Leithner Letter No. 40
26 April 2003

[The United States] goes not abroad in search of monsters to destroy. ... She will commend the general cause [of liberty] by the countenance of her voice and the benignant sympathy of her example. She well knows that by once enlisting under other banners than her own, were they even the banners of foreign independence, she would involve herself beyond the power of extrication, in all the wars of interest and intrigue, of individual avarice, envy, and ambition, which assume the colours and usurp the standard of freedom. The fundamental maxims of her policy would insensibly change from liberty to force [and] she might become the dictatress of the world.

U.S. President John Quincy Adams (1821)

All of us have heard this term “preventive war” since the earliest days of Hitler. I recall that is about the first time I heard it. In this day and time. ... I don’t believe there is such a thing; and, frankly, I wouldn’t even listen to anyone seriously that came in and talked about such a thing.

U.S. President Dwight David Eisenhower (1953)

Bogus and Genuine Business Education

Not a few people regularly pay $A50.00 or more for “how to” books which purport to impart the “secrets” of successful business and investing. Others pay considerably more to attend seminars at which “experts” promise to open the black box that is apparently closed to the benighted; and in order to advance their earnings and career prospects still others dedicate years of study and allocate tens of thousands of dollars towards university courses and degrees. Alas, each of these activities often fills participants’ heads with significant amounts of trivia, irrelevancies and outright nonsense; accordingly, each is at best ineffective and at worst damaging.

The costliest (in terms of time and money) of these activities, the postgraduate business degree, per se provides neither a better career trajectory nor a higher salary. According to Jeffrey Pfeffer, a professor of business at Stanford University who has concluded an analysis of 40 years of research about the economic value of the Master of Business Administration degree (reported in The Chicago Sun-Times on 5 July 2002), this is partly because little that is taught in business schools prepares students for the realities of contemporary commerce. B-students, in effect, neither purchase nor receive education and training. Instead, they acquire a “badge” to place on their résumés and a chance to associate with like-minded people; B-Schools, in turn, enforce a cartel and featherbed their employees.

Prof Pfeffer (whose paper, co-written with a Stanford business student, appeared last year in the journal Academy of Management Learning and Education) says “the simplest advice is that if you don’t get into a leading business school, the economic value of the degree is really quite limited. Obviously, if you get admitted to Harvard or Stanford or another élite school, the very fact of your admission is going to increase your worth in the job market. But there is not much evidence the actual education does very much.” Pfeffer had long been sceptical of the economic value of the MBA. He became convinced after a group of consulting firms and investment banks compared the performance of B-school graduates to those trained in two- or three-week programs that teach new employees the basics of business. They found that the non-MBA benighted did no worse, and in some cases rather better, than their MBA-anointed peers. They also found that more business education did not beget higher rank or salary. The implication is startling: “you have to question what goes on in the two years it takes to get an MBA if someone can virtually be equivalent in two or three weeks. What that suggests to me is that if you take a smart person, and give them [sic] a relatively short course, a mini-MBA if you will, they basically do as well as the MBAs.”

One critical problem with B-schools and universities more generally, then, is that much of their present curriculum (which is quite comparable from one institution to the next) is stuffed with irrelevancies and woolly and esoteric nonsense. Another is that truly valuable ideas embodied in applied works of immediate significance have been banished. At the 2002 AGM of Wesco Financial Services Charles Munger noted that “there’s a lot wrong [with American universities]. I’d remove three-quarters of the faculty – everything but the hard sciences. But nobody’s going to do that, so we’ll have to live with the defects. It’s amazing how wrongheaded [the teaching is]. There is fatal disconnectedness. You have these squirrelly people in each department who don’t see the big picture.”

Generalising his point, Mr Munger continued: “this doesn’t just happen in academia. Companies can get balkanised. Look at what happened at Arthur Andersen and Enron. They weren’t all bad people, but their cultures were dysfunctional. It’s easy to create such a culture, in which you have good people but terrible results. Many areas of government are dysfunctional. Universities are complicit. They don’t feel guilty about the product they’re producing. ... They are strong in the hard sciences, but if you go to business, law, sociology. ...” (see also The Dorm Key Ritual and Must Your Children Run the Collegiate Gauntlet? by Gary North, and Steven Yates’ Can Logic Be Taught on Campus?).

