Monday, June 27, 2011

Munger’s Revenge, Part V: “It’s a Berkshire Type Company”


Author’s Note: we continue contrasting Warren Buffett’s commentary at the April 30, 2011 annual meeting with David Sokol’s March 31, 2011 CNBC interview, using the Lubrizol proxy as a timeline. 
  This entry starts on the date Sokol first spoke to Buffett about Lubrizol as a potential acquisition candidate—one month after he first met with Citi bankers, discussed Lubrizol and first bought shares in that stock; one week after he finished loading up on nearly $10 million worth of that stock; and around the same time he spoke to Lubrizol CEO James Hambrick about what Hambrick appears to have logically reacted to as a takeover feeler.

 January 14, 2011: Sokol finally talks to Buffett.
 Warren Buffett: “Now bear in mind his first conversation when he said he owned the stock was January 14.  In between January 14 and March 14 [when the deal was announced], Dave gave no indication he’d had any contact with Citigroup of any kind…”
 David Sokol: “Mr. Hambrick called me on the 14th, so I either called Warren just before that call or just after it.  And ah, we had a pleasant conversation.  Mr. Hambrick told me about a health issue he had recently had and talked about my son, who has a similar health issue historically.”
 [After thus diverting the issue to family health matters involving his son, presumably to dredge up sympathy among CNBC viewers, Sokol discussed the conversation with Buffett.]
 “And then I called Warren and said, ‘You know, there’s an opportunity here either for you or I to have dinner with James.  And I told Warren I purchased shares in the company.”
 Warren Buffett: “At that time when Dave called me he said nothing about contact with Citigroup or anything of the sort…and I said, I don’t know anything really about the company.  He said, ‘Well, take a look at it.  It…might fit Berkshire.’  I said ‘How come?’  He said… ‘I’ve owned it and it’s a good company.  It’s a Berkshire type company.”
 And now Buffett acknowledges a mistake: “And, you know, I obviously made a big mistake by not saying, ‘Well, when did you buy it?’  But I think if somebody says ‘I’ve owned the stock’ you know it sounds to me like they didn’t buy it the previous week.”
 Indeed, it probably never crossed Buffett’s mind that an employee of his—any employee—would have taken down millions of dollars worth of a stock he had discussed with investment bankers, however innocently Sokol might have believed that discussion to be, particularly if (as the proxy stated) Sokol had been informed on December 17 that the company’s CEO was going to discuss Berkshire’s “possible interest” with his board of directors.
 Nevertheless, the future of Berkshire Hathaway—a conglomerate now roughly the size and scope of General Electric—ought not to be tied to what might or might not cross Warren Buffett’s mind: the fact that Sokol could keep a lid on his Lubrizol purchases for as long as he did, whether or not he violated any laws, illustrates the problem.
 Buffett, however, does not view more bureaucracy as the answer: “We have 260,000 employees… At Berkshire, there are presently three people that can execute trades and then there are a few other clerical people that would see what was done….
 “If you take Berkshire at 260,000 people, you know, that’s about the number of households in greater metropolitan Omaha.  And as perfect as we like to think we are in Omaha, I will tell you there’s lots of things going on in Omaha right now as we sit here that, you know, do not match the rules….
 “The problem, obviously, with the Sokol thing is it hit very very high up, you know.”

 For his part, David Sokol played down the idea that Lubrizol was even a potential acquisition target for Berkshire Hathaway at that point:
 “And frankly, at that time, Warren was pretty cool to the idea.  He says, ‘Yeah, I know the company.  It’s interesting, but I’m not sure it economically makes sense.’ But he hadn’t looked at it for a while.  ‘But, you know what, why don’t you go ahead and have a look and see if there’s anything there.’ And subsequently [I] had dinner with James… I believe it was the 25th.”

January 19: “Members of Lubrizol’s senior management met with Citi and Evercore to discuss Mr. Hambrick’s upcoming meeting with Mr. Sokol.”
 Certainly the Lubrizol team wasn’t “cool to the idea”: they reacted as any public company would react to a potential takeover bid in the works.

