the ugly end of David Sokol’s tenure at one of Berkshire’s largest and most important businesses.
 Buffett’s handling of the abrupt resignation of David Sokol—after it was disclosed that Sokol had traded shares of Lubrizol for personal gain while Buffett was in discussion to acquire the company—triggered shock waves among many of Buffett’s longtime admirers and scorn from his detractors.
 In that fateful March 30 press release, Warren Buffett—the very same Warren Buffett who told Congress 20 years ago, “Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless”—seemed to turn his back on that simple credo by writing, “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful.”
 One month later, 36,000 Berkshire shareholders returned to Omaha to hear Buffett explain his own behavior.

‘I’m Warren, He’s Charlie’
 Omaha, Nebraska, April 30, 2011. It is 9:20 a.m., and the movie is over, the lights are up, and Warren Buffett and Charlie Munger have taken their seats at the small table onstage in the cavernous Qwest Center arena. The applause has died down, and the place goes quiet as we wait for Buffett to speak.
 Both men look robust, despite a combined age that is pushing 170. And they eat like teenagers: On the table in front of them, along with two microphones and the yellow legal pad Buffett will use to keep track of the questions, are two boxes, one of See’s chocolates and one of See’s peanut brittle. In between is an ice bucket with a couple of Cokes cooling off.
 “I’m Warren, he’s Charlie,” Buffett says into the microphone, his voice gruff, friendly, and as grandfatherly sounding as the octogenarian grandfather he happens to be. “I can see and Charlie can hear, so we work well together.” It is the same joke he tells every year, and it draws the same appreciative laughter it always gets.
 Buffett says he wants to talk about two things before taking questions: “We’re going to talk about earnings, and we’re going to talk about the David Sokol situation.”

Twelve Katrinas
 The earnings discussion is brief, but has some surprising news: Even Berkshire Hathaway’s vaunted insurance businesses sometimes lose money. Buffett explains that Berkshire’s earnings were hurt by insurance claims from the March 2011 Japanese earthquake-tsunami-nuclear meltdown, as well as the massive Christchurch, New Zealand, earthquake a month earlier.
 To explain why the Christchurch quake—since overshadowed by the Japanese nuclear disaster—had such an impact on Berkshire, Buffett first asks Munger what the population of New Zealand is.
 “I’d say 4 million,” Munger begins, then corrects himself: “No, about 5 million.” (Either way, he was close: it is 4.3 million).
 Buffett observes that this means the Christchurch damage is the equivalent of “about 12 Katrinas.” That ability to put large things in vivid, clear perspective is a quick reminder of why Buffett will say, later in the day, that he would like to be remembered not as a financial genius but as “a teacher.”
 Still, it is not earthquakes and insurance losses the crowd wants to discuss, and Buffett knows it.

Inexplicable and Inexcusable
 “I’d like to just comment for a few minutes on the matter of David Sokol and the purchase of Lubrizol stock,” Buffett says, and the crowd gets really quiet.
 He starts by referring to the video clip of his Salomon Brothers testimony we all watched a half hour ago and says that what David Sokol did recalled to his mind what he said of the Salomon traders’ behavior at the time: “It was inexplicable and inexcusable.”
 There. For the first time since the news broke, Warren Buffett has said what everyone, deep down, expected him to say. A sense of pride, or gratitude, or relief—or all three—seems to sweep through the crowd. This is the Buffett we thought we knew.
 The “inexcusable” part, Buffett continues, is that “Dave violated the [Berkshire] code of ethics, he violated our insider trading rules, and he violated the principles I lay out every two years in a direct personal letter to all of our managers.”
 It doesn’t get much clearer than that. But still, Buffett is not done. He wants to get at “the inexplicable part” of what Sokol did.
 What is inexplicable, to Buffett, is that Sokol “made no attempt to disguise the fact that he was buying the stock.” Buffett describes how, in the classic insider-trading ring, “People set up trusts in Luxembourg or they use neighbors … or third cousins.” However, Buffett says, “To my knowledge, Dave did nothing like that, so he was leaving a total record as to his [Lubrizol] purchases.”
 Furthermore, Buffett says, by way of explaining why he had no inkling what was happening under his nose, Sokol had once turned down the opportunity to make an extra $12.5 million as part of a generous, but ambitious, incentive plan offered by Buffett, insisting on splitting $25 million of the bonus plan 50/50 with his junior partner. 
 This kind of forthrightness in years past, he says, makes Sokol’s recent behavior doubly “inexplicable.”
 “I think 20 years from now I will not understand what causes a man to voluntarily turn away $12.5 million … without getting any credit for it in the world … and then, ten or so years later buy a significant amount of stock the week before he talked to me” in order to make $3 million.
 It is not only inexplicable, Buffett says, but it is also sad: “sad for Berkshire, sad for Dave.”
 Before opening the floor to questions from reporters and shareholders, Buffett asks Charlie Munger for his thoughts on how to explain Sokol’s behavior.
 “I think hubris contributes to it,” Munger says flatly.
 “Okay, let’s get to work,” Buffett says.
 And with that, the questions begin.

