Category: Corporate Finance

0

DuPont Victory Good Sign for Buffett’s Berkshire

aaaaaYou know the activists have made an impact when the prospects of targeting Berkshire Hathaway are taken seriously enough to warrant a question on the subject to Warren Buffett at the company’s famous annual meeting.  Buffett scoffed at the idea by stressing a combination of performance and size—but there is a bit more to say, and now is a good time to say it, in light of yesterday’s stinging rebuke of the notorious activist Nelson Peltz by shareholders of DuPont. (No, greed is not good.)

Berkshire is among the largest, most diversified and profitable corporations in American history. It owns nine subsidiaries that, if they stood alone, would each be a Fortune 500 company, and boasts scores of diverse companies generating revenue from $1 billion to $8 billion apiece. At present, no sensible activist would target the firm, since Warren Buffett built, runs, and controls it by owning 34% of the voting power.

But just as the 84-year old conglomerate builder plans for Berkshire’s fate beyond his lifetime, no doubt activists are planning too. After all, despite a whopping market capitalization of nearly $400 billion, most analysts agree that Berkshire is worth more—that the sum of the parts is greater than the whole.

Citing criticisms of the conglomerate business model, activists will urge management to sell Berkshire’s struggling units, spin-off the mediocre, and install new managers at any failing to meet publicized performance standards.  In the process, they would call for distributing the cash to shareholders. They would explain how what they offer is worth more than Berkshire shares alone: cash plus shares in spun-off subsidiaries along with the continuing Berkshire shares.

The counterargument, familiar to Berkshire’s stalwart shareholders, will stress the value Berkshire has created from its unique business model. It pledges to business sellers that it will hold them indefinitely and give managers autonomy. Such commitments have great economic value not necessarily reflected in either today’s stock price or the valuations of individual business units.  The only way to preserve that premium is sustaining the conglomerate. The value is amplified by the capacity to relocate capital across subsidiaries without taxes, interest, covenants or hassle. Keeping the whole together reinforces the economic value of these and other intangibles, including a culture of trust, thrift, and teamwork. Read More

0

Warren Buffett & Charlie Munger Annotated by Experts in Wall Street Journal

WB1996Warren Buffett’s latest letter to Berkshire Hathaway shareholders is annotated in The Wall Street Journal by 30 professors, authors, and investors.  Editors Erik Holm and Anupreeta Das assigned us each two sentences in the letter, and/or Charlie Munger’s addendum, to amplify.  Here are my two, followed by the list of contributors. Mine address the role Warren’s son Howard will play in succession and what Munger believes concerning what made Berkshire succeed.

Regarding Buffett’s reference to his son Howard (p. 36):   Buffett tries again to defend the choice of Howard to succeed him as board chairman. Many remain skeptical. But critics should appreciate the plan’s savviness. It deftly carves a niche for the son of a legend, as Howard will: (1) not be asked to perform any task his father has performed (like investing or capital allocation) and (2) be asked to perform only one task, which Warren has never performed (monitoring the CEO for adherence to Berkshire culture and dismissing any who fail). This shrewdly avoids the trap many children of legendary parents face of never being able to measure up.

Notably, besides Munger, Howard is the only individual Buffett identifies by name among Berkshire personnel in his anniversary message and, besides Buffett, Munger only names Abel and Jain. In fact, while Munger and Buffett mutually credit the other for minting the Berkshire model, they never credit any other Berkshire personnel for its success. The omission contrasts with Buffett’s letters, which rightly herald specific executives who power Berkshire and animate its culture. The difference is that these messages, while in form historical, are really about the future, and all three people identified by name are referenced in discussions of succession.

Where Munger asserts (p. 39) that “The management system and policies of Berkshire . . . were fixed early”:   Munger’s statements about how Berkshire’s “system and policies” were “fixed early” is vague. In one sense, it sounds as if they were part of a master plan at the outset back in the 1960s.  But Buffett has often stressed that Berkshire never had a strategic plan nor any business plan. And through the 1980s, most of Berkshire’s “business” consisted of investments in securities for its insurance companies, not wholly owned operating subsidiaries. So it doesn’t seem likely that, in the 1970s or even as late as the 1980s, Buffett’s goal was to create “a diffuse conglomerate.”

