Issue 23 • May 6, 2009

What Would Warren Do?

The atmosphere outside Omaha’s Qwest Center was more like a rock concert than a staid annual shareholder’s meeting. If you didn’t know any better, you could easily believe the endless crowds standing in long lines at every entrance to the arena were gathered to see U2, the Rolling Stones or maybe Jimmy Buffett.

But this was 7:00 am last Saturday morning ... not the usual starting time for a rock concert. Of course, the throngs of faithful Berkshire Hathaway stock holders — over 35,000 strong — were all here to see Warren Buffett, not Jimmy Buffett.

I was one of these pilgrims traveling to Omaha this past weekend for Berkshire’s 2009 annual meeting, which had record attendance. Every level of Omaha’s Qwest Center, a venue normally reserved for NCAA basketball games and concerts, was packed to the rafters. Floor seats, lower deck, upper deck — even the seats behind the giant video screens where any view at all was a view of Warren’s back — were jam-packed with “fans.”

In fact, the Qwest center is configured for less than 20,000 so thousands more watched the annual meeting from video screens in the lobby or on the convention center floor. It was quite a spectacle to behold. Why such an overflow crowd for a business meeting? Berkshire Hathaway is no ordinary business and, of course, Warren Buffett puts on one heck of a show!

The World’s Greatest Investor Posts Worst Year Ever

Warren Buffett is widely considered one of the world’s all-time great investors. Since he (and partner Charlie Munger) took the helm at Berkshire in 1965, the company’s book value has grown at a compound rate of 20.3% per year — that’s about TWICE the return of the S&P 500 Index over the same period.¹

But Warren has repeatedly warned the faithful that such returns are impossible to repeat going forward, especially given the growing size of Berkshire Hathaway and its many subsidiary businesses.

Last year, those warnings finally caught up with Berkshire’s share price.

The stock was very hard hit in 2008, falling about 32% last year, while the S&P 500 lost 37%.² Measured by book value, however, Berkshire Hathaway’s value per share declined only 9.6% in 2008 — but that was still the worst performance ever recorded, at least under Warren’s watch.³ So Berkshire shareholders were understandably anxious to hear what Buffett had to say about last year’s epic decline, the ongoing financial crisis and his outlook going forward.

The question on everyone’s mind at the Qwest Center Saturday morning was: “What would Warren do?”

Warren (and Charlie) delivered plenty of answers, during a tour-de-force Q&A session that lasted for over five hours, with a lunch break in between. I only wish Jimmy Buffett played that long when he’s in concert!

‘America’s Best Days Lie Ahead’

Warren’s overall message was one of cautious optimism. Of course, he is well known as an upbeat and optimistic fellow to begin with. In this year’s annual report to shareholders he candidly proclaimed, “Our country has faced far worse travails in the past ... without fail, however, we’ve overcome them.” He also points out that in the last century, despite “two great wars ... the Great Depression ... and virulent inflation ... the real standard of living for Americans improved nearly seven-fold during the 1900s.”⁴

So it was no surprise on Saturday when Warren repeated that there’s no question “over time, people will live better and better in this country, because we’ve got a system that works. It unleashes human potential. We keep moving forward in fits and starts, now we’re sputtering somewhat, but opportunities will win in the end.”

He also made no bones about the challenges facing our economy and financial system.

In his annual report to shareholders, Warren admits that “investors of all stripes were bloodied and confused” by last year’s bear market. A period when “dysfunctional” credit markets “soon turned non-functional,” leading to “life-threatening problems within many of the world’s great financial institutions.”⁵

Stirring the Kool-Aid then Drinking it Themselves

On Saturday, he explained further that “in mid-September last year, we faced a situation as close to a total financial meltdown as you could get ... we were looking into the abyss.” The problem, as he sees it, is a financial system run amok due to a combination of too much greed, too little risk control, and not enough regulatory oversight.

