Notes from Berkshire Hathaway Annual Shareholders' Meeting:GENERAL BUSINESSAs usual, the procedural stuff was dispensed with quickly and a proposal to extend shareholder charitable contribution program to B-shares was defeated.FIRST QUARTER:Buffett gave a preview of Q1 results that will come out later this week. All information he shared will be posted on BRK website before Monday's market open. Much like many have suspected, 2003 could shape up to be a great year for BRK. Q1 pre-tax operating earnings were $1.7 billion before any gains from marketable securities (coincidentally, securities gains added another $1.7 billion). Buffett made the comment that these are “the best operating earnings we've ever had”. Munger quipped “I hate to be the optimist but we've really added some delightful businesses”.More importantly, the insurance businesses had a $290 million underwriting profit (would have been even better but results include $140 million of “pain-today” retrocessional losses). That's an annual run rate of over $1 billion underwriting profit!Float grew by $1.3 billion to stand at $42.5 billion at the end of Q1.Needless to say, Buffett thought insurance business “was in great shape” although “float probably won't grow much” for the rest of the year. Buffett predicted that over the next five years, BRK should be able to operate at zero, and possibly in some years, positive cost of float. It sounds like in an environment of very low interest rates and excess cash on the balance sheet, Buffett is incenting his insurance divisions that underwriting profit is more important than growth in float.GEICO saw premiums grow by 16% in Q1 and April came in at +17%. GenRe made an underwriting profit and “was not a drag anymore”. Ajit Jain made a big underwriting profit and the other primary insurers “doing remarkably well”.Non-insurance businesses did not do great and they are feeling the effects of a soft economy (other than homes/autos). Buffett believes we are still in a soft recession and that economy will remain sluggish.NEW ACQUISITIONS – MCLANE & CLAYTON HOMES:Buffett shook hands with Wal-Mart to buy McLane's, a large wholesaler to convenience stores, Sams Clubs and Quick Serve Restaurants. McLane's will do $22 billion in revenues this year but makes 1% pre-tax margins. In a business with very narrow margins, you have to perform very well and Buffett believes McLane's does this. He welcomed their CEO (Grady Rozier) who grew business from $3 billion in 1990 when Wal-Mart took ownership. With Wal-Mart's ownership, certain potential customers wouldn't do business with McLane's because it would benefit their competitor (Wal-Mart).Was approached by Goldman Sachs and Wal-Mart CFO came to Omaha last week. They shook hands on deal. “Deal makes sense for both sides. Wal-Mart knows we will be a good owner”. Deal still needs to go through Hart-Scott-Rodino but expects this to be a non-issue and in a few weeks, McLane's will be a part of BRK. Clayton Homes deal came about because 40 students from Univ. of Tennessee-Knoxville come to Omaha every year for a Q&A with Buffett. Students presented Buffett this year with a gift – book that is autobiography of Clayton Homes founder. Buffett followed the industry and called Kevin Clayton after reading the book. Buffett suggested price at which BRK would be interested in acquiring Clayton and deal came about.Manufactured home industry got into trouble because “it went crazy on credit” 4-5 years ago. Conseco serviced $20 billion of mfg. home credit and also got into big trouble. BRK participated in bankruptcy of Oakwood. All firms lost ability to securitize loans. Last year 100,000 new homes sold, 90,000 came back as repo's. Even for Clayton, who had been careful with loans, financing was getting difficult. With BRK as financial backer, Clayton should do well. “We will be useful to them. Buffett feels this is an interesting industry and manufactured homes will continue to have an important share of residential market.EXECUTIVE JETNet Jets will post a significant loss in Q1, due to writedown of planes. Made a modest operating profit in US, operating loss in Europe. Used plane market, entire plane market is very soft. Too many planes has affected pricing of new planes. Despite loss, Buffett maintained it is a popular product and still growing as a business.Three main competitors are all losing significantly on operating basis. Market share as measured from FAA in terms of value of planes is 75% for NetJets and growing. Europe market is one-tenth the size of US and half miles flown in Europe are from US owners.Buffett thinks there will be a shakeout. Noted Raytheon 10-K has “interesting info”. Shakeout may be soon.The long-term business model is still sound. Future market could have 10X the people flying today, however Buffett does not see an operating profit today.FLOAT AS EQUITY – GROWTH OF FLOAT:BRK float is $42.5 billion. Entire US P/C market has probably $500 billion in float so BRK has 8-9% of US P/C float and US is big part of world market. Buffett insisted that it will be difficult to grow in the future and it is really important that its at no cost. If $42.5 billion can be obtained and maintained at no cost, it is equity-like, except that it can't be counted in a liquidation. But it has the utility of funds derived from equity. “If we get float at close to zero it has the utility of equity”.P/C business is not a great business, every now and then industry gets off track. It's a commodity and most P/C insurers don't get float at zero cost. “However it's a great business for us”.Munger added that with interest rates as low as they are now, float isn't worth as much to us short-term. But we have a long-term view.Buffett added that BRK has $16 billion in cash on hand as of March 31st. Currently