This is the twenty-sixth 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 2002 letter weighs in at 14,550 words, an 18% increase from 12,330 words the prior year. Berkshire's gain in net worth during 2002 was $6.1 billion, or 10% of beginning 2002 net worth.
CORPORATE GOVERNANCE--OR THE LACK THEREOF
Buffett engages in quite a lengthy dissertation [some might say, diatribe] regarding the abysmal state of corporate governance in the 2002 shareholder letter. No doubt his complaints at this point were a symptom of the fact that the early 2000s bear market had then been continuing for 3 years. In times when stock prices rise, investors understandably ignore governance concerns; but when they stagnate or fall, these concerns surface. Or, as Buffett has famously said, it is only when the tide goes out that you find out who's been swimming naked.
Buffett's comments on the subject are worth reading in its entirety [we have interspersed our observations in brackets and ALL CAPS therein]...
Both the ability and fidelity of managers have long needed monitoring. Indeed, nearly 2,000 years ago, Jesus Christ addressed this subject, speaking (Luke 16:2) approvingly of “a certain rich man” who told his manager, “Give an account of thy stewardship; for thou mayest no longer be steward.” Accountability and stewardship withered in the last decade, becoming qualities deemed of little importance by those caught up in the Great Bubble. As stock prices went up, the behavioral norms of managers went down. By the late ’90s, as a result, CEOs who traveled the high road did not encounter heavy traffic. [IN RECENT YEARS, WE HAVE SEEN THIS EXACT SAME PHENOMENON REPEAT, AS EVIDENCED BY THE RAMPANT SPREAD OF 'PRO FORMA' EARNINGS AND 'PRO FORMA' EBITDA METRICS]
Most CEOs, it should be noted, are men and women you would be happy to have as trustees for your children’s assets or as next-door neighbors. Too many of these people, however, have in recent years behaved badly at the office, fudging numbers and drawing obscene pay for mediocre business achievements. These otherwise decent people simply followed the career path of Mae West: “I was Snow White but I drifted.”
In theory, corporate boards should have prevented this deterioration of conduct. I last wrote about the responsibilities of directors in the 1993 annual report. There, I said that directors “should behave as if there was a single absentee owner, whose long-term interest they should try to further in all proper ways.” This means that directors must get rid of a manager who is mediocre or worse, no matter how likable he may be. Directors must react as did the chorus-girl bride of an 85-yearold multimillionaire when he asked whether she would love him if he lost his money. “Of course,” the young beauty replied, “I would miss you, but I would still love you.” In the 1993 annual report, I also said directors had another job: “If able but greedy managers overreach and try to dip too deeply into the shareholders’ pockets, directors must slap their hands.” Since I wrote that, over-reaching has become common but few hands have been slapped. [EVEN FEWER HANDS HAVE BEEN SLAPPED RECENTLY; DIRECTORS CONSTANTLY LOOK THE OTHER WAY WHEN MANAGEMENTS RAID THE SHAREHOLDERS TILL; PERHAPS THE FACT THAT THEY ARE USUALLY PAID WELL INTO THE SIX FIGURES FOR THEIR PART-TIME, LIGHT-WORK DIRECTORSHIPS HAS SOMETHING TO DO WITH THIS]
Why have intelligent and decent directors failed so miserably? The answer lies not in inadequate laws – it’s always been clear that directors are obligated to represent the interests of shareholders – but rather in what I’d call “boardroom atmosphere.” It’s almost impossible, for example, in a boardroom populated by well-mannered people, to raise the question of whether the CEO should be replaced. It’s equally awkward to question a proposed acquisition that has been endorsed by the CEO, particularly when his inside staff and outside advisors are present and unanimously support his decision. (They wouldn’t be in the room if they didn’t.) Finally, when the compensation committee – armed, as always, with support from a high-paid consultant – reports on a megagrant of options to the CEO, it would be like belching at the dinner table for a director to suggest that the committee reconsider.