At the annual meeting, Warren talked about the rise of securitization and other derivatives that have poisoned the financial system, saying “These people that were stirring up the Kool-Aid ended up drinking it themselves and they all suffered. You shouldn’t be doing something just because everyone in your industry is doing it. We ran into the same problem at Salomon Brothers many years ago.” Warren was specifically referencing a Treasury bond scandal that embroiled the former Wall Street powerhouse during the 1980s. This episode caused investor Warren Buffett to briefly take the reigns as Salomon’s CEO in order to clean up the mess.

This just goes to show you that nothing on Wall Street succeeds like excess, which has often led to repeated financial catastrophe in one form or another over the years. The current crisis is just the latest in a very long line that includes: the ‘Great Crash of 1929’, the 1987 crash, the junk-bond scandal that helped ignite the S&L crisis in the 1980s, the dot.com bubble in the 1990s, and the recent housing bubble ... just to name a few.

One question asked was whether we could do a better job educating future generations about “financial literacy” as a means to help prevent future financial crises. Warren’s answer: “There’s a problem with financial literacy in our current generation!”

Still, Warren gives the government (both past and present administrations) some credit for doing “the best they could considering the circumstances” in responding to the current crisis. Or, as he said in the annual report: “In poker terms, the Treasury and the Fed have gone “all in” to combat this financial crisis.⁶

He also warned about “unwelcome after-effects” of the government bailout binge in the report. For example, he and I are both in agreement that “one likely consequence is an onslaught of inflation.”⁷ During the shareholder meeting Warren amplified these concerns: “We are doing things in unconventional amounts ... it’s no free ride, and [it] will have huge consequences.”

More Inflation ‘Certain’

On a more poignant note, an 11-year old boy, one of the lucky few who won a lottery drawing for the chance to question the Oracle of Omaha, asked how inflation might affect his generation. Warren answered “It is certain we’ll have more inflation over time. We are following practices now to stimulate business that will definitely have inflationary impact down the road.” In other words, it is not a question of “if” but “how soon” the deflation scare of today is replaced by renewed fears of inflation tomorrow.

“The ultimate price,” he said, “will be shrinkage in the real value of fixed income assets down the road.”

Warren also offered a solution, saying: “the best defense against inflation is your own earning power, or the earnings power from owning a wonderful business.” With that, he raised his trademark can of Cherry Coke to the faithful, a shining example of what he considers a “wonderful business” ... and at Weiss Capital Management, we agree!*

“I will guarantee you that the dollar will buy less, 25- or 30-years from now, and it may be substantially less,” Warren explained. “The deficit spending by governments around the world to combat the downturn is going to cause all currencies to buy a lot less over time. That isn’t going to happen in the next year or two, but it doesn’t mean markets won’t start to anticipate it. You can bet on inflation!”

Warren’s Outlook on Business, the Economy and Housing

As far as business and economic conditions in general, however, Warren wasn’t all that enthusiastic. In the annual report he wrote: “We’re certain that the economy will be in shambles throughout 2009 — and, for that matter, probably well beyond,” although he correctly goes on to say that this “does not tell us” whether stocks might “rise or fall” in the near term.⁸ Nevertheless, stocks have certainly enjoyed a robust rally over the past several weeks, with the S&P 500 well above its March low. (It remains to be seen if this will be sustainable — in our opinion it won’t be.)

On Saturday, Warren went into considerably more detail, admitting that Berkshire’s vast array of businesses “are anywhere from significantly to drastically impacted by the recession. “All of our business results, with a few exceptions, are down.” He went on to say that “retailing, manufacturing, and service businesses” have all been “hit very hard, especially manufacturing related to housing.”

Retail businesses have been severely impacted, “with high-end hit hardest due to big changes in consumer behavior.” He went on to warn that “the experience of the last few years may last a long time. Real estate (in particular, shopping centers) may be a tough business to be in for a very long time.” Meanwhile, “service businesses are generally doing better, because they require less capital and can be more specialized.”

Very Slow and Getting Slower

Turning to housing, a shareholder asked where residential real estate was headed over the next year or two, a topic I have covered frequently in Weiss Advice, and continue to worry about myself. “In the last few months, we’ve seen a pickup in activity, but at much lower prices” Warren responded, “especially in the medium- and lower-priced homes. We are seeing some distortions due to foreclosure moratoriums, but activity is returning.” He went on to explain the math behind the overhang of unsold homes nationwide.

