labels: investment - general
Warren Buffett: The trouble with being a legendnews
By Rex Mathew
21 March 2006
Legendary investor Warren Buffett, the "Oracle of Omaha", has had an unusually lengthy period of underperformance and other troubles. Is he struggling under the weight of his own past achievements or is this just a blip in the legend of Warren Buffet?

Warren Buffett, known as the Oracle of Omaha and probably the most successful investor ever, has been under increasingly higher critical scrutiny during the last one year. He has had a few below par years, compared to his own high standards, in the recent past.

A major scandal involving General Re, an insurance company owned by Berkshire Hathaway - Buffet's company - has become the first instance of regulatory trouble in a company controlled by him.

Buffett's annual letter to Berkshire shareholders is a rare window to his world and views on the economy, corporate practices, his investment philosophy, investments and acquisitions his company has madeamong several others. The letter is usually quite lengthy and often contains his sage pronouncements, all presented with a touch of humour on areas affecting the corporate sector and investments in general.

The 2005 letter to shareholders was released last week and analysts and investors have microscopically gone through each word and phrase to gain an insight in to Buffett's mind - more so since 2005 has been a particularly difficult year for Berkshire.

Is the investing genius fading?
Over the last 41 years, the book value per equity share of Berkshire Hathaway has grown at a compounded annual growth rate of 21.5 per cent from $19 to $59,377. That is a phenomenal performance over such a long period, which has rightly elevated him to a legend and the world's best known investor.

However, the super normal returns the company used to generate regularly till the late '90s are becoming increasingly rare. After a spectacular 48 per cent rise in book value in 1998, the company has achieved growth rate of above 20 per cent only once. During the period 1999 - 2005, the company's growth in book value has been lower than the returns for the S&P 500 stock index for three years.

For 2005, the company earned a pre tax profit of $5 billion when P&G acquired Gillette. Berkshire was one of the major shareholders of Gillette. Buffett has asked investors to ignore this gain as it 'does not make economic sense'. However if this amount is excluded, the company's bottom line would show a substantial decline for 2005.

Even including the investment earnings of $5 billion, the company's bottom line has not seen much growth over the last three years. Net profits for 2005 were at $8.53 billion as against $7.31 billion for 2004 and $8.15 billion for 2003.

True, Berkshire had a particularly bad 2005 as its insurance subsidiaries had to suffer losses of $3.4 billion from hurricane damage claims. Adding back these losses and excluding the $5 billion gain from the P&G-Gillette deal, net profits for 2005 would still show a modest decline over 2004.

Over the years, Berkshire Hathaway has become a huge conglomerate of diverse businesses, from insurance to leasing of private jets to manufacturing pre-fabricated houses. This is a result of Buffett's strategy of achieving better returns by acquiring successful businesses, irrespective of the nature of the business.

This strategy is an extension of his investment philosophy in stock markets. Whether the holdings are only a few shares or the entire company, the value of investments would ultimately depend only on the performance of the company. Therefore, if good ideas are hard to come by in the stock markets, acquiring profitable privately held companies makes sense.

But how long can Berkshire Hathaway grow through acquisitions? The number of potential acquisition targets meeting the criteria laid down in the letter, and more importantly willing to sell out to Buffett, won't be very high.

In the latest letter, Buffett states that "major acquisitions" are required to "produce truly satisfactory returns" as "current businesses would deliver only modest growth in operating earnings". This is the closest he can go without openly admitting that at least some of his acquisitions in the past have been lousy investments which cannot generate above normal returns for shareholders.

It is like a mutual fund manager saying his existing holdings are at best only average performers and he needs to find new ideas to generate market- beating returns. Would he be able to come up with such ideas or would the markets throw up some opportunities to help him out?

If an investor realises that he has made some bad bets in the past, he would try to exit those positions. Berkshire has not revealed any plans to exit under-performing businesses. The company has also not undertaken, or not disclosed, any exercise to review its large portfolio of businesses.

Insurance troubles
General Re, the reinsurance company owned by Berkshire Hathaway, was under investigation last year for allegedly entering into shady reinsurance transactions with insurance major American International Group. These transactions helped AIG to inflate profits by nearly $500 million.

Three senior executives of General Re are facing prosecution for fraud and conspiracy. In the course of investigations, Buffet himself was questioned by the US Securities and Exchanges Commission and other authorities - another first for a man who has been considered a beacon of integrity and fair practices.

