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Berkshire 1998 Shareholder Letter, Part 1 - Cliff's Notes Version

March 25, 2017

This is part 1 of the twenty-second in a series of blog posts that will analyze / summarize Warren Buffett's shareholder letters from 1977-2015. For all of the prior shareholder letters, see here.

 

The 1998 letter weighs in at 12,020 words, a modest 1.9% increase from 11,800 words the prior year. Berkshire's gain in net worth during 1998 was $26 billion, or 48% of beginning 1997 net worth. Most of the net gain, however, resulted from issuing Berkshire shares at well above book value in the $22 billion General Re acquisition.

 

WHAT THE HECK ARE CORPORATE BOARDS THINKING - NET JETS EDITION

 

Berkshire's other large purchase during 1998 was for Executive Jet, now known as NetJets. Buffett explains the competitive advantages of NetJets as follows...

 

Being the leader in [the fractional jet ownership] industry is a major advantage for all concerned. Our customers gain because we have an armada of planes positioned throughout the country at all times, a blanketing that allows us to provide unmatched service. Meanwhile, we gain from the blanketing because it reduces dead-head costs. Another compelling attraction for our clients is that we offer products from Boeing, Gulfstream, Falcon, Cessna, and Raytheon, whereas our two competitors are owned by manufacturers that offer only their own planes. In effect, NetJets is like a physician who can recommend whatever medicine best fits the needs of each patient; our competitors, in contrast, are producers of a "house" brand that they must prescribe for one and all.

 

Given the foregoing description, it is a mystery to us why all Fortune 500 companies don't just ditch their respective fleets of corporate jets and sign up for NetJets. There's no possibility, at least in our view, that having one or more private company jets would be more economical than choosing NetJets for executive travel [as the Berkshire subsidiary should have a massive cost advantage, due to its scale], and likely little possibility that opting for NetJets would be less convenient [since most corporate campuses are located in urban areas, where there should be ample NetJets coverage].

 

But the most glaringly obvious reason is the horrific optics of the corporate jet, especially when the applicable company's stock has been in a tailspin. Take Valeant Pharmaceuticals, for example. The WSJ last week ran a headline shaming the CEO, Joe Papa, for receiving over $62 million in compensation in 2016 while the company's stock price has fallen approximately 60% since his appointment as chief executive. However, what should really make a shareholder's blood boil is the fact that the company charged the shareholders over $617,000 in 2016 for Mr. Papa's personal use of company aircraft [see the 2017 Proxy Statement, page 58]. On page 53 of the proxy, Valeant offers the following [completely lame] justification for this corporate perk, i.e. that '[t]he Talent and Compensation Committee believes that making our aircraft available to our Chairman and CEO allows him to serve shareholder interests by efficiently and securely conducting business during and when traveling.' It apparently doesn't occur to anyone on the comp committee that he could do this just as well--and at no cost to shareholders--by using NetJets instead.

 

And speaking of personal corporate jet perks enjoyed by CEOs of [and inexplicably paid for by the long suffering shareholders of] underperforming companies, note the following totally absurd and lame justification by JCPenney regarding its policy regarding free personal use of the corporate plane...

 

Company Aircraft.  For security reasons, the Board requires the CEO and, in 2016, required the Executive Chairman, to participate in a Key Associate Protection Program (the KAPP), which is intended to safeguard the CEO and Executive Chairman and members of their immediate families. The KAPP is a program approved by the Board as a result of recommendations contained in an independent, third-party security study. As part of the KAPP, the CEO is and, in 2016, the Executive Chairman was, required to use Company aircraft for all business and personal travel. The Company does not generally make Company aircraft available for non-Company business use by Company associates, other than to the CEO and Executive Chairman as recommended by the KAPP. However, in an emergency and/or other unusual circumstance, a Company associate may be permitted to travel on the Company aircraft for personal reasons, provided the travel is approved by the CEO or by the member of the management team with immediate management responsibility for the Aviation Department. Income is imputed to associates, including the CEO and Executive Chairman, for personal use of Company aircraft in accordance with IRS regulations. The Company does not provide a tax gross-up with respect to such imputed income.

 

[Source - JCP 2017 proxy statement, page 40].  Gotta love those Key Associate Protection Programs, resulting from 'independent, third-party security studies'. Of course, of course, it's all in the name of 'security'. Puh-leeze. IN A WORD...UTTERLY RIDICULOUS [OK, two words].

 

To round out the discussion, we would be remiss not include below a picture of one of Valeant's jets - looks pretty nice, we must admit...

 

ACQUISITION OF GEN RE

 

Buffett pulled off a typically brilliant move by acquiring General Reinsurance in 1998. In effect he killed two birds with one stone in the deal. First, he managed to sell stock of Berkshire when the markets were frothy and Berkshire shares were likely overvalued; he did this by paying for Gen Re with stock instead of cash [effectively selling a portion of Berkshire's equity to the former owners of Gen Re]. Second, he acquired in return a massive bond portfolio at a time when equities were extremely expensive, but bonds not so much. Thus he was able to effect a massive rebalancing of Berkshire's overall portfolio of assets in the direction of bonds and away from stocks at exactly the right time [when the former were cheap and the latter expensive].