January 25: “Mr. Sokol and Mr. Hambrick met in Cleveland, Ohio.  The two executives discussed their respective backgrounds and business.  Mr. Hambrick provided Mr. Sokol with an overview of Lubrizol’s corporate culture, philosophy and operations.  Mr. Hambrick also discussed Lubrizol’s overall business and past and expected financial performance….
 “Mr. Sokol indicated that he did not believe that there was any more information that Berkshire Hathaway needed at that time, but said that he would get back to Mr. Hambrick if additional meetings would be helpful….
 Buffett: “It struck me as a business I didn’t know anything about initially.  You know, you’re talking about petroleum additives… Are there competitive moats, is there ease of entry, all that sort of thing.  I did not have any understanding of that at all initially…
 “And I talked to Charlie a few days later…and Charlie says, ‘I don’t understand it either.’”
 Sokol, on CNBC: “Well, just before that dinner, he [Buffett] had sent me an email…saying, ‘The real question is…can they sustain this margin growth…that they’ve had the last couple of years?’…
 “That was the primary conversation then that I had with James [Hambrick].  And James offered that if Warren had an interest in continuing the discussion, he’d love to come and meet Warren.  And so, [I] talked to Warren the next day and from that point on I had no more conversations...”
 At this point, CNBC’s Joe Kernen interrupted Sokol: “You knew at that point you had almost 100,000 shares and the wheels were starting to turn for a possible acquisition by Berkshire.  At that point did that seem to you that this doesn’t smell right and maybe I should sell this right now before—”
 “Not at all,” Sokol said.  “Actually I think it would have been wrong for me to do anything.  Once I mentioned to Warren that James had an interest, to me then it was a Berkshire opportunity, whether Berkshire would want to do it or not was up to Berkshire…”
 Unfortunately, Kernen didn’t press the real issue—that Sokol ought to have realized that it was “a Berkshire opportunity” the minute he spoke to Citi’s investment bankers about Lubrizol back on December 13, which the Lubrizol proxy identified as the day Sokol spoke to Citi’s bankers and told them, according to the proxy, that Sokol was interested in speaking with the Lubrizol CEO “about Berkshire and Lubrizol.”

January 27: “Mr. Sokol responded to Mr. Hambrick’s offer to meet with Mr. Buffett by calling Mr. Hambrick, stating that it would be helpful for Mr. Hambrick to meet with Mr. Buffett… Mr. Sokol also said that, if Mr. Buffett wanted Berkshire Hathaway to proceed with an acquisition of Lubrizol, Mr. Buffett would have a view on what Berkshire Hathaway would be willing to pay, but that Mr. Buffett would not make an offer unless Mr. Hambrick wanted him to do so.”

January 27: “Mr. Buffett…called Evercore’s Chairman and indicated that Mr. Sokol’s feedback on his meeting with Mr. Hambrick had been very positive and that Buffett was interested in having Berkshire Hathaway acquire the outstanding shares…if it could be done at a price that made sense to Berkshire Hathaway.   Mr. Buffett also indicated that he was very interested in an opportunity to meet with Mr. Hambrick, and that, subject to the meeting, Berkshire Hathaway would be willing to make an offer at the meeting on February 8, 2011 if Lubrizol was willing to receive such an offer.”

February 8: “Mr. Hambrick met with Mr. Buffett in Omaha, Nebraska… At this meeting, Mr. Buffett responded to a question from Mr. Hamrick about price by saying that Berkshire Hathaway would like to make an offer to buy all of the outstanding shares of Company common stock for $135.00 per share in cash….”
 Buffett: “What Dave passed along to me after having that dinner with James Hambrick, and which I later confirmed in a lunch when James Hambrick came out here…I got a good understanding of industry dynamics and how the business had developed over time…
 “I looked at the question of ease of entry…I decided there’s probably a good size moat on this.  They’ve got lots and lots of patents, but more than that they have a connection with customers…
 “I felt I had an understanding of the economics of the business… I think Lubrizol will be the leading company for a very, very, very long time.  And that’s the conclusion I came to.”

March 8: “Berkshire Hathaway and Lubrizol entered into the confidentiality agreement.  Later that day, Munger Tolles [Berkshire’s law firm, and Charlie Munger’s namesake] provided Jones Day [Lubrizol’s law firm] with initial comments on the draft merger agreement….”

