Michael Santoli

Warren Buffett and the Three Bearish Questions

Michael Santoli

Along with extolling the cash-spewing powers of Berkshire Hathaway Inc.’s (BRK-A, BRK-B) many operating companies and praising the brilliance of their managers, Chairman Warren Buffett used his eagerly consumed annual shareholder’s letter to launch a search for one brave devil’s advocate on what he termed a "subpar" year (the company's 14.4% increase in per-share book value failed to beat the S&P 500's 16% total return in 2012, its ninth "miss" in 48 years and its third in four years).

In addition to inviting investors, select financial journalists and hand-picked analysts to pepper him and partner Charlie Munger with questions at the massive May 4 annual meeting in Omaha, Buffett for the first time (“to spice things up,” he wrote) will choose one professional investor who’s bearish on Berkshire to supply skeptical queries.

Buffett writes that the “credentialed investor” should preferably be short Berkshire stock, which in the past year has gained nearly 30%, placing the A shares at $152,750 as of Friday’s close. (Only 1% or so of Berkshire shares are sold short, so perhaps there will be a flurry of new negative bets applied by those who aspire to be the lucky bear.) The chosen naysayer will also have to be rather brave and tolerant of hostile feedback: The Berkshire meeting typically draws close to 40,000 Buffett acolytes who feast on the companies’ myriad consumer goods as well as Buffett’s clever folksiness. (Or is it folksy cleverness?)

Here’s an educated guess on three questions a bearish investor might pose to the Oracle:

- Your stock now trades at a 37% premium to its book value. This seems to represent the market paying extra for your stewardship and investment acumen, as well as recognition of the value you have created over nearly half a century.

How can that premium valuation be justified, now and in the future, given three facts: As you have frequently conceded, you will not be here to run things forever; at Berkshire’s present enormous size, it would appear very unlikely the past value creation pace can be approximated; and there are huge latent tax liabilities on the balance sheet from your tremendously appreciated equity positions?

- Why should investors not expect cash dividends from Berkshire? Your chairman’s letter makes the case for why Berkshire can, in theory, generate greater long term value by reinvesting cash at a high return rate and allowing those investors desiring cash to sell a portion of their shares each year.

Fair enough, though, as stated above, the expected rates of return on reinvested cash are not guaranteed and essentially all of Berkshire’s businesses are mature and self-financing. And couldn't an investor quite easily reinvest his dividend back into Berkshire to capture those future returns?

- How can investor gain any confidence in the economics of Berkshire’s core reinsurance business? Persuade us that it is not simply an impenetrable black box. You spend great care in your letter explaining that the tendency of Berkshire’s insurance businesses to generate both large “float” from premiums collected as well as a profit after paying out claims is a glaring exception in the industry as a whole, which tends to compete away float and underwriting profits. How can an investor know that the business is not assuming undue risks or engaging in excessively complex financial arrangements to turn these tricks?

No doubt Buffett and Munger will have thoughtful, ready answers to such queries, as well as any others that the tomato-throwers bring to Omaha. But that won’t stop plenty of wise-guy investors from competing to be the one who tries to prove to the Berkshire faithful that Buffett’s clothes aren’t there.

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