Street Capitalist: Event Driven Value Investments

This past weekend was the Berkshire Hathaway (NYSE:BRK.A / BRK.B) annual shareholder meeting. At one point during the Q&A, a questioner asked Warren Buffett about the status of Berkshire’s CIO candidates. Charlie Munger remarked that one candidate who he is particular close with was up 200% in 2009 with 0 leverage. Some people think that the person Munger is referring to is Li Lu, a fund manager who turned Munger and Buffett onto BYD.

Lu personally owns at least 2% of BYD, which rose 400% in 2009. I don’t know anything about his investments beyond that one position, but I know he is a huge believer in taking concentrated, high conviction positions. If that is the case here, BYD’s spectacular results must have contributed a lot to his returns for 2009 which may make a 200% for the year possible.

Here is a brief bio on Lu:

Li Lu was born in China in 1966. He attended Nanjing University in China and later came to the U.S., and earned three degrees (BA, JD, MBA) simultaneously from Columbia University. After graduation, he worked in an investment bank until 1997, when he founded Himalaya Capital Management, which today manages both LL Investment Partners and Himalaya Capital Ventures, funds focused on publicly traded securities and venture capital. Li Lu was named a global leader for tomorrow by the World Economic Forum in 2001, and a Henry Crown fellow by the Aspen Institute in 1998. He is a member of Council on Foreign Relations and Young Presidents’ Organization.

Fortune: Barnstorm Green

There isn’t a whole lot of information about Lu’s investing style out there. But I thought I would share some notes from a lecture he gave to Columbia Business School back in 2006. All of this is paraphrased, so don’t take anything as a direct quote and there may even be some inaccuracies. Still, I believe you will find these notes insightful, especially with respect to improving your own abilities as an analyst and investor. Even if Lu is not a Berkshire Hathaway CIO candidate, he is an investor with a tremendous work ethic that we could all learn from.

Below are my notes from Lu’s lecture:

Li Lu at Columbia Business School – 2006

-15 years ago, Lu was accidentally brought in to a lecture by Warren Buffett. Had epiphany moment, Lu thought he could do something in the investment business.
-At the time, Lu had just escaped China. Did not know very many people. No money, deep in debt. Worried about making a living in the US.
-In the middle of Buffett speech, made him think differently about the stock market.
-The more Lu thought about it, the more he thought it was something he could do.
-Value investors see themselves as owners of a business. Therefore, fortunes are up and down with the nature of the business.
-You demand a margin of safety.

3 Traits of a Value Investor:

1. Basically, you don’t think of yourself as a paper shuffler who constantly buys and sells securities. You think of yourself as a real owner of the business.
2. You only own a small piece of the business, so you demand a huge margin of safety.
3. Because you think of yourself as an owner, not trading all the time, you think everyone else is different — like Ben Graham’s Mr. Market

On Value Investing

-Under 5% of all assets are run under value investors, a real minority in the investment world.
-The stock market is created for the other 95% of people, that is where your opportunity and challenge is.
-That was one lesson that stuck in Lu’s mind when listening to Buffett’s lecture.
-Biggest challenge: understand whether you are the 5% or the 95%
-It is tempting to do what the other 95% of people do. Emotionally very difficult to be in the 5%, but value investors typically have better returns. The money is really for traders and they tend to amass more assets.
-5% have a spectacular return, but 95% of money probably always resides to somewhere else.
-Understand who you are. You will be tested. You will have to ask yourself whether you are or aren’t a value investor.
-If you are a value investor, you are probably genetically mutated and comfortable being in the minority. This is unnatural to human beings. You have to be comfortable being by yourself. You have to adopt the idea that you are right because your reason and evidence, not because others agree with you.
-You will probably spend most of your time being an academic researcher rather than a professional. You are a researcher or journalist, with insatiable curiosity. You are trying to figure out how everything works.
-The more you know, the better you are as an investor.
-Politics, science, technology, literature, poetry, everything can affect businesses and help you.
-Occasionally you can find insights that will give you tremendous insights that other people don’t have.
-Then you find if the business is cheap. Is the management good? What else? Why is the opportunity there?
-Started fund in late 1997. Been through really traumatic events: Asian Financial Crisis, Tech Bubble.
-Fall of 1998: Lu’s search process is very general. Got hooked on value line, loved to read the whole thing from beginning to end. The best kind of education, you should do this if you want encyclopedic knowledge of companies. Go through it page after page, it is enormously helpful.
-First thing Lu checks is new low list. New low P/Es, P/Bs, etc.
-Does not care where something traded before.
-First looks at valuation. If the valuation doesn’t fit, doesn’t go beyond it.
-If you see a low P/B ratio, ask – What is in the book? How much is the book?
-Encyclopedic knowledge is helpful when looking across different industries.
-Look at pre-tax and pre-interest earnings. Look from an un-leveraged basis. Figure out how much capital is deployed in the business. Look at ROIC.

Example: Timberland

-Start by giving a 5 second look at the business. Timberland. The business is trading around clean book value, consisting mostly of tangible liquid assets, working capital, plus 100M in real estate. Deployed capital is 200M with 100M return.
-Then check why the business fell apart and became cheap. Think if you had owned the entire business at that price.
-At the time, was the height of the Asian Financial Crisis, saw their sales falling off the cliff in Asia. Any thing with exposure to Asia was falling apart. Try to check what other people are thinking about this. You may not listen to their advice but you may want to know what other people are looking at.
-Timberland had no other analysts covering it.
-Why no coverage?
-Look at business across years. Timberland has been growing, pretty profitable, did not need financial markets. Family owned. Owns 40% controlling 98% vote.
-Immediately, that is a turnoff to most people. You can do a quick data search.
-You need to have a curious, active mind to ask questions and find answers.
-Timberland had most of the vote, no analyst coverage, a bunch of shareholder lawsuits. If you were a member of the other 95% of the investment business you might say maybe management is milking the business.
-Download every court document lawsuit. Read it. You NEED a very curious mind to figure out WHAT is happening. Dig every single time. READ EVERYTHING.
-The first time, it takes a couple minutes to look over financials. Then gather questions and do deep research.
-Most lawsuits came from Timberland missing guidance, annoying investors, which annoyed the owner of the business. They decided to stop talking to Wall Street. So it was not about milking the business or fraud. They were not crooks.
-How do you determine if they are good managers? Decent people?
-Act like an investigative journalist. Most business owners leave a trail for you to follow and see how they deal with different situations. Most professional managers would not see this as part of their job, but YOU are part of their 5%.
-Go to their community, visit people they know, their Church, their Synagogue, introduce yourself to their friends and neighbors. It is worth it to spend as much time as possible, to find what these business people have done and what their neighbors say about them to accurately get an idea of their personality.
-The father seemed like a simple, decent guy, just a high school graduate. the son went to business school, was already COO of the company even though he was Lu’s age. Lu saw what boards the son sat on, and noticed that they had a mutual friend. Managed to get himself on the board with the son and became friends quickly. Came to realize these where high quality, very ethical businessmen.
-After all that, saw the stock was still trading low. Decided he did not miss anything. The other 95% may not have done enough research to see this or have some kind of institutional imperative that prevents them from owning.
-If you are not a good analyst, you will never be a good investor.
-But we decide to buy. How much do we buy? Imagine having $900. The other 95% will take tiny positions, 50 basis points. You need to use concentration, a $200 position. Think of how much work you did. Lu visited all the stores to see how margins improved – they had a fad going on where kids wanted the shoes. Their asian business is tiny, reduced earnings by less than 5%.
-Lu put a ton into Timberland. What happened after next 2 years? Stock went up 700%. Propelled by earnings. No real risk – went from trading at 5x earnings to 15x with earnings growing 30% a year. It adds up.

