2010 Pilgrimage, Part III: In Defense of Goldman Sachs, Circa 1976

The essential question for Warren Buffett—“Would you defend Goldman’s actions if you didn’t have a $5 billion investment in the company?”—has not been asked today.

And it will not be.

That’s the downside of the Berkshire meeting format. Despite the fact that half the questions are asked directly by shareholders and the other half are questions that have been submitted to (and sifted by) three reporters, all the questions asked of Warren Buffett and Charlie Munger are asked on behalf of the shareholders.

This is not a press conference.

Thus there can be no follow-ups to whatever glaring howlers, if any, come out of the two men’s responses—and one such howler, we think, there has been.

It was Buffett’s dismissive referrence to one investment bank (Lehman Brothers) as “another carny” while he was stoutly defending another investment bank (Goldman Sachs), whose carny-like behavior went well beyond that of Lehman Brothers in the very example Buffett himself gave to shareholders.

Goldman, for readers who just arrived from Mars, is being pursued by the SEC for creating a destined-for-failure mortgage package at the behest of a hedge-fund client, with the sole purpose of selling it to another client. Lehman, on the other hand, had merely asked Buffett to insure a package of plain-vanilla municipal bonds.

Whether Goldman did anything actually illegal, as opposed to unethical, is the question which the SEC’s complaint has raised in the minds of many on Wall Street and here in Omaha.

Charlie Munger, for his part, clearly sides with the ‘unethical but not illegal’ camp. His earlier summation of the case had generated approving murmers and nods in this crowd:

“I think a lot of companies should decline business that would be legal…the standard should not be what’s legal and convenient.”

Buffett, on the other hand, has cut Goldman some serious slack, admitting neither to illegal or unethical behavior on the part of the “jockeys” in charge of that “horse,” on which he slapped a $5 billion wager during the crisis:

“We think plenty has been wrong, but our experience with Goldman Sachs goes back 44 years… We’ve bought more businesses through them than any other investment bank… They helped build Berkshire Hathaway….And we trade with them as well.

“And they can very well be shorting for their own account…they do not owe us a divulgence of their position any more than we do…they are acting in a non-fiduciary capacity when they are trading with us.”

Nevertheless, regardless of what Goldman might “owe” to its clients, Goldman’s true colors have already been well-aired in public.

And those colors, as anyone on Wall Street might have told anyone on Main Street even before the storm broke when the SEC complaint came down in April, look like this: Goldman Sachs does what is good for Goldman Sachs, period.

The fact that this appears to be a surprise all of a sudden is a mystery to anybody working in Lower Manhattan, and it seems to be a surprise to Warren Buffett.

Indeed, even a casual observor of Berkshire Hathaway might wonder why Warren Buffett would have invested $5 billion of Berkshire’s hard-earned money into Goldman Sachs during the worst financial crisis since the Great Depression unless Goldman operated in its own self interests—and did so always?

And that same observor might also ask themselves how else an investment bank operating in the most cutthroat business on earth could have managed through the storm with only one money-losing quarter, while 3 of its 4 brethren vanished completely?

In any event, today, May 1, 2010, in front of 17,000 shareholders packed into the Qwest Center arena and another 25,000 watching on big screen TVs elsewhere in the building, Buffett has cleverly shifted the discussion away from the legal and ethical issues by providing a sentimental journey of his and Munger’s history with investment bank now under fire.

“Now if they’re working with us on an acquisition or a financing, that’s a different story. I’d like to take you back—some people here will remember this—the very first bond deal Charlie and I did, our maiden voyage in 1967…Slide 2 please…”

Buffett’s call for another slide—this is a very well prepared defense—brings up on the giant screens alongside the stage an image from the front page of a very old prospectus:

“Diversified Retailing Company,” he says, harking back to an early investment of his and Munger’s.

“We went out to raise $5.5 million….What happened in this one was we were having trouble raising $5.5 million, and I called Gus Levy of Goldman Sachs and Al Gordon of Kidder Peabody and said would you guys help me? And both Gus Levy and Al Gordon said to me ‘Warren we’ll take a big piece.’”

A third slide shows the Goldman and Kidder names highlighted in yellow on the back of the prospectus. As Buffett relates the story, neither firm wanted to be on the front page despite their hefty investments:

“They wanted to give us money under an assumed name.”

This brings laughter and Buffett uses that goodwill to say more nice things about Goldman Sachs, and Kidder too.

“I do have a long memory for people that take care of Berkshire over a long time. Al Gordon was a remarkable man. Gus Levy was a remarkable man.”

For the record, Al Gordon sold Kidder to GE in 1986—almost a quarter century ago.

Gus Levy stopped running Goldman Sachs upon his death in 1976—almost 35 years ago.

Things have changed since then. A lot.

Yet this isn’t the first time Warren Buffett has held a quaint, but outdated, view of a business he thought he knew well.

Readers of “Pilgrimage to Warren Buffett’s Omaha” (McGraw Hill, 2008) will recall that Buffett held a similarly rose-colored view of General Reinsurance, for which he spent $22 billion in precious shares of Berkshire Hathaway, in 1998.

Here’s how Buffett described the situation in his almost ten years later:

For decades, General Re was the Tiffany of reinsurers, admired by all for its underwriting skills and discipline. This reputation, unfortunately, outlived its factual underpinnings, a flaw that I completely missed when I made the decision in 1998 to merge with General Re. The General Re of 1998 was not operated as the General Re of 1968 or 1978.

Now, thanks to Joe Brandon, General Re’s CEO, and his partner, Tad Montross, the luster of the company has been restored…

Is the Goldman Sachs of 2010 being operated as the Goldman Sachs of 1976, or 1966, or 1940, when a precocious 10 year old named Warren Buffett visited the firm with his father and traded stock ideas with Sidney Weinberg?

Not likely.

And Andrew Ross Sorkin, the ace New York Times reporter now asking a question, isn’t going to let Buffett off as easily as Becky Quick and the last two Berkshire shareholders.

Those three apparently picked up on Buffett’s vibe that he had finished with Goldman Sachs, and shifted the focus to other areas, including:

1. The current financial reform bill being debated in Washington, of which Munger observed:

“I don’t think anybody in America, including Congress, knows what’s going to happen, and I would guess that most of them have not read the bill”;

2. Buffett’s lobbying to protect Berkshire from derivative collateral changes, which Munger defended by calling the proposal:

“Both dubious and unconstitutional”;

3. The fallout from Greece’s march towards insolvency, of which Munger said flatly:

“I think in this country—and other countries too—responsible voices are now realizing we’re NEARER trouble from government lack of credit than at any point in my lifetime.”

Sorkin, author of the best and most readable account of the financial crisis, “Too Big to Fail,” somewhat apologetically but firmly returns the questioning to Goldman Sachs, with several terrific questions rolled into one. He asks:

“As a Berkshire shareholder, who would you like to see run Goldman Sachs if not Lloyd Blankfein? Were you made aware of the Well’s notice? Would you have disclosed it? Have you been contacted about the Galleon investigation?”

Buffett begins his answer by disposing of the last question, which relates to the fact that a Goldman Sachs board member has been accused of tipping former Galleon hedge fund honcho Raj Rajaratnam about Berkshire’s imminent investment in Goldman Sachs, with a dismissive joke:

“We’ve not been contacted in any way about Galleon. No contact from anybody, and I can’t pronounce the name of the guy that runs Galleon.”

Ironically, Raj—as everybody on Wall Street, even those who didn’t know him personally, referred to him in his Master-of-the-Universe heyday—has a fairly mellifluous surname when it comes to native-born Sri Lankans, at least to American ears.

But Buffett’s point is this: he doesn’t know the guy, period. He then moves on to the Wells notice issue.

A Wells notice is a sort of legal heads-up the SEC provides to those individuals or institutions against whom it is considering bringing a civil action. The SEC had delivered one such Wells notice to Goldman Sachs in July of 2009, but Goldman chose not to disclose it until the SEC filed its complaint in April of 2010.

That lapse raised eyebrows above and beyond the eyebrow-raising that occurred when Goldman’s behavior in arranging the ABACUS transaction hit the tape, because the receipt of a Wells notice by a financial institution whose business relies on a good relationship with its regulators is surely worth knowing about if you’re an investor in that institution.

Buffett, however, disputes the notion that the Wells notice was that type of “material” information and, therefore, would have demaned immediate public disclosure. He does this by going back in time to when General Reinsurance received such a Wells notice:

“The Wells notice, we didn’t get the Wells notice, but then the Gen Re executives got the Wells Notice …that was not us receiving, but we stuck it in the 10-Qs,” the quarterly financial filings required of exchange-listed companies.

