Saturday, March 03, 2007

A Closer Look At Buffett's Annual Letter

Photobucket - Video and Image Hosting For years, Warren Buffett’s annual Letter to Berkshire Hathaway shareholders has been a trove of business insight and commercial wisdom, and this year’s letter (here), released on March 1, 2007, is no exception. While the general focus of the letter is a year-end review of the various Berkshire businesses, Buffett still managed to work in some memorable observations about some larger topics. I review below several of his comments, as well as one substantial omission from the letter to shareholders. (Full dislosure: I own Berkshire shares, although not nearly as many as I wish I did.)

Executive Compensation: After noting that he has been on 19 corporate boards and that he sets the compensation for the CEOs of "around 40 significant operating businesses," he has nonetheless faced "ostracism" from the compensation committees of the boards on which he has served, perhaps because he takes a different view on executive compensation. His concern is that there is a pack mentality on executive compensation, driven by compensation consultants, which results in the following:
CEO perks at one company are quickly copied elsewhere. "All the other kids have one" may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees.

Buffett is not optimistic about changing these practices, either; he says that "irrational and excessive comp practices will not be materially changed by disclosure or by an independent comp committee." Buffett asserts that true comp reform will take place only "if the largest institutional shareholders…demand a fresh look at the whole system." Buffett is skeptical that the fresh look will never take place as long as compensation is engineered by comp consultants who are "deftly selecting ‘peer’ companies," a practice that will only "perpetuate present excesses."

Hedge Funds: Using the example of the wealthy, fictitious Gotrocks family, Buffett examines the way that an investment industry of "helpers" is diverting (rather than creating) wealth through imposition of outsized management fees and other costs. Buffett has particular contempt for the "2-and-20 crowd" that charges 2% of principal and 20% of profit, ensuring enormous fees to the "helper" but inferior returns to investors:
The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these "hyper-helpers." Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.
Dollar Weakness and U.S. Indebtedness: After reviewing the $2.2 billion profit Berkshire earned between 2002 and 2006 from its direct foreign-exchange position (i.e., Berkshire was long on foreign currencies), Buffett reviewed the reasons why Berkshire will continue to attempt to gain from foreign currency exposure, either from "the ownership of foreign equities or of U.S. stocks with major earnings abroad." Buffett expects to gain as the dollar continues to weaken, which he expects because of the massive level of U.S. imports that are not reciprocated by export sales – as a result of which "the U.S. has necessarily transferred ownership of its assets or IOUs to the rest of the world." The U.S. can do this because "we are an extraordinarily rich country that has behaved responsibly in the past." But Buffett believes that this imbalance and outflow of assets and wealth has its consequences, some of which are potentially very dangerous:

our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption. of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual "tribute" so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a "soft landing" seems like wishful thinking.
Photobucket - Video and Image Hosting PetroChina and Darfur: Consistent with Buffett’s commitment going forward to foreign equities, Berkshire has a substantial investment in PetroChina, which is China's biggest producer of oil. According to his letter to shareholders, as of December 31, 2006, Berkshire owned 2.3 billion shares of PetroChina Class H shares (representing 1.3% of the company and making Berkshire the company's largest foreign shareholder), which have a cost basis of $488 million but a market value of $3.3 billion, or a current value of 670% of cost. (Buffett obviously has not lost his eye for a bargain.)

Interestingly, Buffett elected to say nothing in his letter to shareholders about Berkshire’s investment in PetroChina, which has come under fire recently (refer here) for its 40 percent investment in a Sudanese oil venture. (The allegation is that the venture supports the Sudanese government, which is responsible for genocide in the Darfur region. Based on these concerns, Harvard and Yale, among others, have divested their shares in PetroChina.) Perhaps to avoid the necessity for Buffett to address this topic in his shareholder’s letter, Berkshire released a statement (here) the week before the letter was published. Essentially, Berkshire’s response is that it is not PetroChina, but PetroChina’s controlling shareholder China National Petroleum Corporation (owned by the Chinese government) that has operations in Sudan. PetroChina itself does not, and the subsidiary can’t control the parent.

A February 23. 2007 Salon.com column entitled "Warren Buffett Plays Dumb in Darfur" (here) criticizes Berkshire’s response for ignoring the true relationship between PetroChina and CNPC – specifically, that the executive team for both companies consists of exactly the same individuals in the same functions with the same titles. The Salon.com article asserts that "to declare, as Berkshire does, that a subsidiary has no ability to control the policies of the parent, when the two entities are run by the exact same people, is an exercise in specious obfuscation."

The D & O Diary is in no position to judge the merits of the PetroChina dispute. But it has been my observation that commentators have been more hostile toward Buffett since he started his very public bet against the dollar a few years ago. As his investment approach has moved beyond foreign currencies to foreign equities and other foreign assets, media commentators, who idealized him for so long as the "Oracle of Omaha," are now likelier to demonize him. Buffett’s strategy to go long on foreign assets because of his bearish views on the U.S. dollar will likely make him increasingly unpopular. Perhaps Buffett himself is experiencing his own form of "backlash" of the kind he anticipated in his shareholder’s letter’s comments about the fallout from U.S indebtedness. Unlike Buffett himself, many are unable (or unwilling) to regard his decision to invest in foreign assets as the neutral pursuit of superior investment returns. I suspect that going forward Buffett will find himself dogged by similar questions like those surrounding Berkshire's PetroChina investment.

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