Leithner Letter No. 5
26 May, 2005

“The fault, dear Brutus, is not in our stars but in ourselves.”

— William Shakespeare’s Julius Caesar

An Unheralded Facet of Risk

Market participants, aided and abetted by the mass media, can do a lot of harm to themselves. The media can reflect a herd mentality. One consequence of this mentality is that speculators who erroneously believe themselves to be investors either pay good money for poor businesses or pay too much for sound businesses (or both). By catering to their audience’s proclivity towards greed, fear and folly, mass media reports increase the risk that speculators will incur substantial and permanent loss of capital.

Company executives and their legal, financial and management consultants can also contribute to the destruction of shareholders’ equity. Like all other aspects of business, corporate mergers and acquisitions (M&As) are inherently risky propositions. The stark – but usually unuttered – reality is that many and perhaps most M&As fail to achieve what their highly-remunerated and jargon-spewing creators confidently claim that they will achieve. Disturbingly, corporate deal-makers are seldom in doubt but often in error. In Warren Buffett’s words: “the sad fact is that most major acquisitions display an egregious imbalance: they are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer’s management; and they are a honeypot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer’s shareholders, often to a substantial extent.”

Hence my strong preference that the companies in which Leithner & Co. has invested are the ones being bought rather than the ones doing the buying. And notwithstanding the Ralph Review’s incentives to do otherwise, if and when these companies receive a credible offer of merger or notice of takeover, I will generally sell our shares for cash in the open market (at prices which will usually be inflated beyond their intrinsic value by the confident buyer’s generous offer) rather than swap them for the buyer’s shares.

Buffett and Munger Account to their Shareholders

Berkshire Hathaway, Inc. (BRK), a company oriented unflichingly towards the well-being of its shareholders (and which since the 1960s has arguably created more real wealth per share than any other company) held its Annual Meeting at Omaha, Nebraska on 29 April. In several respects its yearly gathering is unique. Most notably, it is one of the world’s largest corporate AGMs. An estimated 15,000 shareholders, a majority of those on its register and hailing from across the U.S. and a range of countries including Australia, Britain and Canada, took the time and trouble to attend. Second, the meeting’s formalities are concluded extremely quickly (normally within 10 minutes). Third, after the formalities’ conclusion there ensues an informal question-and-answer session which lasts up to six hours. Asking the questions are BRK’s shareholders – no queries from journalists, please, they’ll be answered at a news conference after the meeting. Sitting alone on stage to underscore their responsibility and to answer questions are Berkshire’s Chairman (Warren Buffett) and Vice-Chairman (Charles Munger). Fourth, and perhaps most admirably, Buffett and Munger respond clearly, completely and frankly to the questions which shareholders put to them.

Because Berkshire’s executives are demonstrably among the world’s ablest, the company’s shareholders are a select – and, thanks to Messrs Buffett and Munger, wealthy – breed. (Omaha alone boasts more than 50 “Buffett Millionaires.”) Not surprisingly, Berkshire’s 2000 AGM was covered extensively by the American and international news media. (It is as disappointing as it is revealing, however, that The Australian Financial Review accorded it only a few sentences on 1 May and none on subsequent days). The coverage in outlets such as The Wall Street Journal Interactive Edition reflected Buffett’s and Munger’s formidable intelligence, wit and pithy turns of phrase.

Among the highlights of this year’s Q&A

  • The Internet: Mr Buffett stated that he was unsure whether the Internet would pose more threats or opportunities to businesses. It will, however, “become an increasingly important issue on how it affects our businesses.” The Internet would (through lower prices, greater choice and convenience) benefit consumers. At the same, time, however, because the Internet would erode profit margins more than it would facilitate corporate efficiency, it would prove to be a “net negative for capitalists. it will make American business, in aggregate, worth less than it otherwise would have been.”

  • Sky-High Prices and Market Capitalisations: Mr Buffett likened the current frenzy of speculation on Wall Street to the principle which underlies a chain letter. Early signers-on may make money, sometimes considerable amounts of it, but in the end larger numbers will lose even larger amounts. He and Mr Munger “have seen a lot of cases where valuations in the high side are unbelievable [and] don’t see any great cases of dramatic undervaluation in this market.” Mr Buffett noted that some companies which have a market capitalisation of $10 billion are not sufficiently creditworthy to borrow $200 million from a bank. Yet their individual owners could borrow 20 times that amount. This imbalance is “as extreme as anything that has happened – including the 20s.” Mr Munger called it ”the most extreme event in modern capitalism.” Mr Buffett therefore warned that investors should reduce their expectations and feared that ”looking back, you will see this as a period of enormous amounts of wealth being transferred.” He added that he did not know how extensive this transfer would be, or whether it would affect particular sectors of financial markets, the entire market, parts of the real economy or the entire economy: “in five or ten years we’ll know.” In the long run and at all times, however, “valuation does count.”

  • Day-Trading and Other Forms of Reckless Speculation: at the press conference following the AGM, Mr Buffett said that many people today regard the stock market as a casino, and therefore that they speculate rather than invest. “It’s assinine,” he said of their capital allocation decisions. “They are influenced by rumour, what neighbours tell them and what they see on TV. They don’t pay nearly enough attention as when they are buying a TV set.”

  • Tech Stocks: Mr Buffett repeated his oft-stated view that he is unable to estimate the intrinsic value of technology companies. “We have no religious belief that we don’t buy into technology companies. But we’ve never found one where we think we know what the business will look like in 10 years.”

  • Excessive Executive Remuneration: Messrs Buffett and Munger criticised the extraordinary remuneration currently granted to many corporate executives. Mr Munger likened some corporate compensation schemes to “putting a rat colony in a granary.” Both clearly believe that such practices serve shareholders poorly. They also indicated that some of the stock option plans proliferating on Wall Street pose significant risks to shareholders. This is because many of those receiving options “inherently know that they have a lottery ticket” – and may tend to behave accordingly.

  • Financial Advisors and Management Consultants: at the press conference on the day after the AGM, Mr Buffett stated that serious investors should pay little heed to what they hear on television or read in the newspaper about either the stock market or specific companies. Further, financial advice “is basically not worth anything.” Finally, he criticised management and other consultants, asking shareholders rhetorically if Andrew Carnegie would have asked an investment banker whether he (Carnegie) should purchase another steel mill.

Links to More Information About This Year’s Berkshire Hathaway Shindig

Summing Up

As the American actor James Stewart demonstrated in It’s a Wonderful Life, it is indeed a wonderful life. But as the Bedford Falls Savings and Loan Association manager whom he portrayed knew very well, it is also an inherently uncertain life. Human action, we should always remind ourselves, has not just intended consequences, but also unintended and unforeseeable consequences (“each man’s life touches so many other lives, and when he isn’t around he leaves an awful hole.”).

Yet many members of the general public, many businesses and their advisors and most governments continue to underrate this uncertainty. Some, indeed, display overconfidence bordering on hubris with respect to their ability to navigate through it; and a select few breezily dismiss the probability that their actions will have negative, harmful or unintended consequences. Therein lie both risks and rewards. As Mr Buffett concluded during Berkshire’s AGM: “the ability [today] to monetise share holding ignorance has never been exceeded.”

Chris Leithner


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