Whitney Tilson's Notes From Berkshire Hathaway's Annual Meeting

Whitney Tilson submits (via Value Investor Insight): Note: This is not a transcript. No recording devices were allowed at the meeting, so this is based on many hours of rapid typing, combined with my memory. All quotes are Buffett’s, unless otherwise noted. Words in [brackets] are my comments/edits or, when I missed something, my best guess of what was said.

This is an excerpt from my full notes from this year's meeting, which are available here; comments from previous Berkshire and Wesco meetings are available here.

• Berkshire’s Next Chief Investment Officer

Buffett: I mentioned in the annual report that in looking for an investment manager to succeed me, we’re looking for someone who doesn’t only learn from things that have happened, but can also envision things that have never happened. This is our job in insurance and investments. Many people are very smart, but are not wired to think about things that haven’t happened before.

[In response to another question on the same topic:] We’re looking for one or more people – it’s entirely possible that it could be three or four people. We’re not looking for someone to teach – we’re looking for someone who knows how to do it.

We received about 600-700 applications, including one guy who recommended his four-year-old son. We’re heard from lots of good people, but the key is whether they could do it running $100 billion. We want to find someone who can run large sums of money mildly better than the market – and I emphasize mildly because there’s no way anyone can beat the S&P 500 by 10 percentage points per year [running such a large amount of money]. It isn’t going to happen. But a few percentage points per year is possible.

Anything times zero is zero and I don’t care how good the record is in every other year if one year there’s a zero. We’re looking for someone who is wired in such a way as to see risks that haven’t occurred and be cognizant of risks that have occurred. Charlie and I have seen guys go broke or close to it because 99 of 100 of their decisions were good, but the 100th did them in.

We want to give them each a chunk of about $5 billion and have them manage it for a period of time, as if they were managing $100 billion. Then [after watching them and evaluating them for a while], we’d turn over the entire portfolio to one or more of them.

Munger: It reminds me of the young guy who went up to Mozart and said, “I’d like to write symphonies.” When Mozart said, “You’re too young,” the young man replied, “But you were young when you started.” Mozart pointed out, “Yes, but I wasn’t asking anyone else for advice on how to do it.”

Buffett: We’ll find some people. I had to do this years ago when I decided to close the Buffett Partnership in 1969 and had to recommend to my investors where they should put 100% of their money. There were many, many investors with great records, but I chose Charlie, Sandy Gottesman, and Bill Ruane. Charlie wasn’t interested in more partners, but Sandy Gottesman took some individual accounts and those investors have been very happy. Bill Ruane set up a separate mutual fund [the Sequoia Fund], which has also done very well.

So, I identified three people who were conservative, where there was no chance at all that they’d blow up, who were not only terrific investors, but also terrific stewards of capital who would treat investors right. They were my age, which helped – I now have to look at people in a generation where I don’t know many people.

In 1979, I picked Lou Simpson for GEICO. I’d never met him but once I did, it was clear that he’d get an above-average result and there was no chance of a bad result. [Buffett published Simpson’s spectacular record on page 18 of his 2004 annual report (pdf file), showing that Simpson had compounded at 20.3% annually from 1980-2004 vs. 13.5% for the S&P 500.]

I have a job to do and I’ll do it.

• How dangerous are derivatives to the financial system and what can be done to mitigate potential damage from them?

[This was my question]

We’ve tried to mitigate it [raise warning flags about the dangers of derivatives] a little by talking about it, but realize there is nothing inherently evil about derivatives. We have at least 60 of them and will be discussing them at our upcoming Berkshire board meeting.

Derivatives are expanding rapidly, in more and more imaginative ways. They introduce invisible leverage into the system. In the 1930s, after the crash, the government concluded that leverage contributed to the crash and that it was dangerous. So the U.S. government empowered regulators to deal with this. For decades, they policed it and it was taken seriously when the Fed increased or decreased margin requirements.

But the introduction of derivatives has made any regulation of margin requirements a joke. The regulation still exists, but it’s an anachronism.

I believe that we may not know when it becomes a super danger or when it will end precisely, but I believe it will go on and increase until very unpleasant things happen because of it.

