The Buffett Blog

It was with unusual pleasure that we noted Berkshire’s purchase of BUD this week. What a complementary consumption alternative to Coke, all while increasing shareholder value. And BUD sports 50% of the beer market (talk about scale…) and quite carbonated recent ROE numbers. Munger talks about the benefits of scale here, but more in a subscription only OID article which is the best summary of strategic advantage I have ever read, here (subscription only). In the headlines you’ll note Monopoly is now available with Berkshire Hathaway properties – my British friends would describe this as OTT (over the top). If you really are keen, look here for the bobble heads. Finally, last headline -- is Cousin Jimmy a reverse indicator on NY property? I recently heard of a 750sqf 1 bedroom in Nolita for $1.3m, almost $2k/sqf. Reminds me of my days in HK, where soon after I left the average property price was down more than 50% (I’ve seen reports of 65%, and this I note, is average!!!). I believe the average price of luxury prices in HK (on the Peak) was (HK11,000) psf, or USD$1400 (adjust this for relative GDP and the HK heights are just over USD2k psf). Gives me pause… Especially since Nolita is far from the height of luxury. It’s nice, but it ain’t Central Park South. Anyone see the news on the China Peg? No surprise here, but if it goes through, it may encourage obstructionist tariff seekers – never a good thing.

Newsy days, and it will only get busier when the annual meeting convenes next week. I’ve got my plane ticket, do you?

Headlines: Fitch reviewing Berkshire’s triple AAA rating, which is about the biggest joke I’ve seen in a while. $40b in cash not enough? Unless they know something about earthquake risk in CA, it seems they are a tad late. Pay attention to AIG and GM instead. Executive Jet keeps selling airplanes, though I wonder if anyone at NetJets is watching the developments at Eclipse? Then a few articles on Cousin Jimmy, playing here in Chicago for Labor Day at Cubs Park, nominations of “Jimmy for Pope”, and then Jimmy’s upcoming movie filming this summer. Dare I suggest a cameo by cousin Warren? Then, some investing tidbits: beware the oil rush, getting paid for liquidity in the flea market that is the pink sheets, and finally, a great summation of the new business model that Google has created (software based on advertising revenue rather than licensing revenue – software sold like magazines), and how it worries Uncle Bill. Last but not least, Jeremy Grantham’s market summary which always makes for great reading.

Three articles of note out there this week, one in NY Times, one in Barrons (subscription) and a mildly interesting Morningstar piece on tuning out the noise. Barrons writes a complimentary piece, feeling secure about BH as Fort Knox in wake of scandals. NYT paints slightly more lurid picture of Gen Re’s role in notorious insurance transaction, including ‘repapering’ the trade on Gen Re’s side. Perhaps industry standard, but sounds sketchy. Munger’s law firm has known since January, but no one yet has been fired. Perhaps NYT seeing fire where there is just smoke? Who knows… Buffett interview on Monday and Greenberg on Tuesday next week. May make for bland news as stories are retold to accompany the photographs.

John Bogle, the father of indexing, on that topic at the 60^th Anniversary Conference of the Financial Analysts Journal.

That message is simple: Gross return in the financial markets, minus the costs of financial intermediation, equals the net return actually delivered to investors. While truly staggering amounts of investment literature have been devoted to the EMH—the Efficient Market Hypothesis—precious little has devoted to the CMH—the Cost Matters Hypothesis. However, to explain the dire odds that investors face in their quest to beat the market we don't need the EMH. We need only the CMH. Whether markets are efficient or inefficient, investors as a group must fall short of the market return by precisely the amount of the aggregate costs they incur. It is the central fact of investing.

Note that Buffett in the past has acknowledged the usefulness of indexing. From the 1993 Annual...

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when "dumb" money acknowledges its limitations, it ceases to be dumb.

Good article in the NY Times, with an interview with Michael Jensen from HBS. Our Kevin Murphy also gets a brief mention.

Q. After you proposed this in the Harvard Business Review, the use of stock options grew rapidly. But then you soured on the idea. Why?

A. Compensation committees wrongly looked at options as free, and awarded too many to too many people. It diluted the stock. And most stock option programs still rewarded management for building the empire, not the actual value. There was no penalty for investing in projects that did not return the cost of capital. When those projects pumped up the stock, management got a big win - but the shareholders would have still done better if the money had been paid out in dividends.

Q. Lots of companies are switching away from stock options to outright grants of restricted stock. Does that solve the problem?

A. No. Say I offer you $1 million in restricted stock - even if you think the stock will go down 10 percent, you're still getting $900,000, and you're happy as a clam. I'd be handing over a large amount of wealth, yet penalizing executives only slightly for the decline in the value of the stock.

Q. So the maximum stock price is the holy grail?

A. Absolutely not. Warren Buffett says he worries as much when one of his companies becomes overvalued as undervalued. I agree. Overvalued equity is managerial heroin - it feels really great when you start out; you're feted on television; investment bankers vie to float new issues.

But it doesn't take long before the elation and ecstasy turn into enormous pain. The market starts demanding increased earnings and revenues, and the managers begin to say: "Holy Moley! How are we going to generate the returns?" They look for legal loopholes in the accounting, and when those don't work, even basically honest people move around the corner to outright fraud.

If they hold a lot of stock or options themselves, it is like pouring gasoline on a fire. They fudge the numbers and hope they can sell the stock or exercise the options before anything hits the fan.

A Morningstar article speculates that Buffett is acquiring shares of Wal-Mart. At the 2004 annual, he spoke about making an "error of omission" after being scared away from the stock after a small price move. The big box retailer currently trades at 20x 2004 EPS and 16x projected 2005 EPS, and is below 2000 highs - it certainly looks relatively cheap.

Our own Steve Kaplan on Berkshire Hathaway in an ABC News article...