“I’ve been on the board of at least one public company for many years that got a Wells notice and they didn’t disclose. I wouldn’t have regarded it as material either.”

Buffett did not say whether that public company was a financial company dependent on the goodwill of the Securities and Exchange Commission for its daily bread, which would make his example more analogous to the Goldman situation.

More likely, Buffett is referring to Coke, on whose board Buffett served while its make-the-numbers CEO, Robert Goizueta, was driving the business to meet Wall Street expectations so hard that the company would later settle with the SEC on charges of what essentially amounted to channel-stuffing in order to hit earnings targets.

Nevertheless, Charlie Munger supports his long-time business partner’s view:

“I wouldn’t have regarded it as material either,” Munger says, and then makes an excellent point that derives from his perspective as an attorney:

“And you don’t want to give blackmail material to people that make claims.”

Buffett concludes the Wells notice discussion by saying he doesn’t know “what percentage of Wells notices” actually turn into an enforcement action anyway.

As for Lloyd Blankfein, Goldman’s CEO, Buffett gives as complete an endorsement as he can:

“If Lloyd had a twin brother I’d go for him. I haven’t given it a thought. There’s no reason to think of it. Like Penn Central problem in 1972: there was no reason to have someone other than Gus Levy running it. I just don’t see this as reflecting on Lloyd.”

Munger, who has expressed greater discomfort than Buffett with the general “scuzziness” of investment banks, firmly agrees:

“Well there’re plenty of CEOS I’d like to see gone in America, but Lloyd Blankfein isn’t one of them.”

Buffett, who likes to finish up such discussions on a light note, ends the discussion of Goldman Sachs with a nod to Munger, who is not known to hold back when it comes to expressing condmenation:

“I was worried he was going to start NAMING them.”

The crowd chuckles and Buffett moves to the next question, his defense of the ABACUS transaction, Lloyd Blankfein and Goldman Sachs & Company complete and on the record.

It is still early Saturday morning, May 1. There are another 50 questions to come. They will be varied in both quality and topic, and the responses will be varied, too.

In some cases, Buffett and Munger will be entirely predictable…but in others they will be surprising. And that is what keeps people coming back to Omaha.

To be continued…



Jeff Matthews
Pilgrimage to Omaha

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

2010 Pilgrimage, Part II: “A Closer Call” than Buffett Thinks…and Yes, Charlie Did Say “Scuzzy”

“I think the central part of the argument is that Paulson knew more than the bond people….They [the bond people] just made what in retrospect turned out to be a dumb insurance decision.”—Warren E. Buffett, May 1, 2010

So Warren Buffett frames the SEC complaint against Goldman Sachs & Company in the now-infamous ABACUS transaction, and summarizes his defense of that now-tarnished investment bank in front of 17,000 Berkshire shareholders here at the Qwest Center arena in Omaha (and another 15,000 scattered in other rooms watching on monitors elsewhere.)

“ABACUS,” we should add, for readers whose eyes start to glaze over when they see Wall Street deals with testosterone-charged names, was merely a bet by one smart guy—hedge fund manager John Paulson—that a bunch of mortgages would fail.

Paulson helped pick some of those mortgages, and Goldman Sachs & Company packaged those bets and sold them to IBK, a small German bank—all with the blessing of ACA, the supposedly independent third-party bond insurer enlisted by Goldman for the purpose.

Buffett continues his defense, along the lines of ‘let the buyer beware,’ by using a typically Buffettian analogy to bring the thing home for his shareholders:

“Let’s say we had decided to short the housing market in early 2007…I don’t think anybody should blame us.”

With that, Warren Buffett has just done something cagey. Smart, but cagey.

By identifying “the central part of the argument” as John Paulson’s behavior, Buffett has turned the spotlight away from Goldman Sachs & Company’s behavior and on John Paulson’s behavior. Yet nobody—not even the SEC—is claiming that Paulson did anything wrong.

Paulson simply bet that a bunch of old nags (mortgages to people who couldn’t afford them) gussied up like thoroughbreds would keel over and die before they got around the race track. And Paulson won—big-time—at the expense of IBK.

But it is not likely he could have accomplished it on the scale he did without the aid of Goldman Sachs and dumb bond insurers like ACA.

Having thus deflected the issue away from Goldman, Buffett then turns the question over to Berkshire’s Vice-Chairman, Charlie Munger. “Charlie?”

Munger, as is his wont, has been sitting patiently, pouring a glass of ice water for himself and gazing out at the crowd through his Coke-bottle thick glasses while Buffett expounds on Goldman Sachs, John Paulson and the ignoramuses at ACA.

Before he can being, Buffett reminds the audience of something relevant to the discussion: “Charlie has a law degree.”

And in fact Munger started his path to the Forbes 400 not by peddling stocks in his father’s brokerage firm, as did Buffett. Instead, Munger took his Harvard law degree to Los Angeles—where he had been stationed during World War II—and founded Munger, Tolles & Olson LLP.

It was in his capacity as an attorney advising a variety of companies that Munger grasped an important truth which even Warren Buffett hadn’t grasped as a Ben Graham value-maven looking for cheap stocks in the Moody’s manual: it is better to buy a fantastic business at a good price than a bad business at a fantastic price.

That lesson helped create Berkshire Hathaway as we know it, and it underlies the reason Berkshire shareholders have been sitting through a half hour worth of Buffett’s flag-waving defense of Goldman Sachs & Company.

For the investment banking business is not necessarily a fantastic business on its own: it requires fantastic management. As Andrew Ross Sorkin quotes Buffett (in the excellent “Too Big to Fail”) telling Goldman CEO Lloyd Blankfein, “If I’m buying the horse, I’m buying the jockey, too.”

And the Goldman jockeys are under fire.

Munger clears his throat and leans towards the microphone in his deliberate, understated manner, and leads with a reference to the recent revelation that SEC commissioners voted 3-2 to pursue the Goldman case, and were split along party lines.

“This was a 3-2 decision,” Munger says. “If I had been on the SEC I would have been on the minority too.”

This generates a groundswell of good feeling towards Buffett’s defense of Goldman, and Buffett jumps in with another couple of daggers to stock into ACA’s hide:

“I have seen ACA referred to as investor…ACA was a bond insurer, pure and simple—very simple as it turned out.”

Speaking over the ensuing laughter, Buffett prompts Loomis for the next part of the question. “Carol?”

“The next part,” Loomis says, “was, ‘your reflections in light of Berkshire’s large investment in Goldman…’”

This gives Buffett a chance to gloat about Berkshire’s investment in Goldman, which was made during the crisis days of 2008 when the entire financial world look close to falling apart. Buffett invested $5 billion for a fat, dividend-paying preferred, plus warrants to buy Goldman shares for Berkshire’s—and he doesn’t want to give them up.

“Very ironically it’s probably helped our investment in Goldman,” he says. “Our preferred pays us $500 million a year,” and Buffett notes that Goldman has a legal right to pay off the preferred any time it wants, at a 10% premium to Berkshire’s cost.

“If we got that $5.5 billion today we’d put it in very short term securities which might produce $20 million or something”—quite a few dollars less than the $500 million Berkshire is getting from the preferred. “Our preferred is paying us $15 a second. Tick, tick, tick, that’s $15 a second…I don’t want those ticks to go away…they pay me at night, on weekends…”

This generates guffaws, and Buffett—like a comic who knows a good line when he hears the laughs—keeps riffing on that theme while pointing out that the Federal government has been pressuring investment banks to keep as much capital on their books as possible, meaning Goldman probably would be hesitant to repay the Berkshire investment too soon:

“They [the Feds] have been pretty strong with all the TARP companies that they could not pay dividends…and I was just hoping they’d continue to be tough in not letting Goldman call our preferred. ‘Tick tick tick’ will go on so that we will be getting $500 million a year instead of $20 million. We love the investment.”

The audience, likewise, loves the greedy capitalist routine.

When it comes to “losing reputation,” however, Buffett draws what must surely be the weakest quiver from his quiver. Buffett is, after all, almost as famous for the high standard of behavior to which he holds Berkshire managers as he is for making money:

We can afford to lose money—even a lot of money. We cannot afford to lose reputation—even a shred of reputation. Let’s be sure that everything we do in business can be reported on the front page of a national newspaper….Berkshire’s results have benefited from its reputation, and we don’t want to do anything that in any way can tarnish it.