Buffett accepts that it was a mistake not to close down the derivative trading operations of General Re earlier. He writes, "The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re's trading operation. Both Charlie (Charles Munger, vice chairman, Berkshire Hathaway) and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation".

"When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, "My wife ran away with my best friend, and I sure miss him a lot", he adds with a touch of humour.

Who will succeed Buffett?
This question has worried Berkshire Hathaway shareholders for the last many years. Buffett is 75 and though in the letter he says he never felt better and loves running Berkshire, the issue of succession is critical for such a large and complex organisation. There are analysts who believe that uncertainty over the company's performance after Buffett has affected the stock's performance over the last few years.

His long-time partner Charlie Munger, vice chairman of the company, is 82 and cannot take over from Buffett. "Humans age at greatly varying rates - but sooner or later their talents and vigour decline. Some managers remain effective well into their 80s - Charlie is a wonder at 82 - and others noticeably fade in their 60s. When their abilities ebb, so usually do their powers of self-assessment", he states.

So this year he has tried to address the issue, at least partially. He says, "We have three managers at Berkshire who are reasonably young and fully capable of being CEO. Any of the three would be much better at certain management aspects of my job than I. Berkshire's board has fully discussed each of the three CEO candidates and has unanimously agreed on the person who should succeed me if a replacement were needed today. The important point is that the directors know now - and will always know in the future - exactly what they will do when the need arises."

If the board has already identified one candidate who could succeed him, why not reveal the successor's identity? Such a move would reassure the shareholders, if indeed the chosen successor is a good choice. It would also be in the interests of corporate governance and transparency, values Buffett has been preaching all his life, as it would remove the one big uncertainty about the company's future.

The argument that disclosing the names of possible successors would put considerable pressure on those individuals does have some merit. But, anyone succeeding such a legend is bound to be under intense scrutiny for the rest of his or her life. Then why not put them under the arc lights straight away? At least they would be more used to public scrutiny when the time comes to step in to the shoes of the legend.

So the company has a contingency plan in case of an immediate requirement while the board evaluates the three managers who are as yet unidentified. But the issue is far from settled. "The directors stay updated on this subject and could alter their view as circumstances change - new managerial stars may emerge and present ones will age," the letter says.

Present ones will age? Is he trying to indicate that he could possibly go on for another decade or so by when the currently identified candidates would cross their use-by date? After all, Charlie has already worked till 82 and could easily go on for another three years. If Charlie can work full-time till 85, why not Buffett?

Too much to handle even for Buffett?
The Berkshire empire now comprises of 69 operating companies with more than 192,000 employees apart from its minority holdings in companies like Coca Cola, American Express, P&G, Washington Post, etc. The operating companies are independently managed without much involvement from Berkshire.

However, having full ownership of companies is very different from having minority stakes in publicly traded companies. Responsibilities of and demands on the top management of the holding company would be significantly higher from operating subsidiaries.

Is Buffett doing full justice to his job as the chairman and CEO of such a diverse company? Does Berkshire have the top management structure to control its various businesses and other holdings?

In his letter Buffett admits, in an indirect way, that the answers to both these questions are negative.

While discussing the management succession plan, he indicates that the future management structure of Berkshire would be different. "Essentially my job will be split into two parts, with one executive becoming responsible for investments and another, who will be CEO, for operations. If the acquisition of new businesses is in prospect, the two will cooperate in making the decisions needed, subject, of course, to board approval', he states.

So in effect, he is admitting that it would be too much for a single person to handle his job as chairman and CEO of Berkshire. If the job is too difficult, why not straight away appoint a CEO for operations while Buffett remains chairman and retains responsibility for investments?

His billions for philanthropy
Buffett is clear that his holdings in Berkshire would not go to his children (incidentally, his son H G Buffett is a director of Hydreabad-based Agro Tech Foods Limited - a subsidiary of US foods major Conagra) or any other family member. He says, "All Berkshire shares will be left to one or more foundations. In this way, Berkshire will be left with a long-term, very substantial shareholder, guided by the same philosophy and objectives that now set our course. The Buffett family will not be involved in managing the business, only in picking and overseeing the managers who do."

also see : Other reports by Rex Mathew
Could Buffet's successor be an Indian?

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Warren Buffett: The trouble with being a legend