Be a Learning Machine
-When an investment opportunity comes, you have to seize it. Devote day and night so you can act quickly. Do everything complete but do it fast. You have to train yourself to jump on opportunity.
-When opportunity presents itself you can smell it. The only way to do that is by training yourself and reading page after page of financial report.
-Uses S&P manuals for viewing foreign stocks.
-As an owner, don’t think about per share information.
-Use your brain, when looking at stock manuals, each page should really only take 5 minutes. Don’t use calculators. Use mental math.

Example: Korean Company
-60M market cap, pre-tax earnings of 31M, roughly 2x pre-tax earnings.
-Book value of 230M, what constitutes book value? If you are an owner, look at: fixed assets, working capital, don’t count on goodwill.
-Basically you see with 60M in market cap, 30M in pre-tax, $240M in book value ($180M in fixed assets)
-It might be cheap.
-Determine what the earnings is. The book. The working capital.
-Use common sense, common logic and think about the business.
-Most employees never went to business school, Lu finds they are easier to train.
-Of the 70M in current assets, it is all cash
-Of 180M in fixed assets, they own 100% of a hotel, recorded 30M as book. Own 13% of a department store recorded as 30M.
-Look up the department store, it roughly has a market cap of 600M. 13% gives you roughly 80M. So the book value undervalues it by another 50M.
-They own 15% of 3 cable companies and a whole bunch of real estate.
-The department store has exactly the same profile. Trading roughly around cash and investments, good earnings, and own a whole bunch of assets. Turns out they are the second largest cable operator as well
-The department store operates like a hotel, do not take inventory, more like a shopping mall.
-They charge a percentage on the top line of all merchant sales.
-Put it all together: Paying 60M, 70M in net cash, another 100M in stock, 30M in hotel with a value that has not been changed in last 10 years while real estate market has gone up in 10 years. Went to Korea, looked at hotel and department stores.
-Checked recent transaction of properties in neighborhood, value is likely 2-3x what is on the book. But take what is on the book anyway, add 150M. Add that to rest and you get 320M in assets that you are paying 60M for and earning 30M annually from operations.
-Insiders own 50%
-Many factors going in your favor, but you need to look at how local investors see it. They need to be buying it for the price to go up.
-Department store used to trade at 22 went to 100
-This company was at 12 now trades around 70
-each went up 5-6x

Don’t just listen. Do it.

-This type of an approach is not natural to an investor.
-If you decide your personality fits in with the mutated gene pool, that this is something you might be looking to do, there is a lot of money in it — proven by Ben Graham to Buffett
-You have to put in a lot of work into your analysis.
-You can make a lot of money if you are really interested, listening, and actually DOING IT.
-Lu benefited from listening to his value investing class and then actually going out and doing the work required.
-Value investing is not really about theory, it is about what works.
-Young analysts have energy and nothing to lose, so they should go and do the work.
-Before you become a good investor, you need to be a good analyst.

Lu says you need two things to be a good analyst:

1. Provide accurate and complete information. You have to go to an extra length to get it done. Most of the time you will stand alone against everybody else. If you are not competent about what you know, you cannot possibly take conviction positions when things go into free fall and everybody else is laughing at you.

2. Most money is not made in stocks from the examples. They do not provide out-sized returns. You can do the Tweedy Brown/Graham or the Buffett/Munger school. Your returns will come from a handful of stocks. You need tremendous insight by continuous intense curiosity and study.

Investment Mistakes

-Most mistakes come from inaccurate or incomplete information.
-Biggest mistake: most people wanted 2 week or monthly returns. They wanted to go up in down markets.
-Lu’s biggest mistake was straying, was working with Julian Robertson, started shorting — have to think like a trader when you are shorting because your downside can be unlimited. It’s like Charlie Munger says — having your hands tied behind your back while getting into a fight.
-Missed the opportunity to buy a business below cash, even though Lu knew the management and had great insights. The business subsequently went up 50-100x. Could not bring himself to buy it because of his mindset at the time.
-You make a mistake when you have not finished your work but like it enough. You start betting on probabilities instead of real analysis.

Constantly search for ideas

-In your life, you may only have 5-10 key moments of insight. You only get it from continuous learning. Find an American business and then find the Asian counterpart. Some businesses studied for 15 years. You need to know what that business is, how it ticks, so you can swing with conviction. If you cannot do that you will not make huge out-sized returns.
-If you do what Ben Graham or Tweedy Brown does, you will make 15-20% returns but you wont make the huge returns of Buffett.
-The biggest ideas can give 10,000x returns.
-Opportunities are not easy to find. They require a lot of factors to come together – Charlie Munger’s lollapalooza. You need a whole bunch of things working together where you have the insight and are willing to bet.
-This is what drives Lu in business.
-Lu started in physics, mathematics, law, economics, got interested in other subjects. Wife has a PhD in biology, he has learned a lot from her.
-Learn from everything, be intensely curious
-Eventually you will stumble into one big opportunity.
-In the meantime, you will stumble into Timberland style investments which aren’t bad.
-There might be years without opportunities, then years with a lot of opportunities.
-Depends on what becomes available to you.
-They do not come in a steady pace, not like once a week an idea.
-In 6 years, Lu had maybe 3-4 great ideas. But you get progressively better and better, improving the amount of opportunities for you since you will be quicker at your analysis.
-Go through every day by learning something. In a year you have to learn a great deal.
-When Lu reads biology, physics, history, it is all searching for ideas. If one idea jumps out, it is all Lu does. Rest of the time is spent with wife and kids and Lu learns from them too, especially with seeing how human cognition develops which is enormously important.

Li Lu’s Investing Checklist:

1. Is that cheap?
2. Is it a good business?
2. Who is running it?
3. What did I miss?

-Lu goes through the checklist, ‘what did I miss’ is greatly affected by psychology. This kind of cognition happens early on and Lu learns it from interacting with his girls.

Three characteristics of a value investor:

1. Business owner mentality
2. Difference in time horizon
3. Demand a huge margin of safety

Think like a Business Owner

-It all comes from one thing, that you are a business owner. You cannot force management changes, so you demand a margin of safety. You have a long time horizon because you think like an owner.
-But why dabble with stock market? Stock markets are made for people who can dream. That is why 95% of people never buy into value investing. Human nature prevents it.
-You do not belong to the stock market but you have to understand its perspective to position yourself properly. If you are truly think like a business owner, you will eventually leave the asset management business and run a real company. That is why Buffett and Munger left it.
-Or you become a private equity investor.
-The people who the stock market is designed for are fundamentally flawed people. Traders are bound to make mistakes due to fear or greed. They will always make room for value investors.
-Used to be strict about selling with great business. Now, sometimes Lu feels he has insights about the business that allows him to believe the probabilities are in his favor for the business actually improving year after year.
-That is the law of distribution in good businesses. The leaders perform spectacularly well.
-Selling makes you pay a huge amount of tax and you might not get that good buying price again.
-If a business can generate 50-100% ROIC, the mathematics get interesting very quickly.
-Caveat: you have to be very confident. Investment bankers use BS and project into infinity. You cannot project that long. There are only a few opportunities where you can project that long.
-If you are good, and spend your entire lifetime studying, across 50 year career maybe 5-10 opportunities where you can confidently project the next 10-20 years. At that point, you don’t want to sell. By holding you don’t pay the tax on capital gains, so you are really compounding 40% interest free, the business is deploying the capital at 40-100% a year in a tax efficient manner. That is what you do.
-You have to identify businesses that are getting stronger and stronger every year.
-What makes one business more successful than others? Why are they making more and more money compared to others?
-The only way you can find that is by studying the ones that are established.
-Look for great businesses, not just businesses owned by Warren Buffett

