Buffett Wags His Finger

For Bill Mann and thousands of others, the beginning of March marks an annual ritual: waking up early on a Saturday to read the annual letter penned by Berkshire Hathaway Chairman Warren Buffett. This year's letter did not disappoint, as Buffett describes how it is that the company walked into billions of losses by failing to get paid for the terrorist coverage it provided. He also takes a big swing at the ethical deficiencies among many of today's corporate leaders.

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By Bill Mann (TMF Otter)
March 12, 2002

For many red-blooded Americans, the beginning of March allows us to get in touch with our inner geek.  Let's do some free association.

The beginning of March is great because:

- The Sports Illustrated swimsuit edition comes out;
- It's time to fill out those March Madness brackets;
- Spring training starts for baseball;
- Berkshire Hathaway (NYSE: BRK.A) releases its Annual Report.

Which one did you choose? There is, of course, nothing wrong with you if you don't get excited about any of these: In fact, it may be that you quite simply have no inner geek, for which you should be nothing but proud. But there are enough people out there who do such goofy things as travel to Florida for the sole purpose of going to a bunch of spring training games, or waiting outside of newsstands for the SI issue, that I think the above choices cover a great deal of ground.

Me? I was up at 6:30 a.m. on Saturday for the sole purpose of being one of the first to read Warren Buffett's thoughts about Berkshire's operations, as well as a whole host of other things over the past year. I know, pathetic.

This year's letter was more of the same from Buffett, and that's a good thing. If he has done something well over the past year, he'll tell you. If he has screwed up, he'll say so, in no uncertain terms. Shareholders may not LIKE the fact that some of Buffett's actions may have lost them money, but at least they know about it, in detail, when it happens. In 2001, the biggest story in insurance -- which is Berkshire's primary business -- is of course the losses incurred as a result of the terrorist attacks on September 11. Berkshire's share of the insurance claims from the attacks is estimated at $2 billion to $2.5 billion.

Berkshire insures against massive losses; that's just what they do. Berkshire has written policies for the 2002 Winter Olympics and the World Cup for billions of dollars. In this game, occasionally big claims must be paid, and Buffett went to great lengths to state that Berkshire is perfectly willing to write the checks on any and all claims, even massive ones. Where such losses will drive a manager crazy is when they are caused by something for which the company has never been compensated.

Berkshire had not received any premiums for terrorist attacks. What's worse, Buffett admitted that he had thought about the potential for terrorist attacks in the past, but had not done anything about it. And the end result was that losses at Berkshire's General Re subsidiary helped drag the company's book value down by $3.7 billion, its first such loss in 37 years. For the year, Berkshire's earnings came in at $795 million, nearly 70% lower than last year's.

This is going to cause some consternation in the "don't know how to value Berkshire" crowd, because this means that Berkshire, one of the ultimate companies for value investors, is currently priced at a P/E of 118. Just another reason why overdependence on P/E is among the worst mistakes an investor can make.

Buffett's consternation at his own performance pales in comparison to the napalming he did on the conduct of corporate America, saying that though Enron has recently become a symbol of greed, "there is no shortage of egregious conduct elsewhere in corporate America." Buffett lets fly at a number of different practices, stating that he and Charlie Munger are "disgusted by the situation, so common in the last few years, in which shareholders have suffered billions in losses while the CEOs, promoters, and other higher-ups who fathered these disasters have walked away with extraordinary wealth."

Further, Buffett pointedly tells the story about MiTek, a new Berkshire acquisition, in which members of the MiTek management team bought a 10% share of the company with their own cash as part of the Berkshire acquisition. His next few sentences give no doubt as to Buffett's feelings about the practice of granting stock options to executives as incentives. "As they would not be if they had options, all of these managers are true owners. They face the downside of decisions as well as the upside. They incur a cost of capital. And they can't "reprice" their stakes: What they paid is what they live with."

Hallelujah, old man. The more I think about stock option programs, the more I hate them. Yes, as much as I don't want to admit it, I think that the way they are applied by many companies today is completely evil. What started as a great way to add performance incentive for employees has turned into a "heads I win, tails you lose" raping of outside shareholders. When a company's stock goes sky high, executives profit wildly. When it drops, more and more companies are repricing options, or worse, canceling existing ones and issuing new options at a lower strike price. Never mind that in many cases these are the same executives who have been in charge of the company when the stock tanked in the first place.

Unfortunately, as I noted before, this is something that is also taking place at several of the publicly traded companies in which Berkshire Hathaway has a big stake. The most recent was the massive compensation package awarded to Ken Chenault, CEO of American Express (NYSE: AXP), who was granted options worth over $13 million in 2001, along with a $1 million salary. This is nearly double the amount he was compensated in 2000. As we have detailed over and over, under Chenault's watch in 2001 American Express had to write down investment losses of over $1 billion, the lion's share of which came in the quarter after Chenault claimed that there would be no more losses from these investments.

I don't particularly think that Chenault ought to be held over a barrel for these losses, as it seems like AmEx made an honest error in judgment. What I do mind is that his pay skyrocketed in a year AmEx turned in some pretty pathetic results. As part of an agreement that was made when Berkshire bought nearly 10% of American Express, Buffett agreed that the entire Berkshire stake would be voted by Chenault, so he can't vote against such a pay package. But Buffett is the largest shareholder, and he does have the unofficial power of the bully pulpit, where he could start naming names. How he countenances such actions by people and companies he obviously respects is beyond me.

Mr. Buffett, though you have never shown interest in placing the state of American corporate governance on your back, you have proven to be among the best practitioners and spokesmen for the concept of outside shareholders as partners. That some of those on whom you could have the most influence do not feel the need to practice what you preach is mystifying.

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

Bill Mann's wife doesn't understand it, either. Bill owns shares of Berkshire Hathaway and American Express. The Motley Fool has a disclosure policy.