A Model for the Rest of Us

Every year the master of stock investing, Warren Buffett takes the time to create a letter which usually runs about 20 plus pages in length. In the latest letter, he lays out for anyone to see, exactly why he is the premiere investor in the world today. Warren Buffett is the best at what he does because he understands what he is, and what he is not. In over a half century of investing, he has never bought a technology stock. The Chairman of Berkshire Hathaway believes if he cannot envision what a balance sheet of a company will look like in 10 years, he can't own it. Since you can't figure out a high tech company's balance sheet next year, how are you going to figure it out 10 years into the future?

What Buffett had to Say

Berkshire now has annual revenues approaching $100 billion, and 217,000 employees. "Size seems to make many organizations slow-thinking, resistant to change and smug." Buffett is questioning whether size is the right way to go. He does say that Berkshire has become the buyer of choice for many companies seeking to sell themselves. A company bought by Berkshire can still retain its individuality and unique focus. If bought by a strategic buyer, the same company would be torn apart, certain pieces sold off, and employees discarded. On the other hand if a company is sold to a private equity firm, it gets loaded up to the gills with debt. The acquirers really only want to own the company for as few years as possible, and then boom, the company gets sold again.

Buffett is a keen observer of human nature. Small things tell him everything. He recalled the time in the 1960's when he bought an insurance company from Jack Ringwalt. The day of the closing, Buffett is sitting at the conference table waiting for the seller to arrive, and the gentleman is late. Finally when he gets there, the seller announces to Buffett that he was driving around the block looking for a parking meter with unexpired time on it. Since Buffett always kept the old management team in place when took over a company, he knew that Berkshire Hathaway was going to be all right with this investment, since this guy was so cheap, his shoes would squeak. The Sage of Omaha loved every minute of it.

Perhaps one out of a hundred investors is aware of this, Buffett always made his biggest money in the insurance industry. Insurance works off of the float that a company has available. You take money in against potential claims in the future. You have the premiums to work with until some day, some portion of these accumulated premiums, must be paid out in settlements. Now with insurance you have to get a couple of things right.

You have to price the premiums correctly for the potential losses, and you have to invest the premiums until that time comes when you might have to pay them out. It is said that Warren Buffett better than anybody in the world can price risk appropriately.

We already know that he certainly can allocate capital to investments better than anyone else. In the insurance business, this means he can invest those premiums on an interim basis better than his competitors.

As for risk, he says, "We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk. We are not willing, though, to take on even very small exposures at prices that don't reflect our evaluation of loss probabilities." He then goes on to say, "Appropriate prices don't guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses."

Newspapers are a poor Business Model

If you know Buffett's history, you know that he made a killing buying into the Washington Post which is the Graham family newspaper in Washington DC. An $11 million investment in the 60's, is now worth $1.2 billion. Not a bad return at all, but that was then, and this is now. The business model for newspapers has certainly changed. A very bright publisher once said that he owed his newspaper fortune to two basic concepts – monopoly and nepotism.

If you have a town with one newspaper, you have yourself a monopoly. For much of our nation's history, we got our information from newspapers. People knew the different sections, and there were the ads that were incredibly profitable. If there were several newspapers in a town, the fattest newspaper with the most ads would ultimately dominate, and then the profits would go through the roof. Ads would go up in price every year, even though costs could be held constant.

In the last 10 to 15 years, it's obvious that people have more choices as to where to get their information than just newspapers. With the Internet, Television, and Radio, newspapers are simply not experiencing increasing readership. As a matter of fact, circulation is down across the board in just about every city, and sector in America. The business model simply doesn't work anymore.

Comments on Compensation

If he is nothing else, Warren Buffett is a straight shooter who calls them as he sees them, and doesn't mince words. He states that he sets the compensation for every major executive that works for him, which is about 80. Some of these people manage billions of dollars individually. He spends no time on it, and has never had anybody leave him. He has sat on tons of boards through the years, and no one, that's right, no one has ever asked him to sit on a compensation committee. They don't want him.

When selecting directors for Berkshire's Board, he wants them, '….owner-oriented, business-savvy, interested, and truly independent." He believes most board members are not independent, that they absolutely need the money that the Board is paying them. For big companies, Board compensation comes to $150,000 to $250,000 per year. This is a number so large, that for many directors, it's bigger than what they make from their day job, and basically kills off the concept of independence.

The law says that the directors have to faithfully represent owners. These directors are not doing that. Buffett's first question of any potential board member is, "Does he think like an intelligent owner?" Since Berkshire is in the business of running other businesses, they need board members who have "business judgment." There isn't much of that around according to master of investing.

Good bye and good luck,

Richard Stoyeck