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Leithner Letter No. 15
26 March 2001

It’s not at all clear that priming the pump like mad and slashing interest rates will quite do the trick against a downturn that’s rooted in huge overcapacity brought on by a reckless capital-spending boom and a vastly overleveraged economy. None of us has been witness to the strange and more than a little unnerving sight of the Fed pushing on a string, but stick around and keep your eyes open. 

As for the technical signs that lead these seers to the bullish path, we won’t quarrel; they certainly know more about such things than we do. But we don’t think all the indicators in the world are as important as the simple fact that we’ve had a market that has battened on at least five years of unbelievable, almost unimaginable excess, an excess it’s going to take more than nine months and a partial wipeout of Nasdaq to get rid of. What’s happened so far, we’d call a start. And, besides, what kind of a bear market would it be if it didn’t devour some of its own?

Alan Abelson,
Up and Down Wall Street, Barron’s 19 February 2001

The Value Machine

An excellent article by Carol Loomis, The Value Machine, featured in Fortune’s (19 February 2001) coverage of America’s most admired companies. It reviews Berkshire Hathaway’s recent activities and the principles which motivated those activities. For five consecutive years Berkshire has appeared on the Most Admired list; this year it sits in position number 7. 

Part II of the article states that “Berkshire had a remarkable year in 2000, in ways largely unrecognized.” As a result of eight acquisitions, its number of employees doubled and its revenues increased by $US13 billion to $30 billion; and as a result in 2001 Berkshire will be among the top 50 companies on the Fortune 500 list and its earnings may approach $US3 billion. Its recent acquisitions cost $US8 billion and were financed entirely with cash. Moreover, all of this cash was generated from Berkshire’s operations: not a dollar, in other words, was borrowed. This ability to generate large amounts of cash rebounds hugely to Berkshire’s advantage when the business horizon darkens. As Loomis notes, “2000 had a tightening financial character that gave Berkshire an edge in buying companies. The money available for purchases of companies got short as the year went on, with junk bonds tough to sell and big equity investors skittish. In fact, a New York investment banker visiting [Berkshire Chairman Warren E.] Buffett told him that he thought of Berkshire as the only investor in the country that could lay out $5 billion for an equity position.” 

This ability to generate cash, together with Mr Buffett’s decisiveness, enables Berkshire to transact business very quickly. In a typical instance, the purchase of Johns Manville, negotiations were conducted and arrangements finalised within days. This plain-dealing, cash-on-the-barrelhead approach also enables Berkshire to attract and retain a disproportionate number of America’s ablest executives. According to Loomis, after its incorporation into the Berkshire fold, JM CEO John Henry “met with Buffett in Omaha for about six hours. He went into the meeting, Henry says, thinking about plans he had to retire and ready to say ‘I’m gone’ if he got any clue that he couldn’t work with Buffett. Instead, he says, he emerged from the meeting charged up: ‘I came out totally committed to making this thing work. It’s easy to see what happens with Buffett’s companies. You end up saying you don’t want to let this guy down.’” 

Yet as Part III of the article notes, Mr Buffett neither sought to join the Fortune 500 nor possesses a grand plan for its acquisitions – “other than answering the phone.” In Loomis’ words, “the truth is, when it comes to creating value for investors, he doesn’t see the world the way many chief executives do. He doesn’t focus on his company’s stock price; on a given day, he may not know where it stands. [And] he is not searching for synergy.” To the managers of Berkshire’s stable of businesses “Buffett promises independence and respect and then-barring some irreconcilable problem that just has to be dealt with-delivers on the commitment.” In Mr Buffett’s own words, “we don’t have any MBAs running around telling these people what to do. And God knows I wouldn’t know what to tell them.”

