The “Fasten Your Seatbelts” public announcement that the Berkshire Hathaway Annual Meeting was about to begin in Omaha’s packed convention center this past Saturday was like a plane steward’s admonition before a perfectly smooth flight.  It’s difficult to imagine how anything could be going better for Berkshire Hathaway.

Warren Buffett reported that his company’s operating earnings during the first three months of 2013, $4.9 billion, 51% above the first three months of 2012, were the highest for any quarter ever reported.  Berkshire’s four major industry operating sectors all performed well including their largest components:  insurance companies Berkshire Hathaway Insurance Groups and GEICO; regulated companies BNSF (railroad) and MidAmerica (public utility); manufacturing/service/retailing companies Marmon (150 different businesses); and financial companies Clayton Homes (manufactured housing/finance) and CORT (leasing).

But Berkshire’s operating company earnings were only part of the story.  In addition to its $4.9 billion of reported net income was another $5.5 billion of net appreciation of investments representing the increase in book value of Berkshire’s fixed income and equity marketable securities in its investment portfolio.  The largest of these investments were Wells Fargo, Coca-Cola, IBM and American Express aggregating $52 billion at year-end 2012.

On the acquisition front, Buffet is still looking for a couple of “elephants” to purchase with readily available proceeds from Berkshire’s $48 billion in short term Treasuries.  He expressed his satisfaction with Berkshire’s $12 billion investment in Heinz during the first quarter, and he believes that there are other good large investment opportunities to pursue for the benefit of Berkshire shareholders in the future.

Finally in terms of valuation, there is the unrecorded intrinsic value of Berkshire’s operating subsidiaries.  Buffett used the example of GEICO’s first quarter insurance underwriting operations to explain.  Based on its first quarter new insurance policies, GEICO is positioned to write $1 billion of new US auto insurance in 2013 out of $1.5 billion industry-wide.  The intrinsic value of GEICO’s growing insurance business is worth far more than the company’s book value carried on Berkshire’s financial statements, and the same is true for most of Berkshire’s other operating businesses.

Buffett said that Berkshire will acquire its own stock whenever its market value falls below 120% of book value (currently at 140%).  Don’t hold your breath.  The market has responded positively to all the good news from Berkshire Hathaway, and it is now the fifth largest company in total market value after Apple, Exxon Mobil, Microsoft and Google.

As always in recent years, questions were raised about what happens to Berkshire after Buffett is no longer around, and a particular question was raised about the future role of Buffett’s son, Howard.  Warren explained that his recommendation for Berkshire’s future Chief Executive Officer and Chief Investment Officer(s) were confidential, but well known to Berkshire’s Board of Directors.  However, as assurance that Berkshire continue to operate the same, he has recommended to his Board of Directors that after his departure, his son Howard become the non-paid, non-executive Chairman of the Board.  As a Berkshire director and major shareholder, Howard is immersed in Berkshire’s principles and culture.  He would assure that Berkshire’s management would either continue successfully on the same path as before, or if not, request the board make appropriate management changes.

While questions about Berkshire were answered confidently and completely, questions about the ultimate impact of the Federal Reserve Bank’s quantitative easing were not.  Both Buffett and his longtime investment partner, Charlie Munger, agreed that the Fed, led by Chairman Ben Bernanke, responded correctly to the financial market crisis of 2008 and subsequent slow economic recovery, but neither could offer an opinion of its aftermath results.  Munger simply said, “I don’t know,” and Buffett agreed, comparing it to an interesting movie where you don’t know the ending. However, Buffett did comment that that the Fed’s quantitative easing has the potential to be very inflationary and that “bonds are a terrible buy right now,” with which we at Edgemoor concur.  He said that the Fed’s balance sheet, which has swollen to $3.4 trillion, is in unchartered territory, and he observed that when the market gets the signal that the Fed is going to stop purchasing $85 billion of mortgage backed securities per month, it could be a “shot heard around the world.”

Be that as it may, it is this author’s opinion that Berkshire Hathaway’s stock is a good value in today’s market.