—Warren E. Buffett, memo to Berkshire Managers, August 2, 2000

Leaving aside the obvious fact that Goldman’s successful effort to pawn off some lousy mortgage bets on one customer at the behest of another has resulted in plenty of terrible front page stories on every national newspaper left standing (and their web sites, too), Goldman’s reputation is in no way, shape or form what it was before the details of ABACUS were made public.

Yet Buffett—who, as a student of the Dale Carnegie method of winning friends and influencing people, almost never criticizes individuals in public—answers by first offering a bit of a history lesson. Ancient history, for this crowd:

“Losing reputation—there’s no question the press of the last few weeks can hurt moral…it hurts. Incidentally, Goldman Sachs had a situation with the Penn Central years ago…it was a source of great pain to John Weinberg…”

Penn Central was a railroad that went spectacularly bankrupt in 1970, triggering an SEC investigation and civil fraud suits in 1974. Among those investigated was Goldman Sachs, whose CEO was the aforementioned John Weinberg.

Here’s how Time Magazine described, in 1974, Goldman’s role in the affair, which sounds eerily familiar 35 years later:

Goldman Sachs insists that it did nothing wrong in marketing $83 million of commercial paper for Penn Central in the six months before the bankruptcy. But it signed a consent decree under which it promised that it will investigate companies for which it sells commercial paper and tell would-be buyers what it finds out.Buffett, who can see the forest for the trees better than most investors, knows that Goldman Sachs will, ultimately, work through the current bad press, not to mention the efforts of Congresspersons everywhere to look less incompetent themselves by ganging up on Goldman Sachs.

But he uses that long-term view as the means to insist that what Goldman did was not, somehow, a violation of the ‘front page of the newspaper’ standard he himself uses for Berkshire managers:

“I don’t believe the allegation belongs in the category of losing reputation.”

Yet he’s been proven wrong on this one before the doors opened this morning.

As for “advice” he would give to Goldman Sachs, Buffett cites “our motto” when he and Charlie were working hard to rescue Salomon Brothers during their scandal of more than two decades past:

“Get it right, get it fast, get it over with.”

He then allows himself a significant loophole that might make today’s defense null and void:

“If it leads into something more serious then we’ll look at the situation at that time.”

Before handing off the reputational question to Munger, Buffett finishes up by repeating his central argument:

“But what I’ve seen of the ABACUS activity I don’t see that would be any different from me complaining of that list of municipals. Charlie?”

Munger stirs and says words that are undoubtedly on everyone’s mind here today—and what most of us very likely expected Buffett to say when it came to Goldman Sachs:

“I agree with that but I think a lot of companies should decline business that would be legal…the standard should not be ‘what’s legal and convenient.’”

That draws an appreciative murmur: it seems exactly right. Munger then offers a backhanded defense of Goldman Sachs:

“I don’t think there are too many investment banks that didn’t do scuzzy deals.”

(Yes, Charlie Munger—one of the most erudite and literate investors in the word, did say ‘scuzzy.’)

But now it gets really interesting, for Buffett’s ear is sharply tuned to Munger’s words, and he wants to follow up on them. This is no mere crowd-pleasing aspect to their performance. The two men not only listen to their shareholder’s questions carefully, but they listen to each other the same way.

And if one says something the other disagrees with or wants to clarify, he will follow up in front of 17,000 people.

Thus Buffett follows up on Munger’s lumping of the entire category of credit-bubble-era investment banks together as “scuzzy” with a question about Berkshire’s own participation in the excesses of that era—the municipal bond deal brought to Berkshire by “another carny,” Lehman Brothers, which Warren Buffett and Ajit Jain agreed to insure:

“But Charlie,” he asks, “do you think we should have done our municipal bond deal?”

Munger, who may or may not be the only person in the world that doesn’t think twice about disagreeing with Warren Buffett, says without hesitation,

“I think it was closer call than you do.”

And many of the Berkshire Hathaway here will agree with “Charlie,” as it turns out.

To be continued…



Jeff Matthews
Pilgrimage to Omaha

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

The 2010 Pilgrimage to Omaha, Part 1: Defending the Carny

“There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business....”

Quick! Name the public company CEO who wrote those words in late 2008.

If you said, “Warren E. Buffett, Chairman of Berkshire Hathaway,” then you know your Berkshire Chairman’s letters.

More specifically, you know Buffett’s 2008 letter to shareholders, which he wrote less than a year after the now-infamous ABACUS transaction—which Goldman Sachs & Company had helped assemble for the benefit of John Paulson—went (as we say on Wall Street) “tapioca.”

The “Oracle of Omaha” used his annual letter that year to explain why he expected the folks running Berkshire’s extensive utility businesses to behave well “in respect to all aspects of the business.”

Here’s the full version of that discussion:

Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises…

In the regulated utility field there are no large family-owned businesses. Here, Berkshire hopes to be the “buyer of choice” of regulators. It is they, rather than selling shareholders, who judge the fitness of purchasers when transactions are proposed.

There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business…

—Warren E. Buffett, 2008 Chairman’s Letter.

So, one might ask Buffett, how does he think Goldman Sachs & Company “behaved in respect to all aspects of the business” when it comes to the ABACUS transaction?

After all, a regulator is a regulator.

So it seems unlikely that a person, especially one who goes out of his way to judge behavior in terms of strict moral clarity as Buffett himself frequently does, could find a meritorious distinction between, on the one hand, the regulators of public brokers in power and light, and, on the other hand, the regulators of brokers in stocks and bonds.

Yet that, it seems, is precisely what Warren Buffett did when he rose to the benefit of the folks at Goldman Sachs & Company—at length and with slides to back up his words during last Saturday’s Berkshire Hathaway meeting—in their run-in with the SEC, which happens to be the most important regulator in the world of purveyors in stocks and bonds.

Now, for the record, your editor here has expressed the view (in “From BACCHUS to ABACUS: Exhibit A in Defense of Goldman Sachs,” JeffMatthewsIsNotMakingThisUp/blogspot.com ) that while we hold no particular esteem for the moral DNA within Goldman Sachs, from our reading of the claim, the SEC doesn’t seem to have a leg to stand on:

1) By withholding the name of the seller—John Paulson—from the buyer, it seems to us that Goldman was doing nothing more or less than is expected of any broker in any securities transaction;

2) Far from duping a rank minor-leaguer, as claimed by the SEC, Goldman’s buyer was a German bank that had boasted of its major league prowess in the kind of complex instruments it eventually volunteered to purchase through Goldman Sachs & Company.

Many good readers disagreed with us, for many good reasons—particularly the ethical sliminess of a broker seeking a buyer for a cynically-constructed synthetic transaction designed to fail.

But people don’t go to jail for bad ethics, they go to jail for breaking laws, and while the ABACUS deal was quite slimy, it seemed no worse than much else we have seen from Goldman over the years. Thus, although we are not attorneys, and really don’t care what happens to Goldman Sachs & Company, the ABACUS deal seemed far from illegal.

And last Saturday, Warren Buffett emphatically agreed.

Let’s journey to that crisp morning in Omaha inside the 17,000-seat Qwest Center arena…

Carol Loomis, the ace Fortune editor, asks the Goldman question right at the start of the session. And while Loomis is best friends with Buffett, we give her credit for asking some of the most controversial and difficult questions at the shareholder meeting for two years running—no easy thing with 17,000 Buffett acolytes in a Madison Square Garden-sized arena where Warren Buffett and Charlie Munger will be holding forth for five-plus hours.

Loomis launches straight into “Topic A,” as she calls it:

“Warren, every year you use the Salomon clip”—the video of Buffett telling Congress during the 1991 Salomon Brothers hearing that he had advised Salomon employees 'lose money and I will be understanding; lose one shred of our reputation and I will be ruthless'—which Buffett includes in the movie shown prior to the start of every shareholder meeting.

“Clearly Goldman has lost reputation because of the SEC’s action,” Loomis continues, and asks for Buffett’s “reaction to the lawsuit, your reflections, and what advice you would give the Goldman Sachs board.”

Buffett is ready. “Let’s start with the transaction,” he says, and begins what we will soon learn is an extremely well planned defense:

“A few weeks ago a transaction described as ABACUS, subject of SEC complaint—I think it ran 22 pages…” (A note: Warren Buffett knows numbers, so when Buffett says of the complaint, “I think it ran 22 pages,” you can bet it ran exactly 22 pages. It did.)