You saw one example of what can happen under forced sales in October 1987. It was driven by portfolio insurance, which was a joke. It was a bunch of stop/loss orders, but done automatically, and it was merchandized. People paid a lot of money for people to teach them how to put in a stop/loss order. When a lot of institutions do this, the effect is pouring gas on a fire. They created a doomsday machine that kept selling and selling.

You can have the same thing today because you have fund operators with billions of dollars – in aggregate, trillions of dollars – who will all respond to the same stimulus. It’s a crowded trade, but they don’t know it and it’s not formal. They will sell for the same reasons. Someday, you will get a very chaotic situation.

As for what could trigger this and when, who knows? Who had any idea that shooting an archduke would start Word War I?

Munger: The accounting being enormously deficient contributes to the risk. If you get paid enormous bonuses based on profits that don’t exist, you’ll keep going. What makes it difficult [to stop] is that most of the accounting profession doesn’t realize how stupidly it’s behaving. One person told me the accounting is better because positions are marked to market and said, “Don’t you want real-time information?” I replied that if you can mark to market to report any level of profits you want, you’ll get terrible human behavior. The person replied, “You just don’t understand accounting.”

Buffett: When we went to close out Gen Re’s derivatives book, we took a $400 million loss on a portfolio that was “marked to market” by the prior management and auditors – and I’m not criticizing our auditor. Any auditor would have said the same. I wish I could have sold to the auditors instead!

Take a dry cleaning business that owes $15. Their books show a $15 accounts payable and the other company shows an offsetting $15 accounts receivable. But there are only four big auditing firms, so in many cases, if they’re auditing my side, the same firm may be valuing or attesting to the value of what’s on the books of the person on the other side. I will guarantee you that if you add up the marks on both sides, they don’t add up to zero. We have 60 or more derivative contracts, and I’ll bet the other side isn’t valuing them like we are. I have no reason to mark the value up – we don’t get paid for that. If I value it at $1 million on our side, the other side should be marking it at minus $1 million, but I guarantee the numbers are widely different. Auditors should check both sides of derivative trades and the “marks” should sum to about zero. They don’t.

Munger: As sure as God made little green apples, this will cause a lot of trouble. This will go on and on, but eventually will cause a big dénouement.

• Comments on the Subprime Market

The subprime market, encouraged by lenders, intermediaries, builders, etc., led to a lot of people buying houses they couldn’t afford. There will be consequences for these people, but the question is whether it spreads. If unemployment and interest rates don’t go up, then it’s unlikely this factor alone triggers anything in the general economy.

In the 10Qs and 10Ks I’ve read, a high percentage of loans allowed people to make tiny payments early on, made up by higher payments later. I think this is dumb lending and dumb borrowing because someone who can only make 20-30% payments now isn’t going to be able to make 110% payments in the future. Those people and institutions were betting that house prices would keep going up. When this stops, you have a big supply of houses come on the market, like we saw in manufactured housing. You’ll see plenty of misery in that field – you’ve already seen some. But I don’t think it’ll be any huge anchor for the economy.

Munger: There’s been a lot of sin and folly, a lot of it due to accountants who let lenders book profits when no one in their right mind would have allowed them to book profits. If accountants lie down on the job, you see huge folly.

It’s in the national interest to give loans to the deserving poor. But the moment you give loans to the undeserving poor or the stretched rich, you run into trouble. I don’t see how people did it and still shaved in the morning, because looking back at them was a face that was evil and stupid.

Buffett: You’ve seen some very interesting figures in the past few months on people who didn’t even make the first or second payment. That shouldn’t happen. We saw this is in the manufactured-home sector. When someone only has to make a $3,000 down payment to someone who gets a $6,000 payment [the salesperson’s commission], then believe me, you’ll see a lot of bad behavior.

Securitization accentuated the problem. A local banker wouldn’t allow this because he’d see what’s going on, but when the loans are bundled and sold by Wall Street, that discipline disappears.

It will be at least a couple of years before real estate recovers. In some areas of the country, the [housing] inventory overhang is huge. The people who were counting on flipping the homes are going to get flipped, but in a different way.

• Are corporate profit levels sustainable?

