Monday, May 5, 2014

Berkshire Hathaway 2014 Meeting Highlights

***Updated***

Below I've summarized some of the highlights from the 2014 Berkshire Hathaway (BRKa) shareholder meeting.

Berkshire's Cost of Capital
At the meeting, Warren Buffett responded -- according to the Wall Street Journal recap -- to a question about Berkshire's cost of capital and whether the company is likely to exceed that cost in the future:

"We view our cost of capital as the returns we can get from our second-best idea…and we have to exceed that" with our best idea. But he also says he doesn't really trust or believe calculations of cost of capital…and says people who talk about cost of capital often don't know what they're talking about.

"We think we can evaluate businesses" that are available to buy, and measure whether it'd be better to own them or the stocks already in their portfolio.

Seems straightforward enough even if many still think it makes sense to bother calculating the cost of capital in some kind of precise fashion. I think that the following exchange from more than a decade ago does a good job of capturing how Warren Buffett and Charlie Munger think about cost of capital:

Buffett: Charlie and I don't know our cost of capital. It's taught a[t] business schools, but we're skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I've never seen a cost of capital calculation that made sense to me. Have you Charlie?

Munger: Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs -- in other words, it's your alternatives that matter. That's how we make all of our decisions. The rest of the world has gone off on some kick -- there's even a cost of equity capital. A perfectly amazing mental malfunction.

Hedge Fund Bet Update
Buffett also provided an update on a $ 1 million friendly wager he made roughly six years ago with Protege Partners LLC, a New York fund of hedge funds.

The bet Buffett made with Protege was that a portfolio of hedge funds of their choosing couldn't beat the S&P 500 over a ten year period.

The winner's charity of choice is to receive the $ 1 million.

For some background, here's the wording of the specific wager that was made between Buffett and Protege:

"Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses."

So how are the hedge funds chosen by Protege doing so far against the S&P 500?

Buffett
S&P 500: 43.8%

Protege
Hedge funds: 12.5%

Who knows how this ends up and, even if it does go Buffett's way, one bet certainly isn't definitive. On the other hand, considering the differences in fees* and other frictional costs, the outcome so far is not really surprising.

In other words, if it were practical to run the experiment 20-30 times, I think it's not unfair to say the S&P 500 has a pretty good chance to do relatively well most of the time. The willingness by some to pay rather substantial incremental fees seems more than a little bit remarkable.

The behavior would make a whole lot more sense if the long-term performance advantage was plain to see.

Per-share Book Value As A Performance Measure
At the meeting, there was a question about why Berkshire uses book value per share to measure performance. It's, as Buffett has explained in the past, a useful though imperfect measure:

"We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value."

Buffett adds that book value per share is not very meaningful at most companies. For Berkshire, it just happens to be a convenient proxy, as long as an appropriate adjustment is made that takes the inherent understatement into account. Here's how The Motley Fool summarized what Charlie Munger had to say in response to the question:**

For almost all of its recorded history, Berkshire has measured its performance by comparing growth in book value per share to the gains in the S&P 500 index.

But when asked about this comparison, Charlie Munger was uncharacteristically outspoken. Munger noted that, "Warren likes to make it difficult for himself." In effect, he said the measure was an unnecessary handicap...

It's true that per-share book value is an imperfect measure -- and probably to an increasing extent over time -- but it can still be used to roughly understand changes to per-share intrinsic value.

Still, its limits must be recognized. Check out the 2010 letter (page 6) for more on estimating Berkshire's intrinsic value.

Over time, as Berkshire becomes more about operating businesses and less about marketable stocks, this measure seems likely to become even more imperfect for tracking per-share intrinsic value and how much it changes.***

Activist Investors
According to the New York Times, later on in the meeting Buffett and Munger added the following about activist investors.

Buffett: "...it certainly scares the hell out of a lot of managers."

Munger: "I don't think it's good for America."

Apparently, Munger also likened investor activism to the way Oscar Wilde described fox hunting:

"...the unspeakable in full pursuit of the uneatable."

Earlier today, in this CNBC interview, Charlie Munger was asked whether investor activism is generally good for America. His response was only somewhat more charitable:

"Well, sometimes it's good, and sometimes it's awful. And I'm afraid that's just the way it is."

Warren Buffett, sitting next to him in the same interview, said this:

"Some of them [corporations] are going to be poorly run and some of them are going to be run in a very self-interested manner by the managers. What is the correction for that? And activism can be a correction for some of that."

Buffett then later added:

"...an immediate bump in the stock price should not be the measure of whether somebody has accomplished something successfully in a corporation. But there are times when change is needed in corporations and they're not going to do it themselves."

So Buffett seems, on balance, to have a somewhat more favorable view of activists compared to Munger even if that's not saying much. The measure of activist impact -- favorable or otherwise -- isn't, as Buffett says, whether actions move a stock price short-term or, for that matter, even intermediate-term; it's whether their actions produce a lasting impact on long-term business prospects.

It's just worth remembering there are things that will move up a stock price near-term yet do nothing for -- or even hurt -- business performance many years down the road. One can only guess but this may be what Munger means when he says "sometimes it's awful."

Just because someone is in a position to purchase lots of shares in a particular business, it hardly guarantees they're an expert in that business. Large percentage ownership doesn't necessarily mean the challenges that plague a particular business are understood with sufficient depth. The activist who's terrific in one arena might decide, not judging their own limits well, to move into an arena they know a whole lot less well.

Smart people with lots of funds to deploy aren't immune to overconfidence.

Activist investors who tend to buy for the long-term at least have to live with the consequences of their actions. If they influence things in a way that leads to a good long-term outcome, they'll be appropriately rewarded. If not, they'll suffer the same consequences as other owners. With a longer term focus, they're also more likely to develop a deeper understanding of business challenges and opportunities (though this is hardly assured). Well, some just aren't all that oriented to the long-term.

Buffett said the following last year which seems relevant here:

"I do not think that companies should be run primarily to please Wall Street and largely shareholders who are going to sell. I believe in running Berkshire for the shareholders who are going to stay and not the one's who are going to leave."

There are certainly more than a few capable and effective activist investors.

That doesn't mean there are yet enough focused on the longer term effects of their actions.

This seems a real opportunity to greatly enhance the current system.

Too Much Cash?
Later in the meeting, Buffett did indicate that "we will have more cash than we can intelligently invest in the future" and added "It's not on a distant horizon. The number is getting up to where we can't intelligently deploy the amounts coming in."

For some Berkshire investors these comments might be viewed as a hint that buybacks (if/when the price is right), and maybe even dividends, will increasingly need to be where excess capital ends up being allocated.

The question, of course, is just how soon. That's much harder to figure out even if "not on a distant horizon."

Buffett made it clear that any decision along these lines will be driven by the principle that it be in the interest of shareholders.

Adam

Long position in BRKb established at much lower than recent market prices

* Many hedge funds are compensated via the '2 and 20' fees or something along those lines. In contrast, some low cost S&P 500 index funds cost less than 1/10th of a percent.
** According to Bloomberg, Charlie Munger said the following about using per-share book value as a measure of performance: "Warren has set a ridiculously tough standard," Munger said today in Omaha, Nebraska. "If this is failure, I want more of it."
*** In the 2013 letter, Buffett makes the point that the difference between intrinsic value and book value is becoming larger: "As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount."
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