Once again, Berkshire Hathaway’s Annual Meeting was a showcase for the best of corporate America featuring the guru of value investing, 81-year-old Warren Buffett, and his long-time partner and alter ego, 88-year-old Charlie Munger.  Five hours of answering questions from shareholders, financial analysts, and journalists, and they didn’t miss a beat.

Management succession was again a major topic of discussion, but in spite of Buffett’s recent announcement of prostate cancer, the topic did not seem to be the same level of concern as previously.  Buffett said that he “feels good,” he does not require hospitalization, he is undergoing very successful treatment, and he expects to live many more productive years.  Berkshire’s board has designated a CEO successor who was described at the meeting as an existing Berkshire executive immersed in the company’s value investment culture.  As with Buffett, the new CEO would also be Chief Risk Officer who will continue to avoid excess leverage and insurance risk.  Could it be Ajit Jain who has been with Berkshire since the 1980s and is in charge of Berkshire’s own highly successful reinsurance business?  If so, we would applaud his choice.  Buffett praised Jain’s ability to create value and manage risk.

Future designated Co-Chief Investment Officers Todd Combs and Ted Weschler were reported to be performing well with assets under their management increased by $1 billion to $2.75 billion each.  Emphasis was also placed on the quality of Berkshire’s outstanding subsidiary CEOs, who run their companies independently.

Concern about the US economy was much less than that expressed in annual meetings of the last few years.  US banks were described as now being “in fine shape” with most of their “abnormal losses taken,” their capital “buttressed,” and their liquidity “built.”  The Federal Reserve and Treasury Department were given high marks for their actions which benefitted the banks’ recovery.  Problems still needing to be addressed include the ongoing excessive US government fiscal deficits and the high US unemployment rate.  Buffett said that the deficit could be contained by reducing expenditures to 21% of GDP and increasing revenues to 19% for a 2% differential as opposed to the current 8.5%.  Munger estimated the future US long-term real economic growth rate (above inflation) at 1% annually, which would increase the income of each succeeding generation by 25%, although income distribution between the wealthy and the poor could pose a problem.

Less confidence was expressed for Europe.  The European Central Bank’s support of the European banking system by providing one trillion euros of liquidity has kept the European banks in business, but successful resolution of the 17 member European Union’s sovereign debt crisis will be difficult to achieve politically.

Most of the annual meeting was spent discussing Berkshire’s operating subsidiaries and their future.  Buffett considers Berkshire’s stock significantly undervalued, and so do we. Historically, Berkshire Hathaway has traded in the range of 1.5–1.7 times book value, which we think more accurately reflects its true value.  Buffett renewed last year’s pledge that the company would repurchase its shares should their price fall to 110% of book value and further said Berkshire would be willing to purchase “tens of billions of dollars” of Berkshire stock at that level.   On the subject of dividends, Buffett believes that he can reinvest earnings for greater value to shareholders, so there will be no dividends forthcoming from Berkshire.

Buffett said that Berkshire’s major operating subsidiaries are performing extremely well.  GEICO’s share of the automobile insurance market has increased from 2% in the 1990s to 10% today, and he projects continued growth in underwriting profits and reserves available for investment.  As a regulated electric utility, MidAmerican Energy has significant opportunity for profitable additional investment.  So does railroad Burlington Northern Santa Fe, whose transport of one ton for 500 miles requires only one gallon of diesel fuel.  While MidAmerican and Burlington Northern are in capital intensive industries, Berkshire is “happy with their 12% return on equity” for new investment.  Altogether, Berkshire owns 79 operating companies plus many investments in publically held enterprises, the five largest of which are The Coca-Cola Company, International Business Machines Corp., Wells Fargo & Company, American Express Company, and The Procter & Gamble Company.

In response to a question, here’s a list of investment don’ts from Buffett and Munger:

• Stay away from companies you don’t understand and can’t forecast long term;
• Avoid highly priced stocks and look for those selling at less than intrinsic value;
• Stay away from initial public offerings (seller has too great a timing advantage);
• Avoid big disasters.

Sounds simple, but the trick is to execute like Warren Buffett.

As those who have followed our investing approach know, preferred stocks have been mainstays of our income portfolios for many years.  In today’s environment of low interest rates, including a yield of 2% on the 10-Year Treasury, the much higher yields offered by preferred stocks are particularly attractive.