Example of a great business: Bloomberg LP

-Product was superior to others, high switching costs
-Bloomberg is a fabulous case study, it came out of no where.
-Gained market share little by little, crossed a milestone point, became a monopoly
-At a certain point, after being highly relied upon for daily work, the switching costs become to high so winner takes all.
-Suppose you have an opportunity to see how an industry evolves early on. At a certain point they cross the line
-Maybe when introduced to all businesses. There is a time when that line gets crossed and a public company is poised to benefit by becoming a monopoly business.
-Why did Microsoft succeed over Apple? Little by little they eroded Apple’s 100% market share.
-Offices were using Windows. Today – do you have a choice of not using Bloomberg?
-Bloomberg visits almost every month and asks what you do, how you use the system. Bloomberg terminals have tens of thousands of functions, they don’t give you a manual
-They want you visually hooked so it is a behavioral connection and you don’t mind paying tens of thousands of years where you don’t have a choice if they raise prices
-They keep coming back to you because they know you are a trader and want to provide you with more services so you are hooked.
-That is why Bloomberg is a fabulous business because you get hooked. Think about switching from that or a competitor coming up with a rival product. How do you compete with that?
-Lu doesn’t know. Suppose you know the inflexion point. Do you want to invest? Lu would invest in Bloomberg at that point.
-You need insight. Study every business. They all have more or less this type of dynamic.
-Your job as a good financial analyst is to study that business ALL THE TIME. Observe those trends.
-Once in your life, maybe you will find that opportunity.
-Why doesn’t Bloomberg want to sell? He doesn’t need to sell.
-When you have a business like that, you don’t need to sell.
-Lu has made many private investments, ex: CapitalIQ, which copies Bloomberg’s business model. Same method with an investment in an engineering service.
-Lu likes to know as much as he can. He likes to be friends with people, with Timberland, the CEO and his son actually became investors in Lu’s fund.
-You can learn and observe from everyday business decisions and learn dynamics.
-Nothing is constant. Everything is changing that is why you have to keep learning.
-Businesses change, Microsoft has threats now.
-You need an active mind, so you are prepared to act and you can seize opportunity due to your insights.

I’m not in Omaha this year to attend the Berkshire Hathaway annual meeting. But, I saw Warren Buffett’s advice for entrepreneurs at the meeting and thought it was worth sharing:

There’s nothing like following your passion. Find your passion and don’t let anything stop you. $500 built Nebraska Furniture Mart’s 78 acres of store in Omaha. Rose Blumkin loved what she did. Think about what that produced. It is incredible.

For those of you unfamiliar with Nebraska Furniture Mart:

Nebraska Furniture Mart is the largest home furnishing store in North America selling Furniture, Flooring, Appliances and Electronics. NFM was founded in 1937 by Mrs. B (Rose Blumkin) in Omaha, Nebraska. She worked in the business until age 103. In 1983, Mrs. B sold a majority interest to Berkshire Hathaway with the famous handshake deal with Warren Buffett. NFM now has three stores. The Omaha store is over 420,000 square feet (39,000 m2) of retail space and is on 77 acres (310,000 m2) of land. The Kansas City, Kansas store is also 420,000 square feet (39,000 m2) of retail space and is on 88 acres (360,000 m2) of land and sits across from the Kansas Speedway. The third store is in Des Moines, Iowa and is 24,000 square feet (2,200 m2) and sells appliances, flooring and televisions.

From the 1983 letter, we get a good idea of just how great of an entrepreneur Rose Blumkin really was:

Last year, in discussing how managers with bright, but adrenalin-soaked minds scramble after foolish acquisitions, I quoted Pascal: “It has struck me that all the misfortunes of men spring from the single cause that they are unable to stay quietly in one room.”

Even Pascal would have left the room for Mrs. Blumkin.

About 67 years ago Mrs. Blumkin, then 23, talked her way past a border guard to leave Russia for America. She had no formal education, not even at the grammar school level, and knew no English. After some years in this country, she learned the language when her older daughter taught her, every evening, the words she had learned in school during the day.

In 1937, after many years of selling used clothing, Mrs. Blumkin had saved $500 with which to realize her dream of opening a furniture store. Upon seeing the American Furniture Mart in Chicago – then the center of the nation’s wholesale furniture activity – she decided to christen her dream Nebraska Furniture Mart.

She met every obstacle you would expect (and a few you wouldn’t) when a business endowed with only $500 and no locational or product advantage goes up against rich, long-entrenched competition. At one early point, when her tiny resources ran out, “Mrs. B” (a personal trademark now as well recognized in Greater Omaha as Coca-Cola or Sanka) coped in a way not taught at business schools: she simply sold the furniture and appliances from her home in order to pay creditors precisely as promised.

Omaha retailers began to recognize that Mrs. B would offer customers far better deals than they had been giving, and they pressured furniture and carpet manufacturers not to sell to her. But by various strategies she obtained merchandise and cut prices sharply. Mrs. B was then hauled into court for violation of Fair Trade laws. She not only won all the cases, but received
invaluable publicity. At the end of one case, after demonstrating to the court that she could profitably sell carpet at a huge discount from the prevailing price, she sold the judge $1400 worth of carpet.

Today Nebraska Furniture Mart generates over $100 million of sales annually out of one 200,000 square-foot store. No other home furnishings store in the country comes close to that volume. That single store also sells more furniture, carpets, and appliances than do all Omaha competitors combined.

One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.

Mrs. B is wise as well as smart and, for far-sighted family reasons, was willing to sell the business last year. I had admired both the family and the business for decades, and a deal was quickly made. But Mrs. B, now 90, is not one to go home and risk, as she puts it, “losing her marbles”. She remains Chairman and is on the sales floor seven days a week. Carpet sales are
her specialty. She personally sells quantities that would be a good departmental total for other carpet retailers.

We purchased 90% of the business – leaving 10% with members of the family who are involved in management – and have optioned 10% to certain key young family managers.

Berkshire Hathaway – Letter to Shareholders (1983)

Rose Blumkin was an amazing entrepreneur. She continued to be involved with day-to-day operations until shortly before her death at 104 years old.

Today, CNBC had Warren Buffett of Berkshire Hathaway (NYSE:BRK-A / BRK-B) on for a few hours, answering questions on everything from Coca-Cola to Greece’s financial crisis. There were some interesting exchanges and you can pore over the entire transcript at CNBC, but I would like to highlight a bit of it.

On Coca-Cola

I’ve blogged in the past on Coca-Cola’s (NYSE:KO) decision to purchase its bottling unit Coca-Cola Enterprises (NYSE:CCE). To me the strategic rationale was that Coke wanted to get control over distribution so that they could more agilely deploy new products to the market place. Buffett seems to agree here, and does note that the bottling business is in general worse than the concentrate business. I thought it was interesting that Indra Nooyi was brought onto the call, she provided some good insight on why Pepsi did their deal:

QUICK: Well, we do want to ask you about another one of your companies, Warren. Coca-Cola came out and surprised a lot of people with this news that it’s going to be buying the North American bottling operations. This is different than what they’d been talking about in the past.