Mr Buffett’s Letter

In dramatic contrast to costly, largely ineffective and to a significant extent damaging seminars and university degrees, Berkshire Hathaway’s Annual Reports, which can be accessed free-of-charge, are priceless. More than one person has observed that a thorough comprehension of the principles set out in these reports provides a first-class education in business and finance (see in particular Lawrence Cunningham, ed., The Essays of Warren Buffett: Lessons for Corporate America, The Cunningham Group, 2001, ISBN: 0966446119). Berkshire’s 2002 Report was released over the Internet on 8 March.

Each Report’s centrepiece, the Chairman’s Letter, is a rarity and a delight. Although its final draft is edited by a close friend and long-time shareholder, Carol Loomis of Fortune magazine, it is written personally by Berkshire’s Chairman, Mr Warren Buffett, and not by a committee of advisors, intermediaries, flaks or dissimulators. In the same spirit of thoroughgoing simplicity and common sense, Berkshire’s headquarters at Omaha, Nebraska employ no PR, media or marketing people; further, by all accounts it appears to be a committee-free zone. (Berkshire’s many and various subsidiaries employ more than 100,000 people). Accordingly – and equally unusually, admirably and surely not co-incidentally – the most prominent attributes of Mr Buffett’s annual communications include clarity, candour, acuity and sheer readability. Given these attributes, to say nothing of his track record since the mid-1950s, the ethics and actions of Mr Buffett and his Vice-Chairman, Mr Charles Munger, repay careful study and emulation (see also Letters 3, 15 and 28).

Berkshire’s Operations

In his most recent Letter, Mr Buffett proclaimed that 2002 was a “banner year” for Berkshire Hathaway. Its revenue increased 10% to a record $42.3 billion; the company ended 2002 with $US10.3 billion in cash and equivalents on its balance sheet; float from insurance operations (“money we hold but don’t own”) rose to $41.2 billion and its cost decreased to 1%; and most importantly, the increase of Berkshire’s book value (10%) outstripped the S&P 500 index by 32 percentage points. That result “was a welcome change from the last few years, during which my investment record was dismal.” Mr Buffett cautioned, however, that “there will be years in which the S&P soundly trounces us. That will in fact almost certainly happen during a strong bull market, because the portion of our assets committed to common stocks has significantly declined.”

Mr. Buffett criticised the failure of General Re, a subsidiary of Berkshire and one of the world’s largest reinsurers, to generate low-cost float. He admitted that his evaluation of General Re in 1998, when Berkshire purchased it, had been “dead wrong.” “Unbeknownst to management – and to me – the company was grossly mispricing its current business. In addition, Gen Re had accumulated an aggregation of risks that would have been fatal had, say, terrorists detonated several large-scale nuclear bombs in an attack on the US.” If General Re had been independent in September 2001, then “the World Trade Centre attack alone would have threatened the company’s existence.” General Re reported an underwriting loss of $1.4 billion in 2002, compared with a loss of $3.7 billion in 2001. With the exception of Scott Fetzer Cos., Berkshire’s non-insurance companies increased their operating earnings last year.

Boards of Drongos and the Stewardship of Capital

Mr Buffett attributes to boards of directors and trustees much of the blame for the apparent withering of managerial accountability in corporate America. He pointed to a “boardroom atmosphere” (where collegiality supersedes disinterested scrutiny, constructive criticism and Emersonian independence) for the recent, systemic and painful failure to protect the interests of companies’ shareholders. He said that most of the roughly 250 directors with whom he has served on boards had made a “minimal at best and too often negative” impact upon the businesses they supervised. Mr Buffett did not absent himself from criticism: “too often I was silent when management made proposals that I judged to be counter to the interests of shareholders.”

