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Leithner Letter No. 3
26 March 2002

Mr Buffett Speaks

Berkshire Hathaway’s 1999 Annual Report was released over the Internet on 11 March 2000. Berkshire’s transmission of quality information to its owners, in my opinion, has long been a model of management’s moral and legal accountability to shareholders. I strive to emulate its standard of communication and responsibility and therefore urge you to take a look at it.

The Chairman’s Letter, which leads each year’s report, is particularly worthy of attention. Like its predecessors, this year’s Letter received has extensive media coverage (including a front-page article in The Wall Street Journal). As in previous years, however, most of this attention has focussed on Berkshire’s short-term “performance.” In contrast, the media have almost completely ignored the old-school ethics which permeate Berkshire’s operations – and which, it seems to me, provide one of the two bases which underlie its unparalleled long-term results.

Frankness and Attribution of Responsibility

The Chairman’s Letter is written personally by Warren Buffett – not by committees of lawyers, PR and media specialists or other intermediaries. (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. During 1999, for example, the company’s per-share book value increased by one-half of one per cent ($358m). Mr Buffett did not attempt to obfuscate or distract attention from this result. Quite the contrary, he focussed upon it and interpreted it unambiguously: “we had the worst absolute performance of my tenure and, compared to the [Standard & Poor’s 500 Index], the worst relative performance as well.” 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 transparently honestly as Mr Buffett.

Further, no doubt was left about where the responsibility for this result lay: “even Inspector Clouseau could find last year’s guilty party: your Chairman. ... [M]y grade for 1999 is most assuredly a D. What hurt us during the year was the inferior performance of Berkshire’s equity portfolio – and responsibility for that portfolio. is entirely mine.” Executives are virtually always quick to claim bouquets. Few, however, are equally prepared to accept – and fewer still nominate themselves for – brickbats.

Giving Credit Where Credit Is Due

Mr Buffett is not just quick to blame himself for Berkshire’s very few shortcomings: he has long been equally eager to give credit to others for its many successes. This year’s letter, like its predecessors, emphasises that Berkshire’s outstanding long-term results owe much to the people who run its various businesses. The Chairman gave most of his operating managers an “A” not only because they delivered excellent results; more importantly, they conducted themselves with the highest standards of ethics. This year’s letter devoted a page (with a subsection headed “A Managerial Story You Will Never Read Elsewhere”) to praise the integrity of the head of one of Berkshire’s subsidiaries. Mr Buffett concluded his tribute with the words “you can understand why the opportunity to partner with people like Bill Child causes me to tap dance to work every morning.”

Similarly, this year’s letter stated that “there are a number of people who deserve credit for [our success in the reinsurance business] over the years. Foremost is Ajit Jain. It’s simply impossible to overstate Ajit’s value to Berkshire. ...” Investors in Australian companies such as GIO Holdings Ltd, New Cap Reinsurance Ltd and Reinsurance Australia Ltd have in the past eighteen months developed a very keen appreciation of the skills required to assess reinsurance risk accurately and profitably.

Finally, “See’s Candies deserves a special comment, given that it achieved a record operating margin of 24% last year. Since we bought See’s for $25m in 1972, it has earned $857m pre-tax. Give the credit for this performance to Chuck Huggins.. Chuck gets better every year. When he took charge of See’s at age 46, the company’s pre-tax profit, expressed in millions, was about 10% of his age. Today he’s 74, and the ratio has increased to 100%. Having discovered this mathematical relationship – let’s call it Huggins’ Law – [Berkshire Vice Chairman] Charlie [Munger] and I become giddy at the mere thought of Chuck’s birthday.”

Berkshire’s extraordinary long-term results help to explain Mr Buffett’s frankness and infectious enthusiasm. Since 1965, when he became its Chairman, its per-share book value has grown from $US19 to $US37,987. The company’s net assets currently stand at $US57.8b – yes, that’s almost fifty-nine billion American dollars. This implies a compound growth rate of 24.0% per annum over a thirty-five year period. This record has not been equalled – indeed, arguably it has not even been approached – by any other investor.

Given this stellar record, the positive tone of Berkshire’s 1999 report is justifiable. Mr Buffett cautioned, however, that “equity investors currently seem wildly optimistic in their expectations of future returns.” Moreover, given Berkshire’s enormous size it is likely that the rate of growth in its intrinsic value over the next decade will exceed that of the Standard & Poor’s Index by no more than modest amounts. In Buffett’s words, “our optimism about Berkshire’s performance is also tempered by the expectation – indeed, in our minds, the virtual certainty – that the S&P will do far less well in the next decade or two than it has done since 1982. A recent article in Fortune expressed my views as to why this is inevitable.”

