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Berkshire Hathaway
Finance Companies and Human Factors

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By hartmanbirge
March 31, 2005

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Hi gang...nothing like getting jolted awake at 3am by a 5 yr old and realize that you were dreaming of financial implosions. Someone recently made brief mention of some of the finance companies and the merits of their valuations. I'd like to explore that a bit more. As with the drug sector discussed a few months ago, the financial sector I think we can safely characterize as one that is in "duress." What's the quote..."Oh I like you and you're very intelligent, but you make me nervous" or something to that effect. Some of the biggest names in American finance are struggling right now. The recent headlines have been AIG of course so the insurance sector has been hit. We've also had Fannie Mae and Freddie Mac in the mortgage business. Washington Mutual (Nygren's love child) is still priced at what appears to be very attractive levels. Fifth Third is creating new 12-month lows on a daily basis. H&R Block is struggling with the turn in its mortgage portfolio. JP Morgan is paying significant fines. What's going on here?

I am reminded of Munger's commentary related to financial companies and that one must exercise extreme caution. Yet I note that huge swaths of the Berkshire portfolio are tilted towards finance companies (Wells, Moody's, HRB, M&T Bank, American Express). Berkshire has made a TON of money investing in finance companies and is itself a finance company of sorts. It's interesting that in all of our speculation on Wal Mart that Citigroup warrants nary a mention. I think there's a good reason for that....

Are the above companies struggling because they aren't making money? Is GE Capital struggling to make ends meet? AIG is getting pounded in the market like a batting practice pitcher yet the company cranked in nearly $100 billion in revenue and had net income of $11 billion. All things considered, it seems to be printing money.

Perhaps the problem is a rational one related to the abundance of capital which creates surpluses without good venues for placement. It causes decision makers to do things that are a little less than ideal. It's human nature to be careless with things that have little value and likewise it's an economic law that when something is easily acquired that it loses its value - money being no exception. I think it can be said that this has led to a lot of slop and carelessness. The environment has created poor incentives. In general speak, managements seem to be pushing the envelope just a bit as money pours in, but returns on capital have withered. I note that Berkshire seems to be an exception here - sitting on significant sums earning less than 1%. Perhaps it can be said that this course of action is not acceptable to most of the companies mentioned above - so they push it a bit.

The question of the day is whether or not the market's pricing of these companies is correct or misplaced. Is value disconnected from reality? Great as the numbers at some of these companies are, by definition a finance company is not as good of a business as something eminently simple like selling Coke or razor blades through huge global distribution networks. Finance companies have that element of unseen engineering and maneuvering and deal making which places a premium on management competence and integrity. Pick a company that an idiot can run because "some day an idiot will." I think that the market has priced in an Idiot Factor with many of these companies. Perhaps the value of some is far above their current price and therein lays opportunity. One definitely needs to ask the question - How does company X really make its money? That said, I'm not so sure that the investing public can EVER really know what a lot of these companies do on their behalf. I think that has to be an underlying investment assumption. So more importantly still, I will argue that the far more important issue comes down to the assessment of management competence, integrity, and the organizational culture.

I can look at AIG or FNM right now and see what looks to be a cheap stock. Both are also in the throes of a complete management overhaul. Does one instantly assume that the new management comes in with integrity and competence? These things are not some pre-ordained trait that comes with being new to the job. Without knowing the background and history of these individuals how does one know? Greenberg's gone, new guy's here, everything's fixed. I don't think anyone can make that assumption and I do think it's a big assumption. Talking about probability theory.... what are the odds that the new management possesses the highest integrity and ability? Given all of that I am inclined to agree with the market on this one. These businesses are loaded with human factors that must carry more weight in the final investment analysis. They cannot be flown on autopilot. They take enormous amounts of integrity and competence. The average of their lot deserve to be priced cheaply. In no other sector are you betting so much on human factors. I think it's imperative to get a good comfort level with managements of finance companies and it ain't easy to do that from afar. Why should one have to say, "he's a nice guy but he makes me nervous." Conversely, I think we're extremely fortunate to know our management team so well at Berkshire and there should be a premium for that - There's a market inefficiency.

HB


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