On the other hand, Munger subsequently clarifies (p. 40) that Buffett “stumbled into some benefits [of these policies] through practice evolution” over his career. And Buffett sculpted much of Berkshire’s culture late in the company’s life as part of a process that is still ongoing and extends well beyond these policies. Therefore these passages should not obscure the fact that the “Berkshire system” looks sharper from today’s vantage point than from Buffett’s desk “early” on. That’s important to recognize lest observers commit errors associated with hindsight bias like believing that observed outcomes were predictable, a weakness of human psychology which Munger often lectures against.

Cunningham is the author of Berkshire Beyond Buffett: The Enduring Value of Values and editor and publisher, since 1997, of The Essays of Warren Buffett: Lessons for Corporate America. For more commentary on this topic, see today’s New York Times Dealbook column, here. Read More

7

Fed Officials Accused of Perjury in AIG Bailout Trial

In the financial trial of the century, the most important document is missing. The document is the term sheet that the government says it gave AIG’s board right before taking the company over in Sept. 2008.  The government says the AIG board thus approved the Draconian terms that benefited Goldman Sachs and other rivals. But other evidence, including  AIG’s contemporaneous securities filings, suggests the board was agreeing only to sell the government warrants not transfer 80% of the common stock to it for a song.  The missing document would prove which side is telling the truth.

That’s one of many amazing points of contention noted by Yves Smith of Naked Capitalism in her relentless digging into what government really did during the financial crisis. Most recently, she alleges and documents perjury and obstruction of justice by top federal officials in the pending case of former AIG shareholders against the US. The case alleges that the government trampled on corporate law rights and that the Fed exceeded its authority—allegations that I document in my book, The AIG Story, written with Hank Greenberg, lead plaintiff in the case.

Smith lays out her claims in an extensive blog post at Naked Capitalism, accompanied by reams of additional documents and examples. For those looking for a skinny version, here is an abridged adaptation. Most examples concern Scott Alvarez, general counsel of the Board of Governors of the Federal Reserve; there is one with with Tom Baxter, general counsel of the New York Fed, who worked with Tim Geithner. The shareholders are represented by the noted trial lawyer, David Boies. The point about the term sheet is at the end.

Example 1

Boies: Would you agree as a general proposition that the market generally considers investment-grade debt securities safer than non-investment-grade debt securities?

Alvarez: I don’t know.

 

Example 2

Boies: [Presents a copy of the Financial Crisis Inquiry Commission report stating that the Fed had lowered the standards it applied for the quality of collateral for its loans under two programs then devised to support lending and asks] Do you see that?

Alvarez: I see that. . .

Boies: . . . [W]ould you agree that the Federal Reserve had lowered its standards regarding the quality of the collateral that investment banks and other primary dealers could use while borrowing. . . ?

Alvarez: No.

Boies: You would not agree with that?

Alvarez: Right.

 

Example 3 Read More

1

Walmart versus Apple aka Revenue versus Profit

Which business would you want to be? The Economist Espresso reports that Walmart takes “about 65 seconds to collect $1m in revenue,” but Apple needs “very nearly three minutes.” Looks like Walmart is where the money is. And it is, but when it comes to profit, “Apple, with its high margins, is fastest in the profit stakes: chalking up $1m takes it less than 13 minutes and 20 seconds, whereas Walmart needs more than half an hour.” Looking at the chart, Apple and Google have good profit margins but banks like JPMorgan Chase and Goldman Sachs do even better (all above 20%). Coke (17.4) and Pepsi (10.4) are quite good too. So how much does the law affect these sectors and which the best to be in? Hard to tell.

No matter what, any regulation be it about disclosures about practices or nutrition or oversight or safety or labor or where a good is made or liability for property rights or ability to weather an economic downturn, can shape a sector. Given the high profits in some of these sectors, you will see some arguing that they are getting away with too much and others saying that any regulation will kill the sector. Both positions are likely incorrect. That said, watching where new money, new offices (for old and new ventures), and start ups go may tell us something about where people believe they can do well.

One thing I am thinking about is how much state-by-state regulations and barriers to labor mobility influence business decisions. Although work on intellectual capital and noncompetes is quite strong that lower restrictions help business overall, alleged protection of voting systems and other entry barriers matter too. Someone may have studied this point. If so, please share. But my guess is that a company that has trouble getting people (and I mean U.S. citizens) to their headquarters won’t be happy about that cost.