With Benjamin Graham’s and Warren Buffett’s ideas figuring prominently in my thinking, I concluded that technology has revolutionised, is changing and will likely continue to transform the production, trade and consumption of goods and services. That is rather obvious. Less evidently, however, very few if any investors have the capacity – I certainly haven’t – to predict with any useful degree of precision which technologies and companies will do the transforming, which will emerge as winners and losers, etc.

These two points are discussed in Berkshire’s 1999 Annual Report. Mr Buffett reiterated that he lacks the expertise to evaluate new technologies and that consequently he is generally unwilling to purchase “technology stocks” (it is noteworthy, however, that Berkshire acquired a small stake in Microsoft Corp. last year). When Buffett and Munger cannot understand a company’s operations to their satisfaction, and therefore cannot estimate its intrinsic value, they avoid its securities: “this explains. why we don’t own stocks of tech companies, even though we share the general view that our society will be transformed by their products and services. Our problem – which we can’t solve by studying up – is that we have no insights into which participants in the tech field possess a truly durable competitive advantage. Our lack of tech insights, we should add, does not distress us. ...”

Share Buybacks

Berkshire’s 1999 Annual Report also canvassed two topics to which I have devoted some thought lately. The first is share buybacks and the circumstances under which companies should undertake them. (In the past six months two of the companies in Leithner & Co.’s portfolio have repurchased 7-8% of their shares.)

In this year’s letter Mr Buffett indicated that he may consider a limited repurchase of Berkshire’s shares. He wrote that “there is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds. and second, finds its stock selling in the market below its intrinsic value, conservatively calculated.” (In the last fortnight, various writers in The Wall Street Journal have given very divergent estimates ($US45,000-$80,000 per share) of Berkshire’s intrinsic value.)

Mr Buffett also wrote: “please be clear about one point. We will never make repurchases with the intention of stemming a decline in Berkshire’s price. Rather, we will make them if and when we believe that they represent an attractive use of [its] money.” Further, although share repurchases “are all the rage,” they are “all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price.” Hence many companies are “overpaying departing shareholders at the expense of those who stay. I can’t help but feel that too often today’s repurchases are dictated by management’s desire to ‘show confidence’ or be in fashion rather than by a desire to enhance per-share value.”

Executive Behaviour and Remuneration

Mr Buffett also noted in this year’s letter that companies often repurchase their own shares in order to offset the options issued to their senior executives. The remuneration paid by companies in the form of grants of options over shares is the second topic to which I have devoted some thought lately.

This subject matter has lately been in the news in Australia. John Hurst, in an article in the 20 March edition of The Australian Financial Review, ably expressed its crux.. In his words, “a new arrogance towards shareholders has crept into [Australian boardrooms]. It is typified by the reluctance of directors to take responsibility for blunders and to curb executive [remuneration] when companies are not performing.” One of this country’s largest listed companies provides a glaring example. Last year it recorded a $A424m net loss – in no small part because it bought a reinsurance business which has lost approximately $A1.2b. Earlier this year, however, its American CEO departed Australia with an $A13.2m handshake. Yet neither its Chairman nor its Board of Directors have accepted responsibility for – indeed, they have conducted little public discussion and explanation of – these events.

Further, as reported in The AFR on 1 March, this company’s “top executives from around the world [have been assembled] to the Hyatt Regency at Coolum on Queensland’s Sunshine Coast for a spot of golf, sun, surf and seafood, oh, and maybe a few sessions nutting out the strategy going forward to turn the ship around. That’s right, as we speak at least 50 executives, including a complement from Britain, are at a management conference in the sun, a move we expect the punters, not to mention institutional investors, are likely to be just slightly miffed about.”

Compare the deeds of this company’s executives and the attitude which seems to underlie them to Buffett’s and Munger’s deeds (and those of their senior executives) and the old-school ethos which generates them. Also peruse Berkshire’s Annual Reports between 1977 and 1999. In so doing you may come to two conclusions which are coalescing in my mind. The first is that Berkshire’s outstanding long-term record is caused by, and not merely correlated with, its adherence to both old-school ethics and value investing. The second, a corollary of the first, is that the mediocre (by Berkshire’s long-term standard) results displayed by most other companies can be attributed partly to the fact that, to greater or lesser extents, they apparently regard these two sets principles as quaint and passé.

Chris Leithner


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