March 14: “Berkshire Hathaway and Lubrizol announced the signing of the merger through a joint press release.”
 Buffett: “On March 14, when the deal was announced in the morning, I got a call from John Freund…John Freund works for Citi in Chicago, and he…has handled the great majority of our business in equities for decades, and I’ve got a direct line to him…  And he called and said ‘congratulations and…that Citi’s team had worked with Dave on this acquisition, and they were proud to be part of it…
 “And this was all news to me…
 “And the next day, I had Marc Hamburg, our CFO, call Dave, and Dave readily gave him the information about when he had bought the stock and how much.”
 So far, so good, until Hamburg asks Sokol about Citi’s involvement:
 “Dave said…he thought he called a fellow there to get their phone number, which turned out to be somewhat of an understatement.”
 How much of an understand Buffett will find when he reads the “Background to the Merger” detail in the draft of the Lubrizol proxy statement…

March 18: Buffett receives Lubrizol proxy draft material, detailing Sokol stock purchases.
Buffett: “At that point…our law firm got involved…in their input to the Lubrizol lawyers as to what we had seen that was different or what we had seen that they didn’t know about that we could add…
 “And I believe he [Sokol] was interviewed at least three times about both the stock purchases, the history of things with…his relationship with Citigroup, and they were assembling this information…
 “And we decided that when we got back [from Asia] we would need to have a prompt meeting of the Berkshire Board about this matter…
 “And we got back on…Saturday the 26th, and on the 28th we were going to bring Charlie [Munger] into it before calling a board meeting…. And then, about five or so in the afternoon a letter was delivered by Dave’s assistant, which really came out of the blue…
 “He said he felt he was retiring on a high point and he gave the reasons why he was retiring... I don’t know whether the questioning the previous week had affected his attitude.  He would say not.  But in any event, we had that resignation…
 “So I drafted up a press release, which has since been the subject of at least mild criticism…”

March 30: “Berkshire Hathaway issued a press release announcing the resignation of Mr. Sokol.  The press release also indicated that Mr. Sokol purchases shares of Lubrizol common stock on December 14, 2010 and on January 5, 6 and 7, 2011. Lubrizol first learned of these share purchases and Mr. Sokol’s resignation on March 30, 2011.”

Buffett: “Now, in there was included the fact that Dave had no indication that—that Lubrizol had any interest in an approach from Berkshire and that, at least according to the final Lubrizol proxy, is not the case…. The Lubrizol proxy now says that Dave did know that Lubrizol had an interest on December 17.
 “But both in the two chances he had to review it [the March 30 press release] and then when he went on CNBC on a Thursday and talked for half an hour, he made no attempt to correct any of the facts in it.
 “Now, on Wednesday when we put out the report, we had to have a board meeting first… We also delivered—we, through our law firm, we phoned the head of enforcement division of the SEC and told them exactly the facts regarding the stock purchases and anything else that they might have cared to know.
 “So I think we acted in that case, very very promptly…
 “So from our standpoint and my standpoint, Dave was gone, minimum severance costs, minimum chances for lawsuits about compensation due to him and we had turned over some very damning evidence, in my view, to both the public and to the SEC.”

All very rational, and Warren Buffett is, if nothing else, entirely rational.  However, there is the matter of “being ruthless,” and here is where Buffett gets defensive.

 To be continued…
  
Jeff Matthews
Author “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.

Friday, June 17, 2011

Munger’s Revenge, Part IV: Serious Benjamins



At the Berkshire Hathaway shareholder meeting, continued…

“Why did you handle this matter in the inadequate way you did?”
 This, the first question of the day, is the most direct criticism ever leveled on Warren Buffett from an actual shareholder, and it is greeted not by boos and catcalls, but by applause.
 Buffett begins his answer by attempting to explain what he knew and when he knew it—which turns out to be surprisingly little.
 To show just how little Buffett knew of what was going on, we’re going to arrange Buffett’s Sokol comments from the meeting along the timeline provided in the Lubrizol proxy statement (in italics), as  events occurred, rather than in the order in which Buffett spoke at the meeting, and contrast them with Sokol’s own version of events from his March 31, 2011 CNBC interview.

