Berkshire's Prodigal Children

Warren Buffet is perhaps the most high-profile advocate for good corporate governance in the world today. He shuns stock options as compensation, preaches self-control in investing only in businesses one understands, and believes that investors in his company are partners. But some of his biggest investees don't follow his rules.

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By Bill Mann (TMF Otter)
February 19, 2002

Without a doubt, Berkshire Hathaway's (NYSE: BRK.A) Chairman Warren Buffett is one of the paragons of righteous shareholder-focused corporate management. He takes only $150,000 per year in salary, uses cash incentives, rather than bloated stock option plans, to motivate his senior managers, and writes by his own hand an essay for Berkshire's annual report that describes all the major events of the past year, good and bad, that befell Berkshire. How many other corporate managers would make a statement like this one, from Berkshire's 1999 annual report: "My "one subject" is capital allocation, and my grade for 1999 most assuredly is a D"? 

To the outsider, Warren Buffett seems to run his company by something perhaps best described as "benevolent neglect." He prides himself as a great judge of character, and in fact this may be the best advantage he has over other investors. But I cannot for the life of me figure out why it is that several of Berkshire Hathaway's largest holdings show some tendencies that are completely inimical to how Buffett himself operates.

There are few people of this or any era who have been as influential in the realm of investing. Well, maybe Karl Marx, but he was influential in a "nothing belongs to you anyway" kind of way. Buffett is the quietest of activists. He has led by example and has run a distributed management company nearly to perfection. The executives of several Berkshire Hathaway subsidiary companies have never traveled to Omaha to the Berkshire corporate office. Many have never met one another. Buffett does not expect weekly progress reports, and generally keeps an open door policy of "call me when you need me."

Perhaps this is Warren Buffett's great Achilles heel. He is such a good judge of character and value that on the occasions when some leadership from Buffett would help he lacks the will to provide it. As one of the largest outside shareholders of these companies, Buffett wields significant influence, should he choose to use it. And he has used it, for example in pressing Coca-Cola's (NYSE: KO) board to quash a bid to spend $15 billion to acquire Quaker Oats in 2000. He also showed his leadership mettle when he took over as Chairman of Salomon Brothers in 1991 when that company was wracked by scandal and teetering on collapse. It seems quite interesting that Buffett would have been invested in such a company in the first place. But this was a situation he fixed, even if it was in the 11th hour. Still, several of these companies seem to violate key management philosophies practiced by their biggest shareholder.

Buffett: "The fact [Fair Disclosure] came about because of coercion rather than conscience should be a matter of shame for CEOs and their investor relation departments."

Coke is Berkshire's largest public company holding, its stake valued at approximately $9.4 billion, and Buffett has occupied a board seat for more than a decade. But, until the Securities and Exchange Commission (SEC) enacted Regulation Fair Disclosure in 2000, Coca-Cola unapologetically limited access to its conference calls to a select few Wall Street analysts where they would discuss the details of their financial position and prospects. Buffett, on the other hand, has long been a proponent of the concept of outside shareholders being partners in his business, and has neither given preferential access to analysts nor limited the information stream to shareholders.

Buffett: "Never invest in a business you cannot understand." 

This past year American Express (NYSE: AXP), of which Berkshire owns a $5.4 billion stake, had not one, not two, but three consecutive quarters in which it had to take writedowns totaling more than $1.1 billion of investment losses due to junk bond portfolios. AmEx's CEO, Ken Chenault stated in a conference call following the third such loss that AmEx did not fully understand the risk of these instruments it had underwritten. American Express has at its fingertips the person who likely understands risk assessment as well as anyone in the world in Buffett, and yet never thought to consult him either when constructing the products, or after the first or second quarter of multi-million dollar writedowns. After the second one, AmEx said that there would be no further problems with these products. Three months later the company took another $800 million loss.

Buffett: "Our record of persuading decent, intelligent people to stop doing dumb things is very poor."

Four years ago Berkshire Hathaway acquired all of the outstanding stock in General Reinsurance Corporation. General Re has an enormous float (the money paid by premium holders not yet paid out as claims), but it lacked good underwriting discipline, something Berkshire's other insurance entities have in spades. Four years later, we are still having to deal with massive underwriting losses at General Re, this time it was $1.27 billion for the fourth quarter. Some of this, to be fair, is a result of the World Trade Center attacks, but the majority comes from underreserving for losses even after General Re became a subsidiary of Berkshire. Long-tail reinsurance policies can cause surprises years after they were written, but it seems amazing after four years that questions of discipline remain.

Buffett: "We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own assets."

The Salomon Brothers scandal, so aptly described by both Michael Lewis and Roger Lowenstein, is the complete antithesis of "adding shareholder value," yet Warren Buffett, was an aggressive buyer of Salomon stock. Although Berkshire no longer owns either Disney (NYSE: DIS) or Citigroup (NYSE: C) -- the successor company to Salomon -- both are famous for the ludicrous amount of compensation they provide their senior executives, both in cash and in stock options. To a lesser extent, Coca-Cola and American Express do the same. Buffett dislikes excessive use of options due to their distorting qualities on a company's income statement, and the fact that they are not adequately disclosed under GAAP. Some companies voluntarily expense their options, most notably Level 3 (Nasdaq: LVLT). Why has Buffett put up with years of dilution through outsized options grants to executives at companies in which Berkshire has big stakes, particularly the companies on which he has a board seat?

These issues simply trouble me. The only publicly traded company owned by Berkshire that seems to have its management philosophies mostly in line with Warren Buffett's is the Washington Post Company (NYSE: WPO). I don't have much in the way of answers here, rather I just have questions. I do wonder if these questions have been voiced to Buffett in the past, and if not, why?

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Burma Shave! Bill Mann owns shares of American Express and Berkshire Hathaway. The Motley Fool has a full disclosure policy.