“I think there’s been misreporting—not intentional of course,” Buffett says of the brew-ha-ha surrounding the ABACUS deal, “I would like to go through that transaction first, then we’ll go through the questions.”

And go through it he does.

“The transaction, there were four losers…Goldman Sachs was a loser, they didn’t intend to be I’m sure, they kept a piece and they loss $90 or $100 thousand”—and while Buffett knows numbers, he did say ‘thousand,’ not ‘million,’ which is an odd mistake for a guy who really keeps track of money.

“… The main loser was a very large bank named ABN Amro which became part of RBS. Why did they lose money? They lost money because they guaranteed credit of another company.… They guaranteed the credit of another party.

“We do it all the time. Berkshire has made a lot of money guaranteeing these over the years. We lost money—years ago—on syndicates of Lloyd’s of all things, who found ways not to pay when they found our name on the thing.”

Buffett is teeing up his answer, demonstrating the broad working knowledge he possesses, while also making the point that there was nothing particularly unusual about the deal, except that the players were, by and large, sloppy:

“ABN…took on a $900 million of risk, and they got paid $1.6 million. The company they guaranteed went broke… It’s very hard to get upset about that.”

So far, so good. ‘What kind of moron guarantees $900 million in return for a lousy $1.6 million premium?’ Buffett is asking, before answering it himself: ‘ABN Amro, that’s who.’

Buffett then gets to ACA, the most visible party in the transaction:

“ACA was a bond insurer…they started out as a municipal bond insurer…all those companies started out insuring municipal bonds…and there was a big business and then the profit margins started getting squeezed….and what did they do? They got involved in other deals.”

Demonstrating his age and his 50’s-era sense of humor, Buffett repeats a hoary old joke he has employed many times over the years, in a variety of situations:

“I described this in the annual report a few years ago…like Mae West said, ‘I was Snow White but I drifted.’”

There is a bit of laughter, but clearly not all that many people know who Mae West is any more.

(The 50-for-1 stock split not only attracted a larger crowd of investors this year—20% bigger than 2009, we’d guess—but a younger crowd. At the Borsheim’s open house on Friday night, the crowd was much rowdier than in years past, and the number of Bud drinkers—as opposed to white wine drinkers—was distinctly higher. Still, what matters most to Warren Buffett is they were buying: every counter at Borsheim’s had customers looking over some piece of jewelry.)

Buffett concludes his point about municipal bond insurers like ACA that moved outside their field of expertise this way:

“They all did it and they all got into trouble, every one of ‘em.”

He then brings it back to Berkshire Hathaway:

“Now interestingly enough Berkshire went into the bond insurance business when these guys got into trouble,” although, he makes sure to emphasize, “we stayed away from things we didn’t understand…never insured a CDO.

“I wanna give you an example of something we did insure…if the projectionist would put up slide number one.”

Aha! Buffett has—as he has done in the past—prepared slides to support a point he knows he will be making sometime during the meeting.

The first slide of the day shows a list of $8.3 billion worth of state bonds broken down by state, including the likes of Florida, Illinois, Delaware and Utah:

“Somebody came to us a couple years ago…a large investment bank and they said take a look at this portfolio… They said to us, ‘Will you insure that these bonds in these states will pay for 10 years?’

“I looked at the list and Ajit Jain [Buffett’s ace reinsurance exec] looked at the list and we had to decide would we insure them and what premium we would charge. We offered to charge $160 million for 10 years… We will pay somebody on the other side—the counterparty they call it—if these states don’t pay, we will pay as if they did pay.

“We didn’t dream up this list,” Buffett says, and then makes one of the most revealing statements of the session.

“Another carny dreamed up this list.”

Who was the “carny” in this particular case? “It was Lehman Brothers,” Buffett reveals.

He then names several different reasons why Lehman may have been seeking insurance on the bonds, but adds flatly,

“We don’t care which scenario…if they told me Ben Bernanke was on the other side of the trade, it wouldn’t make a difference to me. It shouldn’t matter…we did with these bonds exactly what ACA should have done with these bonds.

“ACA said there’s about 50 we’d be willing to insure and then got another 30 more… We didn’t do that, we could have, but it was a totally submitted list.”

Buffett then brings it back to ABACUS:

“Now in the end the bonds in the ABACAUS transaction all went south very quickly…. It wasn’t that apparent at the time… Now there could be trouble in the states we insured, there could be big pension liabilities…but I seeing nothing whatsoever, I mean if I lose money on these bonds I’m not gonna go to the other side.

“I think the central part of the argument is that Paulson knew more than the bond people…they just made what in retrospect turned out to be a dumb insurance decision. Let’s say we had decided to short the housing market in early 2007 I don’t think anybody should blame us.”

Thus, Warren Buffett says that nobody should blame John Paulson or, by inference, the broker who packaged and sold the ABACUS transaction.

Take notice, however, of what Buffett just called Lehman Brothers: he called them “another carny.”

Thus, in Warren Buffett’s eyes, Lehman Brothers is a mere carnival barker hawking rigged games to tempt cash out of unsuspecting bystanders.

So how is this different from Goldman Sachs & Company?

Well that is the very question Loomis wants answered: she now prompts Buffett to move from the transaction itself to the question of how the SEC investigation makes him feel about Berkshire’s investment in Goldman, and its reputation.

The first part of the follow-up gives Buffett a chance to play the amusingly-greedy capitalist to the friendly crowd:

“Goldman pays us $500mm a year… $15 a second. Tick, tick, tick, that’s $15 a second…I don’t want those ticks to go away…they pay me at night, on weekends… We love the investment.”

This draws laughter and allows Buffett to move on to what might be the touchiest part of the issue, Goldman’s reputation, with a reservoir of good feelings on which to draw:

“Losing reputation—there’s no question the press of the last few weeks can hurt moral…it hurts…. I don’t believe the allegation belongs in the category of losing reputation…”

Hmmm... Let’s go back to Buffett’s own words from that 2008 letter to shareholders:

“There is no hiding your history when you stand before these regulators. They can – and do – call their counterparts in other states where you operate and ask how you have behaved in respect to all aspects of the business....”

Does Warren Buffett really hold his own utility companies to a higher standard of “behavior” than his friends at Goldman Sachs?

Consider it this way: if, at the behest of one of its customers, a Berkshire natural gas pipeline were to contract for a lousy batch of natural gas in order to sell it to another Berkshire natural gas pipeline customer, would Buffett defend that behavior?

The answer, of course, is no.

In that light, it would seem that the most rational—and successful—investor of his times has merely rationalized the behavior of yet “another carny.”

And he has done so for the sake of, oh, $15 per second.

This becomes clearer when Buffett asks Charlie Munger—his longtime sounding board, nicknamed “The Abominable No-Man” by Buffett for his deeply skeptical view of most deals (even deals that get the “Oracle of Omaha” temporarily excited)—what he thinks of the Goldman deal.

Munger, an attorney who happens have founded a highly successful West Coast law firm in addition to being half of the most successful investment team in modern history, will agree with his partner in the strictly legal sense, but it becomes clear he has a different sense of the ethics of the thing....

To be continued...


Jeff Matthews
Pilgrimage to Omaha

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

2010 Pilgrimage to Omaha Preview: Buffett to SEC, “You Have No Case!”

The Berkshire meeting is over. Shareholders have given Buffett and his vice-chairman, Charlie Munger, a standing ovation. And now the parties start.

The ovation is for many aspects of Buffett’s stewardship of Berkshire Hathaway, but mainly it seems his “all-in wager” on the American economy—the purchase of Burlington Northern—looks like it’s already paying off.

The economic pickup that “looked spotty” just a few months ago, Buffett has told us, is picking up steam: rail cars in use are up dramatically. And Berkshire is “net, hiring.”

But the show-stopper came early on, “at the top,” as they say in show business—speaking of which, what was George Lucas doing in the Berkshire director’s section before the meeting began?—when Buffett defended Goldman Sachs…and forcefully.

No, Buffett didn’t actually say to the SEC, “You have no case,” but neither did Gerald Ford actually say to New York, “Drop Dead!”

And yet both men might as well.

Carol Loomis asked the Goldman question right out of the gate, without mincing words—reminding Buffett of his famous, and often-repeated “lose a shred of reputation and I will be ruthless” video from the Salomon Brothers days—and Buffett responded without mincing words.

To be continued…


Jeff Matthews
Pilgrimage to Omaha

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Questions We’d Like to Hear: ‘Pilgrimage to Omaha’ Top Ten List

Well it’s that time of year again.