Sokol/Lubrizol Timeline

Fall of 2010: Sokol meets with various bankers “from time to time” to discuss “capital-raising and transaction ideas.”  This includes Citigroup bankers, from whom Sokol asks for “more information regarding possible transactions in several industries, including the chemical industry.”  The Citi bankers generate “a list and descriptions of 18 companies, including Lubrizol…”

 According to Sokol, “I get dozens of packages from investment bankers all the time, on ‘Hey, have you thought of some of these companies?’ or this and that.”  Furthermore, Sokol claims he already knew of Lubrizol on his own initiative.  “I got interested in Lubrizol—frankly I can’t tell you where I first heard the name—sometime last fall.  I pulled their 10-K.  Found what they’ve been doing the past couple of years interesting.  I made a decision to buy some shares….”
 Buffett will not hear of Sokol’s interest in Lubrizol until January 2011.

December 13, 2010: Sokol and Citigroup meet “to discuss the list of companies” assembled by Citigroup bankers.  “During the course of the meeting, Mr. Sokol said that the only company on Citi’s list that he found interesting was Lubrizol.  When Mr. Sokol learned from Citi’s representatives that Citi had an investment banking relationship with Lubrizol and its Chairman…James L. Hambrick, he asked one of the Citi representatives to inform Mr. Hambrick that he was interested in speaking with him and discussing Berkshire and Lubrizol, if Mr. Hambrick were available.  Mr. Sokol also advised Citi that Berkshire Hathaway does not engage in hostile transactions, and that Mr. Hambrick should understand that if they met and nothing came of the meeting, their meeting would remain confidential.  Thereafter, Citi made Lubrizol aware of these discussions…”

This is the kind of stuff that M&A activity is made of—serious M&A activity, but Sokol plays it down on CNBC, making his focus on Lubrizol seem personal, not related to business:
 “Now they had sent me a package earlier, with a whole number of chemical companies listed in it, again, all public information.  And they wanted to sit down and see if I wanted to follow up on that.  I mentioned to ‘em when they called, I said, ‘Listen, I’m going to be in New York on the 13th, you know, let’s talk.’ Only a couple of them even seemed to be interesting. And I had mentioned Lubrizol as one of those because it was a company I’d already been looking at, and since it was on their list, I said, ‘well, if we’re going to sit down, let’s talk about it.’”
 Of course, anybody who knows anything about investment bankers knows that they pretty much don’t even go to the bathroom without trying to figure out a way to make money on it: they are out to sell businesses.
 And David Sokol probably knows as much about investment bankers as any businessman on earth.
 Furthermore, it is reasonable to assume that the “package” sent by Citigroup’s bankers went to Sokol’s business address, not his personal address—as would be the case if he had been looking for personal investments.
 But Sokol describes the meeting as a general get-together rather than a discussion about a potential acquisition for Berkshire Hathaway:
 “We had a broad conversation where one of the bankers who was in the meeting said he knew the CEO of Lubrizol, and I said, ‘Gee, if you know him well enough to set up a meeting, that would be great, I’d love to meet him.’”
 Buffett knows nothing of this.

December 14: Sokol buys his first Lubrizol.  According to Sokol, “I put an offer in, actually, to buy 50,000 shares with a limit price.”  He gets 2,300 shares.
 Buffett is still in the dark.

December 17: Citigroup contacts Lubrizol CEO Hambrick and relays “the substance of the conversation between Citi and Mr. Sokol on December 13.”   Hambrick “indicated he would inform the Board of Berkshire Hathaway’s possible interest…”
 “Later on December 17, 2010, Citi informed Mr. Sokol that Mr. Hambrick had indicated that he would discuss Berkshire Hathaway’s possible interest with the [Lubrizol] Board.”
 Buffett knows none of this.

December 21: Sokol sells his 2,300 Lubrizol.  “Tax-planning,” he described it on CNBC.