BUFFETT: Right.

QUICK: And it follows what Pepsi did about a year ago; in fact, follows very closely what they’d been doing. What do you think about this deal?

BUFFETT: Well, I think on balance I like it. I mean, Muhtar Kent has done a fabulous job with Coke, and there’s a lot of execution problems in doing anything like that. Pepsi will have them and we’ll have them at Coke. But with Muhtar, I feel confident in the fact that it will get carried off right now. The bottling business is very different than what they call the concentrate business, which is making the Cola-Cola concentrate, gets turned into syrup, gets turned into Cola-Cola. The bottling business is very capital intensive and has low margins. The concentrate business is not capital intensive and has very wide margins. Literally, Coca-Cola with 5 billion of capital could make 8 or 9 billion pre-tax just from the concentrate business. But the bottling business is an entirely different business. So long-term, I like being in the concentrate business much more than the bottling business. But the bottling business, Coca-Cola has what they call a fountain division that sells direct. They have the bottlers. Any time they get a new product there’s a question of how it comes under this contract that originally goes back to 1899. It needed rationalization and this move is a big, big step toward rationalizing it, make it so it’s more–it’s more friendly to the big box retailers of Walmart or some–Costco or somebody like that. And it–but it will–there will be some real execution time involved in it and over time, you would hope that Coca-Cola would have less money involved in the bottling business, because it’s a less attractive business.

QUICK: Obviously, you’re a long-term shareholder, but when you say that there are very likely to be come execution steps, some difficulties along the way, maybe some stumbles, how much patience do you have as an investor? You talking about year or two?

BUFFETT: I–well, no, I just say that–whenever you’re doing anything this big you better–you have to have a lot of confidence in the management and I have confidence in Muhtar to carry this off…

KERNEN: All right. I kind of understand a lot of that, how, you know, you don’t want the two companies competing. But there was a rationale at one point to do it that way, and Mr. Buffett had pointed out the different–you know, it’s a low margin bottling business vs. a high margin syrup business. What exactly changed? Why–you are going to deploy more capital–or you have deployed more to own the bottlers. Why not leave them owned by someone else with a lower margin business? What’s changed? You say something’s changed to make it make more sense.

NOOYI: Yeah, that’s a great question, Joe. So 10, 20 years ago, the market–the beverage market in North America was essentially carbonated soft drinks, and there were a few megabrands that controlled the business, and the market was growing 6, 7 percent in terms of volume. Fast-forward to today. Carbonated soft drinks are now less than 50 percent of the total market, and that’s a very highly profitable part of the whole market. And the overall liquid refreshment beverage business is growing in volume about minus 2 percent and in value about 1 percent positive. So this is not a huge growth business. It’s a big market, it’s about $100 billion category. But it’s not growing in leaps and bounds like it used to a couple of decades ago. When you have one or two publicly listed companies positioned as growth companies trying to fight over a profit pool, that’s not a very good situation, especially if the profit pool is not growing enough to feed the appetites of two or three publicly listed companies. So the only way to compete and stay ahead of competition in this environment is to bring the profit pools back together and figure out how to operate more efficiently.

KERNEN: Warren, you were going to talk about the Coke strategy abroad, right, with their–I guess they’re not buying in those assets, right?

BUFFETT: Well, the–no. The franchise operation works extremely well around the–around the world. And, I mean, you take somebody like Coca-Cola FEMSA in Mexico, I mean, the per capitas there are incredible. I think they’re up close to 500 or thereabouts. And so the franchise system in just country after country, 200 countries around the world, has developed the market in a way that’s been very good for the bottlers and very good for Coca-Cola. And actually, in many countries the bottling operation has been considerably more profitable than it has been in the United States, partly because of the growth aspect that Indra mentioned. So it’s not a system that needs fixing at all around the world. There can be an occasional spot where the bottler isn’t doing the job and the Coca-Cola company will buy it and then–and put it back on its feet and then resell it to somebody in that country. But having local bottlers really works pretty darn well around the globe.

QUINTANILLA: Warren, some people…

QUICK: Warren, there–right.

QUINTANILLA: Some people have been saying that you–people historically bought Coke as an international growth play. Now all the sudden North America’s an awfully bigger piece of the pie. Does it dilute some of the reasons that people got into the stock in the first place?

BUFFETT: No. In terms of where the money is being made, you know, Coke makes, I don’t know exact percentage, but 80 percent of its money around the globe, and it’s growing and just in country after country. Coke has been gaining share really quarter after quarter around the world. And add–none of that volume’s going away, or none of that growth is going away because they’re integrating the bottling system in the United States. It does–it means a concentration more of assets in the United States, but it does not take away from the profit growth that is occurring around the–around the world. I think Coke earned like 9 billion pretax last year, and I think well over 7 billion of that was from outside of North America. And that 7 billion is going to have the same kind of growth rate, which has been substantial, whether or not–you know, wherever the bottling system in the United States is owned.

On Currencies
This is a pretty interesting question because in the past, Berkshire has done some currency trading, particularly with the Brazilian Real.

QUICK: You said, though, that a bet either for or against a currency is a bet for or against that government. If you were worried, and let’s say you’re worry level and let’s just measure a couple of things against each other, euro vs. the dollar, which worries you more?

BUFFETT: That’s a tough–that’s a tough call. I mean, both the euro, European Union countries and the United States are running very large deficits. I mean, they–both of those currencies in terms of purchasing power will decline in value over time in my judgment.

QUICK: British pound vs. the dollar. Is that the same story?

BUFFETT: Same way. I–there are all–they are all following policies that will cause their currencies to lose value. Which one will lose more value than the other, it’s so hard to tell.

QUICK: Yen vs. the dollar? Same story?

BUFFETT: The yen is–Japan is the great mystery of all time. I mean, in terms of the policies they follow, what happens, you know, low interest rates, huge deficits and all of that sort of thing. That one is a mystery I don’t even try to think about solving.

Private Equity:

Private equity gets a lot of criticism for acquiring companies and then piling them up with debt to juice their returns. Usually, the companies that can survive that kind of treatment end up performing quite well when IPOed, but many fail in the process. I am expecting that if we see a big bankruptcy wave, these companies will do pretty well. A lot are great businesses that are just overburdened with debt. I would imagine distressed debt guys like Baupost, Third Avenue, and others will make a killing on these plays. After all, Buffett himself said that he would love to buy TXU at bargain prices if it went into bankruptcy.

KERNEN: One of the reasons I brought up that TXU situation was because in the piece it said there’s a lot of really great companies that–in the private equity universe that have really lousy balance sheets based on the bubble that was around in 2007. So there’s going to be some problems. But is that somewhere where you can look to try to help work out some of the situations? There must be some real gems in there that just, for whatever reason, I look at the fees that the PE firms take, and I look at the dividends that they pay out, and it used to work, but now they actually got to manage some of these things. I mean, couldn’t you find some nuggets in there?