In a few days something like 35,000 people from literally all around the world will begin suffering United Airlines connections in Chicago, Minneapolis and elsewhere, for Omaha, where the only for-profit annual shareholder meeting among New York Stock Exchange-listed companies is about to take place: the Berkshire Hathaway meeting.

Or, as Warren Buffett likes to call it, “Woodstock for Capitalists.”

(Those Berkshire shareholders who do not suffer commercial airline connections to get to Omaha will either be driving or arriving in style courtesy of NetJets, which Berkshire naturally owns.)

As always, the heart of the three-day extravaganza will be the Saturday morning question-and-answer session held by Buffett and his acerbic Vice-Chairman, Charlie Munger (“The Abominable ‘No’-man,” as Buffett calls him).

When we attended the Berkshire meeting in 2008 while writing “Pilgrimage to Warren Buffett’s Omaha,” the question-and-answer session was dominated by non-financial, non-Berkshire questions, thanks to Buffett’s remarkably democratic question-selection technique (he simply called on anyone who got up early enough to grab a spot at one of the 12 or 13 microphones placed inside the Qwest Center arena).

That led to predominately “What Would Warren Do”-type of questions by adoring Buffett fans, as opposed to hard questions about Berkshire and its businesses.

Last year, Buffett refined the methodology, inserting three reporters into the mix to screen the questions, and the result was a much sharper Q&A, without the WWWD stuff. (Buffett, by the way, loves answering those “WWWD” questions—he’s a natural teacher; he likes the stage; and he’s smarter than anyone else in the room except Munger, so what the heck).

The only refinement at this year’s meeting will be that Buffett is adding 30 minutes to the 5-plus hour Q&A, so instead of handling the usual 50-55 questions, Buffett thinks he’ll be able to accommodate 60.

Which brings us to today’s topic: the Top Ten list of Questions We’d Like to Hear is back at these virtual pages.

Readers should submit their best question—the one they’d like to see Warren Buffett (or Charlie Munger) answer next Saturday in front of 35,000 people.

We’ll select the Top Ten, publish them here Friday and submit them to Andrew Ross Sorkin. (Let us know if you want your name used, should Mr. Sorkin ask it.)

While there is no guarantee at all that any one of our Top Ten will be used, chances are most of them will be asked in one form or other. (Last year’s batting average was .800.)

Following the meeting we’ll publish how well our readers anticipated the reporters themselves.

Send them to pilgrimagetoomaha@gmail.com. And soon.

JM.




Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

Stotlar to Buffett: “Your Burlington Deal is Working Already: Stuff is Moving Again”

UPS upgraded to Overweight at Piper Jaffray; tgt $79
Piper Jaffray upgrades UPS to Overweight from Neutral and sets target price at $79 following UPS's strong upside 1Q10 pre-report. They believe the report, and operating leverage / margin implications, exhibits UPS has finally taken drastic enough past measures to improve its global network cost structure.—Briefing.com

The least helpful calls an investor will receive today—and there are more than the one from Piper summarized above—all pertain to a single news item: last night’s upside earnings announcement by UPS.

UPS, as long-time readers know, is one of a pair of what we here at NotMakingThisUp consider two of the most important canaries in the global economic coal mine, along with FedEx.

So what exactly did UPS say, aside from the fact that the just-finished quarter’s earnings came in 20% higher than previously expected, which has triggered so many unhelpful calls from Wall Street’s Finest this morning?

Well, for starters, UPS said international volumes “grew significantly” in the quarter (like 9% in the export side and 24% within international boundaries). And that the U.S. turned in its first year-to-year increase since 2007. Finally—and this should really be no surprise to anyone: when good things happen to a company that has been cutting costs like crazy, earnings go higher—UPS raised guidance for the year.

This last is a lesson much of corporate America has been trying to teach Wall Street’s Finest since the economic recovery began.

From a small restaurant chain serving the supposedly dead-and-buried American consumer to a giant integrated circuit company serving the supposedly dead-and-buried American businessperson, companies that cut costs as if the world was coming to an end in 2008 and 2009 are now reaping the benefits of an economic recovery.

And that recovery appears to be quickly gathering steam before the bemused and sardonic eyes of millions of scarred and scared investors, both professional and not, who got off the stock market train when it came off the tracks in 2008 and refused to get back on before it left the station in 2009.

Of course, there is one investor who not only got back on the train before it left the station: he literally bought the train.

We speak of Warren Buffett, of course, who announced his purchase of Burlington Northern last November as an “all-in wager” on the U.S. economy.

Shortly after Buffett made his move—the near-final piece of the Berkshire jigsaw puzzle, we think—your editor wrote about it in these virtual pages.

In “Why Buffett Finished Off Burlington: It’s the Inventories, Stupid” from November 19, 2009, we described some of the dramatic cost-cutting and inventory-draining then rampant in Corporate America, then offered the conclusion that Buffett was going to be proved right fairly quickly.

And if the recent news from UPS, and CSK, and Intel, and California Pizza Kitchen, and Con-way are any indication, Buffett’s already right.

“What exactly is the recent news from Con-way?” sharp-eyed readers may be asking themselves, since that company doesn’t report earnings for another two weeks.

Well, Douglas Stotlar, the CEO of the giant trucker, told Bloomberg news yesterday his company “is turning down as many as 145 load orders because of capacity constraints.”

“A year ago, we were looking at downsizing the workforce and cost control,” Stotlar said in an interview. “Now the issues are how do you take advantage of an economy that appears to be rebounding, how do you take advantage of the surge in demand.”

Con-Way’s truckload volumes were up 30 percent in January and February from the same months in 2009, Stotlar said. The company is also seeing growth in its partial truckload business, where shipments from more than one customer are moved in one truck.

“It appears to be across both retail” and manufacturing, Stotlar said. “We are seeing multiple touch points that are verifying to us that the economy is definitely recovering.”
—Bloomberg News, April 14, 2010

No, Douglas Stotlar didn’t actually tell Warren Buffett “Your Burlington deal is working already: stuff is moving again,” as we titled this piece.

But he doesn’t have to: Buffett already knows it.

After all, he owns a railroad.



Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

What I Learned, Part VI: No Brilliant Ideas, but a Dig at Kraft

The second-to-last question of the day is asked, and it’s about Burlington Northern.

“Are you also purchasing rights of ways and do they have other purposes?” a shareholder wants to know.

He is, no doubt, wondering whether the “Oracle” has divined an additional use for the rights-of-way on which the Burlington Northern track sits—one that takes such clever advantage of those long, uninterrupted stretches of railway beds that, years from now, other railroad operators will smack their foreheads and mutter “How did we miss that!”

Buffett knows exactly where the question is going, for there has been speculation that he has his eye on using those rights-of-way to expand his electrical distribution operations in some sort of grand scheme to both help fortify the tired, aging national grid while likewise making buckets of money for Berkshire.

So he gets right to the heart of the matter:

“ I think Phil Anschutz found a way to do this in the case of his railroad, but no, Burlington Northern does not have a lot of excess land, and I don’t have any brilliant ideas to use the right of way, the rolling stock, the tonnage, the bridges…”

Buffett knows his history: Phillip Anschutz was the genius, Kansas-born, land/farming/oil magnate who began installing digital fiber-optic cable along the tracks of the Southern Pacific Railroad in the 1990s, creating Qwest Communications out of thin air—or, rather, thick dirt.

Anschutz was copying the model created by Williams Companies, a pipeline operator that had been stringing decommissioned oil pipelines with fiber-optic cable since 1985.

Buffett, however, will not be copying Williams or Anschutz: he merely wants the railroad.

Having made this clear, he winds up the subject with a dig at Kraft—the food company whose shares Berkshire owns and which is buying Cadbury for what is, in Buffett’s mind, an offensively high price using offensively low priced stock:

“Unlike Kraft, we do NOT expect dramatic synergies.”

This gets a laugh from the sympathetic crowd, and Buffett continues by accentuating the positives, and also displaying more of his command of financial history—the kind of command he will put to greater effect at the annual shareholder meeting when he and Charlie Munger will answer these types of questions for more than five hours:

“Matt Rose does a wonderful job running it [Burlington Northern]... I do not see its utility elsewhere. The Burlington had lots of oil, real estate [years ago], and they spun those things off. The railroads have nothing like the surplus of assets they had 20-30 years ago.

I looked at a map of the Union Pacific the other day, when they were chartered in the ‘60s I think they had 10% of the land in Nebraska.”