getting 7/10 of 1% after-tax on that cash. “that doesn't make us salivate” But part of that money was used in $1.5 billion McLane's acquisition.LIMITATIONS OF BLACK-SCHOLES MODEL IN OPTIONS PRICING:Any option has value, but you have to understand that value. You don't need B-S to understand that value. “People who are slick, get options for very low dollar amounts”B-S attempts to value options mechanistically. Biggest variable is past volatility. But this is not always the best indicator. BRK has low beta but that doesn't mean that the value of a BRK option is less than another stock with high beta. It's a mechanical system that misprices from time-to-time.Last year, we revealed that we made $120 million on a bet at the expense of “other side” that used mechanistic system. (S&P option?).Munger added that B-S is a “know-nothing” system. If price is teaching you, then B-S is OK. However, the minute you get into a longer-term type option – its not so useful. Costco, in a relatively short period issued options with strike prices of $30 and $60, B-S valued the $60 option higher than the $30 option – “its insane”.Buffett added that he would like it if you could give him prices on 3-year options for a few hundred companies priced by B-S and let him choose among them. He noted that was part of the thinking in SQUARZ where he gave up option value but got more value back.ALIGNING EMPLOYEE COMPENSATION TO SHAREHOLDER INTEREST:Munger said that stock option system will give great reward to some and nothing to others giving great effort. Rewards are capricious.Buffett added that BRK inherit options from acquisitions. GenRe employees benefited from other BRK subsidiaries operating performance at a time when GenRe didn't deliver much over a number of years. He believes in tying performance to compensation however he has seen more misdirected compensation in last ten years than previous 100. During 1990's there has been wealth created but also large wealth transfer. Need to include opportunity cost of capital and tie rewards to operating performance sphere of control.Munger added “if we are right, the implication is that 99% of corporate compensation systems are crazy. We're not against rewards for people who make big contributions”Buffett chimed – executive compensation is not a market-based system like a baseball player salaries. Player negotiates with owner who lays out his own money. There is a “parity of concern”. Labor negotiations are like this too. You sit across the table and try to negotiate with union and there is a fight over each transaction in the contract. For compensation committees, “its like play money” Its other people's money. Most executive compensation is not a real negotiation.EXPECTATION OF INFLATION AND OUTLOOK FOR STOCKS:No question that low inflation is a big plus for investors. Low inflation of 2% + GDP real growth of 3% = 5% nominal GDP growth. Over the long-term, corporate profits will also grow 5%. Add dividends of 2% and you can expect 7% total returns. Starting point in terms of market price level (overvalued/undervalued) will affect that somewhat but basically expect 7%. Problem is when people are expecting 14-15% as happened in late 1990's. Math isn't bad, just bad relative to what investors were expecting.7% isn't the end of the world. You have $10 trillion economy that may someday turn into $20 trillion. You have 100 million people in US workforce using your capital to create 10 trillion of goods and services.High inflation can turn real results into zero or even negative returns.STATE OF ECONOMY – OUTLOOK FOR CONSUMER/RISING INCOME INEQUALITY:Consumer better off today but not dramatically better. Buffett doesn't have broad ideas about this but thinks American economy will do OK. Remembers when it used to cost $18 to make station-to-station call to San Francisco – this represented an average week's wages. Consumer businesses are soft. Furniture business was soft in Q1. Buffett thinks we have been in recession for two years. GDP is up 2% over that time, but population is up too, so GDP/capital maybe only 1% growth. Its GDP/capita that counts. GDP lately also included extra police, extra security at airports – its not what we want, but what we need and it goes into GDP. Cost of war goes into GDP. If we lose planes and have to build new ones to replace lost fighters – that goes into GDP. In Buffett's opinion quality of GDP growth lately isn't something that's talked about.Munger added that figures about income inequality obscures that people move through income bands. If Dupont have to clip coupons and come down and someone invents Pampered Chef and moves up it creates churn. Churn is what makes people think the overall system is fair.ACCOUNTING BOOK REFERENCE:Buffett admitted he didn't really have one. Mentioned some text he read in college. It's a framework that you build upon by reading annual reports and business magazine articles that contribute to knowledge. It's a lifelong process. “If I can't understand 10-K, then maybe management doesn't want me to understand.”Munger added “Asking WEB about good books on accounting is like asking him for good books on breathing.”INSURERS RISK EXPOSURE IN CREDIT DERIVATIVES:Credit guarantees has become very popular with standard p/c insurers, many of whom really don't know what they're doing. Its easy, get money in exchange for a piece of paper and a promise.In mid-1980's, Mutual of Omaha went into reinsurance market. They didn't write many contracts but succeeded in losing half their equity which had built up over decades. “if you're willing to write underpriced policies, people will find you. Even if you're in the middle of the Atlantic, brokers will swim to you ….with fins showing.”Cash comes in and it seems easy. GEICO gained $70 thousand in premiums