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Michael Saeltzer was born and raised in Sacramento. He attended both public and private schools before attending Jesuit High School. After graduating he attended U.C. Berkeley and completed a Bachelor of Arts in Rhetoric. Michael returned to Sacramento and began teaching at a visual and... More
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  • Berkshire Hathaway's Owner's Manual: A Discussion of Owner Related Principle 4

    In 1983 Warren Buffet set down 15 owner-related principles that he thought new shareholders would find helpful in understanding his managerial approach.  Now, nearly 30 years later much has changed.  For example, the company issued B shares, then split them 50 to 1, and announced a stock buyback policy.  Also let's face it, Berkshire is under close scrutiny as David Sokol was essentially fired this year, a once regarded shoe in for succession, and now new and largely unheard of "players" have been recruited, not to mention the stock price has recently underperformed the S&P 500.

    This is the forth in a series of analytical articles which will examine the Berkshire Hathaway of today against the backdrop of the 15 principles outlined in 1983 and see if any valuable insights might be gained from such an exercise. Previously we examined Principles 1-3 in Berkshire Hathaway's Owner's Manual and now we turn our attention to Principle 4.

    Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.

     Buffett states that the goal of Berkshire is simply to grow the value of its stock at a faster rate than the S&P 500 (Principle 3). In his Owner’s Manual discussion of Principle 4 Buffett explains that he hopes to achieve this goal by purchasing businesses, or purchasing stock.  The funds that will be used to make these purchases are generated primarily through the Berkshire’s insurance subsidiaries “float”.  For an excellent description of “float” and its role in Berkshire’s business structure I strongly recommend the article Buffett’s Berkshire Hathaway Buoyed By Insurance ‘Float’ published in the Wall Street Journal.  From the article:

    This float is money Berkshire holds to pay insurance claims in the future, but in the meantime can be put to work in stocks and long-term investments that earn returns for Berkshire's own benefit. Effectively borrowed funds at little or no cost, Berkshire's float enables the company to acquire businesses and assets beyond what its equity capital alone would permit, Mr. Buffett has previously said.

    And, in the 2009 Annual Report Buffett describes the concept of float as follows:

    If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float…Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most — though certainly not all — future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest. (p.6)

    Buffet goes on to explain that the entire Property & Casualty Insurance industry usually does worse with float, that most years premiums have been inadequate to cover claims plus expenses, and that the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500.  He credits the unusual success of his company to outstanding managers who lead unusual insurance businesses.  Buffett highlights a couple.  The first is GEICO which is led by Tony Nicely.  Tony joined GIECO at age 18 and is now 66 and is portrayed of course as the typical Berkshire manager brimming with joy, talent, and would rather be doing nothing else. 

    Then there is Ajit Jain who heads National Indemnity which issues only a very few policies each year but they are huge and unusual whereas GIECO issues millions of small auto insurance policies.  Although Ajit writes billion dollar limits Buffett boasts that he does not lay off one dime to other insurers – he carries the full load.  Ajit is often mentioned when the notion of Buffett’s successor’s come up and indeed Buffet states openly in the Annual Report of 2009 “If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit.”

    Jan 17 1:39 PM | Link | Comment!
  • Berkshire Hathaway's Owner's Manual: A Discussion of Owner Related Principle 3

    In 1983 Warren Buffet set down 15 owner-related principles that he thought new shareholders would find helpful in understanding his managerial approach.  Now, nearly 30 years later much has changed.  For example, the company issued B shares, then split them 50 to 1, and announced a stock buyback policy.  Also let's face it, Berkshire is under close scrutiny as David Sokol was essentially fired this year, a once regarded shoo-in for succession, and now new and largely unheard of managers have been recruited, not to mention the stock price has recently underperformed the S&P 500.

    This is the third in a series of analytical articles which will examine the Berkshire Hathaway of today against the backdrop of the 15 principles outlined in 1983 and see if any valuable insights might be gained from such an exercise. Previously we examined Principles 1 & 2 in Berkshire Hathaway's Owner's Manual and now we turn our attention to Principle 3.

    “Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. We are certain that the rate of per-share progress will diminish in the future – a greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation.”

     

    Buffet uses the term intrinsic business value which is a term used to mean the true earnings potential of a company over time.  Intrinsic value has to take into consideration everything about a business including but not limited to things such as the current and future economic environment of the industry it is in, the competition it faces now and in the future, its ability to create and grow revenues over the life of the business, the value of its brand name, its copyrights and its research. 

    As one might expect the chances of two people coming up with the exact same value of a company are slim because each individual is forced to estimate, and to base their value on many assumptions.  If they share similar lines of thinking about how to value all of the aspects of a business then their numbers may be similar, but the important thing is to realize that the intrinsic value of a company is always open for debate.

    This concept by its nature presents significant challenges to a shareholder of Berkshire.  First of all, the intrinsic value of a company of the size and complexity of Berkshire is hard to figure.  Nobody knows for sure the true worth of the company now, or in the future.  Secondly, Buffett is making it quite clear that because Berkshire is now such a massive entity it is impossible to grow the value at the same rate as in its younger years.  So he is telling his shareholders there is no way he can do for them what he was able to do in the past.  The glory days are over, plain and simple. Thirdly, Buffet is saying his goal is to beat the growth rate of the average American large company, or in other words outperform the S&P 500 in the long run.

    Rather than going headlong into any brainy economic valuation debate, I am going to suggest that the most valuable information to glean from shareholder principle 3 is that the goal of Berkshire is simply to grow the value of its stock at a faster rate than the S&P 500, and to make it absolutely clear that all shareholders of Berkshire should never expect the company to perform at the same level that it has done in the past simply because Berkshire is so big now.  Investors should keep in mind that the S&P 500 has had wide variances in its ability to generate returns depending upon when one invested and what period one is looking at - even if the periods are long ones such as decades.    