By “’60s” Buffett is, of course, referring to the 1860’s, but I wonder if the youthful side of today’s crowd makes that connection.

The final question of the day—at least the last question Buffett will answer—is about his partner, represented today by a color cut-out of a youthful Charlie Munger...“What is Charlie’s view on the split?"

Buffett says,

“We consult on anything important—like this. We’re paying a full price, and paying part of the price in stock is unpleasant.”

When a shareholder from La Jolla tries to sneak in a question on Buffett’s view on the price of oil, the Oracle seizes the chance to cut things off:

“We should really limit this,” he says. “Charlie, any last words?” he asks his cardboard partner.

Instead of Munger’s voice, we hear him snoring.

This draws laughter and makes for the sort of humorous coda with which Buffett likes to end his public appearances. He stands and shareholders start moving to the front of the concert hall, their cameras ready.

As the cameras start flashing, Buffett obliges. He stands next to the image of Charlie and makes a “V” with his fingers behind Munger’s head.

The flashes go off.

Then Buffett waves and walks quickly offstage.

To be concluded…


Jeff Matthews
I Am Not Making This Up

All images and Text © 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

What I Learned, Part V: On Expected Returns and Diluting the Berkshire Gene Pool

“What is the expected return on capital from Burlington?” asks the shareholder from Hamburg, Germany. “And if you can’t buy more railroads would you expand into shipping?”

As Warren Buffett launches into his answer, I muse that this is not the first time a German has asked the best question at a Berkshire shareholder meeting.

In “Pilgrimage to Warren Buffett’s Omaha” (McGraw-Hill 2008) I described the one and only question that really challenged Warren Buffett throughout more than five hours on a Saturday morning two years ago—and it was asked by a shareholder from Bonn.

The fact that only one question—out of more than 50—attempted to scratch the surface of the Oracle’s brainy-but-folksy demeanor is not as striking as it might appear to those who have only seen Buffett hold court on CNBC, where he delivers opinions on everything from the inheritance tax to the environmental advantage of railroads versus trucks.

Despite the fact that the centerpiece of the annual “Woodstock for Capitalists” is a five-hour, no-holds-barred question-and-answer session with Warren Buffett and his vice-chairman, Charlie Munger, the fact is that in recent years not many shareholders asked questions even marginally related to Berkshire and its businesses.

That changed at last year’s meeting, of course, when Buffett eliminated the first-come, first-served lineup at the microphones and instead selected three financial journalists to pose questions submitted in advance by shareholders and anyone else with an internet address.

The new format eliminated the tendency of past meetings to veer towards “What Would Warren Do?”-type queries from awestruck acolytes asking Buffett advice on how to become a great investor, or what issues Buffett would tackle if elected President, or—and I am not making this up—“Do you know and believe in Jesus Christ, and do you have a personal relationship with God?” (The answer to that one is—well, buy the book and find out.)

Indeed, at the May 2008 meeting only one question related to the businesses owned by Berkshire Hathaway. It was also the only question Buffett ducked. (By contrast, he answered the “Jesus Christ” question as he answered most of the rest: straight ahead, with no irony.)

And that was too bad, because it was a great question that indirectly got to the heart of what will likely become the central issue at Berkshire Hathaway: what happens when Warren Buffett—the best capital allocator in the world—is no longer allocating capital at Berkshire.

Using Berkshire’s See’s Candies as an example, the Man from Bonn asked whether Buffett would prefer a slower-growing but higher-margin business, as See’s is, to a global but somewhat lower-margin business, as Swiss chocolate giant Lindt & Sprüngli has become.

It was (and still is) a an excellent observation: when Buffett and Munger bought See’s for $25 million in 1972, it was a small, west-coast candy company. 37 years and $1.5 billion in profits later, See’s remains a small, west-coast candy company.

While that’s good news for Berkshire shareholders—after all, Warren Buffett reinvested that $1.5 billion of cash from See’s into other high-return opportunities, to the benefit of Berkshire and its shareholders—it’s not necessarily good news for See’s Candies in a world gone global. (To see how Buffett ducked the German’s question, read “The Decline and Fall of the Sainted Seven,” Chapter 36 in “Pilgrimage.”)

The question asked today by the shareholder from Hamburg is equally good:

“What is the expected return on capital from Burlington,” he has asked, “And if you can’t buy more railroads would you expand into shipping?”

This time, Buffett does not duck it:

“I think the return will be satisfactory but not mouth-watering,” Buffett says. “It’ll be similar to our energy utilities.”

Berkshire’s utilities earn decent, regulated returns on investment—not remotely close to the See’s Candies-kinds of returns that most investors associate with Warren Buffett—but “satisfactory” nonetheless.

The reason “satisfactory but not mouth-watering” returns are appealing to a guy famed for growing Berkshire’s book value at 20% a year for 45 years is simple: the sums involved are now so vast ($43 billion, give or take, in total capital for the Burlington Northern deal), that a merely “satisfactory” return on an elephant-sized investment still means a lot of money will be coming in Berkshire’s door every year for many, many years.

And any money manager—Buffett, especially—will tell you it is far more difficult to grow large amounts of money than small. Thus, in Burlington Northern, Buffett has found precisely the kind of “elephant” he has been hunting for years.

That does not mean, however, Buffett thinks the Burlington acquisition is without risk.

By comparing the railroad business to Berkshire’s existing utilities businesses, Buffett makes an important point. For unlike See’s Candies, which sells a discretionary consumer product and therefore may raise prices or introduce new products or enter new markets at will, the railroad business is subject to significant oversight from the Feds—less so than in the past, when pricing was regulated, but still significant—much like a public utility.

Indeed, at this very moment, Jay Rockefeller’s Senate Commerce Committee is considering new rail legislation to beef up regulatory oversight and put the screws to railroads—legislation that the CEO of Union Pacific, Burlington’s chief rival in the west, complained about on his company’s recent earnings call.

And so it is that Buffett proceeds to discuss the risk this government interference poses:

“We are counting on society to behave well with us in allowing us a reasonable return on capital IF we do our job of behaving reasonably well,” he says.

Asked next what would happen if government regulation got “more intense” on railroads, Buffett says matter-of-factly:


“The governments could strangle our utilities… They have the ultimate authority…they could raise the corporate tax rate to 80% or something…

Our basic position is that if we behave well, they’ll behave well. Our utility customers oughta feel very sure that when they flick a switch the lights’ll go on,” he says, adding, “They’re gonna need the railroads in this country big time.”


Buffett’s age (he’ll be 80 in August) seems to be catching up with him: despite shielding his eyes from the glare of the spotlights, he can’t discern where the next question is coming from. He looks intently at the unused microphone near us while the shareholder asking the question is at the microphone on the other side of the concert hall:

“How would the stock split affect Berkshire’s ability to be in the S&P 500?”

It is a bit unsettling to see Buffett continue to stare at nobody, but the spotlights are bright and what the hell, this is Warren Buffett, who cares where he’s looking?

Besides, this is a question with big dollars at stake. Berkshire is not in the S&P 500 Index, despite the fact that its market value is larger by far than any other company outside the index—and bigger than most that are in it.

The reasons Berkshire has been excluded up to now are straightforward: two of the Standard & Poor’s Index Committee’s five ‘admitting criteria’ haven’t been in Berkshire’s favor since the day Buffett took control in 1965—one being trading volume and the second being the amount of stock in public hands.

Before the Burlington deal was announced in early November, a less-than-whopping 40,000 shares of Berkshire “B” shares traded on a good day, not adjusted for today’s proposed 50-for-1 stock split. And the volume in “A” shares, through which Buffett controls Berkshire, barely rounded up to a 1,000 a day prior to the announcement.

Answering the question, Buffett observes:

"We’re by far the largest co that’s not in the S&P 500… the A/B situation creates problems for us, but eventually we’ll be in the S&P 500, we’ll be so large.”

So far, so clear; but it is in discussing the effects of this dramatic change in his shareholder base (over which Buffett was once so obsessed that he used to keep track of how many shareholders lived in his own zip code) that Buffett exhibits an ability that at once makes him so remarkable, and, to some investors, so hypocritical—the ability to rationalize any particular stance at all, whenever it suits his purpose:

“If they put us in the S&P, it’s good for shareholders,” he says, because “if 6-7% of funds are in index funds it’s a block of stock that’s essentially there forever, which is EXACTLY what we’re looking for.”