Fidelity recently published a detailed review of the benefits and risks of investing in preferreds.  Click here to read the article and learn more about these securities.

For more on our approach to income investing, click here.

The Sokol Affair

Together with other regulars from Washington, DC who every year catch the single daily nonstop flight to Omaha, NE to attend the Berkshire Hathaway Annual Meeting, I shared opinions about the topic du jour and what Warren Buffett would say about it while waiting to board our plane.

I’m referring of course to the David Sokol scandal and the conflict of interest in putting his own personal investment in Lubrizol ahead of that of his employer.  So what would Buffett have to say about his once favored and now disgraced potential successor?  The news media hype about the need for Buffett to explain his previously issued inadequate press release on the subject had been intense.

It was topic number one at the meeting, and Buffett was well prepared.  A video preceding the annual meeting featured Buffett appearing in 1991 before a Congressional committee inquiry into Salomon’s violation of US Treasury Bond bidding rules and showed him saying, “Lose money for my firm, and I will be understanding.  Lose a shred of reputation for the firm, and I will be ruthless.”

Then came the meeting and the questions.  Buffett described Sokol’s behavior as “inexplicable and inexcusable”:  inexplicable in that Sokol made no effort to disguise his eventually disclosed improper purchase of $10 million of Lubrizol stock just before recommending its purchase by Berkshire, a trade almost certain to be questioned by the authorities; and inexcusable because Sokol never revealed his collaboration with Citibank which had been retained by Lubrizol for exploration of its purchase by Berkshire.

When the draft proxy statement from Lubrizol describing Sokol’s role with Citibank in seeking its acquisition by Berkshire was received, Berkshire’s counsel interviewed Sokol three times whereupon Sokol resigned before his involvement was to be reviewed by Buffett with Berkshire’s board.

Buffett acknowledged that his initial press release about Sokol’s Lubrizol stock purchase transgression had been inadequate.  He said he had tried to both announce Sokol’s inappropriate Lubrizol behavior but also recognize Sokol’s positive contributions to Berkshire.  Given his prior experience with Sokol, Buffett said he could not understand Sokol’s violation of Berkshire’s ethical standards.

In this writer’s opinion, Buffet acquitted himself well, but clearly this is not the last we will hear of the matter.  Whether or not legal action will be taken remains to be seen.

Management Succession

Buffett is 80, and significant preparation for his succession is already in place.  Plans call for a Chief Executive Officer to manage the operating subsidiaries, one or more Chief Investment Officers to manage investments and an independent Chairman with significant stock voting authority to provide oversight.  Berkshire already has several excellent internal management candidates for the CEO position, has employed investment manager Todd Combs as a potential CIO, and named Buffet’s son Howard to succeed his father as Chairman.  Meanwhile, Buffett continues to enjoy excellent health.

US Government Debt Ceiling

Buffett was outspoken about the need for Congress to raise the US Debt ceiling.  Failure to do so would be “the most asinine thing Congress has ever done.”   He also said, “There is no chance that the debt ceiling won’t be raised.”

Protection Against Inflation

For Buffett, investing in companies which can raise their prices and profits is the only sure way to protect against inflation.  Their higher earnings will support higher values for their stocks in an inflationary environment.

He doesn’t think much of gold or foreign currency for inflation protection. Gold doesn’t produce anything and historically has not been a good inflationary hedge.  Currency value is determined by the behavior of government which is too difficult to predict.

Berkshire Hathaway Stock

Buffett will not say what he thinks Berkshire’s stock is worth, but he does say that its current price is undervalued.  As a result, he is only interested in purchasing other companies for cash and is not interested in using Berkshire shares for making acquisitions.

Nor does Buffett have any interest in Berkshire paying a dividend.  He strongly believes that Berkshire can earn more by redeploying its cash flow to new investments than its stockholders could earn by reinvesting any dividends from Berkshire.

Conclusion

So in a nutshell, that’s the 2011 Annual Meeting of Berkshire, still well worth attending just like all that preceded it. The Sokol scandal will not be of lasting significance, and it’s a good thing that the unsuitability of Sokol as a CEO candidate is known now rather than later.  Meanwhile, the fundamental strength of Berkshire Hathaway continues.