1

JOBS Act, Sarbanes-Oxley and US Stock Market Competitiveness

Steve Bainbridge posts that we now have evidence that the facilitations that the JOBS Act provided to emerging growth companies for going public are ineffective. Steve also points out that since the early 2000s we have seen the US stock markets appearing less competitive than foreign markets. Let me add that we also have evidence that the Sarbanes-Oxley Act of 2002 (SOX) lengthened the time to going public and increased the probability of a private sale instead of an IPO. (SSRN has tons of papers on the mostly negative consequences of SOX but also a couple of papers suggesting indeterminate answers.) This means that SOX moved returns away from entrepreneurs and public investors to private equity funds. Although the costs of compliance have dropped and perhaps we cannot definitively say that SOX was a mistake, we cannot say it was a success either and the JOBS Act did not cure the inefficiencies that SOX produced. So, it is time to accept that the way to restore competitiveness is to repeal the dubious SOX provisions. Read More

0

Argentina and Sovereign Insolvency

Thanks to Gerard for the nice introduction. Indeed, I am here to rant about bankruptcy, securities, and corporate, mostly. The vineyard lies dormant now (but any offers for it will be considered).

So, how about Argentina and Elliot? We pay our nice subsidy to the IMF out of our taxes and it finances sovereign restructurings by essentially buying the vote of bondholders into accepting restructurings that are good for both the bondholders and the insolvent sovereign (compared to it wallowing in a depression for years). Then, after the sovereign turns around its economy, our own courts let the holdout bondholders collect on the bonds that, if everyone had held out as they did and the sovereign stayed in a depression for decades, would not have had much value.

We could have a sovereign insolvency regime but the banks opposed the IMF charter amendment to that effect and it did not go through. Or our courts could go back to their equity receivership jurisprudence and try to fashion a sovereign insolvency regime.

Instead, our courts give ammunition to the holdouts, making bonds of insolvent sovereigns more attractive gambles, and pushing up the amount that the IMF will have to pay to buy out the bondholders’ vote in the next restructuring.

How would a sovereign insolvency regime work? It would not be pretty but it would be much prettier than this. Think of Detroit. It makes a bankruptcy filing and proposes a plan that keeps taxes rational and the city viable. No lender of last resort needs to get involved. Bondholders cannot extract any favorable bargains. Our tax dollars do not get wasted.

0

Buffett’s Evolution: From Stock-Picking Disciple of Ben Graham to Business-Building Devotee of Tom Murphy

While everyone knows that Warren Buffett modeled himself after Ben Graham for the stock picking that made Buffett famous in the latter 20th century, virtually no one knows a more important point for the 21st century: he has modeled himself after Tom Murphy in assembling a mighty conglomerate.   Murphy, a legendary executive with great skills in the field of acquisitions that resulted in the Capital Cities communications empire, engineered the 1985 $3.5 billion takeover by Capital Cities of ABC before selling it all to to Disney a decade later for $19 billion.  You did not hear that explicitly at Saturday’s Berkshire Hathaway annual meeting, but Warren mentioned it to me at brunch on Sunday and, when you think about it, it’s a point implicit deep in the meeting’s themes and many questions.

In fact, Berkshire mBBB COvereetings are wonderful for their predictability.   Few questions surprise informed participants and most seasoned observers can give the correct outlines of answers before hearing Buffett or vice chairman Charlie Munger speak. While exact issues vary year to year and the company and its leaders evolve, the core principles are few, simple, and unwavering.  The meetings reinforce the venerability and durability of Berkshire’s bedrock principles even as they drive important underlying shifts that accumulate over many years.  Three examples and their upshot illustrate, all of which I expand on in a new book due out later this year (pictured; pre-order here).

Permanence versus Size/Break Up. People since the 1980s have argued that as Berkshire grows, it gets more difficult to outperform. Buffett has always agreed that scale is an anchor. And it’s true that these critics have always been right that it gets harder but always wrong that it is impossible to outperform.   People for at least a decade have wondered whether it might be desirable to divide Berkshire’s 50+ direct subsidiaries into multiple corporations or spin-off some businesses.  The answer has always been and remains no.  Berkshire’s most fundamental principle is permanence, always has been, always will be. Divisions and divestitures are antithetical to that proposition.

