NEW LOW OBSERVER

This year, the New Low Observer team (including our ten year old daughter) went to Omaha, Nebraska for the 2013 Berkshire Hathaway shareholder meeting.  The following are some observations based on the comments of Warren Buffett and Charlie Munger:

According to Buffett, Burlington Northern Santa Fe is running on all cylinders.  Carloading of freight for BNSF exceeded that of the top four competitors in the industry combined. It could not be ignored that carloading is a metric for determining the health of the rail industry.  In regards to getting oil from remote regions, oil travels faster by rail than by pipeline.  Although this  point was reiterated in the meeting, there was not enough explanation of why this is the case.  Some possible explanations were that pipes require constant maintenance.  Upkeep of the pipeline requires stopping the flow in order to repair the system.

A shareholder asked about book value per share growing at less than average as compared to the price of the S&P 500, to which Warren said [paraphrasing]: “…the last ten years have not been very good, 2013 will be the first 5 year period Berkshire has fallen short of the S&P 500 [index]. Berkshire Hathaway is likely to do better in down years rather than up years. Book value is the best ‘approximate’ value that is closest to intrinsic value.” Munger [paraphrasing]: “…of course, annual gain is going to be a little less than before, because of the substantial growth in prior years.”  On the topic of Berkshire’s book value, we found this little tidbit in the 1979 Letter to Shareholders that is of critical concern on the topic:

“If we should continue to achieve a 20% compounded gain – not an easy or certain result by any means - and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.

“That combination - the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.” (source: Buffett, Warren. 1979 Berkshire Hathaway Letter to Shareholders. March 3, 1980. page 3. http://www.berkshirehathaway.com/letters/1979.html.)

It seems that the shareholder’s concern about the failure of the book value to keep pace  with the price of the S&P 500 in the last 10 years isn’t as significant as the threat of a high inflation period.  Buffett closes on the topic with the following thought:

“We intend to continue to do as well as we can in managing the internal affairs of the business. But you should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.” (source: Buffett, Warren. 1979 Berkshire Hathaway Letter to Shareholders. March 3, 1980. page 3. http://www.berkshirehathaway.com/letters/1979.html.)

We've already expressed our belief that Warren Buffett expects that inflation is coming in our March 10, 2013 article titled “Warren Buffett Leverages Up on Inflation Hedge” (found here).  If inflation comes, Berkshire Hathaway shareholders will not have to worry about trailing the S&P 500 as a primary concern.

Regarding the recent Heinz deal, it was asked, “…do you expect the market to underperform based on the favorable terms set up with the Heinz?”  Buffett said [paraphrasing]: “actually, just the opposite, we would have paid more if Charlie and I took a less leveraged position in the Heinz deal.”  We believe the Heinz deal was a constructive effort to circumvent the issues that high inflationary or relative market underperformance may present going forward.

On the topic of reinsurance, Buffett said, “reinsurance is very unfavorable and other companies will find this out over time.”  This reminds us of the following quote, also  from the 1979 shareholder letter:

“We think the reinsurance business is a very tough business that is likely to get much tougher. In fact, the influx of capital into the business and the resulting softer price levels for continually increasing exposures may well produce disastrous results for many entrants (of which they may be blissfully unaware until they are in over their heads; much reinsurance business involves an exceptionally ‘long tail’, a characteristic that allows catastrophic current loss experience to fester undetected for many years). It will be hard for us to be a whole lot smarter than the crowd and thus our reinsurance activity may decline substantially during the projected prolonged period of extraordinary competition” (source: Buffett, Warren. 1979 Letter to Shareholders. March 3, 1980. page 6. http://www.berkshirehathaway.com/letters/1979.html.)

The assessment by Buffett that, “…softer price levels for continually increasing exposures may well produce disastrous results for many entrants…” seems to have been proven correct as noted in the 1985 Shareholder Letter with the following commentary:

“We correctly foresaw a flight to quality by many large buyers of insurance and reinsurance who belatedly recognized that a policy is only an IOU - and who, in 1985, could not collect on many of their IOUs. These buyers today are attracted to Berkshire because of its strong capital position. But, in a development we did not foresee, we also are finding buyers drawn to us because our ability to insure substantial risks sets us apart from the crowd.” (source: Buffett, Warren. 1985 Letter to Shareholders. March 4, 1985. page 13. http://www.berkshirehathaway.com/letters/1985.html .)

A shareholder asked Buffett if the Progressive Insurance (PGR) snap-shot selection method was a threat to the GEICO model.  Buffett said, “We’re confident that GEICO is a successful model based on our sales and ability to generate profit.”  Buffett also said that it was too early to tell whether the new approach by PGR was in fact a viable option over the long-term.  Buffett emphasized the fact that each company has their own model for running a successful business.  Buffett said that he is one to wait 2-3 years to see if the new model for issuing insurance works.  Our take on this matter is that if the new PGR snap-shot selection method is successful and not over-reaching then BRK will buy Progressive.

A question was asked about the corporate profits as a percentage of GDP and whether the current ratio was any indication of an over-valued stock market.  Buffett’s reply was that there is no magic formula for what level was too high or too low.  Buffett then referenced a 1999 Fortune article (found here) which highlighted his concerns about the long term prospects of the stock market based on the relative level of U.S. GDP.  One question related to the efforts of the Federal Reserve in staving off deflation.  Buffett said that the best way to increase nominal GDP is through inflation. However, as far as Buffett and Munger are concerned Bernanke’s action are a huge experiment.  Buffett said that it is like a good book, especially when you don’t know the ending.  Buffett said that “…the next century will be harder (was this a forecast?) due to the current policies.”