Why Did You Handle this Matter in the Inadequate Way You Did?
 “Carol, you’re on,” Buffett says. Carol Loomis, of Fortune magazine, is as good a reporter as they come. She launches straight into the question that is on everybody’s mind, and she does not hold back: It is a doozy.
 It comes, she says, from a longtime shareholder. “When you found out the details of [Sokol’s] stock purchases,” Loomis begins, reading the question, “I do not understand your reaction. Surely you realized immediately that these facts…were going to damage Berkshire’s reputation, something you have said repeatedly you would ‘be ruthless’ in protecting. ‘Be ruthless’ probably would have meant your firing Sokol on the spot,” the shareholder wrote, echoing the sentiment among many investors here, “but you didn’t do that.” Instead, Buffett praised Sokol’s efforts over the years and declared his actions weren’t “in any way illegal.”
 “Why,” the shareholder wants to know, “did you handle this matter in the inadequate way you did?”
 There’s a pause, and then something happens that I’ve never heard after a tough question of Warren Buffett: Scattered applause rumbles throughout the arena. It is clear people want an answer.
 And for the next 15 minutes—an unprecedentedly long time—Buffett gives it, providing a detailed timeline of what happened and when it happened, as well as the nature of Sokol’s conversations with Buffett, all of which make Sokol’s behavior even more disturbing.

‘I Plead Guilty to That’
 Buffett, for example, says he heard “not a word” from Sokol about any contact with Citigroup investment bankers—the very investment bankers Sokol had contacted to help identify chemical companies that might be attractive takeover candidates for Berkshire—until the day the deal was announced, when a friend of Buffett’s at Citigroup called. “This was all news to me.”
 Worse, Buffett says, when Sokol was then asked about his contacts with Citigroup, “Dave said … he thought he called a fellow there to get their phone number. Which,” Buffett adds dryly, “turned out to be somewhat of an understatement.”
 The details are unsettling—not only because of what Sokol seemed to do to cover his tracks, but also the fact that it happened on Warren Buffett’s watch. Furthermore, there is a distinctly false note in Buffett’s self-defense when he attempts to explain why he allowed Sokol to resign rather than firing him for cause: Buffett says it saved Berkshire “some money.”
 Still, he acknowledges the lack of “ruthlessness” in the press release: “What I think bothers people is that there wasn’t some big sense of outrage.” Buffett concludes, “I plead guilty to that.”
 He turns the floor over to Munger.

Not the Cleverest Press Release
 “I think we can concede that that press release was not the cleverest press release in the history of the world”—a harsh self-evaluation, coming from the supremely self-confident Munger. “But I would argue that you don’t want to make important decisions in anger,” he says, quoting Berkshire director Tom Murphy: “You can always tell a man to go to hell tomorrow if it’s such a good idea.” The line gets a laugh, and Munger finishes with a typically rational observation. “I don’t think it was wrong to remember the man’s virtues as well as his error.”
 This generates applause—not enthusiastic applause, and not a great deal more than the applause that greeted the question—but the two men have gone a long way toward clearing the air. 
 And while the next question moves away from the Sokol affair, it is not the end of the Sokol questions.
 Right now, however, it is back to the business of Berkshire Hathaway.