Thus in one easy, plain-spoken sentence the investor who for fifty years has warned against following the herd; who has railed against diversification by serious investors (“ass-backwards,” his business partner, Charlie Munger, calls it); and who has refused to split his stock for fear of diluting the intellectual gene pool of those “quality shareholders” in the Berkshire Hathaway shareholder base, who now blithely claims that index funds—big, stupid, mechanical, massively diversified index funds—are “Forever.”

If, by “Forever,” Buffett means “So long as Berkshire’s market capitalization stays proportional to the index,” then he’s correct.

If, on the other hand, by “Forever” he means “Whatever happens to Berkshire Hathaway,” he can’t be more wrong.

After all, if Berkshire is one day hit by some strange off-the-wall disaster—an asbestos lawsuit, say, or a problem with the Berkshire derivatives portfolio—that causes its stock to get cut in half while the S&P 500 stayed steady, then those same “Forever” index funds will sell half their Berkshire so as not to be “out of balance” with the index.

And they will not think twice about it, because they are run by computers.

It is an astonishing piece of rationalization by the Oracle, even for most of the investors seated in this room, yet the prevailing reaction seems to be a shoulder-shrugging 'Warren-being-Warren'.

Buffett then rationalizes the effect on the Berkshire gene pool in an equally offhand way:

“By now our identity is pretty well known. I don’t worry about downgrading the quality of our shareholders.”

He concludes the stock-split discussion with one more remarkable statement:

"Charlie and I should have done it when we bought Gen Re.”

The final question of the day gets to something that’s been on people’s minds since Buffett first announced the Burlington deal: what kind of hidden assets he sees in the Burlington railroad balance sheet.

To be concluded….



Jeff Matthews
I Am Not Making This Up

Image of Warren Buffett and all text © 2010 NotMakingThisUp, LLC
Image of Burlington railcar from Wikipedia

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

What I Learned Writing a Book, Part IV: Of Colonoscopies, Cash and Cutouts

The question Buffett’s been asked is a simple one: ‘What’s the difference between Berkshire using undervalued stock to buy Burlington Northern, and Kraft using undervalued stock to buy Cadbury?’

It’s also quite a good one.

After all, Buffett has been beefing to anybody who’ll listen—and CNBC pretty much listens whenever he’s awake—about the price Kraft CEO Irene Rosenfeld is paying for Cadbury PLC, the iconic British chocolate company: in particular, the fact that much of that price will be in shares of Kraft.

Buffett’s beefing about it because Berkshire Hathaway happens to be the single largest holder of Kraft stock.

But what really gets Buffett is that Rosenfeld did an end-around the “Oracle”—imagine that!—by cutting back on the stock portion of the deal to less than 20% of shares outstanding precisely so that Buffett wouldn’t have a chance to vote against the deal, as he promised to in a highly public, early January, press release.

(Charlie Munger, seen above looking over Buffett’s shoulder, no doubt feels equally slighted.)

For the record, Rosenfeld’s Kraft is paying roughly $21 billion all-in for Cadbury. That amounts to 24-times Cadbury’s trailing annual earnings, 14.3-times Cadbury’s trailing cash operating income (what analysts call ‘EBITDA’), and 3.8-times Cadbury’s book value.

(We use trailing, money-in-the-bank numbers here. While most deals are priced on forward-looking sales and earnings forecasts, everyone at this meeting knows that investment bankers and chief financial officers can, and will, come up with whatever they need as far as futures go to justify their salaries and their bonuses. 'Garbage in, garbage out,' as Buffett himself would say.)

For all that money, Kraft is getting in Cadbury a business that generates a modest 45-50% gross margins, a paltry 12% operating margin, and throws off only enough cash from operations to cover capital expenditures. When it comes to branded consumer businesses similar to Cadbury, this lack of “free cash flow” is hard to fathom, and is sure to change under Kraft ownership.

Some—including Kraft and its advisors—have argued that Kraft is picking up an irreplaceable consumer franchise at a multiple of sales and operating cash flow that would have looked like a steal during the credit boom’s glory days.

Blackstone Group, after all, paid Cadbury-type multiples of revenue and operating cash flow for Freescale Semiconductor, a business—semiconductors, for goodness sake—that’s as cyclical, unstable and unpredictable as the chocolate company’s is non-cyclical, stable and predictable.

Oh, and the semiconductor business is low-margin and highly capital-intensive, to boot.

Nevertheless, Warren Buffett opposes the Kraft-for-Cadbury deal because, as he said during an early morning interview today, in a typically Buffettian utterance, that as Kraft’s largest shareholder “I feel poorer.”


So let’s compare what Kraft is willing to pay for Cadbury with the price Warren Buffett is willing to pay—using both cash and a slug of shares of Berkshire Hathaway—for Burlington Northern.

Burlington is a “Class 1” American railroad that was assembled through mergers at the rate of one-per-decade starting in the 1970s. Its tracks stretch from Chicago to the Gulf of Mexico and west to ports on the Pacific Ocean.

Berkshire, which already owns 22% of Burlington (most of that purchased for close to $80 a share) is paying $100 a share for the other 78% of the company. All-in, that amounts to $34 billion for the equity plus about $9 billion in Burlington debt, for a total price of roughly $43 billion.

Keep in mind, Burlington is a railroad, not a chocolate maker. While railroad operating margins in the good times can hit 23%, in the bad times they can get down to 15%, or less. Cash flows tend to be healthy, but so do capital expenditures.

Indeed, the Chief Financial Officer of CSX, one of the other three “Class 1” (it means “big”) railroads in the U.S., reflected on just that subject at an investor conference this week:

“Yes, we spend a lot of money. We always have. People are always, for some reason I’m perplexed with, [asking] why the industry spends between 15 and 17% of our revenue. It is a highly capital intensive business.”

For this cyclical, GDP-dependent railroad operator, Berkshire is paying almost 20-times trailing earnings, 9-times trailing cash operating income (EBITDA), and 2.7-times book value.

None of those numbers look like a steal.

Indeed, as Buffett himself has often pointed out, the “book value” of a consumer brand business like Cadbury is far more valuable than an industrial business, for the simple reason that the cash generated by a consumer brand doesn’t need to be invested in capital expenditures simply to keep the business going—as with a railroad.

All in all, it looks like Buffett’s Burlington investment, as he has been widely and memorably quoted, really does represent an “all-in wager on the economic future of the United States.”

As for using precious Berkshire stock in his deal, while at the same time criticizing Kraft for doing the same in their deal, Buffett’s answer here today is not so memorable:

“I’ve written the annual letter,” he says—Buffett drafts his unique, 20-page annual shareholder letter by hand; ace Fortune Magazine editor and longtime Buffett confidant Carol Loomis edits it with, I am told, a very light touch—“and I deal with this.”

He continues with a line from his earlier CNBC interview:

“Charlie and I like using stock for an acquisition about as much as we like preparing for a colonoscopy.”

It’s a great line that generates laughs and will surely be the quote of the day, as Buffett surely knows.

“We are paying $100 a share [for Burlington]…but it costs us somewhat more than that because we are using stock on the low side of its historic range of book value, as a proxy for value.”

Buffett moves his hand up and down to indicate a theoretical price range, and keeps his hand down to reflect the lower end of that range: it is the first time in years he has publicly offered an observation on the current market value of Berkshire Hathaway stock.

“So when we looked at the Burlington deal we regarded it costing us somewhat more than $100 a share because we are using stock we would not like to issue.”

Having admitted to paying with undervalued stock, Buffett rationalizes the price in two ways:

“We already owned 22.5% of Burlington... We’re getting to use $22 billion of cash advantageously, and we will get to use more cash in that business, we think advantageously… So we thought the deal was okay.”

As to why use stock at all, Buffett says, without stating this out loud, that the deal wouldn’t have happened without some stock being offered to Burlington shareholders:

“If we had to use more [Berkshire] stock, I wouldn’t have done it. They TALKED about us using more stock, but I wouldn’t have done it.”

He then takes a parting shot at Kraft, with Charlie Munger’s input:

“I wish that Kraft, looking at THEIR deal, [had considered the value of Kraft stock in their offer]. I hope they considered that when they were making their calculations…”

Charlie Munger’s voice—Buffett has been sitting next to a cutout of his partner the entire meeting—breaks in, and breaks up the 150 or so shareholders watching:

“I couldn’t agree more.”


In “Pilgrimage to Warren Buffett’s Omaha”—a hedge fund manager’s journey to the heart of Berkshire Hathaway—I noted that a remarkable number of German shareholders manage to line up first at the microphones in order to ask questions of Buffett and Munger during the Saturday question-and-answer session.

