Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway Inc's (BRK.A, Financial) (BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, I cover the 2004 letter.
Three questions that truly count
In the 2004 letter, Buffett talks more about the importance of independent directors and how he thinks independence is defined. He says institutional owners have only three questions that truly count. “First, does the company have the right CEO? Second, is he/she overreaching in terms of compensation? Third, are proposed acquisitions more likely to create or destroy per-share value?”
On such questions, Buffett says the interests of the CEO may well differ from those of the shareholders. Unfortunately, directors will sometimes lack the “knowledge or gumption” to overrule the CEO. Therefore, Buffett says “it’s vital that large owners focus on these three questions and speak up when necessary.”
Buffett's Experience with Coca-Cola Co
Buffett gives the example of the situation at Coca-Cola Co (KO, Financial) where he was a board member and on the audit committee. Several institutional shareholders and their advisors decided Buffett lacked “independence” in his role as a director. “One group wanted me removed from the board and another simply wanted me booted from the audit committee.”
My first impulse was to secretly fund the group behind the second idea. Why anyone would wish to be on an audit committee is beyond me. But since directors must be assigned to one committee or another, and since no CEO wants me on his compensation committee, it’s often been my lot to get an audit committee assignment. As it turned out, the institutions that opposed me failed and I was re-elected to the audit job.
Conflict of Interest and Independence
Some institutions questioned Buffett’s independence because, among other things, Berkshire holdings McLane and Dairy Queen bought lots of Coke products. Although those institutions were correct in noting the potential conflict of interest, Buffett highlighted the economics of any conflict was so small as to not be relevant.
I’m puzzled how anyone could conclude that our Coke purchases would “control” my decision-making when the counterweight is the well-being of $8 billion of Coke stock held by Berkshire. Assuming I’m even marginally rational, elementary arithmetic should make it clear that my heart and mind belong to the owners of Coke, not to its management.
Buffett summed up the situation with the quote from Matthew 6:21 “For where your treasure is, there will your heart be also.”
Berkshire’s rules for board members
Buffett says he thinks the Berkshire Hathaway Inc (BRK.A, Financial) (BRK.B, Financial) board is a model because board members are truly aligned with shareholders:
(a) every director is a member of a family owning at least $4 million of stock; (b) none of these shares were acquired from Berkshire via options or grants; (c) no directors receive committee, consulting or board fees from the company that are more than a tiny portion of their annual income; and (d) although we have a standard corporate indemnity arrangement, we carry no liability insurance for directors.
Whose treasure, exactly?
Munger and Buffett based on their considerable boardroom experience, have found that the least independent directors are often to be those who receive “an important fraction” of the money they make, from board fees for their board membership. While Buffett says most of these directors do a good job, it’s only human to work in your own financial self-interest to protect your comfortable board position.
Buffett then goes on to give the example of a company that received an acquisition proposal, which management supported, the bankers supported and was at a good premium to the stock price. The board rejected it. Buffett notes several of the board received annual fees of about $100,000 annually, (remember this is 20 years ago). Buffett also noted that the board didn’t own a significant amount of stock themselves, so the premium was less interesting to them. So even though most of the board were “independent”, if the deal had gone through, their fees would have ended, so they were not really that independent and objective. Buffett says self-interest inevitably blurs introspection.
Board Members' Remuneration and Shareholding
Buffett also points out at the same meeting at which the deal was rejected, the board voted itself a significant increase in directors’ fees. The lesson learned is to pay attention to board member’s remuneration and shareholding, to see if they are really independent or not.
Foreign Currencies
Berkshire Hathaway Inc (BRK.A, Financial) (BRK.B, Financial) owned about $21.4 billion of foreign exchange contracts at the end of 2004, spread across 12 currencies. This is because Buffett thought “the evidence grows that our trade policies will put unremitting pressure on the dollar for many years to come”. This wasn’t because Buffett and Munger had doubts on America.
This investment is because, as Buffett argued in a November 10, 2003 article in Fortune, America’s trade practices were weighing down the dollar.
The decline in its value has already been substantial, but is nevertheless likely to continue. Without policy changes, currency markets could even become disorderly and generate spillover effects, both political and financial. No one knows whether these problems will materialize. But such a scenario is a far-from-remote possibility that policymakers should be considering now. Their bent, however, is to lean toward not-so-benign neglect: A 318-page Congressional study of the consequences of unremitting trade deficits was published in November 2000 and has been gathering dust ever since. The study was ordered after the deficit hit a then-alarming $263 billion in 1999; by last year it had risen to $618 billion.
Understanding Current Account Deficit and National Budget Deficit
Buffett also points out that it is a source of confusion is that the current account deficit (the sum of three items, the most important by far being the trade deficit) and America’s national budget deficit are often lumped as “twins” saying “They are anything but. They have different causes and different consequences.”
A budget deficit in no way reduces the portion of the national pie that goes to Americans. As long as other countries and their citizens have no net ownership of the U.S., 100% of our country’s output belongs to our citizens under any budget scenario, even one involving a huge deficit.
Deep-rooted structural problems
However, Buffett wrote he thought there were deep-rooted structural problems that would cause America to continue to run a huge current-account deficit “unless trade policies either change materially or the dollar declines by a degree that could prove unsettling” to financial markets.
Buffett writes that Berkshire Hathaway Inc (BRK.A, Financial) (BRK.B, Financial) hopes the US would adopt policies that would “quickly and substantially reduce the current-account deficit”. While this would likely cause Berkshire to lose money on its foreign-exchange contracts, as Berkshire’s resources remained heavily concentrated in dollar-based assets, “both a strong dollar and a low-inflation environment are very much in our interest.”
Macro Forecasting and Currency Investments
Buffett notes again the difficulty of macro forecasting and that in essence the currency investments are a hedge. He also quotes John Maynard Keynes’ masterful The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally” noting that Berkshire is running a reputational risk with the currency investments. But Buffett says, he and Munger “believe in managing Berkshire as if we owned 100% of it ourselves. And, were that the case, we would not be following a dollar-only policy.”
The lesson I take is that macro hedges, for a relatively small portion of your portfolio, is wise, if you have strong conviction on fiscal or monetary or trade policies.