BUFFETT: It’s possible, Joe, but on balance, if you notice, the private equity firms are very reluctant, it seems to me, to come forth with anything that involves big losses. I mean, they–what they usually try and do is get bond holders to make concessions or something. But I’ve not seen them wanting to sell the businesses at large losses. Now, you know, if they go into bankruptcy, then you buy them for the bankruptcy process. I mean, if the old TXU gets to 2,014 and they can’t meet the maturities that they have at that time or they haven’t done it earlier, you know, we may buy–we might think about buying the whole place, you know. But we’ll–we might buy it cheaper after a bond default than we would buy it from a private equity place.

KERNEN: Well, you know how to run utilities, and you might get the chance with, I forget how much is coming due.

BUFFETT: We might get the chance.

KERNEN: Yeah, 20 billion or something.

BUFFETT: Yeah, we might get the chance.

Health Insurance:

Unfortunately, I don’t see his ideas here happening. Although it is interesting to hear about how much Buffett and Munger admire Gawande, whose works are popular among value investors.

KERNEN: But you’re saying start over and do it on a bar–bipartisan basis is what you just said.

BUFFETT: I would–I would call in the smartest people in the health care field. I mean, you know, people like the fellow out of Kaiser Permanente or Mayos or this fellow the…

KERNEN: Mayo, Cleveland Clinic, Safeway…

BUFFETT: Or Gawande, the doctor–yeah, yeah. Cosgrove at…

KERNEN: Whole Foods.

BUFFETT: …Cleveland Clinic and…

KERNEN: There’s a bunch of smart–there’s a bunch of people that have some great private market–or free market ideas. And to do it…

BUFFETT: I’d lock them–I’d lock them in a room, Joe, and I’d tell them, you know, come out when you figure out how–some way to get this going in the other direction toward 13 or 14 percent. And it can be done. It can be done…

QUICK: Right. Warren, very quickly, so a viewer wrote in, Greg Robinson from Portland, Oregon, on this subject, said, “Wouldn’t a better fix for health care be a system similar to auto insurance? Could you give a specific–a simple scenario of how Geico would insure a large portion–population of people, perhaps having them pay a portion of the bill themselves so they will police the doctors? I’m a big believer in catastrophic care, but paying for your own maintenance.” Does that sound like a feasible idea?

BUFFETT: Yeah, it probably does. But the truth is, I would get people that know a lot more about it than I do. And, I mean, it–if you get the fellow that’s written on health care recently in the New Yorker, Gawande. I mean, he had–he had an article last summer that was absolutely magnificent (THE COST CONUNDRUM – Atul Gawande). My partner Charlie Munger sat down and wrote out a check for $20,000 to him and he’s never met him, never had any correspondence with it, he just mailed it to the New Yorker and he said, `This article is so useful socially.’ He says, `Just give this as a gift to the–to Dr. Gawande.’ It compared medical costs in McAllen, Texas, to El Paso, and it just showed how, with no better results, that in McAllen they were, you know, they were spending close to twice as much per person. And you have these enormous variances around the country. And, you know, if you had some really smart people running it that knew a lot about medicine, they’re going to–they could do a lot about it.

Using Stock as Currency:

I think this is a case where over simplification causes people to get the wrong idea. I believe that while Buffett was pretty opposed to issuing stock for deals, he can act rationally and do it when the terms make sense. In Kraft’s case, making sure you are not using stock that is greatly undervalued to purchase something that is less than a bargain– especially when you have to sell off key pieces of your business at ultra low prices, like the pizza business.

KERNEN: Welcome back to SQUAWK BOX. Still to come in the next hour, PepsiCo CEO Indra Nooyi, that’s coming up at 8:10. Let’s get back to Omaha, that’s where we find our very own Becky Quick with Warren Buffett. Beck, I was thinking about Matt Rose and Burlington and using stock and Warren with Kraft and Cadbury and I love to get him talking about that, to try to figure out why stock was a good idea for Burlington, that it wasn’t a good idea for Kraft and I love it when you say you don’t like that deal, even though you love management. Go into that again. What was the difference between Kraft using stock and you using stock, other than maybe valuation on the company being acquired?

BUFFETT: Yeah, well, we hate using stock. No question about it, Joe. And because we already owned some Burlington beforehand, it turned it we had to use about 30 percent stock and as I put in the annual report, even though the Burlington holders were getting $100 a share, we felt it cost us more than that because we thought our stock at the time we made the deal was somewhat underpriced. We’d have done all cash if I’d felt comfortable in terms of our balance sheet, using all cash. But I never want to put us in a position where we’ve–we’re stretched in the least. So to make the deal, I had to do it. And I came to the conclusion that using 30 percent stock, which was about 6 percent of all the shares we had outstanding, still left us with a deal that made sense. But if it had to have been all stock or 50 percent stock, we couldn’t have done it and if I’d had enough cash around to do it, so I could’ve done it all cash, I would’ve liked it better.

KERNEN: How about Kraft? You warming up to that finally? Or are you still–you still don’t like it. You don’t get to vote, I guess, do you?

BUFFETT: No, we didn’t get to vote. And it wasn’t just–it wasn’t just the stock that was being used, although that was a terrible currency to use, just as our own stock is a terrible currency to use. But it wasn’t just the stock, it was the price being paid and it was the fact that the pizza business was sold in a very tax inefficient manner to partly fund the purchase. And it just–in the end, I felt poor after the deal was made. But I, you know, I wish Irene the best on executing well on it and I hope it works out. We’ll be a lot better off financially if it does, but I wouldn’t have done it.

QUICK: Warren, that question that Joe raised is one that we got from a lot of viewers, too. In fact, Todd in Parker, Colorado, wrote in and said, “In your annual report, you say that you’ll consider issuing stock when we receive as much in intrinsic business value as we give up. When exchanging Berkshire shares for Burlington Northern, did Berkshire shareholders receive less, equal or more in intrinsic value?”

BUFFETT: Well, we felt, Charlie and I, felt that we received as much or a tiny bit more in intrinsic value as we gave up. But we factored into that some other things I mentioned in the annual report. Namely, that putting $22 billion of cash to work made good sense for us in this business and that the opportunities over the next 40 or 50 years to keep putting more and more cash at reasonable returns in, just like we do in our utility business, also was an attractive opportunity. We’re going to generate lots of cash over the years and we don’t always have great places to put that. This offers one vehicle where we can put it at decent rates of return. Not great rates of return, but decent rates of return.

Animal Spirits and Acquisitions:

QUINTANILLA: Warren, you go–we know this is–you’re passionate about this from the letter, you go into a long hypothetical about company A buying company B whose stock is undervalued. You say that CEOs long on confidence and short on smarts, wants to buy company B for the prestige and maybe the compensation. Is that a–is that a veiled slight at Rosenfeld?

BUFFETT: No, it’s 50 years of being in board rooms and just seeing what happens. And you know, Keynes talked about–probably the best–the best chapters written on investing were chapters eight and 20 in “The Intelligent Investor” for individual investing. The best chapter ever written in sort of describing how the world works in markets is chapter 12 of “The General Theory” written by Keynes and in it he talks about animal spirits and what causes people to do the deals and all of that. It’s a marvelous chapter. And I’m not sure that he had Kraft in mind, but he had a lot of the companies that I’ve experienced over the years in mind. It’s a very normal thing. I mean, you know, everything looks–everything looks rosy, you know, when you first are looking at a deal. You don’t see the downsides. You don’t see the execution problems, you don’t see the people who are going to leave. You don’t see–you don’t see all kinds of things. And I’m guilty of that, too, incidentally. I’ve made some dumb deals in my life and I’ll make some more dumb deals and animal spirits will enter into those dumb deals. I guarantee you that. I just try to keep them under control and if I don’t, I count on Charlie to keep me under control.