from some policies written some time ago. The claims on those policies have been $93 million … so far.Buffett continued “back-tested arrangements based on studies of risk class based on credit rating are OK but the problem is correlation. Risks can accumulate. Example, the telecom industry was an unrecognized concentration of risk.VALUE OF AAA RATING TO INSURERS – IMPACT ON SWISS RE, MUNICH RE:AAA rating means BRK gets offered first,….and last. But Swiss Re and Munich Re losing AAA doesn't mean BRK is accepting lower risks or writing with less discipline. Gen Re has been tightening.Munger “I hope we're better underwriters than Munich Re…”Buffett cuts Charlie off – “Munich Re is a fine company. Remember Charlie, we praise by name, and we criticize by category.”BRK BUYING REMAINDER OF COLOGNE RE:Press misreported facts on this deal. GenRe acquired Cologne Re with a put/call feature on the remainder. We (BRK) bought with intention to buy all of Cologne Re – it was a fait accompli that we would exercise option when it came time. Put/call feature became effective this year and something had to be done and we always knew we would own all of it. Press implied that something was new but it wasn't.LONG-TERM VISION FOR MEC:Buffett feels PUHCA is outdated but can't predict that it will be repealed. Feels BRK brings something to the energy field. With or without PUHCA repeal, MEC is already significant and will become bigger. Its certain that BRK will look at big deals, however whether they get one made is uncertain. “These energy businesses aren't lemon-aid stands” so acquisitions if they happen will be big.MEC management has contributed to BRK by helping with other deals that MEC couldn't do, but BRK could and they didn't get any compensation for it.Munger feels that energy is an enormous field and that “modern civilization needs energy”.FORTUNE ARTICLE – DERIVATIVES WARNING:Carol Loomis edits annual Chairman's letter. Buffett thought derivatives section would benefit wider audience than reads BRK report. Section doesn't talk about BRK results so no reg FD issue in pre-releasing.Buffett predicted again that there is a low, but not insignificant risk that in 3,5, 20 years derivatives could accentuate in a significant way systemic problems. He hoped article would be a mild wake-up call. Saw it recently in the energy field and it destroyed or nearly destroyed some companies.In 1998, credit markets nearly paralyzed because of small hedge firm LTCM. Buffett and Munger are thinking about low probability events all the time. Munger added that in engineering, people put in safety systems and safety margins – especially in atomic power plants for example. In finance, people “don't give a damn… and the accounting doesn't help.” Munger said he is more negative on this than Warren. In 5-10 years “I'd be surprised if we don't have a major blow-up”.Buffett added Coca-Cola can deal with forex change, but when KO lays off currency risk and other firms do too and it concentrates in a few hands. And those firms are vulnerable due to weakness of those institutions due to high leverage and intersection between those institutions who all have the same culture – there's a risk of a systemic weakness.FANNIE MAE/FREDDIE MAC – DERIVATIVES EXPOSURE:Buffett explained that an operation has a problem in matching assets and liabilities duration and timing inherent in a mortgage instrument due to optionality. Fannie Mae can have a 30-year instrument if it's a bad deal (for Fannie Mae) and a 30-minute instrument if it's a good deal (consumer refinances). And the consumer has gotten savvier and penalties aren't that high so consumer isn't shy about getting a better deal if its in consumers' interest.If you run a huge institution, that is highly leveraged, you'll try as hard as you can to match assets and liabilities – but its not easy to do. Fannie tries to do that in a number of ways, including using derivatives and they're very, very good at it.However, it can't ever be perfect. The thing that destroys institutions are the five-sigma and six-sigma events. Financial markets don't lend themselves well to modeling these in the real world. Gaps or discontinuities can cause a highly leveraged institution to come down.I'd be terribly concerned about optionality built into assets. I'd try to reduce those gaps in a conservative way. I'd also worry about counterparties. The terrible thing that is happening to you is probably also happening to your counterparties. Munger added – Fannie Mae and Freddie Mac weight risk counterparties won't pay lower than we do. And counterparties are behaving in a way that is much less conservative than Fannie and Freddie.GEN RE – GOODWILL STATUS/POSSIBLE IMPAIRMENT:If 1998-2001 was representative of the future, then you'd be looking at an impairment charge. GenRe is worh more today than when we bought it. Buffett gave example that will be in 10-Q of changing discount rates on workers comp from 4.5% to 1% to be more conservative. He was emphatic that GenRe will create zero cost float.DISCOUNT RATE TO USE AT A TIME OF LOW INTEREST RATES/HOW TO THINK ABOUT OPPORTUNITY COSTS:Buffett uses the same discount rate across all securities he is looking at. Doesn't use current short-term rates. In fact, he maintains same minimum threshold whether rates are at 6-7%, 3-4% or 1%. Doesn't get hooked on making long-term investments locking in short-term rates.Buffett's expectation from investments is 10%. He wants equities which will return 10% or more and thus set threshold at 10% which is not that high after-tax. WEB is guessing that he will get opportunities to invest at 10%. If interest rates were to settle in a prolonged period of very low rates - he might adjust this hurdle downward a bit.
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