These “social” difficulties argue for outside directors regularly meeting without the CEO – a reform that is being instituted and that I enthusiastically endorse. I doubt, however, that most of the other new governance rules and recommendations will provide benefits commensurate with the monetary and other costs they impose. The current cry is for “independent” directors. It is certainly true that it is desirable to have directors who think and speak independently – but they must also be business-savvy, interested and shareholder oriented. In my 1993 commentary, those are the three qualities I described as essential. Over a span of 40 years, I have been on 19 public-company boards (excluding Berkshire’s) and have interacted with perhaps 250 directors. Most of them were “independent” as defined by today’s rules. But the great majority of these directors lacked at least one of the three qualities I value. As a result, their contribution to shareholder well-being was minimal at best and, too often, negative. These people, decent and intelligent though they were, simply did not know enough about business and/or care enough about shareholders to question foolish acquisitions or egregious compensation. My own behavior, I must ruefully add, frequently fell short as well: Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders. In those cases, collegiality trumped independence. [NOTE THAT DIRECTORS ALSO BEAR VIRTUALLY NO CONSEQUENCES FOR THEIR FAILURE TO ACT AS FIDUCIARIES FOR SHAREHOLDERS; COMPANIES PURCHASE DIRECTORS LIABILITY INSURANCE AND PAY ANY LEGAL BILLS THAT MIGHT ARISE FROM CLASS ACTION SUITS, SO THERE IS NO LEGAL JEOPARDY FOR BAD ACTORS; IN ADDITION, SHAREHOLDERS ARE UNBELIEVABLY LACKADAISICAL IN HOLDING DIRECTORS ACCOUNTABLE; FOR EXAMPLE, IN AN ARTICLE ABOUT WELLS FARGO TODAY THE WSJ REPORTED THAT IN THE PAST 5 YEARS A GRAND TOTAL OF 9 DIRECTORS OF S&P 500 COMPANIES HAVE RESIGNED DUE TO NEGATIVE VOTES BY SHAREHOLDERS AT ANNUAL MEETINGS - NINE INSTANCES OUT OF 500 COMPANIES OVER 5 YEARS]
So that we may further see the failings of “independence,” let’s look at a 62-year case study covering thousands of companies. Since 1940, federal law has mandated that a large proportion of the directors of investment companies (most of these mutual funds) be independent. The requirement was originally 40% and now it is 50%. In any case, the typical fund has long operated with a majority of directors who qualify as independent. These directors and the entire board have many perfunctory duties, but in actuality have only two important responsibilities: obtaining the best possible investment manager and negotiating with that manager for the lowest possible fee. When you are seeking investment help yourself, those two goals are the only ones that count, and directors acting for other investors should have exactly the same priorities. Yet when it comes to independent directors pursuing either goal, their record has been absolutely pathetic. Many thousands of investment-company boards meet annually to carry out the vital job of selecting who will manage the savings of the millions of owners they represent. Year after year the directors of Fund A select manager A, Fund B directors select manager B, etc. … in a zombie-like process that makes a mockery of stewardship. Very occasionally, a board will revolt. But for the most part, a monkey will type out a Shakespeare play before an “independent” mutual-fund director will suggest that his fund look at other managers, even if the incumbent manager has persistently delivered substandard performance.
When they are handling their own money, of course, directors will look to alternative advisors – but it never enters their minds to do so when they are acting as fiduciaries for others. The hypocrisy permeating the system is vividly exposed when a fund management company – call it “A” – is sold for a huge sum to Manager “B”. Now the “independent” directors experience a “counterrevelation” and decide that Manager B is the best that can be found – even though B was available (and ignored) in previous years. Not so incidentally, B also could formerly have been hired at a far lower rate than is possible now that it has bought Manager A. That’s because B has laid out a fortune to acquire A, and B must now recoup that cost through fees paid by the A shareholders who were “delivered” as part of the deal... Investment company directors have failed as well in negotiating management fees (just as compensation committees of many American companies have failed to hold the compensation of their CEOs to sensible levels). If you or I were empowered, I can assure you that we could easily negotiate materially lower management fees with the incumbent managers of most mutual funds. And, believe me, if directors were promised a portion of any fee savings they realized, the skies would be filled with falling fees. Under the current system, though, reductions mean nothing to “independent” directors while meaning everything to managers. So guess who wins? Having the right money manager, of course, is far more important to a fund than reducing the manager’s fee. Both tasks are nonetheless the job of directors. And in stepping up to these all-important responsibilities, tens of thousands of “independent” directors, over more than six decades, have failed miserably. (They’ve succeeded, however, in taking care of themselves; their fees from serving on multiple boards of a single “family” of funds often run well into six figures.)
When the manager cares deeply and the directors don’t, what’s needed is a powerful countervailing force – and that’s the missing element in today’s corporate governance. Getting rid of mediocre CEOs and eliminating overreaching by the able ones requires action by owners – big owners. The logistics aren’t that tough: The ownership of stock has grown increasingly concentrated in recent decades, and today it would be easy for institutional managers to exert their will on problem situations. Twenty, or even fewer, of the largest institutions, acting together, could effectively reform corporate governance at a given company, simply by withholding their votes for directors who were tolerating odious behavior. In my view, this kind of concerted action is the only way that corporate stewardship can be meaningfully improved. Unfortunately, certain major investing institutions have “glass house” problems in arguing for better governance elsewhere; they would shudder, for example, at the thought of their own performance and fees being closely inspected by their own boards. But Jack Bogle of Vanguard fame, Chris Davis of Davis Advisors, and Bill Miller of Legg Mason are now offering leadership in getting CEOs to treat their owners properly. [WHATEVER ATTEMPTS BOGLE, DAVIS AND MILLER MADE IN THE EARLY 2000s CLEARLY DIDN'T HAVE MUCH OF A LASTING EFFECT, SINCE THE 'AGENCY' PROBLEM APPEARS TO BE WORSE THAN EVER TODAY; THE DOMINANCE OF INDEX FUNDS HAS LED TO A EXACERBATION OF THE 'ABSENTEE OWNER' PROBLEM--IT DOES NOT APPEAR THAT VANGUARD OR BLACKROCK OR ANY OTHER PROPRIETOR OF INDEX FUNDS HAS BEEN POUNDING THE TABLE FOR BETTER CORPORATE GOVERNANCE RECENTLY, ALTHOUGH VANGUARD CLAIMS IT ADVOCATES FOR BETTER STEWARDSHIP BEHIND THE SCENES [SEE LINK HERE]]
