Woodstock for Capitalists: 2006's Greatest Hits

We recently made our yearly pilgrimage to the  Berkshire Hathaway (BRK.B) annual meeting in Omaha, Neb., and while we always gain insights from listening to Warren Buffett and his partner Charlie Munger answer shareholder questions, we thought that last weekend's dialogue was particularly enlightening. Here are some of the more salient thoughts we gleaned from the meeting; we believe that they will help all investors understand how Berkshire's dynamic duo think about investments, business, and managing the company.

Incentives
We've always believed that one of Buffett's biggest strengths has been his ability to create incentive systems that appropriately motivate and reward Berkshire's managers. So when a shareholder asked both he and Munger how they would design a compensation system for a management team in a highly cyclical industry, such as mining, we were particularly interested in the response.

In typical Buffett fashion, he indicated that he if were running a copper mine, he would not pay managers based on the profitability of the mine, since profits are largely dependent on the level of worldwide copper prices, and even the "village idiot" would look like a genius when prices were high. Rather, he said that he would base a manager's remuneration on his ability to cost-effectively extract copper from the mine, as this is largely dependent on the manager's skill and aptitude. We think that Buffett's focus on compensating managers based on aspects of the business that are directly under their control frees Berkshire's managers to think like long-term owners of their businesses. In our view, this attitude is a key element of Berkshire's culture.

Passing the Baton
Speaking of Berkshire's culture, Buffett repeatedly referred to the strength of the firm's culture every time he addressed the topic of his eventual successor. We don't doubt that Berkshire's culture will endure long after both Buffett and Munger are gone, but we think that Buffett was trying to gently assure shareholders that he has taken the appropriate steps to safeguard their wealth.

Munger was a bit more poignant on the topic, asking rhetorically, "Do you really think Warren is going to blow the job of passing the baton?"

We don't, and we're even more comforted by the fact that Buffett and the board have identified one person that will take over should he "die tonight." While this person will not be identified, Buffett did indicate that this individual is very deal-savvy. We think this is appropriate, as this person will be charged with shrewdly investing Berkshire's ample cash flow. What's more, we think shareholders should rest easy now that Buffett's successor has been identified.

International Investments
Buffett introduced shareholders to his first international acquisition at this meeting when he revealed the purchase of 80% of Iscar Metalworking Companies for $4 billion. Iscar is an Israel-based manufacturer of metal cutting tools and appears to have all the elements of a typical Buffett acquisition. Iscar operates a simple and profitable business whose fundamentals won't change much in five or 10 years' time. In addition, Iscar has been owned and operated by the Wertheimer family, and they share Buffett's long-term outlook and intend to maintain their 20% stake in the company. While Buffett did indicate that he looks for a larger margin of safety when making international investments, we think that he was able to get a favorable valuation from the Wertheimer family, since they sought Berkshire as their partner.

We look for more international purchases from Berkshire in the coming years, given the heightened competition for domestic acquisitions and Buffett's continued belief that large U.S. trade deficits will eventually cause the dollar to weaken.

Insurance
After a bruising two years of large hurricane losses, a shareholder asked Buffett if insurance rates were increasing and also if there was a flight to quality within the industry. Buffett indicated that there were "great variances" within the insurance market, with prices up substantially throughout Florida and the Gulf Coast, but still declining in other areas. He also assured shareholders that even if the industrywide losses from Katrina were $250 billion, about 4 times bigger than the storm's actual losses, Berkshire would incur about a $10 billion loss, which it could comfortably pay.

Buffett did say, though, that if catastrophe prices continue to increase, Berkshire is prepared to "take on more risk." While Buffett refrained from making any weather or earthquake forecasts this year, he did indicate that he and Ajit Jain--Berkshire's reinsurance guru--still expect to make pleasing returns from Berkshire's "mega-cat" policies over time.

Investment Advice
Each year, several shareholders ask Buffett and Munger for investment advice, and in our view their responses are timeless. We were particularly stuck by two comments this year:

"...you must have a willingness to do something when everyone else is petrified."
and
"...you must learn the lesson of following logic over emotion."

These comments resonate with us, as they imply that successful investing is based on a level-headed temperament and reasonable judgment, rather than a magic formula or a black box.

When we apply these same tenets to analyzing Berkshire, we think that they indicate a compelling case for an investment in the conglomerate. A myriad of risks continues to pressure Berkshire's stock price, including the question of Buffett's eventual successor, the large hurricane losses, and Berkshire's inability to quickly reinvest its prodigious cash flow. However, given some reasonable assumptions and forecasts, we believe that the underlying value of the company is much greater than what the current share price indicates. (In the Tortoise Portfolio of our StockInvestor newsletter, we have our money where our mouth is.) We think astute investors may want to take this opportunity add to their Berkshire holdings.