January 5: Sokol begins buying Lubrizol again, in size.  “I thought it was a good company, a company I’d be happy to be invested in long-term.  The stock came back down, I put an offer in to buy a hundred-thousand shares…”

January 6: Lubrizol’s board has a special meeting during which “Mr. Hambrick outlined Berkshire Hathaway’s possible interest as he understood it from his conversation with Citi.  The Board engaged in an intensive and thorough discussion about Berkshire Hathaway’s possible interest.”
 Lubrizol’s Board retains a law firm and an investment back to help it “review Berkshire Hathaway’s possible interest in acquiring Lubrizol.”
 Sokol buys more Lubrizol.

January 7: Sokol finishes his purchase of Lubrizol, a total of 96,060 shares.  That’s close to being a $10 million investment—some serious Benjamins.
 He still hasn’t spoken to Buffett about Lubrizol.

January 10: Lubrizol holds a special Board meeting for “an extensive and thorough discussion about Berkshire Hathaway’s possible interest.”  The Lubrizol Board instructs CEO Hambrick “to arrange a meeting with Mr. Sokol.”

January 12: Citi calls Sokol to arrange a meeting.
 Sokol tells CNBC, “The next thing that happened is, I think it was January 12th, the banker from Citibank called me and said, ‘Hey, I think Jim Hambrick is going to give you a call to see if you want to…get together for dinner.’”

January 14: “Mr. Sokol and Mr. Hambrick had a telephone conference during which they generally discussed the corporate cultures and philosophies of both Berkshire Hathaway and Lubrizol, and arranged to have an in person meeting on January 25, 2011.

January 14 or 15: Sokol finally talks to Buffett about Lubrizol.

To be continued…


Jeff Matthews
Author “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.

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.

Thursday, June 02, 2011

Munger’s Revenge, Part II: The Elephant in the Room



  It’s only 9:00 a.m. on a quiet Saturday morning, but the Qwest Center in Omaha, Nebraska is full, almost literally to the rafters, and the most widely-attended financial gathering in the world is already underway.
 36,000 Berkshire Hathaway shareholders, company managers, Wall Street analysts and reporters have descended on Omaha for the weekend, and half are here in the main Qwest Center arena, half  are in other parts of the complex watching along on jumbo screens.  While 36,000 sounds like a lot, and it is a lot, it’s still less than last year’s meeting: the first and only time in our records that Berkshire’s attendance has dropped.
 I suspect this has a lot to do with the Elephant in the Room—i.e. the David Sokol Affair, which has not only caused much in the way of “I told you so”-type commentary from the somewhat secret club of Warren Buffett Loathers (which is bigger than you might think), but even a lot of head-scratching and “What was he thinking?” from the bigger, public club of investors and non-investors who pretty much view everything Buffett does and says as being The Word.
 Headcount and Elephant aside, what all 36,000 of us are watching is the hour-long movie that traditionally kicks off the proceedings an hour before the start of the main event: six hours of questions-and-answers with Buffett and his longtime business partner, Berkshire vice-chairman Charlie Munger.

As usual, this year’s movie has a rousing mix of fast-paced TV commercials from Berkshire companies such as Dairy Queen and Geico, clips from previous Berkshire gatherings, as well as slick new bits, including a preview of “Too Big to Fail,” a new movie from Andrew Ross Sorkin’s excellent book about the sub-prime financial crisis, in which Warren Buffett played a behind-the-scenes role.
 (Unfortunately, Buffett is portrayed by Ed Asner—Mary Tyler Moore’s old TV boss—and Asner looks and sounds more like Mary Tyler Moore’s old TV boss than he looks and sounds like Warren Buffett.)
 But for now, all eyes are focused on what comes next: grainy, 20 year-old footage of a man giving testimony before a Congressional committee.

“Mr. Chairman, I thank you for the opportunity to appear before this subcommittee. I would like to start by apologizing for the acts that have brought us here.”
 So begins the centerpiece of the Berkshire movie—a brief, riveting video clip of Warren Buffett testifying in the midst of a financial scandal, in which bond traders at Salomon Brothers were caught trying to corner the U.S.Treasury market.
 For reasons lost to the history, Buffett was testifying before the “Subcommittee on Telecommunications and Finance of the Energy and Commerce Committee of the U.S. House of Representatives,” and he might as well have been testifying before  “Subcommittee on Getting TV Cameras into a Room and Looking Serious While We’re Actually Thinking We Would Kill for a Scotch and Soda Right Now,” for all the good Congressional testimony has ever done the U.S. Financial System.
 In any event, Buffett continues his testimony in his gruff, familiar voice (his hair blacker but his eyebrows just as bushy as now), and the words carry a familiar sense of moral rectitude Buffett has been projecting for the better part of his near-50 years as CEO of Berkshire Hathaway:
 “The nation has a right to expect its rules and laws to be obeyed.  And at Salomon, certain of these were broken. Almost all of Salomon’s 8,000 employees regret this as deeply as I do. And I apologize on their behalf as well as mine.”

