I made the trip to Omaha this weekend for the 2009 Berkshire Hathaway Annual Meeting. This was my first trip to Omaha since 2005 and attendance at the meeting has grown considerably over the past few years. I still remember my first Berkshire Annual Meeting in 2001 at the Omaha Civic Auditorium when attendance was quite a bit lower. If attendance grows much beyond the 35,000 who showed up this year, the meeting will soon outgrow the Qwest Center.
For reasons that I will not go into here, I was only able to attend the morning question and answer session. I will provide some thoughts on the highlights of the morning session in this post and will follow up with another post listing the best resources I have found online for those who were unable to attend the meeting this year.
My usual routine at Berkshire meetings is to join the mad race to secure seats for the meeting and then to browse the displays in the massive exhibit area. As usual, a wide variety of products were on display including surprisingly cheap Fruit of the Loom products ($2 Berkshire T-Shirts), Garanimals display with Berkshire t-shirts for kids, See’s Candies, Justin Boots, Dairy Queen, Clayton Homes, and more. I found the Clayton Homes i-house to be particularly interesting. This environmentally friendly home is compact and functional, requires approximately $1/day to run, and starts at under $80,000. A wide variety of books were also on display. I compiled a list of the displayed books for those who were not at the meeting.
Morning Q&A Session Highlights
After the company movie, the question and answer session began at around 9:30. This year, the Q&A format was much better than in prior years. Half of the questions were asked by a panel of journalists who pre-screened and selected the best questions from shareholders. The rest of the questions were asked by shareholders directly based on a random drawing. This dramatically increased the number of Berkshire related questions while still leaving room for some of the entertaining off topic questions that dominated meetings in recent years. What follows is not a direct transcript and is not necessarily in order. Instead, I have commented on what I considered to be the most interesting questions from the morning session.
Derivatives Impact on Berkshire’s Intrinsic Value
Buffett was asked to reconcile his famous characterization of derivatives as “Weapons of Financial Mass Destruction” with Berkshire’s activities in derivatives over the past few years. In particular, have the equity put and credit default derivatives hurt Berkshire’s intrinsic value, if only temporarily, due to investor perceptions? Buffett stated that his job was to make money over time and that he structured the derivatives to require very low collateral requirements. As of March 31, only 1% collateral was posted for all derivative positions. Meanwhile, Berkshire is holding $4.9 billion for 15 to 20 years.
Buffett stated that the odds are very good that the equity puts would work out very well over time. Of course, it would have been better to issue the puts with the strike price near the market lows this year, but Buffett noted that the kind of favorable collateral requirements he secured would not have been available in the turmoil of the past six months. He noted that the credit default derivatives have deteriorated somewhat since he wrote the annual letter to shareholders in late February but Berkshire will likely still do well with these derivatives once investment gains on the funds being held due to issuing the derivatives are accounted for.
It appears that Buffett essentially reaffirmed his prior statements on derivatives exposure, although his outlook on the credit default swaps is more negative based on recent developments. I wrote about Berkshire’s misunderstood derivatives shortly after the annual letter came out and I still believe that Buffett’s moves in this area should turn out very well over time.
Investment in Moody’s
Buffett was asked about Berkshire’s continued investment in Moody’s given the performance of the ratings agencies in the recent past and specifically related to the failure of the ratings agencies to downgrade CDOs before the housing bubble burst. Buffett stated that he has never attempted to influence the ratings agencies in any way just as he would not attempt to micromanage the business decisions of other investees. He still believes that the ratings agencies have potentially good businesses with very low capital requirements and limited competition.
Buffett appeared to indicate that he did not believe that the compensation model for the ratings agencies was directly responsible for recent failures. He also commented on how Berkshire and other investors should do their own work when it comes to evaluating securities rather than simply taking the ratings at face value. To a great extent, Berkshire and others can make money on situations where a security is inappropriately rated.
Financial Models and Investing
There were a couple of questions related to how Buffett and Munger perform free cash flow analysis, come up with discount rates, and handle their investments without using spreadsheets or fancy computer models. Buffett repeated the “bird in the hand is worth two in the bush” analogy and emphasized that if you need a computer model to figure out if something is cheap, you would be best served to move on to something that is obviously cheap without having to resort to elaborate calculations. Munger added that some of the worst business decisions have been made due to fancy financial models. These models are developed in business schools because they have to do something. Buffett noted that any academic who simply wrote about “a bird in the hand is worth two in the bush” would not get too far on the tenure track.
My view is that Buffett and Munger are not trying to diminish the work of academics as much as to emphasize that intelligent investment decisions should not require the use of higher math and fancy modeling. In other words, intelligent investments should be obviously cheap to the point where one does not require great precision to know whether the commitment should be made.
Buffett confirmed that the three candidates for the CEO position that he had in mind before are still on the list and that all three currently work for Berkshire Hathaway. The four investment managers on the short list for Chief Investment Officer are also still on the list. Although Buffett does not have exact figures, he does not think that the four candidates did much better than the S&P 500 in 2008 but all of them still have ten year records that exceed the market average. Munger stated that Berkshire would not want a CIO that is a market timer and tried to go to cash early in 2008 and then figure out when to re-enter the market.
Another question dealt with the concept of naming the CEO candidate while Buffett remains as Chairman in order to have a longer transition. This could also reduce the pressure on Buffett and possibly keep him around for a longer period of time. Buffett does not think that there is a good way to do this since the candidates are already in important operating roles and any move to bring one of them to headquarters now would reduce shareholder value. These candidates do not need apprenticeships and will be ready on day one. Munger believes that it is better training for candidates to run their own operating subsidiaries than to be at headquarters while Buffett is still able to run the company.
A related question was asked regarding Ajit Jain who runs several of Berkshire’s reinsurance operations. Buffett said that no one is going to replace Jain and that his eventual successor would simply not be given as much latitude to make decisions. With Jain, Buffett is able to delegate much more power and authority than he would with anyone else. Jain and Buffett talk every day, but this is due to Buffett’s interest in the business rather than Jain’s need to seek approval.
A shareholder asked Buffett and Munger to comment on Berkshire’s valuation at the end of 2008 compared to a year earlier. I was surprised when Buffett provided quite a bit of commentary on this point. First, Buffett clearly affirmed that Berkshire has two sources of value: Investments, including businesses and securities purchased based on the existence of insurance float, and the earnings power of the operating businesses. This seems to be an affirmation of the “two column” approach but I believe Buffett and Munger also clearly indicated that the value of cost free float could exceed the current value of investments based on the float. Munger commented on the long term power of free float.
Buffett indicated that Berkshire is cheaper based on the two column approach at the end of 2008 compared to the end of 2007, but he also stated that nearly all other securities are cheaper as well. Investors value securities based on the valuations assigned to all other securities, so the fact that investment alternatives to Berkshire are less expensive now impacts Berkshire’s valuation as well.
An 11 year old shareholder asks how inflation will impact his generation. Buffett repeated his comments on inflation in the annual letter and indicated that inflation will be a major problem in the future. He believes that taxpayers are not the ones who will ultimately pay for the current expansion in government spending. Instead, the holders of government debt in the form of bonds will end up paying (including the Chinese). Buffett advises the shareholder to invest in his own earnings capability to ensure that he will be able to claim his share of the national “economic pie” regardless of the value of the dollar. Investors in high quality companies will also handle inflation relatively well. A worker in the future will be willing to give up five minutes of labor in exchange for a Coca Cola product, so in relative terms, the business value of companies with an economic moat should persist.