“About 1.3 million new households are formed in the U.S. each year on average, so if you have 2 million housing starts annually, as we did a few years ago, you’re going to get into trouble. [Housing] starts are now down to 500,000 or so per year, but there’s still excess inventory on the market of about a 1.5 million homes right now.” Crunching these numbers, “it will probably take several years longer to work through this. Some markets, like South Florida (gulp!) will take even longer to recover.

“We’re on the road to a solution, but the problem wasn’t created in a day, a week or a month, and it won’t be solved that way either. In a couple years, we may get close to equilibrium in housing again.”

Warren wrapped up his outlook for the economy with some sobering intelligence about Berkshire’s vast array of diversified businesses, which provide a good reality-check on a big cross section of our economy. He said, “In terms of the figures we’re seeing from all of our businesses, the American economy is slow ... very slow ... and at the moment still getting slower. Things are going to be tough for awhile.”

Perfectly in character, however, Warren was quick to add: “The cheaper things go (in terms of stock prices), the better I like it!”

Warren’s Favorite Stock Pick?

Since returning from Omaha, I’ve seen a number of stories in the media reporting the Berkshire meeting. Not all of these stories are entirely accurate either, which is why it’s better to be there in person. Case in point, one Web site reported, “Warren Buffett says he’d buy all of Wells Fargo!”⁹

True? Maybe, but it’s only HALF the story. Warren told us the whole story on Saturday.

In March, while much of the U.S. financial sector was staring into the abyss, he was speaking to a group of college students who asked: “If you had to put all your money into just one stock, what would it be?” Warren’s answer: “Wells Fargo at $9 would be the one investment I’d put my entire net worth into.” Warren went on to say that “Wells Fargo is a fabulous bank, with advantages other banks don’t have,” such as easy access to ultra-cheap government bailout money.

He went on to explain that Wells Fargo, along with a few other banks (Goldman Sachs and U.S. Bancorp were the others he mentioned Saturday) have “plenty of equity ... and plenty of earnings power too.” Buffett clearly believes these banks will not only survive this crisis, but potentially thrive as well.

What Warren did not say on Saturday was whether or not he’d still be an eager buyer of Wells Fargo today, after the shares more than doubled from that panic low in March. Just the same, it didn’t stop the press from widely reporting that Wells Fargo is Warren’s “favorite stock.”

Not surprisingly, Wells Fargo shares surged higher right from the opening bell Monday, gaining nearly 24% in just a single day!¹⁰ Clearly Warren’s words still carry a lot of weight ... but Wells doesn’t have as much of a “margin of safety” at today’s elevated share price as it did in March.

To any of you college kids who may have bought Wells Fargo with your tuition money on Warren’s advice in March, you’re now up about 150% on your money ... in just nine weeks.¹¹ Not bad! But with stress test results due tomorrow, and Wells rumored to be on the list of banks needing to raise additional capital ... maybe now is a good time to grab your gains in this volatile market!

After all, not everyone has a holding period of “forever,” like Warren Buffett’s Berkshire Hathaway.

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

* Coca-Cola is a holding in one of Weiss Capital Management’s managed programs as of the date of this publication

Important Disclosures:

The discussion regarding Berkshire Hathaway and the mention of specific securities such as Coca-Cola and Wells-Fargo are intended to be informative in the context of the article and should not be construed as specific recommendations to buy or sell any security

¹ Berkshire Hathaway Inc., 2008 annual report: 2/27/09
² Bloomberg market data: 5/5/09
³ Berkshire Hathaway Inc., 2008 annual report: 2/27/09
⁴ Ibid
⁵ Ibid
⁶ Ibid
⁷ Ibid
⁸ Ibid
⁹ The Business Insider.com: “Warren Buffett says he’d buy all of Wells Fargo!”, 5/3/08
¹⁰ Bloomberg market data: 5/5/09
¹¹ Ibid