I recently returned from Berkshire Hathaway's (NYSE:BRK.A) annual meeting in Omaha, and -- as I am every year -- was impressed with both the extraordinary intelligence, rationality, and capital allocation abilities of Warren Buffett and Charlie Munger (Berkshire's chairman and vice chairman, respectively) as well as the fabulous collection of businesses they've assembled over the past 30-plus years.
In this column, I will try to distill all that I heard down to the most important things. I've added a little commentary, but will generally let Buffett and Munger speak for themselves.
As always, Buffett did most of the talking, so all quotes are his unless otherwise noted. Recording devices are not allowed in the meeting, so in many cases I am paraphrasing because I couldn't write quickly enough.
Berkshire Hathaway's first-quarter performance
Berkshire Hathaway has not yet reported Q1 earnings, but Buffett shared some of the highlights, which were spectacular. While the company's non-insurance businesses "didn't do so great," reflecting the "sluggish" economy, the insurance operations "are in exceptionally good shape. (Buffett raved that "I can't imagine a better group of companies and people.") For a non-promotional guy like Buffett to use words like this, they must be really firing on all cylinders.
Berkshire's insurance operations generated a pre-tax underwriting profit for the quarter of about $290 million (adjusting for $140 million in charges for retroactive insurance contracts). Its float (the net amount of liabilities due to policy holders) grew by $1.3 billion to a mind-boggling $42.5 billion. (At last year's annual meeting, Munger doubted that float would continue to grow much, yet it was up 8.8% year-over-year in Q1.) Buffett noted that much more important than the amount of float is its cost, and here Berkshire's performance was outstanding. Though Buffett didn't give exact figures, he said that, "We have a very good chance of having low or no cost float for as far as the eye can see." (For perspective, the cost of float in last year's first-quarter was 13%.)
After-tax net earnings, including securities gains, are expected to be about $1.7 billion.
Risks in the financial system
Buffett and Munger have long warned about how risky the U.S. financial system is becoming, and Buffett even took the unprecedented step two months ago of pre-releasing a portion of his annual letter (published in Fortune), in which he warned that "derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
Buffett warned that many companies issuing financial guarantees "don't know what they're doing" and are underpricing their insurance. "If you're willing to do dumb things, people will find you. Even if you're in a rowboat in the ocean, the brokers will swim to you, with their fins showing. It's brutal. You'll see a lot of cash, won't see any losses for a little while, and then the roof will fall in."
Munger added that "accounting [for financial guarantees] is terrible, and is most terrible in accounting for guarantees a long way out. People pay attention to numbers without consideration for reality, which can lead to bad decisions."
As for derivatives, Buffett repeated the warning in his annual letter, noting that "Charlie and I think that there is a low but not insignificant probability that at some time -- I don't know when; it could be three years, it could be 20 years -- derivatives could lead to a major problem. The problem grows as derivatives get more complex."
Munger, as is his nature, was more pessimistic: "In engineering, people have a big margin of safety. But in the financial world, people don't give a damn about safety. They let it balloon and balloon and balloon. It's aided by false accounting. I'm more pessimistic than Warren. I'll be amazed if we don't have some kind of significant blowup in next 5-10 years."
Invest in quality companies
As always, Buffett and Munger encouraged investors to invest in quality companies, which Buffett defined as "one that generates very high returns on capital and can invest that capital back into the business at equally high rates." Of course, he noted, "there are very, very few businesses like this. [Even] Coke (NYSE:KO) has high returns on capital, but incremental capital doesn't earn anything like its current returns." Buffett added, "We want a business that we think, if run well, is going to have a competitive advantage. We don't buy hula hoop or pet rock companies, or companies with explosions in demand but we don't know who the winners will be."
Be wary of management and analyst projections
While Buffett values outstanding managers very highly, he evaluates them himself and has no use for their projections: "Almost everything we learn is from public documents.... We do not find it particularly helpful to talk to managements.... The numbers tell us a lot more than the managements. We don't give a hoot about anyone's projections. We don't want even want to hear about it."
He had even greater scorn for analysts: "I don't read any analyst reports. If I read one, it's because the funny pages weren't available. I don't know why anyone does it."
Accounting shenanigans
For years Buffett and Munger have lamented the accounting shenanigans that even the most-respected American companies engage in. In the context of noting a change Berkshire made in the first-quarter to a more conservative accounting assumption, Munger said, "This accounting change is typical of Berkshire. We're so horrified by aggressive accounting that we reach for ways to be conservative. It helps our business decisions and protects Berkshire. How did we get in a situation where we're all so close to the line?"
Buffett added, "I felt much more comfort working with financial statements in the 1960s than today. There was more information then, even though there was less disclosure.... [Overly aggressive accounting] is a quick fix, but it's like heroin.... People are encouraged by their CFO or auditors to play with their numbers. It never works.... It's so much better to address problems."
EBITDA earnings
Munger always has at least one zinger. Saturday's was (in the context of Buffett critiquing EBITDA -- earnings before interest, taxation, depreciation, and amortization) as follows: "I think that, every time you see the word EBITDA [earnings], you should substitute the word 'bullshit' earnings."
CEO compensation and stock options
Buffett and Munger believe that CEO compensation, especially from stock options, has spiraled out of control and needs to be reined in. Buffett commented, "We saw more crazy stuff in the 1990s than in the previous 100 years. There was wealth transfer that has never been experienced before." Changes in this area are, Buffett said, the "acid test of corporate reform."
Buffett and Munger had particularly harsh words for those people (mostly CEOs, who of course benefit massively from stock options) that are fighting to keep the cost of stock options off of financial statements. Buffett argued that the "truth is that American companies have been paying people without recording it on the income statement. But that game is over." Later, he added that those who "argue that the cost of options is included in the footnotes [of the 10-K], [I say] why not pull all expenses in footnotes? Then you could just have two lines on the income statement: sales and the same amount on the next line, profits."
Munger added: "It's such a rotten way to run a civilization to make the accounting wrong. It's like getting the engineering wrong when making a bridge. When perfectly reputable people say options shouldn't be expensed, it's outrageous."
Happiness and success
One young questioner asked Buffett and Munger to share their thoughts on happiness and success. Buffett replied:
"I tell college students, when you get to be my age you will be successful if the people who you hope to have love you, do love you. Charlie and I know people who have buildings named after them, receive great honors, etc., and nobody loves them -- not even the people who give them honors. Charlie and I talk about wouldn't it be great if we could buy love for $1 million. But the only way to be loved is to be lovable. You always get back more than you give away.... There's nobody I know who commands the love of others who doesn't feel like a success. And I can't imagine people who aren't loved feel very successful."
Munger added, "You don't want to be like the motion picture exec who had so many people at his funeral, but they were there just make sure he was dead. Or how about the guy who, at his funeral, the priest said, 'Won't anyone stand up and say anything nice for the deceased?' and finally someone said, 'Well, his brother was worse.'"
Buffett and Munger are, without doubt, two of the greatest investors and capital allocators of all time, so investors would be well-served to study their thinking carefully. I recommend reading Buffett's annual letters, which are on Berkshire Hathaway's website. You can also find the entirety of my notes from the meeting here.
Finally, Fool community members are always discussing all-things Buffett on the Berkshire Hathaway discussion board.
Whitney Tilson is a long-time guest columnist for The Motley Fool. He owned shares of Berkshire Hathaway at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at [email protected]. The Motley Fool is investors writing for investors.