 

Below is Buffett's summary of the transaction in the 1998 letter...

 

On December 21, we completed our $22 billion acquisition of General Re Corp. In addition to owning 100% of General Reinsurance Corporation, the largest U.S. property-casualty reinsurer, the company also owns (including stock it has an arrangement to buy) 82% of the oldest reinsurance company in the world, Cologne Re. The two companies together reinsure all lines of insurance and operate in 124 countries.

         

For many decades, General Re's name has stood for quality, integrity and professionalism in reinsurance -- and under Ron Ferguson's leadership, this reputation has been burnished still more. Berkshire can add absolutely nothing to the skills of General Re's and Cologne Re's managers. On the contrary, there is a lot that they can teach us.

         

Nevertheless, we believe that Berkshire's ownership will benefit General Re in important ways and that its earnings a decade from now will materially exceed those that would have been attainable absent the merger. We base this optimism on the fact that we can offer General Re's management a freedom to operate in whatever manner will best allow the company to exploit its strengths.

        

Below is a sample of the contemporary reaction to the merger from the NYT...

 

Buffett Takes General Re Into His Fold

By JOSEPH B. TREASTER

JUNE 20, 1998

 

Warren E. Buffett added to his vast financial empire yesterday, agreeing to buy the largest United States insurance company that specializes in covering the risks of other insurers for $21.7 billion in stock. The acquisition of the General Re Corporation by Mr. Buffett's investment company, Berkshire Hathaway Inc., sharply expands his presence in insurance. General Re, based in Stamford, Conn., would join a stable of insurers that includes Geico and National Indemnity. The company also holds stakes in several other companies.

 

For Berkshire, a phenomenally successful investment vehicle, General Re offers an additional $24 billion in stock and bond investments held by the insurer. And while General Re is already the world's third-largest reinsurer, a combination with Berkshire Hathaway would give it more capital to enable it provide greater coverage and expand its operations around the world.

 

''We are creating a Fort Knox here,'' Mr. Buffett said yesterday at a Manhattan news conference. ''Previously General Re has been limited in how much business they have been willing to take on. Now they will be a position to do anything they want.'' 

 

Mr. Buffet is known for not overpaying for companies and analysts said he paid in the middle range of what other recent re-insurance companies have fetched. ''I wouldn't say it was a bargain,'' said James R. English, the senior property and casualty analyst with J. P. Morgan Securities, ''but I think what he paid was reasonable.''

 

General Re's revenue of $8.25 billion last year was down slightly from $8.30 billion in 1996 and Ronald E. Ferguson, the chairman and chief executive, said in May that revenue was not expected to grow this year. But analysts said this reflected a trend toward lower prices for corporate insurance and did not suggest the company was in trouble.

 

''General Re is certainly an exceptional franchise,' said Alan Murray, a senior analyst with Moody's Investors Service, the credit rating agency.

 

The merger was announced after the regular close of the stock market. In late trading, shares of General Re rose $51.50, or 23 percent, to $275. Class A shares of Berkshire Hathaway, the highest-priced stock on the New York Stock Exchange, rose $4,900 to $80,900. Under the terms of the deal, General Re shareholders will receive 0.0035 class A share or 0.105 class B share of Berkshire Hathaway for each of their shares. As a result, the deal values General Re at $283.15 in class A stock or $284.025 in class B, for a total of $21.7 billion....

 

Mr. Buffett said he did not have ''lots of great ideas or even lots of good ideas'' on how to invest the new money that would be available through General Re. ''But,'' he said, ''there will be a time when we do have a good idea and when we do we will deploy all the money we can get our hands on.''

 

It should be noted, however, that Buffett claimed in the 2016 Berkshire shareholder letter that he regretted  the decision to use Berkshire stock as the acquisition currency: 'I...foolishly us[ed] Berkshire stock–a boatload of stock–to buy General Reinsurance in late 1998. After some early problems, General Re has become a fine insurance operation that we prize. It was, nevertheless, a terrible mistake on my part to issue 272,200 shares ofvBerkshire in buying General Re, an act that increased our outstanding shares by a whopping 21.8%. My error caused Berkshire shareholders to give far more than they received (a practice that – despite the Biblical endorsement – is far from blessed when you are buying businesses).'

 

PART 2 - TO BE CONTINUED

 

In the next blog post, we will cover the second half of the 1998 letter, including a discussion of so-called 'pro forma' financial information then peddled by 'bold, imaginative' executive management teams across the country. And speaking of the Bible, this particular topic reminds us of another apropos biblical quotation...

 

What has been will be again, what has been done will be done again; there is nothing new under the sun.

 

Till next time.

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