    Jan 10 1:43 AM | Link | Comment!
  • Berkshire Hathaway's Owner's Manual: A Discussion of Owner Related Principle 2

    In 1983 Warren Buffet set down 15 owner-related principles that he thought new shareholders would find helpful in understanding his managerial approach.  Now, nearly 30 years later much has changed.  For example, the company issued B shares, then split them 50 to 1, and announced a stock buyback policy.  Also let's face it, Berkshire is under close scrutiny as David Sokol was essentially fired this year, a once regarded shoo-in for succession, and now new and largely unheard of "players" have been recruited, not to mention the stock price has recently underperformed the S&P 500.

    This is the second in a series of analytical articles which will examine the Berkshire Hathaway of today against the backdrop of the 15 principles outlined in 1983 and see if any valuable insights might be gained from such an exercise. Previously we examined Principle 1 in Berkshire Hathaway's Owner's Manual and now we turn our attention to Principle 2.

    "In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking."

    "Charlie’s family has 80% or more of its net worth in Berkshire shares; I have more than 98%. In addition, many of my relatives – my sisters and cousins, for example – keep a huge portion of their net worth in Berkshire stock. Charlie and I feel totally comfortable with this eggs-in-one-basket situation because Berkshire itself owns a wide variety of truly extraordinary businesses. Indeed, we believe that Berkshire is close to being unique in the quality and diversity of the businesses in which it owns either a controlling interest or a minority interest of significance. Charlie and I cannot promise you results. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner. We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when our partners do and in exactly the same proportion. Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours."

    Are there any other fund managers or CEO's out there who sink 98% of their net worth (Buffett's was estimated at $39 billion in Sept 2011) into the fund or company they control? If so, I am not aware of them. 

    Consider also that Buffett's salary is $100,000 per year and has remained so for decades.  Berkshire also pays for his personal and home security costs which are around $350K/year.  By contrast the amount of money that the country's top ten wealthiest CEOs made in the most recent year is $604.9 million, or an average of $60.49 million per year per CEO. Furthermore, if we look back at the average salary of the American worker over the past 20 years and adjust for inflation it has remained where it is today - possibly even declined since the downturn of 2008 (it was $33,000/year in 2008).  Over that same time span the salary of the country's wealthiest earner has grown by a third.   http://www.dailymail.co.uk/news/article-2049405/Meet-Americas-10-highest-paid-bosses-Forbes-list-wealthiest-CEOs.html#ixzz1hsSDrDEz

    According to PayScale, in November 2010, annual salary ranges for portfolio managers were about $44,000 to $86,000 for less than a year of experience, $64,000 to $100,000 for five to nine years, $82,000 to $133,000 for 10 to 19 years, and $82,000 to $140,000 for 20 years or more of experience. Usually structured as partnerships, private equity firms invest private equity in businesses they consider attractive. The partners tend to be high-net-worth individuals, pension funds, foundations and sovereign wealth funds. In a small-sample November 2010 PayScale survey, the annual salary range for private equity fund managers was about $96,000 to $275,000.

    Comparing Buffett to other money managers we see that in 2010 he awarded himself the salary of the typical portfolio manager with 5-10 years of experience.  When compared to private equity firm managers Buffett’s salary is on the low end.  Clearly the man is not out to rip of his investors by paying himself a huge salary or benefiting from short term performance bonuses (he gets no bonuses).

    It’s worthwhile to note that when examining the effect of a manager “putting their money where their mouth is” a recent study by Morningstar concluded that, on average, the more money a fund manager invests in their fund, the better the fund does.

    Interestingly, those mutual funds in which the manager invests their own money are ranked higher in the Morningstar rankings and have been in existence, more than twice as long as those who don't. I would imagine that managers who have their skin consistently in the game over long periods of time do better than those who do not, though I have no evidence to this.  For those of you out there who invest in mutual funds in 2005 the SEC started requiring mutual fund managers to disclose how much money they have invested in the funds they manage.  Recent studies have estimated that fewer than 40% of managers invest in their own funds.  See http://www.moneymanagerslive.com/paragonwealthmanagement/2011/06/put-your-money-where-your-mouth-is.html

    Back in 2009, Fool co-founder Tom Gardner wrote an article titled "How I Find Great Stocks." Right at the outset of the article, Tom says that if he had to choose just one metric to base his investment decisions on it wouldn't be growth, price-to-earnings ratio, return on equity, or balance sheet cash. Here's what he wrote:

    "The metric is straightforward, easy to find (just look at a company's 14A filing), and it doesn't require any math or investing experience to interpret. You'd be amazed by how closely correlated it is with stock market success, and yet it is still overlooked by the majority of investors. You MAY have guessed it ... my metric of choice is insider ownership."


    Tom then goes on to highlight that MF Global (OTC: MFGLQ) CEO Jon Corzine at the peak of his ownership, had $3 million invested in MF Global, which equated to roughly 0.24% of the company's outstanding shares. Currently the thousands who invested in MF Global are as a group missing $1.2 billion after the broker's epic collapse.

    In conclusion, when the Berkshire of today is held up against Principle 2 in the Owner's Manual, the company and its shareholders still can rest easy.  Although a manager’s pay and skin in the game are not the only indications of a well-performing investment, as we have seen here they certainly do help.

    Next up an analysis of Principle 3!



    Disclosure: I am long BRK.B.
    Dec 29 6:28 PM | Link | Comment!
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