Still earning after all these years - By Buttonwood

Buttonwood

Still earning after all these years

May 3rd 2005
From The Economist Global Agenda
Source

The legendary investor who stood the efficient-markets thesis on its head has hit a spot of bother. But Warren Buffett has survived such spots before


“I’M WARREN. He’s Charlie. We work together. We really don’t have any choice, because he can hear and I can see.” Thus Warren Buffett and his vice-chairman, Charles Munger, to some 19,000 shareholders assembled in Omaha, Nebraska, for the annual general meeting of Berkshire Hathaway, a publicly-quoted investment holding company that has wiped the floor with the S&P 500 in all but six of the past 40 years. The average age of the two gurus is 78, but in a fine display of stamina and humour they tossed questions back and forth for six hours on everything from the end of civilisation as we know it to selling furniture. Your columnist legged it to the land of the tall corn to sit at their feet.

It was an extraordinary weekend. Queuing for food at Saturday’s barbecue supper, or to buy Mr Munger’s new book, “Poor Charlie’s Almanack”, sports-jacketed strangers chatted away happily to each other. America’s Midwest is like that, of course, but this seemed also to reflect a shared sense of community—even smugness—at belonging to the prescient group who invested in a share that has consistently outperformed the market, and in an unleveraged and, so far, scandal-free manner.

Berkshire’s managing partners disposed of first-quarter news before the investment tutorial that is the real meat of the AGM got going. In a reasonably positive start to the year, pre-tax operating profits are up about $400m over the first quarter of 2004, buoyed by good insurance results. But investments are showing a net loss of $120m, thanks to a big bet against the dollar that would generate a $310m loss if the $21 billion in foreign-exchange contracts were liquidated now.

Berkshire shareholders are not, on the face of it, a bolshy lot. They go to Omaha for the wit and wisdom of the Woodstock for Capitalists, not to roast their leader for getting the dollar wrong of late. Many were more interested in the chairman’s hint that Berkshire might even pay a big dividend in another few years; its last dividend was 10 cents per share in 1967.

Worried about the Sage's age

But there are three broad and related issues facing the company that has looked so good for so long. The first is the outlook for its insurance business. The second is the slowing pace of constructive investment at Berkshire. And the third is what will happen to the firm when its fabulous oldsters step down.

Insurance is at the core of Berkshire’s operations: General Re, GEICO, Berkshire Hathaway Reinsurance and others produce the virtually free capital “float” that allows the gurus to go out and buy things on which they mostly make good money. The regulatory climate in which insurance companies operate has got a lot tougher recently, highlighting some questionable calls. And in buying General Re in 1998, Berkshire bought itself a particular lot of problems.

Berkshire's insurance operations have been caught up in three regulatory probes. One involves reinsurance sold by General Re for years to a professional-liability insurer in the state of Virginia, now bust and with unpaid liabilities. The second involves financial reinsurance sold some time ago in Australia. The third and most conspicuous turns on “finite risk” insurance sold by General Re to American International Group (AIG), which may have helped that company plump up its earnings inappropriately. The Sage of Omaha himself was summoned to Washington last month for questioning as a witness.

The probes seem unlikely to find a general pattern of wrongdoing at Berkshire. But they may do two things: blight the chances of Ajit Jain, Berkshire’s insurance mastermind, to move higher in the firm when the gods depart; and, by tarnishing Berkshire’s reputation, worsen the terms on which it writes insurance.

That might, in a sense, reduce the second problem, which is that Berkshire is sitting on a growing pile of cash with no obvious use for it. Cash and cash equivalents at the end of 2004 totalled $43.4 billion, up from $36 billion a year earlier. Since then Berkshire has bought a significant stake in Anheuser-Busch, a brewer, and Mr Buffett expects to buy an insurer, for less than $1 billion, in the next few weeks.

But the big deals are not there, in part because private-equity firms and hedge funds are bidding up prices too high. Might foreign firms, less subject to these pressures, beckon? Berkshire is happy with the 1.3% it owns of PetroChina, but seems not to want more. Mr Buffett says that he is “comfortable” with both German and British companies and owns a bit of both. But for a man who has spent only a few of his 74 years out of Omaha, “there is some disadvantage to being in a culture you don't perfectly understand.”

The real problem, though, is Berkshire’s sheer size. With a market capitalisation of some $130 billion, a modest investment, however good, simply will not “move the needle”. If the situation has not changed in a few years, Berkshire’s chairman says, the company might look to make “very substantial” payments to shareholders. The new presence on the board of Microsoft’s Bill Gates, who paid shareholders a special dividend of $32 billion last year, might reinforce that possibility.

And this brings us to the third issue: the succession. Mr Buffett used to have more ideas than capital, he says. “Unfortunately, in recent years my capital has outrun my ideas.” As long as what ideas he has are good ones, that may not matter, and the octogenarian Mr Munger is no slouch either. But it is beginning to affect public perceptions. Last month, Fitch, a credit-rating agency, downgraded the outlook for the triple-A rated firm to “negative”, citing Mr Buffett’s age as the main reason. “They discovered that I was mortal…though I hope to prove them wrong,” he says. The emphasis at this year’s AGM was on continuity, and on fireproofing Berkshire so that, come what may, it will continue to embody the culture and characteristics that it has today. But can that be guaranteed?

Mr Buffett—an investor who famously thinks of a stock as “part of a business rather than a thing that moves around on a chart”—has always stuck in the craws of those theorists who concluded that in efficient markets stock-picking was a waste of time. He has had far more successes than failures. As a result, the per-share book value of Berkshire has gained 286,865% since 1965, while the S&P 500, with dividends included, has risen by 5,318%. His “business model”, if such it can be called, was surely a help. Mr Buffett was one of the first to understand how the cash generated by one company can be diverted into investments of all sorts.

But it was his emphasis on underlying value, on long-term investment, on continuity and on taking the high road (most of the time), more than the shuffling of cash, that created and shaped Berkshire Hathaway—and no amount of Bill Gateses on the board can really replace him. Charlie, any thoughts on that one?


***
Copyright © 2005 The Economist Newspaper and The Economist Group.