Trust and Autonomy versus Internal Control. Every time there is a problem at a given subsidiary or with a given person—spotlighted at 2011’s meeting by subsidiary CEO David Sokol’s buying stock in Lubrizol before pitching it as an acquisition target—people want to know whether Berkshire gives its personnel too much autonomy. The answer is Berkshire is totally decentralized and always will be-another distinctive bedrock principle. The rationale has always been the same: yes, tight leashes and controls might help avoid this or that costly embarrassment but the gains from a trust-based culture of autonomy, while less visible, dwarf those costs.

Capital Allocation: Berkshire has always adopted the doubled-barreled approach to capital allocation, buying minority stakes in common stocks as well as entire subsidiaries (and subs of subs).  The significant change at Berkshire in the past two decades is moving from a mix of 80% stocks with 20% subsidiaries to the opposite, now 80% subsidiaries with 20% stocks.  That underscores the unnoticed change: in addition to Munger, Buffett’s most important model is not only Graham but Murphy, who built Capital Cities/ABC in the way that Buffett has consciously emulated in the recent building of Berkshire.

For me, this year’s meeting was a particularly joy because I’ve just completed the manuscript of my next book, Berkshire Beyond Buffett: The Enduring Value of Values (Columbia University Press, available October 2014). It articulates and consolidates these themes through a close and delightful look at its fifty-plus subsidiaries, based in part on interviews and surveys of many subsidiary CEOs and other Berkshire insiders and shareholders.   The draft jacket copy follows. Read More

0

Individuals & Teams, Carrots & Sticks

I promised Victor Fleisher to return to his reflections on team production. Vic raised the issue of team production and the challenge of monitoring individual performance. In Talent Wants to Be Free I discuss some of these challenges in the connection to my argument that much of what firms try to achieve through restrictive covenants could be achieved through positive incentives:

“Stock options, bonuses, and profit-sharing programs induce loyalty and identification with the company without the negative effects of over-surveillance or over-restriction. Performance-based rewards increase employees’ stake in the company and increase their commitment to the success of the firm. These rewards (and the employee’s personal investment in the firm that is generated by them) can also motivate workers to monitor their co-workers. We now have evidence that companies that use such bonus structures and pay employees stock options outperform comparable companies .”

 But I also warn:

 “[W]hile stock options and bonuses reward hard work, these pay structures also present challenges. Measuring employee performance in innovative settings is a difficult task. One of the risks is that compensation schemes may inadvertently emphasize observable over unobservable outputs. Another risk is that when collaborative efforts are crucial, differential pay based on individual contribution will be counterproductive and impede teamwork, as workers will want to shine individually. Individual compensation incentives might lead employees to hoard information, divert their efforts from the team, and reduce team output. In other words, performance-based pay in some settings risks creating perverse incentives, driving individuals to spend too much time on solo inventions and not enough time collaborating. Even more worrisome is the fear that employees competing for bonus awards will have incentives to actively sabotage one another’s efforts.

A related potential pitfall of providing bonuses for performance and innovative activities is the creation of jealousy and a perception of unfairness among employees. Employees, as all of us do in most aspects of our lives, tend to overestimate their own abilities and efforts. When a select few employees are rewarded unevenly in a large workplace setting, employers risk demoralizing others. Such unintended consequences will vary in corporate and industry cultures across time and place, but they may explain why many companies decide to operate under wage compression structures with relatively narrow variance between their employees’ paychecks. For all of these concerns, the highly innovative software company Atlassian recently replaced individual performance bonuses with higher salaries, an organizational bonus, and stock options, believing that too much of a focus on immediate individual rewards depleted team effort.

Still, despite these risks, for many businesses the carrots of performance-based pay and profit sharing schemes have effectively replaced the sticks of controls. But there is a catch! Cleverly, sticks can be disguised as carrots. The infamous “golden handcuffs”- stock options and deferred compensation with punitive early exit trigger – can operate as de facto restrictive contracts….”

 All this is in line with what Vic is saying about the advantages of organizational forms that encourage longer term attachment. But the fundamental point is that stickiness (or what Vic refers to as soft control) is already quite strong through the firm form itself, along with status quo biases, risk aversion, and search lags. The stickiness has benefits but it also has heavy costs when it is compounded and infused with legal threats.

2

Berkshire Hathaway’s Unique Permanence

aaa rock of gibralterPermanence is the most distinctive trait of Berkshire Hathaway, the diversified Fortune 10 conglomerate whose unusual features, thanks to iconoclastic chairman Warren Buffett, are legion. Permanence is salient because, unlike any other conglomerate in history or rival in the acquisitions market, Berkshire has never sold a subsidiary it acquired.