And today, the first international shareholder happens to be from—yes—Germany.

Specifically, from Hamburg, which is mainly famous as the port city where the Beatles developed their chops while playing to drunken sailors and other detritus of World War II.

And although this shareholder’s question has nothing to do with the Beatles, the second half of it does relate to Hamburg’s historic role in the Germany economy.

“What is the expected return on capital from Burlington? And if you can’t buy more railroads would you expand into shipping?”

Buffett responds, and the answer is both surprising and entirely expected.

To be continued…


Jeff Matthews
I Am Not Making This Up

Photographs and Content © 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

What I Learned Writing a Book, Part III: “He Can’t Not Answer A Question.”

Buffett runs the meeting briskly and efficiently—so much so that within minutes of his first appearance on stage we reach the guts of the thing: he offers a motion to approve the 50-for-1 stock split and elimination of paper certificates for the Berkshire “B” shares.

Now, for shareholders accustomed to the spectacle of the annual meeting, when 17,000 shareholders pack into the Qwest Center arena for the sole purpose of watching Buffett and his vice-chairman, Charlie Munger, take questions, it is an odd thing to sit in a Berkshire Hathaway meeting and hear Warren Buffett ask for a second to a motion.

And it is odder still to have shareholders respond “Second!” from the floor.

The annual meeting, or “Woodstock for Capitalists,” as Buffett likes to call it, is, after all, a highly moveable affair. Shareholders come and go as they see fit during the five-plus hours of Buffett and Munger’s question and answer session: they grab a cup of coffee to help stay alert; or they go shopping among the Berkshire booths at the nearby exhibition hall; or they skip out to take advantage of the shareholder discount at the Nebraska Furniture Mart. After all, their presence is not required.

But nobody’s moving from this meeting. This is real business.

Buffett moves quickly. The motion has been seconded, and we may now discuss it, he says. Shielding his eyes from the spotlights trained on his seat, he points out two microphones set up for the purpose—one in each aisle—and warns us that the discussion is strictly about the motion to split the stock.

This is disappointing.

Nearly everyone in this room braved the chancy odds of making Chicago airplane connections, not to mention the cold, sleety weather and slippery sidewalks outside to ask Warren Buffett some good, old-fashioned questions. There will be none of the “What should I do with my life?” type of back-and-forth that permeates the annual meeting from this crew.

I sense from those around me that every one of the individuals in this room has at least one question they’d like to ask, given the chance. My seatmates glance at one other after the no-straying-off-topic admonishment.

“Well he can’t not answer a question,” somebody says hopefully.

But it does not look good: there is one lone shareholder standing at the microphone placed in the aisle near us. This is a far cry from the dozens of hopefuls that line up at each of the thirteen microphones placed in the Qwest Center for the Buffett and Munger Q&A session at the annual meeting.

Buffett—who has trouble seeing through the glare of spotlights which microphone the question is coming from: the one in the aisle to his left, or the one in the aisle to his right—is told there is a question, and he calls on the one brave shareholder

The shareholder is from Princeton, New Jersey (the same protocol as that which governs the annual meeting is in place here: shareholders state their name and where they’re from before asking their question), and he begins by pointing out that the proposed stock split will occur whether or not the Burlington Northern acquisition goes through.

So, he asks, “what is the benefit to vote for the split even if the deal doesn’t go through?”

It’s a good, reasonable question, and Buffett drops all pretence of keeping things brief by starting a classicly Buffettian answer—long and rambling, but to the point.

“Burlington has 250,000 shareholders,” Buffett says, warming-up to the topic. Paying part of the price with Berkshire stock “enables Burlington shareholders to get a more tax-efficient transaction.”

This is true: shares sold for cash in a takeover trigger capital gains tax, but shares swapped for stock trigger no taxable event. Thus, most individual investors—and individuals monitor their after-tax returns far more carefully than mutual fund managers—prefer stock swaps to all-cash tenders. Buffett wants to accommodate those Burlington shareholders looking to avoid a tax hit.

Now, it is precisely this kind of matter-of-fact maneuvering around the U.S. tax code that drives a healthy slice of investors crazy when it comes to Warren Buffett.

Buffett is a master of such maneuvers, going back to his early days running a hedge fund (yes, Warren Buffett ran what amounted to a hedge fund: see the chapter titled “Beyond Buffett” in “Pilgrimage to Warren Buffett’s Omaha”.) And for years he benefitted mightily from same the tax-advantaged carried interest provisions of private partnerships which he now criticizes.

(His type-written letters to his limited partners from those years, which are available on the internet, are worth every bit as much to read as his annual Berkshire “Chairman’s Letter.”)

And if there is one thing I have learned writing a book about Warren Buffett and his company—or, more precisely, while giving speeches about the book itself—it is that in almost every crowd there is at least one investor who actually despises Warren Buffett.

I’ve learned to spot them quickly.

They tend to sit in an uptight position, with arms and legs crossed, making a tight face. When question time comes around they inevitably raise their hand aggressively and ask in a louder-than-normal voice how it is that Warren Buffett gets off blabbing about taxes when he, Warren Buffett, ran a hedge fund for years; or when he, Warren Buffett is avoiding the inheritance tax by giving away his stock to his billionaire friend, Bill Gates; or when he, Warren Buffett, could just pay higher taxes if he wanted to….

Buffett himself has been asked these questions over the years, of course: he merely responds, quite rationally but, to his critics, quite lamely, that the laws are the laws, and he obeys those laws.

Thus it is that if the Burlington Northern Board of Directors wants part of the purchase consideration from Berkshire to be stock, both in order to avoid capital gains taxes on a good portion of their shareholders’ profits and to benefit from future growth in Berkshire Hathaway (although Buffett does not mention the second part of that rationale here today), well, Buffett is going to accommodate them.

The stock split is necessary, he explains, because Burlington Northern shareholders would need to own more than $3,000 worth of Burlington stock to convert to Berkshire, since the current price of Berkshire “B” shares is over $3,000.

And if he must split his own company’s high-priced stock so that small investors in Burlington may get the same tax advantages as large investors who will choose to sell out for stock rather than cash, then Buffett is perfectly willing to do it:

“We want to earn the reputation of treating every shareholder equally and with respect,” he says. “To not offer people with less than $3,000 of Burlington Northern the same as those with more, we felt it was the wrong way to go…”

As for his own well-known, and long-voiced, opposition to splitting Berkshire’s stock, Buffett explains his change of mind this way:

“I worried in the past that people would be enticed by the stock price. I’m less worried about that.” He adds ruefully, “in fact our recent record will help with that.”

This generates laughter and is precisely the kind of self-deprecating remark by which Buffett diffuses even mildly contentious questions—and it works here today: he calls for the next question.

The shareholder moves his question gingerly outside the realm of stock splits: “Why Burlington Northern, and not Union Pacific?” he asks.

“They’re both wonderful railroads,” Buffett responds, in his usually tactful manner. (Unless the subject is greedy investment bankers, remorseless mortgage brokers or Greek-alphabet-pushing academics, Buffett follows the Dale Carnegie rule of not to criticize, condemn or complain.)

“And there’s no way one will do better or worse…their fates are locked,” he says.

Then, getting to the heart of the question, Buffett says, “I like the western railroads a little better. If you look out 10 or 15 or 20 years, the West will grow a little faster.”

Clearly, he is looking to China and India as engines of worldwide growth.

The next shareholder asks how he will handle the annual meeting when its shareholder attendance—already north of 30,000—is inflated by some portion of those 250,000 Burlington Northern shareholders to whom he will be giving stock.

Buffett smiles and says, “Maybe if Charlie stays home we’ll only have a hundred people.”

There are now shareholders at each of the two microphones, and their questions contain no pretense of staying on the subject of the stock split. In fact, it is the next question, from a local Omaha shareholder, that is most clearly on everyone’s mind: it is about the Kraft bid for Cadbury.

And while Buffett has already this morning been asked a variation on the same question by the Buffett-friendly CNBC anchor Becky Quick, it is here among his most serious admirers that Buffett won’t be able to glibly toss off an amusing response to his favorite talking head.

Buffett, the shareholder notes, has complained about Kraft using “undervalued stock” to buy Cadbury, yet Buffett is using his owned undervalued stock to buy Burlington Northern.

“What are the differences using undervalued Berkshire stock to buy Burlington Northern?” he asks.

Buffett begins to speak, and we listen.


—To be continued...

Jeff Matthews
I Am Not Making This Up

Photograph and Content © 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.