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Author: xFatOtt Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 214614  
Subject: Some notes on the meeting Date: 5/8/2003 4:32 PM
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Here are some comments about my experience at this year's meeting. Some of this stuff will have been covered by earlier posters. These items are less of a transcript and more of the “FatOtt Experience” (which you can find at Amazon.com between the Cato Salsa Experience and the Jimi Hendrix Experience). In the interest of brevity, I'll refrain from talking about my Sunday travel or the wonderful tornado situation that made it oh-so-special.:

[Follow-up note: this turned out to be pretty long. Before you click
next
, I'm really interested in comments regarding the last section – things said in the meeting that I disagreed with.]

1. The people: This is the second time I've been to the AGM, and both times I've found the people to be very warm and friendly, which is admirable considering they've got to deal with an inflow of 15,000 self-imagined financial genii from around the world on an annual basis. [Actually, I take it back, I saw 1 semi-psychotic idiot in the NFM parking lot, blaring his horn for about 240 consecutive seconds, then actually getting out of the car and screaming curses at all of the onlookers. Very disturbing. Excluding that guy, the people were top notch.]

2. Gorat's: I had dinner at the infamous steakhouse on Friday night with EtaEqualsOne, AtlantaDon, UsuallyReasonable, howardroark, EightTrack, and GreenMartian. The service at Gorat's was quick and friendly, which makes for an excellent combination. As for the food, I was somewhat disappointed. The T-bone was moderate, while the hash browns were really dry and fairly tasteless. The prices were definitely reasonable, but I guess I just don't share WEB's taste buds.

3. The bathroom/shower in my hotel room had so many bars and apparatus that I expected to see Mitch Gaylord and Janet Jones shooting a remake of American Anthem. I probably could have rented it out as a jungle gym while I was at a meeting, but I digress.

4. The bar: howardroark already detailed the proceedings at the Liquid Lounge, so I'll just describe my conduct in the same way many internet firms describe their financial results: On a pro forma basis, excluding the effect of abundant amounts of Fat Tire beer (http://www.mylifeisbeer.com/beer/bottles/bottledetail/295/), I carried on many meaningful conversations and retain a precise recollection of what everyone said. On a GAAP basis, however, I was a bumbling, stumbling idiot.

5. The meeting: Although we arrived fairly early to the Civic Auditorium, there weren't really any good seats left. We ended up sitting in the second level, directly facing the stage. This angle was a nice improvement over my previous trip, where I had been significantly closer to the stage but kept my neck at a sharp angle for 6 hours. Rumor has it that there was a mad “land grab” when the doors first opened, which would have been fun to watch.

6. I saw a Segway in the Auditorium, my first one! Nothing more to add.

7. My favorite things from the meeting were basically a few comments that changed my way of looking at things. I think Buffett and Munger both have the ability to take complicated topics and distill the essential points and present them in an easy to understand fashion. The things I really liked:

On the subject of income inequality: Someone asked about the ratio of CEO pay to average worker pay – how it's been rapidly growing and what their thoughts were. Charlie made the comment that a significantly large difference in wealth between the classes of people isn't a problem in itself. The real measure is to look at the churn in the relative positions. If the system is structured such that people currently on the bottom have upward mobility, that's probably a good system. This point of view never crossed my mind: simple yet not obvious.

Regarding the US economy, Buffett commented on how he looked at identifying a recession based not on GDP growth, but on per capita GDP. Again, this struck me as a very meaningful measure, but one I hadn't considered before. He also described how all GDP is not equal, which is something I had considered. Roughly the idea that if increased expenditures are necessary to maintain current utility (increased spending on security and defense, for example), that spending shouldn't necessarily be considered as equal to GDP growth of existing products and services through increased productivity.

Finally, with regard to the bid for Burlington, and the associated breakup fee. Buffett talked about thinking of acquisition breakup fees as a put option premium. This blew my mind because it's so simple and so obviously right, yet I didn't see it this way before this weekend. This item really changed my perspective on how to think about breakup fees and I agree that the breakup fee in the Burlington case was probably insufficient premium for the potential liability incurred by writing a multi-month option on buying a company. I'm not sure that bankruptcy judges will ever view breakup fees in this way, but I think they should – it makes good economic sense.

8. Unfortunately, I was disappointed in some of the things Warren and Charlie said. I'd really love to know the degree to which I disagree with their statements, primarily because they may have just taken some shortcuts to simplify the subject.

First, with regard to valuing options. Right off the bat, despite Warren's repeated claim to the contrary, beta is not volatility, and it irritates me to the point of channeling datasnooper when he claims that it is.

Moving on, it's clear that Warren and Charlie think that Black-Scholes is a poor way to value long-term options. I'd like to know why. Specifically, is there something within the B-S formula that makes it improper for valuing options? Is it the assumption of lognormal stock returns? Could it be that the combination of negative autocorrelation in returns and the tendency for employees to exercise before expiration leads to options that are worth more than the theoretical model would suggest? Or is it simply that estimates of future volatility are ridiculously imprecise ? [Remember that the Black-Scholes formula doesn't call for using prior volatility, it's just that's past volatility is often the easiest estimate of future volatility over the option period, which is what the formula really calls for.] Or even more simply that the stock price at the point of option grant often differs from intrinsic value?

I have a feeling it's the last point that drives Charlie's distaste for the valuation model, especially when he offers the illustration wherein an option to buy at $60 is priced by B-S as more valuable than the option to buy the same stock at $30. If that's the case, it's consistent with their general belief that markets are not efficient. But it also means that, if they want to value options where the current stock price differs from the intrinsic value, they can still use Black-Scholes and substitute the intrinsic value for the current stock price. If it's something else that makes them shun the B-S formula, I'd be really interested to hear it.

The second thing that I disagreed with at the meeting was the disdain for cost of capital measures. Certainly, as Charlie stated, opportunity cost should drive most decisions. However,

- Berkshire charges a hurdle rate on reinvested cash to their subsidiaries. From the subsidiary perspective, this hurdle rate is their cost of capital. It's easy to measure and use: any project that will exceed this hurdle rate/cost of capital should be undertaken. The only difference between the subsidiary perspective and a stand-alone firm perspective is that the stand-alone firm doesn't precisely know the cost of capital. But that doesn't prevent the cost of capital from being an important measure. They still need some metric to evaluate whether it's worthwhile to use current funds or issue equity in order to take on some project. If not measured in terms of cost of capital, what do you use? Of course it's easy to calculate a cost of capital if you're a Berkshire Hathaway company, it's just
Cost of Capital = Rate that Warren sets
.

- From the headquarters perspective, they say cost of capital is equal to opportunity cost. Well, yes, because they're in a position where they don't have to ever go to the equity or debt markets to get funding. They're swimming in funds – the only decision is where to deploy the funds. That's just weighing a bunch of opportunity costs against each other. But how do they know that the next-best-available asset gives a high enough return? What's the benchmark? How did Warren know that pricing of the SQUARZ deal was advantageous to Berkshire? I suspect that both Warren and Charlie would agree that a firm can make better decisions knowing its cost of capital than it would without. I also suspect that the calculations they scorn are those having some relation to beta, while there are obviously different methods of coming up with it.

At the end of the day, it was a great meeting and a great experience. As loony as it sounds to a lot of people, I think making at least one trip to Omaha to attend this event is a very worthwhile experience.
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