Ironically, the experience that led to this unique practice culminated in the reluctant sale of Berkshire’s original business, textile manufacturing, in 1985. That sale was so painful for management, employees and other stakeholders that Berkshire committed to avoid a replay.

Instead, it adopted a policy of up-front screening, rigorous acquisition criteria that cut the chances of owning a business that would be tempting to sell. Berkshire then turned that policy into a huge advantage, assuring prospective sellers of companies a permanent corporate home.

In turn, the assurance of permanence appealed strongly to the kinds of companies that would meet Berkshire’s rigorous acquisition criteria: those owned and loved by families, entrepreneurs and other owner-oriented types. Some fifty acquisitions later, the promise has never been broken.

That is why I found so peculiar the following passage in William Thorndike’s well-selling book, The Outsiders, a profile of select big-name CEOs, including Buffett, whom Thorndike considers to have been similar to each other but different from everybody else. After referencing the 1985 closure of Berkshire’s ailing textile business, he writes: Read More

0

Brian Tamanaha’s Straw Men (Part 1): Why we used SIPP data from 1996 to 2011

(Reposted from Brian Leiter’s Law School Reports)

 

BT Claim:  We could have used more historical data without introducing continuity and other methodological problems

BT quote:  “Although SIPP was redesigned in 1996, there are surveys for 1993 and 1992, which allow continuity . . .”

Response:  Using more historical data from SIPP would likely have introduced continuity and other methodological problems

SIPP does indeed go back farther than 1996.  We chose that date because it was the beginning of an updated and revitalized SIPP that continues to this day.  SIPP was substantially redesigned in 1996 to increase sample size and improve data quality.  Combining different versions of SIPP could have introduced methodological problems.  That doesn’t mean one could not do it in the future, but it might raise as many questions as it would answer.

Had we used earlier data, it could be difficult to know to what extent changes to our earnings premiums estimates were caused by changes in the real world, and to what extent they were artifacts caused by changes to the SIPP methodology.

Because SIPP has developed and improved over time, the more recent data is more reliable than older historical data.  All else being equal, a larger sample size and more years of data are preferable.  However, data quality issues suggest focusing on more recent data.

If older data were included, it probably would have been appropriate to weight more recent and higher quality data more heavily than older and lower quality data.  We would likely also have had to make adjustments for differences that might have been caused by changes in survey methodology.  Such adjustments would inevitably have been controversial.

Because the sample size increased dramatically after 1996, including a few years of pre 1996 data would not provide as much new data or have the potential to change our estimates by nearly as much as Professor Tamanaha believes.  There are also gaps in SIPP data from the 1980s because of insufficient funding.

These issues and the 1996 changes are explained at length in the Survey of Income and Program Participation User’s Guide.

Changes to the new 1996 version of SIPP include:

Roughly doubling the sample size

This improves the precision of estimates and shrinks standard errors

Lengthening the panels from 3 years to 4 years

This reduces the severity of the regression to the median problem

Introducing computer assisted interviewing to improve data collection and reduce errors or the need to impute for missing data

Introducing oversampling of low income neighborhoods
This mitigates response bias issues we previously discussed, which are most likely to affect the bottom of the distribution
New income topcoding procedures were instituted with the 1996 Panel
This will affect both means and various points in the distribution
Topcoding is done on a monthly or quarterly basis, and can therefore undercount end of year bonuses, even for those who are not extremely high income year-round

Most government surveys topcode income data—that is, there is a maximum income that they will report.  This is done to protect the privacy of high-income individuals who could more easily be identified from ostensibly confidential survey data if their incomes were revealed.

Because law graduates tend to have higher incomes than bachelor’s, topcoding introduces downward bias to earnings premiums estimates. Midstream changes to topcoding procedures can change this bias and create problems with respect to consistency and continuity.

Without going into more detail, the topcoding procedure that began in 1996 appears to be an improvement over the earlier topcoding procedure.

These are only a subset of the problems extending the SIPP data back past 1996 would have introduced.  For us, the costs of backfilling data appear to outweigh the benefits.  If other parties wish to pursue that course, we’ll be interested in what they find, just as we hope others were interested in our findings.