Thirty Five thousand Berkshire Hathaway shareholders descended on Omaha Saturday to bask in the wisdom of their Chairman and Vice Chairman, Warren Buffett and Charlie Munger. From the floor of Omaha's Qwest Center, here are my notes of some of the highlights, which I paraphrased in my own words:
On recent government interventions: Buffett and Munger believe government officials should be judged more leniently in times of extreme crisis, as they had little time to respond to grave dangers. It is unreasonable to expect perfect decisions when we were close to a financial meltdown in September, with commercial paper markets freezing up and $4 trillion in money market accounts at risk.
They believe Treasury Secretary Paulson and Fed Chairman Bernanke acted honorably and intelligently when they forced BofA to close the Merrill Lynch acquisition. Considering the fragile situation at the time, had BofA been allowed to invoke a major adverse change clause and back out, it may have been disastrous for the financial system. And although they have sympathy for Wells Fargo's complaints about being forced to accept TARP money against its will, by and large they believe the government handled the financial crisis well.
Moody's: One of the most controversial issues this year was the way Berkshire handled its 20% stake in Moody's, the bond rating agency now tarnished in the mortgage debacle. Buffett and Munger contend Moody's problem was not a conflict of interests, but the belief that housing prices could never fall significantly. That belief was wrong, and proved a major mistake for Moody's, albeit a mistake shared by a myriad of others.
They believe the rating agencies are still a good business with few competitors, one that is important to a large segment of the economy and requires little capital. Their business in the future will be smaller but still fundamentally a good one.
Moody's recent downgrade of Berkshire's ratings was another controversial area. Berkshire lost its AAA rating recently, which Buffett said he was disappointed and irritated with. But other than losing the bragging rights and some of his pride, this will have very little impact on Berkshire, who does not borrow money. And its CDS premiums (which other companies pay to insure their Berkshire related assets) actually declined recently (down from as much as 5% annually just a few months ago).
Buffett and Munger still believe Berkshire is a strong credit and deserves to be rated AAA. Their obligations, such as payments on workers comp policies that may run decades into the future, are more important to them than next quarter's earnings, and they manage the company accordingly. Berkshire wants the people who rely on those checks to never have to worry about getting them and, pursuant to this philosophy, Berkshire keeps an ample reserve of cash at all times.
For example, Buffett estimates that in the event of a major catastrophe, Berkshire would suffer between 3% and 4% of the total, nationwide losses. Even if such catastrophe amounts to $100 billion in total damage (for reference, Hurricane Katrina leveled about $60 billion of losses), Berkshire could easily handle a $4 billion payment.
Housing Market: The United States creates about 1.3 million new households every year, as a result of natural growth in population, new families, etc. For a while, the county was building approximately 2 million new homes, which exceeded the need and was therefor unsustainable. Now we are building only about 500,000 new units of housing a year, and so the excess inventory is being removed. In the not too distant future, the housing market will reach equilibrium.
Inflation: The aggressive stimulus policies will have consequences, and might produce inflation. The US borrows from the rest of the world and will have an incentive to reduce the cost of that debt by inflating the currency. It is the easiest way out, and therefor the most likely. Incidentally, US revenue from taxes this year is going to be lower than last year, and so the people actually paying for the AIG bonuses and all those other expenditures we had recently are the Chinese, and other foreigners that are buying US government bonds. They will see their purchasing power erode, perhaps substantially. The impact of foreign exchange rates is unclear since other countries are doing even worse than we are, running even larger deficits per GDP in order to offset falling demand.
The best inflation hedge, said Buffett, is to invest in yourself. Great education will make you the best physician in town, who can always raise rates to keep up with inflation. The best businesses are also a great inflation hedge.
Executive compensation: Today, we have the honor system. Shareholders have the honor, the executives have the system.
The best way to get executives to change their behavior is to shame them publicly. In that way, AIG had a huge impact on executive compensation. Directors do not like to see their names in the papers in negative connotation, looking foolish or greedy. Large institutional investors should therefor occasionally speak publicly against the most extreme, egregious cases. That would serve as a restraining factor.
Munger believes that the problem with that solution is that many investment managers are themselves overly compensated, and thus unlikely to champion that particular cause. And the public pension plans are dominated by labor union and politicians, who are also unlikely to pursue major changes.
Buffett believes a board should hire the right CEO, create incentives for that CEO to correctly exercise independent judgment on acquisitions. Those are the most important jobs of a board, whose members should think and act as owners.
Succession: The designated CEO in succession has not changed over the last year, but interestingly, the four candidates designated as possible successors to the position of overseeing Berkshire's vast investment portfolio did not outperform the general market last year.
Competitive advantage: Berkshire has the best large insurance business in the world, and probably also the best utility business in the world, as well as other exceptional businesses in other areas. This is a major achievement, and forms a durable competitive advantage for Berkshire. In addition, Berkshire has a strong corporate culture and a unique business model that offers private companies a permanent home for their operations, something no other company can offer. Berkshire can also move faster than anyone else, because it has available cash, trusts its managers and is predisposed to act without consulting committees, lawyers or bankers. Those tenets are hard to duplicate, and form long lasting, sustainable and substantial moat.
Interestingly, the biggest risk Buffett and Munger see to their insurance business is the unlikely scenario that runaway inflation would cause public outrage over escalating insurance premiums, and will lead to Congressional action to nationalize the industry.
Wells Fargo: Buffett sounded upbeat about the prospects of Wells Fargo bank, of which Berkshire is the largest shareholder. He believes its cost of capital and investment spreads have never been better, and that the Wachovia acquisition is a great franchise that will pay off. He expressed surprise that Wells Fargo traded at just below its book value a few months ago.
Recent investment in Goldman Sachs and GE: Buffett and Munger believe the two companies are good quality businesses run by good managements. But the impetus for those investments was the terms. The investments both offer security together with a rich 10% cash coupon, as well as warrants.
Newspapers: Berkshire would not buy most newspapers at ANY price. Some have only unending losses to look forward to. Twenty years ago newspapers were essential, with pricing power and monopoly over local advertising, but their "essentially" eroded. Readers no longer need them, and hence advertisers do not need them either. There is nothing on the horizon to change that.
The next few years are also going to be tough for retail businesses and shopping centers, because consumer behavior has changed and is not likely to be reversed soon. No quick rebound for South Florida real estate either, as the supply / demand situation in housing is still devastating.
First quarter results: Berkshire did not release its quarterly results yet, but Buffett said it had about $1.7 billion in operating earnings for the quarter, excluding investment income. The utilities and insurance businesses are doing well, but the rest of the businesses in Berkshire's diversified stable are still struggling. The company ended the quarter with about $20 billion in cash.
Future of the world's economy: While they have no idea what the near future holds, Buffett and Munger believe that overtime people will live better. We are able to produce today much more than our ancestors did, even though they had the same inherent intelligence and natural resources we have. But our system unleashes human potential and that process has only just started. There will be greed and fear, but the trend will be improving. Despite all the horrors of the 20th century, with two world wars, political turmoil, a Great Depression and several recessions, US standard of living improved seven fold. Our enormous human potential will generate much more progress, despite occasional hiccups.
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