Debt Problems in the US

QUICK: All right. Let’s get to some more questions that came in from shareholders. There’s one guy’s–number 184 for the control room. This came from Scott Deller in New York. He says, “How much debt would sink the United States? If the answer’s unknown, isn’t it risky to race at top speed toward that line?” There were a lot of questions like this that came in.

BUFFETT: Yeah. Well, we are doing things that are causing the debt to rise at a very rapid rate, I mean, when you’re running, you know, a fiscal deficit like we are. As long as you issue debt in your own currency, debt doesn’t sink you. Now it–what it does is it destroys the value of money over time. So you can make–you can make it so that the person who lent you money, 10 years from now or 20 years from now gets back dollars that aren’t worth very much. But you can–as long as you’ve got a printing press, you can–you can issue any amount of debt in your own currency. It’s when the world says to you, `We don’t want debt in your currency any more, issue it in something that’s more solid,’ and that’s what they do–they’ve done to various developing countries. That’s what they used to do to South American countries and so on. And then the music stops. The IMF comes in and whatever they take. We have this great reputation for 200 years, and people will accept dollars for a long time. But if the printing presses would run at a sufficient rate, people after a while would say, `Wait a second. We’re going to get stuck.’ You know, it’s interesting, when we talk about what’s happened in the last year or two how the taxpayers paid for this or the taxpayers paid for that, taxpayer hasn’t paid for any of it. We haven’t raised taxes on anybody. What we’ve done is the lenders have paid for it. So it’s…

QUICK: Well don’t those–don’t those costs eventually get passed onto the consumer too, though?

BUFFETT: Not–the costs really get passed on–generally speaking, they get passed onto the saver. They just–inflation steals from savers, and inflation is the logical consequences of printing too much money.

QUICK: And seniors who are living on fixed incomes.

BUFFETT: Anybody that’s living on any kind of fixed income. I mean, you know…

QUICK: And small businesses that are maybe hoping to get a loan from a bank that can’t give it at this point.

BUFFETT: …anybody that has their money–anybody that has their money in a money market fund or anything like that, you know, if we issue enough–if we keep printing enough–if we keep a large enough fiscal deficits we will eventually print a lot of money and money will be worthless. And incidentally, if the United States runs up trillions and trillions and trillions of debt to the rest of the world, you know, I will guarantee you that the politicians of 10 or 20 years ago will not want to pay that back in hard money. It just doesn’t–it doesn’t make any sense.

The Financial Crisis in Greece
Buffett’s advocates swift action in dealing with the problem in Greece. I think that this is pretty appropriate. What we saw in the financial crisis here was that companies which did not deal with their problems fast enough wound up dead. When you are in a situation where you depend on borrowed money, you don’t have the luxury to sit and twiddle your thumbs. You’ve got to act before your credit lines dry up.

QUICK: When you look at the situation in Greece right now and what’s happening with the trouble they’ve gotten into, do you believe that contagion spreads to not only other EU nations, but potentially other states here in the United States? Is that a huge worry for you?

BUFFETT: There’s a huge incentive for the EU to handle something like Greece and, of course, that’s what you’re seeing now. I mean, it isn’t–it isn’t because the rest of–the other 15 countries in the EU have suddenly developed this great affinity for Greeks. They just–they know the consequences of, you know, if A is going to lead to B and you can’t stand B, solve A. And that is essentially the situation. That’s what we went through a year and a half ago, you know, after–when we stepped in and guaranteed money market funds and commercial paper and all of those things. We saw a run on the country developing, and, believe me, it was developing. And no one has to lend money to country A or country B or country C. And if they lose money with country A they’re going to get more worried about country B and country C just like the same experience we had with financial institutions in the fall of 2008. The time to stop runs is early on.

QUICK: But do you think that this is something that could happen here in the United States, if you look at California or New York, if you start looking at some of the states that have very large financial problems?

BUFFETT: Yeah, and they can’t print money.

QUICK: They can’t.

BUFFETT: No, no. What they can do is one of three things. They can cut expenses, they can raise income, or they can go to Washington eventually.

QUICK: And you think Washington would cover all of those problems?

BUFFETT: It would be very tough if you’re in Congress and they say, `Well, you bailed out General Motors, and you did this and that. And are you going to say, “People in the largest state in the union or whatever it is, that we’re not going to take care of you? I mean, the political problem would be huge. But there’s no question that states and municipalities the fiscal–the financial situation for them has deteriorated dramatically. We did not write any municipal insurance to speak of in 2009. The risk got higher and the premiums got lower and that just–it made it a dumb sort of thing to do in our view.

QUICK: Tying this back to Europe and if Europe and Germany do step in and provide for Greece, as it looks like they very–may very well do at this point…

BUFFETT: Almost have to, yeah.

QUICK: …does that make you think that all these hedge funds that are betting against the Euro are on the wrong side of this fence?

BUFFETT: Well, I don’t know what happens to the euro exactly, but I mean, there are–I’m sure there are hedge funds that are betting against the euro that are hoping that for one reason the Germans gets mad at the Greeks, or whatever it may be, you know, they are–let’s say there are two banks in town. You own a bank and I own a bank. Now, if I want to put you out of business what do I do? I go out and hire 50 bums on the street and get them to stand in line in front of your bank. You know, that’s all I have to do. You know, and those 50 will become 100. And after a while, I can let the 50 bums and go, and it will create its own dynamic. You do not want that to happen with countries. So you better stop it, you know, right off the bat. And everybody realizes that. The only question is whether it gets it gets bogged down in something or other.

I woke up at 7AM yesterday to have a chance to read Warren Buffett’s Berkshire Hathaway 2009 letter to shareholders (PDF). This year’s letter did not disappoint. I would like to highlight a few key ideas from the letter.

Intrinsic Value

At the beginning of each letter, you will see a table of how Berkshire Hathaway’s growth in book value fared versus the S&P 500′s. Now, as Buffett states below, book value does not precisely peg intrinsic value but it comes close:

The ideal standard for measuring our yearly progress would be the change in Berkshire’s per-share intrinsic value. Alas, that value cannot be calculated with anything close to precision, so we instead use a crude proxy for it: per-share book value. Relying on this yardstick has its shortcomings, which we discuss on pages 92 and 93. Additionally, book value at most companies understates intrinsic value, and that is certainly the case at Berkshire. In aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value. By this measurement, as the opening paragraph of this letter states, our book value since the start of fiscal 1965 has grown at a rate of 20.3% compounded annually.

Whitney Tilson takes a different approach for figuring out the company’s intrinsic value: you take the company’s per share investments and add them to pretax earnings per share with a multiple attached. This is closer to what Warren Buffett has recommended for pegging Berkshire’s intrinsic value, but it is also more difficult to determine. For most people, the book value approach should be sufficient enough.

Float

Most people don’t understand float, but it is probably the key factor in Berkshire Hathaway’s growth over the last 40 years. Let’s say you are a value investor and you manage to take control of a company. In general, your opportunities range from reinvesting in the business you have acquired, to looking at outside opportunities. These can be acquisitions of other businesses or simple investments in securities. Normally, such investments must be paid for using free cash flow or debt. But if you were to acquire an insurance company, you would have one more weapon in your arsenal, float:

Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.

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. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of 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.

Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses. Our insurance CEOs deserve your thanks, having added many billions of dollars to Berkshire’s value. It’s a pleasure for me to tell you about these all-stars.

Bolded for emphasis. The $16M to $62B figure is absolutely amazing and speaks to the power of a disciplined insurance operation. Not to detract from the 2009 letter, but I think the following discussion on National Indemnity from the 2004 is quite insightful here. Indeed, in Buffett’s 2004 letter, he said that without the acquisition of National Indemnity, Berkshire would be nowhere close to its size today:

So, you may ask, how do Berkshire’s insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage? We’ve attacked that problem in several ways. Let’s look first at NICO’s strategy.

When we purchased the company – a specialist in commercial auto and general liability insurance – it did not appear to have any attributes that would overcome the industry’s chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.

Many insurance companies end up chasing premiums without adequate risk management and blow up. They never have the time to really endure and grow, the way that Berkshire has done with National Indemnity and its other operations. Now, back to the 2009 letter.

Buffett uses the rest of the insurance section of the letter to praise Ajit Jain’s activities at Berkshire Reinsurance and mentions that GEICO has gone from the country’s 6th largest auto insurer to the third largest in just 15 years. One of the best things about Buffett is he always owns up to his mistakes. It seems as if a foray into the credit card business did not work out so well for GEICO:

And now a painful confession: Last year your chairman closed the book on a very expensive business fiasco entirely of his own making.

For many years I had struggled to think of side products that we could offer our millions of loyal GEICO customers. Unfortunately, I finally succeeded, coming up with a brilliant insight that we should market our own credit card. I reasoned that GEICO policyholders were likely to be good credit risks and, assuming we offered an attractive card, would likely favor us with their business. We got business all right – but of the wrong type.

Our pre-tax losses from credit-card operations came to about $6.3 million before I finally woke up. We then sold our $98 million portfolio of troubled receivables for 55¢ on the dollar, losing an additional $44 million.

GEICO’s managers, it should be emphasized, were never enthusiastic about my idea. They warned me that instead of getting the cream of GEICO’s customers we would get the – – – – – well, let’s call it the non-cream. I subtly indicated that I was older and wiser.

I was just older.

That kind of honesty is unparalleled in shareholder letters, which usually read more like corporate propaganda than honest assessments of the business.

Burlington Northern Santa Fe

(Flickr: SP8254)

The regulated utilities section of the letter provides some insights on why the Buffett chose to acquire Burlington Northern. I think that for the most part, guys like Bruce Berkowitz were right in their assessment on Burlington Northern:

CONSUELO MACK: Let me ask you about the Burlington Northern acquisition, the largest acquisition that Berkshire Hathaway has ever made. The Wall Street Journal coverage of it saidWarren Buffett is turning Berkshire Hathaway into a big industrial operator and it’s no longer thenimble investment firm that it was once. What’s your view of what Warren is doing in buying thesebig industrial companies?

BRUCE BERKOWITZ: Berkshire has a tremendous amount of flow from the premiums received from long-term insurance policies. That flow has to be invested in very secure, sound financial instruments such as: electric utilities cost plus or a railroad business which has the stability unlikemany businesses. So here he’s taking money that’s actually got a zero cost to it and then investing itat a reasonable, not at an egregious yield, but at a reasonable investment yield. But when the cost iszero, the returns are phenomenal. He’s brilliant. Warren Buffett is being Warren Buffett in that he’smarried another great big business to Berkshire Hathaway that’s going to make a sizeable difference overtime

Buffett believes that BNSF should be looked at as a utility as well:

Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come. Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant…

In the future, BNSF results will be included in this “regulated utility” section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital.

Buffett does not say explicitly what he thinks the returns on invested capital will be for the railroad business but that it should increase over time. Burlington Northern should definitely have the kind of pricing power it needs to ward off the frictional forces of inflation, should regulators act properly.

NetJets

(Course Correction: NetJets)

When David Sokol took the reigns at NetJets, I think people looked at the situation in two ways. 1. This would be a test for Sokol, to see if he has what it takes to be the CEO of Berkshire Hathaway. 2. Berkshire’s businesses aren’t infallible and may need guidance from time to time. Here is what Buffett said of the situation:

We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that both operating and capital decisions are occasionally made with which Charlie and I would have disagreed had we been consulted…

The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our dominance in the field remains unchallenged.

NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.

Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of NetJets in August. His leadership has been transforming: Debt has already been reduced to $1.4 billion, and, after suffering a staggering loss of $711 million in 2009, the company is now solidly profitable.

Most important, none of the changes wrought by Dave have in any way undercut the top-of-the-line standards for safety and service that Rich Santulli, NetJets’ previous CEO and the father of the fractional- ownership industry, insisted upon.

With the debt reduced to $1.4B and the company profitable, David Sokol looks as if he has passed the test. Sokol has gradually had the opportunity to get more face time with the media. We saw this with his activities at NetJets and the investment in BYD. I think he is poised to be the right operations guy at Berkshire, with Ajit Jain handling the insurance operations and the still unnamed CIO handling investments.

Financial Products and Derivatives

On occasion, Buffett has criticized the government’s lending policies with good reason. Berkshire is unable to get the kinds of lending rates that TARP recipients received in the past, which put the company at a decided disadvantage when it came to bidding on parts of companies such as AIG. But in this year’s letter, Buffett sheds light on another problem:

The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 51⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.

In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton’s homes offer terrific value. If the buyer needs mortgage financing, however – and, of course, most buyers do – the difference in financing costs too often negates the attractive price of a factory-built home…

Our product is first-class, inexpensive and constantly being improved. Moreover, we will continue to use Berkshire’s credit to support Clayton’s mortgage program, convinced as we are of its soundness. Even so, Berkshire can’t borrow at a rate approaching that available to government agencies. This handicap will limit sales, hurting both Clayton and a multitude of worthy families who long for a low-cost home.

These kinds of double standards hurt buyers of Clayton’s homes, especially considering that Clayton’s buyers are not speculators. Most are simply people looking to buy a home and live in it. They aren’t the gluttonous home flippers that helped fuel the excess supply in the housing market.

One of the problems with the media and Warren Buffett is that they often try to over simplify what he says, boiling things down into sound bytes that don’t give the full picture. This is definitely the case with derivatives.

A number of commentators have criticized Buffett for investing in derivatives contracts after calling derivatives weapons of mass destruction. The thing is, Buffett was criticizing how most financial institutions were using derivatives. For the most part, companies like AIG were writing billions upon billions of dollars worth of CDS contracts using faulty math behind defaults. They were totally unrealistic. We see now that Greece tried to use contracts to fudge their budgetary accounting and make their deficits appear artificially lower. These kinds of uses of derivatives are pretty stupid and can cause the mass destruction that Buffett described. Actually, if you look at AIG and the state of Greece, you could argue that they have already caused that destruction.

The Berkshire approach to derivatives is different. For the most part, Buffett looks at these like he does insurance. He is trying to find mispricings where the risk is limited and the duration from now till when money must be exchanged is sufficiently long enough to earn enough from the float to limit any kind of damage that would occur if Berkshire is on the losing side of these contracts:

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.

It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.

Most people incorrectly assume that value investing means just investing in well run large cap stocks. It doesn’t. Value investing is buying a dollar for 50 cents. Where that dollar exists should not matter. A good investor should be willing to travel across asset classes in search of these bargains, and that is what great investors like Seth Klarman, Prem Watsa, and Warren Buffett have done in the past.