Pension funds, as well as other fiduciaries, will reap better investment returns in the future if they support these men. The acid test for reform will be CEO compensation. Managers will cheerfully agree to board “diversity,” attest to SEC filings and adopt meaningless proposals relating to process. What many will fight, however, is a hard look at their own pay and perks. In recent years compensation committees too often have been tail-wagging puppy dogs meekly following recommendations by consultants, a breed not known for allegiance to the faceless shareholders who pay their fees. (If you can’t tell whose side someone is on, they are not on yours.) True, each committee is required by the SEC to state its reasoning about pay in the proxy. But the words are usually boilerplate written by the company’s lawyers or its human-relations department. This costly charade should cease. [TODAY PROXY STATEMENTS ARE SO LONG-WINDED AND FULL OF MEANINGLESS BOILERPLATE, 'COMPENSATION CONSULTANT' RECOMMENDATIONS, ETC, THAT WE WOULD GUESS LESS THAN ONE PERCENT OF SHAREHOLDERS ACTUALLY READ THE REPORTS OF THE COMPENSATION COMMITTEES INCLUDED THEREIN, LET ALONE ARE ABLE TO UNDERSTAND HOW AND WHY EXECUTIVES ARE BEING PAID THE WAY THEY ARE; THE OBFUSCATION APPEARS DELIBERATE TO US]
Directors should not serve on compensation committees unless they are themselves capable of negotiating on behalf of owners. [GOOD LUCK WITH THAT ONE] They should explain both how they think about pay and how they measure performance. Dealing with shareholders’ money, moreover, they should behave as they would were it their own. In the 1890s, Samuel Gompers described the goal of organized labor as “More!” In the 1990s, America’s CEOs adopted his battle cry. The upshot is that CEOs have often amassed riches while their shareholders have experienced financial disasters. Directors should stop such piracy. There’s nothing wrong with paying well for truly exceptional business performance. But, for anything short of that, it’s time for directors to shout “Less!” It would be a travesty if the bloated pay of recent years became a baseline for future compensation. [IT IS; 'PEER' ANALYSIS OF COMPENSATION HAS RESULTED IN A CONSTANT RATCHETING UP OF PAY FOR C-SUITE EXECS] Compensation committees should go back to the drawing boards. [AMEN]
Buffett suggests that one way to deal with the 'agency' problem is to 'select directors who have huge and true ownership interests (that is, stock that they ortheir family have purchased, not been given...or received via options)... [A] director whose moderate income is heavily dependent on directors’ fees – and who hopes mightily to be invited to join other boards inorder to earn more fees – is highly unlikely to offend a CEO or fellow directors, who in a major way will determine his reputation in corporate circles'. Active investors should likewise make sure that any company whose shares they decide to purchase has a true alignment of interests between those on the Board of Directors and the shareholders at large; if not, they should expect to pay an 'agency fee' in the form of excessive executive/director compensation and low accountability for results, much as mutual fund investors must pay an annual management fee [penalty] in the range of 1-3 percent.
CAVEAT EMPTOR WHEN IT COMES TO MANAGEMENT 'HAPPY TALK'
Speaking of stewardship, management teams today routinely engage in what we refer to as 'happy talk' when discussing results of operations with analysts and shareholders. The constant refrain is 'everything is great' even when things are obviously going terribly. No matter what abysmal results they have just reported, management 'remains confident' about the future. Of course, none of the analysts on company conference calls are willing to call out CEOs and CFOs on B.S. statements, for fearing of offending them and losing access. And shareholder ownership is usually far too dispersed for corporate executives to fear any revolt by the masses.
Buffett thus has the following advice for investors with respect to these and related issues generally...
Three suggestions for investors: First, beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?
Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.
Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).
Charlie and I not only don’t know today what our businesses will earn next year – we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future – and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.
DERIVATIVES AS FINANCIAL WEAPONS OF MASS DESTRUCTION
In the 2002 letter Buffett was also prescient about the dangers of derivates, which he labelled 'financial weapons of mass destruction'. Indeed, just 5 years later his warnings were proven accurate as AIG completely imploded [and nearly caused the implosion of the entire U.S. financial system] due to the derivates book run by its small, little-noticed subsidiary AIG Financial Products Corporation [see further discussion here]. The following is what Buffett had to say on the topic in 2002....
I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.
Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown. [NOTE - THIS IS EXACTLY WHAT HAPPENED TO AIG]
Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.
In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.
For the record, in 2002 Berkshire's stock fell 3.8%, outperforming the S&P 500 by 18%, the Angels beat the Giants 4-3 in the World Series, the Bucs beat the Raiders 48-21 in Super Bowl XXXVII and the Bear Market of 2002 ended on September 24th, with an overall loss of $5 trillion in market value since January 1st of 2001. Next up, 2003, the year the 2nd Iraq War began.