>Mr Buffett directed particularly harsh criticism towards the trustees of managed funds who retain mediocre managers and fail to negotiate cheaper management fees. He dubbed the perennial retention of fund managers “a zombie-like process that makes a mockery of stewardship. ... A monkey will type out a Shakespeare play before an ‘independent’ mutual-fund director will suggest that his fund look at other managers, even if the incumbent manager has persistently delivered substandard performance.” Similarly, the ability of most funds’ boards to secure lower fees and charges from managers has been ”pathetic.” “Believe me, if directors were promised a portion of any fee savings they realised, the skies would be filled with falling fees.” Similarly, the method and amount of executive remuneration received a blast. When deciding the CEO’s package, directors far too often act as if they are “tail-wagging puppy dogs;” and to question – or, better yet, reject – the “megagrant of options to the CEO ... would be like belching at the dinner table.”

>Buffett also criticised his fellow CEOs. Far too many have “behaved badly at the office, fudging numbers and drawing obscene pay for mediocre business achievements.” Alas, he offered little hope that this behaviour is likely to change. A remedy, he suggested, is that big institutional investors, the custodians of capital for millions of individuals, grasp the nettle. “Today it would be easy for institutional managers to exert their will on problem situations. Twenty, or even fewer, of the largest institutions, acting together, could effectively reform corporate governance at a given company, simply by withholding their votes for directors who were tolerating odious behaviour.” But here too Mr Buffett was not holding his breath: “unfortunately, certain major investing institutions have ‘glass house’ problems in arguing for better governance elsewhere; they would shudder, for example, at the thought of their own performance and fees being closely inspected by their own boards.”

Financial Weapons of Mass Destruction

In this year’s letter Mr Buffett calls derivative contracts “financial weapons of mass destruction, carrying out dangers that while now latent are potentially lethal” (see also What Worries Warren and Robert Samuelson’s article A Financial Time Bomb? in the 13 March edition of The Washington Post). As a related matter, substantial credit risk has become concentrated “in the hands of relatively few derivatives dealers.”

Derivatives “call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years), and their value is often tied to several variables. Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them.”

Mr Buffett said that he and Vice Chairman Charlie Munger regard derivatives as “time bombs, both for the parties that deal in them and the economic system.” Before a derivatives contract is settled, the counterparties may often record “huge” profits and losses on their earnings statements “without so much as a penny changing hands.” “The range of derivatives contracts is limited only by the imagination of man [or sometimes, so it seems, madmen].” Further, “they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties.” Such events can become “a spiral that can lead to a corporate meltdown.” Mr. Buffett informed Berkshire shareholders that he has been unable to sell General Re’s derivatives portfolio and is now terminating it. “The reinsurance and derivatives businesses are similar. Like Hell, both are easy to enter and almost impossible to exit.”

Prices of Equity and Debt

Mr Buffett reported that “last year we were ... able to make sensible investments in a few ‘junk’ bonds and loans. Overall, our commitments in this sector sextupled, reaching $8.3 billion by year-end.” Investing in bonds and stocks is similar in the sense that “both activities require us to make a price-value calculation and also to scan hundreds of securities to find the very few that have attractive reward/risk ratios.” He acknowledged, however, that junk bonds involve “enterprises that are far more marginal. ... Therefore, we expect that we will have occasional large losses in junk issues. So far, however, we have done reasonably well in this field.”

Mr Buffett believes that the prices presently paid for most American companies (or parts thereof) are significantly greater than values received in return. Accordingly, “despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge.” Accordingly, unless he sees a “very high probability of at least 10% pre-tax returns ... we will sit on the sidelines.” In summarising his view, Mr Buffett uttered a sentence that virtually never passes the lips of the typical broker, analyst or strategist: “occasionally, successful investing requires inactivity.”

That view seems to be congruent with the view expressed by Alan Abelson (Up & Down Wall Street, Barron’s 10 March 2003). “For their part, once the fighting’s over, investors will need to admit to themselves a truth they’ve long suspected: the shadow of war has been a handy excuse for the market’s decline, just as it has been for the economy’s malaise. Both actually have been suffering from a severe case of the busted-bubble blues that even a quick and triumphant war, no matter how enspiriting, will not cure. What we need in the stock market is a new psychology to expunge the huge excesses of the bubble mentality; we’ve made a start, but we’re by no means there yet. What the economy needs is to work off the heavy legacies of the late speculative boom. That’ll take time and the emergence of managements free of dangerous entanglements, most particularly with Wall Street.

Chris Leithner


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