(To be continued…)

Jeff Matthews
Author of “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett”
(eBooks on Investing, 2011)    Available now at Amazon.com


© 2011 NotMakingThisUp, LLC
                                                             
The content contained in this blog represents only 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, and should never be relied on in making an investment decision, ever.  Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored.  The content herein is intended solely for the entertainment of the reader, and the author.

9 comments:

Alex said...

For all his support of progressive tax reform, Buffett laughed of questions from the Squawk Box crew at CNBC as whether he would voluntarily increase his tax payments. He said something to the effect of "a voluntary system isn't going to get much done."

One way to read that interview is that Buffett is practical, first, and then ideological. Voluntarily excessive tax payments merely subsidizes the "underpaying" rich. Similarly, when corporate boards play buddy buddy with management, the green mail checks are already written. Buffett's refusal to play the game merely transfers the benefits to another player, with no substantive effect on business culture.

A lack of martyr's spirit combined with normative language may seem hypocritical, but it may also represent a practical person's compromise with ideals.

Kevin said...

"Finally, Warren Buffett himself is dodging what must surely be the biggest estate tax bill of them all by giving away all his Berkshire stock instead of selling it."

This is rhetorical nonsense. It's like saying a fella "dogded" a trip to his mother-in-law's tea party by dying.

Jeff Matthews said...

Kevin, the more accurate analogy would be if your mythical fellow killed himself to avoid the tea party, rather than merely dying, which could be involuntary.

The point is that Buffett is acting to avoid a large tax bill. It is not being avoided for him. If Buffett wanted to help the US Treasury, he could instead sell his shares, pay the capital gains tax and give the remaining cash away.

But he has chosen a different, highly tax-efficient path--one that does not mesh with his views on the rich needing to pay higher tax rates. Anybody else in his shoes would do the same: they just wouldn't be so high-handed about what everyone else should be doing. That's what rankles so many.

Cheers,
JM

Kevin said...

Jeff, I have to disagree. The crux of the statement is that the primary reason Buffet is giving his money away is to avoid paying taxes. I think he's giving it away because he's a philanthropist. That the transfer is tax free is secondary - and may not even be a factor. To imply that he's being in any way disingenuous by not going about his business in the most tax INefficient way possible is silly in my view. Sure, he could first sell his stock and then give the proceeds away, but that would foil the objective, as the beneficiary would receive less than intended! Following your reasoning, you could just as easily say "well, since Buffet chooses not to voluntarily pay his taxes at a higher rate, his stance that the wealthier should bear a greater tax burden is somehow diminished." I don't buy it. You don't have to be a martyr to hold a genuine position or to be an agent of change. And it doesn't make you a hypocrite to believe that a law should be changed while living within the parameters of that law.

Sean said...

I think it’s very narrow to say the point is that Buffett is acting in a way to avoid a big tax bill.
I think the point is that Buffett is acting in a way that is in line with his views against aristocracy and huge class and tax divisions.
“There's class warfare, all right, but it's my class, the rich class, that's making war, and we're winning.”
By giving away his money to charities - and not to his children - he is acting exactly in line with his espoused values. It may be high-handed, but his money is exactly where his mouth is. I find it hard to see the hypocrisy in this and the argument seems like a big reach on Jeff’s part. The Gates Foundation is not where the typical tax avoider’s money ends up. Not even close.

Jeff Matthews said...

Kevin and Sean make well-reasoned points. Buffett is in fact acting in a way he'd like all wealthy people to act: he's giving most of it away.

However, if he really believed he and the other mega-rich should pay higher taxes, there is nothing stopping him from selling the stock, paying the taxes he wants everyone else to pay, and giving the net cash to charity.

But he has chosen to donate the stock in a highly tax-efficient manner. That's all.

Cheers,

JM

Nick D. said...

The whole notion of voluntary excess tax payments is absurd. Using this "suggestion" to demean the value of the charity is cynical in the extreme. I'm with Kevin & Sean on this one with a nod to Alex's eloquence.

Colin P said...

While Buffett is hypocritical, I am not sure I agree with the "giving away his estate and avoiding one of the largest tax bills" argument as an example of that hypocrisy.

I will say it's disingenuous that he did not do much for charity his entire life, then decides to give it all away and even more ask his fellow billionaires to do the same.

Anonymous said...

Is this piece going to be completed before next year's meeting? I'll check back in December.