Mr Buffett’s Letter to Shareholders

Still on the subject of Berkshire Hathaway: its 2000 Annual Report was released over the Internet on 10 March. Berkshire’s transmission of quality information to its owners has long been a model of management’s moral and legal accountability to shareholders. Mr Buffett – not a committee of lawyers, PR and media specialists or other intermediaries – writes the Chairman’s Letter personally. (Berkshire employs few or no such staff; equally admirably, it appears to be a committee-free zone). Its most refreshing attributes thus include clarity, candour and sheer readability. Mr Buffett’s Letter therefore repays careful study. Some of its highlights:

  • Operations and Results Mr. Buffett said that Berkshire’s net worth increased by $4 billion in 2000. Net profit more than doubled to $3.3 billion, or $2,185 per share, compared to $1.6 billion, or $1,025 per share, in 1999. (Mr. Buffett has called 1999 one of the company’s worst years).

  • Buying Businesses With Cash “We remain awash in liquid assets and are both eager and ready for even larger acquisitions. Try to control your excitement. [we] embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint.”

  • Berkshire’s Portfolio of Assets In 2000 Berkshire sold nearly all of its holdings of mortgage giants Fannie Mae and Freddie Mac. Mr Buffett did not elaborate the decision to shed the issues in an equity portfolio he described as “only mildly attractive.” He added that whilst Berkshire owns shares of some “excellent businesses ... most of our holdings are fully priced and are unlikely to deliver more than moderate returns in the future.” There were only modest other changes in Berkshire’s other large equity stakes.

  • The Stock Market’s Speculative Binge “It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of businesses that underlay them.” (Mr Buffett warned in last year’s letter that investors’ hopes for returns on tech stocks were “wildly optimistic” and that when their outlook returned to more realistic levels “the market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated.”)

  • In Hindsight, Even the Best Make Mistakes Perhaps because virtually none of them own a plurality of the shares of “their” companies, few if any corporate leaders assess their performance as bluntly and with such transparent honestly as Mr Buffett. His 2001 Letter pointed candidly to problems in various Berkshire-owned companies. He acknowledged, for example, that last year he wrongly predicted that “we would get our money’s worth from stepped-up advertising” at Geico (a major insurer). He also stated that while most of Berkshire’s manufacturing, retailing and service businesses “did reasonably well last year,” the exception was its Dexter shoe unit. “Our attempt to keep the bulk of our production in domestic factories has cost us dearly [and] we face another very tough year in 2001. I clearly made a mistake in paying what I did for Dexter in 1993 [and] compounded that mistake in a huge way by using Berkshire shares in payment.”

Speculators Still Don’t Get It

The cycle of boom and bust which has made its presence felt on markets for financial assets in the past few years – and may presently be unfolding in the markets for goods and services – can be explained partly in monetary terms. What remains unexplained, however, is the widespread confidence – in some places ebullience and in a few places unabashed conviction – which continues despite signs of bust to be placed in the New Economy and tech stocks. Although there are some individual exceptions, as a whole and as a rule the economic foundations of information, knowledge, It – and hence tech companies – are transitory and weak. Yet even in the wake of the tech wrecks of 2000, few recognise the grave risks which continue to inhere in the ownership of New Economy securities.

The ‘irrational exuberance’ (as Robert Shiller has dubbed it) present in financial markets since the late 1990s has been a consequence of three things. The first is a conceptual confusion between savings and credit – and the deleterious consequences stemming from the diminution of savings and strong growth of credit. The second is a logical confusion between correlation and cause. The phenomenal rise of the Internet and the increase of economic activity since the mid-1990s are correlated (in the sense that they occurred at the same time), but the former did not cause the latter. Rather, both may be consequences of a common cause: the suppression of market rates of interest below their natural rate.

The third is the problematic economic status of knowledge, information and technology. If this central conclusion is correct, then we face a cruel irony. In Peter Hartcher’s words (The Australian Financial Review Weekend Edition, 3-4 March 2001), “to turn a Silicon Valley favourite back on its originators, these guys just don’t get it. The rise and fall of the Nasdaq, and of the U.S. economy itself, is part of an old paradigm – a paradigm that has prevailed since people stopped bartering and started using money. Easy money fuels a boom. And the easier the money and the longer the boom, the more likely that tons of liquidity will create a big run-up in the price of assets – and that will lead to a mania. Then, when the money starts to tighten, a savage retrenchment begins. ...”

Chris Leithner


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