The entire letter is worth reading, especially for getting a more detailed insight into some of Berkshire Hathaway’s lesser known subsidiaries and overall performance for 2009.

Whitney Tilson just put out a great presentation describing why Berkshire Hathaway (NYSE:BRK.B / BRK.A) is undervalued. I wanted to highlight a few points from the presentation:

Tilson notes that Berkshire Hathaway is transitioning away from being primarily an investment company, to being driven by earnings from its operations. A number of analysts have noted that one of the reasons for the Burlington Northern acquisition was to lessen the need for a great investor to manage Berkshire’s huge cash horde. The acquisition is expected to add a steady stream of income from a business that Buffett believes has great long-term prospects.

Tilson goes on to use a methodology for estimating Berkshire’s value that comes straight from Buffett himself: you take the company’s per share investments and add them to pretax earnings per share with a multiple attached. The chart shows that usually, the market ends up exceeding the company’s intrinsic value, although recently this has not been the case. There could be a number of reasons for this, including the recent financial crisis.

Using Tilson’s $142,500 estimate, we see that given current prices, Berkshire is undervalued by about 26%.

Lastly, Tilson points out that even though the intrinsic value of Berkshire Hathaway is just $142,500, the company should grow and add to cash within a year. Adjusting for these changes, Berkshire Hathaway may be undervalued by as much as 44%. Be sure to read the full presentation for more details on Tilson’s analysis.

This is great news for any Berkshire Hathaway shareholder. By being added to the index, managers are going to be forced to pick up B shares and in turn help drive the stock’s price up:

Buffett, who is Berkshire’s chairman and CEO, wasn’t immediately available to comment Tuesday afternoon, but he discussed the prospect of Berkshire joining the S&P 500 during last week’s special shareholder meeting on the stock split.

Buffett said he expects Berkshire will benefit from joining the S&P indexes, saying it will suddenly have buyers for about 6 percent of its shares because many investment funds buy stock in the companies in the S&P indexes to mirror the moves of the indexes. And those mutual fund buyers would plan to hold the stock long-term, which is what Buffett wants.

“Over time, if it’s in the S&P, I think it’s a slight plus for shareholders,” Buffett said last week.

Buffett’s Berkshire to be added to S&P indexes

Now about that Dow Jones Industrial Index…

Quick Notes:

-Wells Fargo has done exactly what they said they could do. Their $40B of pre-provision earnings could handle large losses of $20B.
-The government did the right thing in acting fast in the financial system

Q: Why the share split?
A: We wanted to give a cash and stock option for the shareholders of Burlington Northern. It was an easy decision.

Q: Berkshire Hathaway a member of the S&P 500?
A: Never talked to S&P about it. It would be a plus for shareholders.

-Wells runs a terrific bank. A very customer oriented bank. Their revenues will come through. When the stress test was done, the people evaluating them were way off on the revenues. Wells felt that people did not understand their revenue ability. Wells will never disappoint on revenue.

Q: The Bank tax?
A: I don’t understand that. Some banks like Wells were forced to take it. The government made a lot of money off of banks with TARP, where they will lose money is with the automakers.

Q: What about the AIG bailout?
A: The banks got paid but so did millions of other contract holders.

Q: Should the banks be backstopping commercial and investment banks?
A: I don’t think the government should be backstopping Morgan Stanley or Goldman Sachs.

Q: How do you get around the idea where the commercial bank is with the investment bank? This notion of too big to fail.
A: The banks that were too big to fail had management problems at the top. The board of directors should have something where if the bank has to go to the federal government to be saved, the CEO and CEO before of two years should sign something where they get wiped out. The CEO should say: If this place goes down, I’m busted.

Q: You are saying guys like Chuck Prince?
A: Yeah.

Q: Should there be a split forced by Congress? Or the director plan like you said?
A: I would like what I just suggested. I think banks should be reigned in on leverage and activities they can’t engage in.

-Buffett trusts the Fed. to do more financial regulation on banks.
-Congressional elections are a reflection of voters, they don’t feel good about the health bill and the economy. Those feelings converged with feelings on the candidates.
-American people’s expectations were probably too high on the economy. To President Obama’s credit, he tried to dampen their feelings too. When it grinds along, they unreasonably expected better things by this point and that wasn’t in the cards.
-The stimulus bill could have been used in a way that has a faster more immediate impact.
-Some of the benefits of the stimulus bill were wasted because they were Washington as usual.

Q: Does legislative uncertainty affect corporate hiring?
A: At Berkshire, we are down 25,000 in employment off of base in the last year–year and a half. Our carpet business is down to 6,500 people. That is concentrated to a small area in Georgia. We will hire people when the orders come in. We have 1,000 people down from the peak in our Acme Brick business. We hire based on what is happening in our order book. We aren’t getting orders yet so we aren’t hiring. Unemployment will be a tough figure.
-Until things improve for the economy, the American people will remain unhappy. The Christmas tree approach to legislation where you add on earmarks is not encouraging to the American people.

Q: What do you think about the Kraft deal?
A: I feel poor. They sold a fine pizza business – Kraft sold it for what they said was $3.7B for it but because it had practically no tax basis they really got $2.5B when Nestle is willing to pay $3.7B. That business earned $280M pretax last year, they sold it 9X pretax but then paid 13X EBITDA for Cadbury. They are paying more than that, EBITDA is not earnings, depreciation is a very real expense. Then on top of that they are spending $1.3B on rearrangements at Cadbury, $390M of deal expenses, they are using 260M of stock that their own directors are saying is significantly undervalued, when they calculate the 13 they are using market price not what they think it is worth. So, the actual multiple is 16 or 17 and they are selling earnings at 9X.

I’ll add the video when it comes up:

Warren Buffett tells CNBC in a live interview on Squawk Box this morning that he has “a lot of doubts” about Kraft’s planned purchase of Cadbury and that he “feels poor” in the wake of the deal.

The deal does not need to be approved by shareholders, but “If I had a chance to vote on this, I’d vote no.”

…Despite his criticism, Buffett rejected Joe Kernen’s suggestion that he show his displeasure by selling Berkshire’s stake of over 9 percent in Kraft. That, he says, would be too expensive because Kraft’s stock is still “undervalued” but not as undervalued as it was three weeks ago.

Buffett also strongly criticized Kraft’s recent sale of a pizza business to Nestle at a price he believes was too low.

But he says Kraft CEO Irene Rosenfeld is a “good operator” and a “good person.” He has “cordial relations” with her despite their “difference of opinion.”

Warren Buffett: I Would Have Voted Against Kraft-Cadbury Deal (CNBC)

Buffett’s displeasure for the Kraft (NYSE:KFT) is not new, weeks ago Buffett lamented Rosenfeld’s wasteful plan to issue stock for the deal. Now, with the cash portion of the bid raised, the deal is less dilutive but still too rich for Buffett. Remember that he thought the deal was fairly valued when Rosenfeld made Kraft’s initial offer. Finally, it looks as if Buffett thought that the decision to sell Kraft’s pizza business was a poor one, going for below average multiples (9X) just to generate cash for raising the company’s bid.

On the other hand, Bill Ackman of Pershing Square seems very positive about the deal. He feels that the margins and the international market access that Kraft will gain from the deal will add tremendous value. It’s always interesting to see great investors disagree and it shows you that investing is often more art than science.