Buffett also mentioned that the primary interest for Berkshire Hathaway, on the acquisition front, was the purchase of companies that they already have a stake in.  Buffett made it clear that as a bank holding company, American Express (AXP) was not under consideration because Berkshire is already at the limit according to federal banking regulations.

It was asked, “has Fed policy hurt BRK holdings and companies?” Buffett replied that it has helped BRK holding companies. They’ve been able to borrow to buy out companies that were of particular interest but there will be other problems that come with it. On this topic, Charlie Munger said “I suspect that interest rates will not stay this low for very long, with $48 billion in short-term securities it is earning nothing, if rates get back to 5% then we will have income that we didn’t already have.”

Warren Buffett said something that stood out in our mind and that was “…[I] do not like holding 50 stocks…”  We have always understood Buffett to feel that diversification wasn’t the goal when it comes to investing.  The goal was to seek out large positions when he felt confident about an investment opportunity.  Below are some reiterations of this concept of concentration over diversification:

“As our history indicates, we are comfortable both with total ownership of businesses and with marketable securities representing small portions of businesses. We continually look for ways to employ large sums in each area. (But we try to avoid small commitments – ‘If something’s not worth doing at all, it’s not worth doing well’.)” (source: Buffett, Warren. 1982 Berkshire Hathaway Letter to Shareholders. February 26, 1982. page 1. http://www.berkshirehathaway.com/letters/1982.html .)

“With our financial strength we can own large blocks of a few securities that we have thought hard about and bought at attractive prices. (Billy Rose described the problem of overdiversification: “If you have a harem of forty women, you never get to know any of them very well.”) Over time our policy of concentration should produce superior results, though these will be tempered by our large size.” (source: Buffett, Warren. 1984 Berkshire Hathaway Letter to Shareholders. February 25, 1985. page 17. http://www.berkshirehathaway.com/letters/1984.html .)

“John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F. C. Scott, on August 15, 1934 that says it all: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . . One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.’” (source: Buffett, Warren. 1991 Letter to Shareholders. February 28, 1992. page 11. http://www.berkshirehathaway.com/letters/1991.html)

The strategy we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. (source: Buffett, Warren. 1993 Letter to Shareholders. March 1, 1994. page 9. http://www.berkshirehathaway.com/letters/1993.html)

“…if you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential.” (source: Buffett, Warren. 1993 Letter to Shareholders. March 1, 1994. page 11. http://www.berkshirehathaway.com/letters/1993.html)

Buffett mentioned that the insurance industry allows for being able to afford to wait for competitors to do stupid things like underprice the product, which ordinarily forces well managed firms in other industries to exit the business. Instead, in the insurance industry, the prudent firms can wait for the stupid to fail. This is not usually the case for most industries.

“A particularly encouraging point about our record is that it was achieved despite some colossal mistakes made by your Chairman prior to Mike Goldberg's arrival. Insurance offers a host of opportunities for error, and when opportunity knocked, too often I answered. Many years later, the bills keep arriving for these mistakes: In the insurance business, there is no statute of limitations on stupidity.” (source: Buffett, Warren. 1990 Letter to Shareholders. March 1, 1991. page 11. http://www.berkshirehathaway.com/letters/1990.html )

Regarding a question about whether or not he would bring his elephant gun to the European Union, Buffett said that he did not specialize in investment opportunities in foreign markets.  In spite of this fact, Buffett said that if he were seeking opportunities in Europe,  he would be interested in farm equipment companies. Below are previous references to farm equipment in the Letter to Shareholders:

“CTB, which operates worldwide in the agriculture equipment field, has now picked up six small firms since we purchased it in 2002. At that time, we paid $140 million for the company. Last year its pre-tax earnings were $89 million. Vic Mancinelli, its CEO, followed Berkshire-like operating principles long before our arrival. He focuses on blocking and tackling, day by day doing the little things right and never getting off course. Ten years from now, Vic will be running a much larger operation and, more important, will be earning excellent returns on invested capital.” (source: Buffett, Warren. 2008 Letter to Shareholders. February 27, 2009. page 10. http://www.berkshirehathaway.com/letters/2008ltr.pdf )

“CTB, our farm-equipment company, again set an earnings record. I told you in the 2008 Annual Report about Vic Mancinelli, the company’s CEO. He just keeps getting better. Berkshire paid $140 million for CTB in 2002. It has since paid us dividends of $160 million and eliminated $40 million of debt. Last year it earned $106 million pre-tax. Productivity gains have produced much of this increase. When we bought CTB, sales per employee were $189,365; now they are $405,878.” (source: Buffett, Warren. 2010 Letter to Shareholders. February 26, 2011. page 13. http://www.berkshirehathaway.com/letters/2010ltr.pdf )

In closing, there are two concepts that left the most impression on our visit to Omaha.  First, Buffett and Munger made a concerted effort to debunk questions that related to what most people hear in popular media about their investing style.  When asked about what fundamental metrics they look for when selecting a stock Buffett said, “…understanding the math of company fundamentals is not how I select a company.”  When going through the shareholder letters, it is clear that the defining element is the management of the company that makes the difference when deciding to invest in any company.  The numbers can look great but if the managers aren’t of a certain caliber then Berkshire Hathaway will take a pass on the opportunity to invest.

Second, Buffett iterated something that we’ve understood but have had difficulty in conveying to others.  Buffett said [paraphrasing], “the stock market offers the only option to buy [companies] at exceptionally low prices.”  Basically, [stock] markets are inefficient.  Those who take the time to understand the stock market have the opportunity to participate and succeed over an extended period of time.  Those who happen to step into a systematic approach to investing at an early age are the most likely to succeed, all things being equal.