“Berkshire is About Building Earning Power” — Fun with Warren and Charlie

By | May 5, 2014

Warning: This is a long post. For the lazy ones among you, here is the “Twitter version” (136 characters): “It was big fun! Buffett addressed Coke’s compensation plan issue in more detail. We learned some new things and really enjoyed the show.”

The Meeting

As usual, it started with an animated movie in which the US hockey team, led by Buffett and Munger, beat Russia’s team by a smart trick applied by Warren and Charlie. There was another funny parody about the typical Wall Street banker meeting investors and speaking to them in a non-Wall Street open and candid fashion. When his clients complained about the bad performance of the stocks that the banker recommended he replied: “Why are you surprised? we held this stock and we wanted to get rid of it so we recommended you to buy it so its easy for us to sell our stake.” As funny as it sounds, stuff like that happens every day.

It was pretty entertaining and the arena was packed with Berkshire fans (“Berkies”) who cheered, applauded and laughed throughout the meeting. We saw many famous people in crowd: Bill Gates, Todd and Ted (the investment managers Buffett hired to manage some of Berkshire’s float) and CEOs of Berkshire’s operating companies.

Full house at the Century Link Arena in Omaha

Full house at the Century Link Arena in Omaha

Assaf and I with Mohnish Pabrai at BRK's AGM

Assaf and I with Mohnish Pabrai at BRK’s AGM

Coke’s Compensation Plan

The first question was related to the saga around Coke’s compensation plan.

Buffett: “I spoke to Muhtar Kent (Coke’s CEO), and told him we admire the management and what they achieved but we think the compensation plan was excessive. In addition, we had abstained from the vote and in terms of having an effect of Coca Cola’s compensation practices (and other companies’ compensation practices) we think its the most effective way to go about it (by abstention). We will see what happens with compensation between now and the next AGM at Coke.”

Buffett: “Charlie…”
Munger: “I think you handled the situation really well”
Buffett: “He certainly remains my chairman”
Fun!

Buffett offered his perspective about how to calculate the effect of the dilution:

– Coca Cola repurchases shares and share count comes down just a little bit because of the dilution.
– Coca Cola has a 500M options that will be introduced over 4 years
– Let’s assume that Coca Cola trades around $40 and when the options are exercised the stock is at $60
– At that point there have been a $10bn transfer of value ($20/share * 500M shares dilution)
– Tax deduction results in $3.5bn tax savings
– When the options are exercised the Coca Cola company receives $20bn from exercising the options (500M options exercised with a strike of $40) and $3.5bn from tax savings the Coca Cola company receives $23.5bn
– Given that the share is at $60 at the end of the period, using the $23.5bn of proceeds, the Coca-Cola company can repurchase 391,666,666 shares.
– In effect, the Coca Cola Company net would be be out 108M shares on the base of 4.4Bn shares.
– He doesn’t like dilution but this is a far cry from the numbers that were thrown around (refers to David Winters’ calculation)

Ignorance Removal

Munger referred to See’s Candies main contribution to Berkshire as “ignorance removal.” He meant it in the context of retail — See’s made him aware of how difficult the retail business is because you have know what people want. People in the East like white chocolate more and a certain amount of sweetness while people in the west liked different type of chocolate and through See’s, Berkshire became aware of the great challenges in retail. I believe that we can all look at some life experiences that we have had and how they contributed to our own “ignorance removal”, reflect on it and learn from it going forward to avoid repeating the same mistakes and learn where our circle of competence is. With a great degree of humility, Munger concluded by saying “We, at Berkshire, still have a lot of ignorance to remove.” — if they do, so do all of us. Another great lesson from uncle Charlie.

BAC and Probabilities

The discussion about Bank of America’s securities that Buffett holds was interesting — not for the technicalities but for showcasing Buffett’s decision making process. He assigned a probability for the case that the non-cumulative would skip payments then he calculated the benefit that he receives from changing the preferred to become non-callable for five years. I won’t get into the technicalities of BAC’s preferred shares but we can learn a lot from his thought process:

1. Deal with something you know and understand well

2. Assign probabilities in an informed manner for each scenario

3. Calculate the risks and benefits based on the probabilities and the benefits/risks that are associated with each scenario

4. Make the right decision!

Trust in People vs. Tight Controls

This is maybe the most important lesson here. Ask yourself, how much trust do you have in the people around you? do you micromanage them or do you give them freedom and run the risk that they will do mistakes? Charlie Munger addressed this point in the context of Berkshire but I believe that the lesson here can be applied to many aspects of our life.

Charlie said that he rather give freedom to people at subsidiaries and live with the risk that somebody will something wrong. With that risk, comes the benefit of people doing great things that were unexpected, taking initiatives and feeling more like owners than like hired guns. Another insight is that the costs that are associated with a mistake are easily quantifiable so people have hard time dealing with mistakes of others without “tightening internal controls” because the costs of mistakes is usually easy to measure. However, no one can measure the benefits that a company enjoys by giving its employees freedom to make decisions and mistakes, take initiatives and act like owners. Most people tend to resort to more control and procedures when mistakes happen but Munger believes that this is not the right approach — decentralization is a main tenant at Berkshire.

With that, Buffett said “lose money and I will be understanding, lose reputation and I will be ruthless.” Corporate culture at its best.

Tom Gayner from Markel with Assaf and Nathi (at Markel's AGM)

Tom Gayner from Markel with Assaf and Nathanael (at Markel’s AGM)

Iscar

The Israeli cutting tools manufacturer owned by Berkshire, Iscar, had its best month ever in April and great first quarter performance. According to Buffett, Iscar’s performance is a good indicator for how well the global economy is doing because it makes real products that are used to in manufacturing processes of real things. Playfully, Buffett said that nobody buys Iscar’s products because they will look nice in the office or because its a status symbol, so, the fact that there is record demand for Iscar’s products is a positive indicator for global economic activities.

On Retail

I wrote a post about it before in Assaf’s blog, those who are interested can read it here. Buffett nicely summarized it: “It’s easy to think you understand retail until you find out you don’t.”

Tip for interviewing managements

Buffett said that when he was young and he went to visit companies one of the questions he would always ask management teams is: “Except for your company, which one of your competitors would you go long on? and whom would you short?”

Equipped with that tip, we are off to Missouri, Texas and Louisiana to meet with management teams of our portfolio companies and potential investments — this will be the topic of one of the upcoming posts.

 

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