Though now a mere footnote in the history of 20th Century finance, the Salomon Brothers scandal was a whopper in its day, and only the great exertions of Buffett and Munger saved the company from prosecution and ruin…and, of course, protected Berkshire’s investment in the firm.
 The reason Buffett’s solemn, straightforward testimony is shown to the Berkshire shareholders and managers here at the meeting every year is this: to reinforce the message that, above all things, Buffett wants to protect Berkshire’s reputation, even at the expense of profits.
 Buffett describes his new mandate for Salomon’s people
 “After they first obey all rules, I then want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper, to be read by their spouses, children, and friends…
 “If they follow this test they need not fear my other message to them: Lose money for the firm, and I will be understanding; lose a shred of reputation for the firm, and I will be ruthless.”
 Those words, spoken 20 years ago, carry a special meaning at this meeting, thanks to a press release that stunned Wall Street and many of the people in this arena.

The press release that stopped Wall Street in its tracks and left investors around the world in a state of disbelief and wonder went across the wires on March 30, 2011, one month before the Berkshire meeting.
“This press release will be unusual,” it began.  “First, I will write it as if it were a letter. Second, it will contain two sets of facts, both about Dave Sokol, Chairman of several Berkshire subsidiaries….”
 The author was Warren Buffett, investment legend and “Oracle of Omaha,” and what followed, in 14 short paragraphs of Buffett’s characteristically clear, straightforward style, was the announcement of the abrupt and unexpected resignation of David Sokol following what seemed, to most professionals reading the news, to be shockingly inappropriate behavior.
 Sokol had been the longtime chairman of Berkshire’s hugely profitable MidAmerican Energy utility and was widely perceived to be first in line to succeed Warren Buffett himself at the helm of Berkshire Hathaway, and what he had done, Buffett disclosed, was this: he traded in shares of Lubrizol for himself while lobbying Buffett to buy the chemical company for Berkshire, without disclosing his trades until after the $10 billion deal was announced.
 Not only did Sokol make a personal profit of some $3 million based on the figures in Buffett’s letter, he made Warren Buffett look foolish.
 After all, trading for your own account while working on behalf of another company, whether for a profit of three dollars or $3 million, is called “front-running” on Wall Street, and it is one of the first things even a summer intern learns never—ever—to do.
 Sokol, of course, was no summer intern. He was a veteran, not merely of boardrooms but also of the ways of Wall Street. He also ran MidAmerican Energy, one of the largest Berkshire businesses, and he was quite well paid for doing so—close to $90 million on cash compensation plus another $145 million in stock-related proceeds over the course of his decade-long career with Berkshire.
 Why would Sokol risk that position, not to mention the prestige of being considered a potential successor to Warren Buffett as CEO of the greatest financial success story of our times, by doing something so tawdry?
 Buffett offered no answers in his March 30 press release, but neither did he display any of the “ruthlessness” he had promised Congress 20 years ago.  In fact, he appeared to dismiss what Sokol did, as others had, writing:
 “Neither Dave nor I feel his Lubrizol purchases were in any way unlawful.”
 For all the good Warren Buffett has done for his shareholders over the years—and growing Berkshire’s stock price from $15 a share to over $100,000 a share is only part of what has drawn 36,000 shareholders to Omaha this weekend—it is that press release that is one everyone’s mind here this morning.

In fact, once the movie ends and the lights go up, the first question of this meeting will be long, a stinging rebuke to the Oracle of Omaha from a Berkshire shareholder that winds up with, “Why did you handle this matter so inadequately?”

(To be continued...)


Jeff Matthews
Author “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.