Corporate profits as a percentage of GDP are at a record. I’ve been amazed. After being in a range for decades, it’s jumped up. I’d have to look at a chart, but other than maybe a year after World War II, I think there have only been two or three years in the past 75 where corporate profits have been as high [as they are today]. I would not think it would be sustainable. When they get up to 8% or more of GDP, that’s high, but so far there’s been no reaction like higher taxes.

You have lots of businesses earning 20% on tangible equity in a world where corporate bonds are yielding 4-5%. That’s astonishing. If you read a book, it would say it’s not possible. This is high, which means someone else’s share is going down, namely labor’s. Does it become a political issue? Congress has power to change this very quickly. Corporate tax rates used to be 35%, but now many companies are paying only 20%.

Corporate America is living in a great time. History shows this is not sustainable. I would imagine that it will not be.

Munger: A lot of profits are not in manufacturing or retailing, but in financial sectors. There’s been a huge flow of profits to banks and investment banks. That has no precedent. I don’t think it’s ever been as extreme as it is now.

Buffett: We’ve invested in and owned banks. If 20 years ago you’d asked me whether it was possible, in a world of 4.75% bonds, that countless banks would earn 20%+ returns on tangible equity, I’d have said no. In part this is due to leverage. A 1.5% return on assets leveraged 15 times is a 22.5% return on equity. But even so, you’d think once everyone was doing it, return on assets would drop to 1%, but it hasn’t happened yet.

Munger: Some of this is due to consumer credit, which has been pushed to extremes. Other countries that have done this have suffered bad consequences – South Korea, for example, really suffered for two or three years. I don’t think this is a time to swing for the fences.

Buffett: In South Korea, it produced some of the cheapest stock prices I’ve ever seen.

• Is the private-equity boom a bubble?

We’re competing with those people, so I started to cry, thinking about the difficulty of finding things to buy.

Due to the nature of private equity, it’s not a bubble that will burst. They lock up their money for 5-10 years and buy businesses that don’t price daily. It takes many years for the score to be put on the board and the investors can’t leave. It’s not like leverage in marketable securities.

What would slow it down is if the spread between high-yield bonds and safe bonds widens. This would slow down deals, but won’t cause investors to get their money back.

There’s another factor: if you have a $20 billion fund and get a 2% fee, you’re getting $400M a year. But you can’t raise another fund with a straight face until you’ve invested it, so there’s a great compulsion to invest it quickly so you can raise another fund and get more fees.

We can’t compete against these buyers. We buy forever and it’s our own money. I think it will be quite some time before disillusion sets in [among the investors in private-equity funds].

Munger: It can continue to go on for a long time after you’re in a state of total revulsion. [Laugher]

Buffett: The voice of total optimism has spoken. [More laughter]

• Declining U.S. Dollar

We think the dollar, over time, unless policies change in a major way, will likely decline somewhat more against most major currencies. At one time, we backed this up with $22 billion in foreign currencies, but then the carry made that an expensive way to express that belief, so now we buy into companies that earn a lot in foreign currencies. It’s a factor, but not a 50% factor, in what we buy.

We’re following policies in this country that will lead to a decline in the dollar – the fundamental forces are fairly strong.

We own one currency position right now that will surprise you – we’ll tell you about it next year.

Munger: The inflation factor at Costco is zero. It’s perfectly amazing how well we’ve done so far.

Buffett: Look at oil going from $30 to $60 and the euro from 83 cents [per dollar] to $1.35, so the price of oil for Europeans has gone up very little – 25% vs. 100% for us. It’s easy to anchor on your own currency.

You’ll have to think more about currency than you have. Around the world, others think about currencies, but the average American hasn’t had to.

• How Buffett Would Invest with a Small Amount of Money

If I were working with a very small sum – you all should hope this doesn’t happen – I’d be doing almost entirely different things than I do. Your universe expands – there are thousands of times as many options if you’re investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money. Everyone can’t do it, but if you know what you’re doing, you can do it. We cannot earn phenomenal returns putting $3, $4 or $5 billion in a stock. It won’t work – it’s not even close.

If Charlie and I had $500,000 or $2 million to invest, we’d find little things we could do, not all of it in stocks.

Munger: But there’s no point in our thinking about that now.