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As has tended to happen often in recent years, the importance of Indian-born Ajit Jain was once again highlighted in a number of Berkshire shareholder questions at the AGM. In this segment, 2016’s final burst, most of questions focused on heavy financial issues. But one of the more insightful lines of inquiry centred on Jain, a man whom many believe will eventually succeed Buffett. As the Oracle of Omaha fully intends living past 100, Jain – or any other would-be Berkshire CEO for that matter – may have a long wait ahead. So, what would Berkshire do if it last its resident insurance genius? – Alec Hogg
The final segment of the Berkshire AGM question and answers session starts with response to an inquiry around BNSF, the railroad subsidiary that is chewing up lots of fresh capital expenditure – far more than the annual depreciation charge. That has an obvious impact on free cash flow – but Warren Buffett is unrepentant…..
WARREN BUFFETT: As I mentioned in the annual report, in the case of all railroads, merely spending their depreciation expense will not keep them in the same place. Depreciation is an inadequate measure of the actual steady state capital expenditure needs of a railroad. Even in these fairly, non-inflationary ways, and that’s an important consideration in buying the business. We knew that going in and it’s been reinforced since. We spent a lot of money in 2015 because we had a lot of problems to correct and that was the one we spent the $5.7bn. I would say that the true maintenance Capex, if you’re looking at $4.3bn, is higher than 60 percent of that number when you really evaluate. Keeping the railroad in competitive shape to do just the same volume as it would be doing the year before. There is an additional expense at the BNSF that is not reflected in the figures.
There we also have a lot of intangible expenses of some other businesses that aren’t real expenses. I mean overall, I think that Berkshire’s figures actually are on the conservative side in relation to real economic earnings but that’s not true at any railroad. They’ve also had something called Positive Train Control, which amounts to a lot of money for the industry. I think we may be a little further along than most of them in paying for that, but that’s $200m or R300m a year and maybe, whether it will be close to $2bn or something like that on aggregate. It is a very, capital-intensive business. At the BNSF we run far more, gross in revenue ton-miles than any other railroad in North America and that has obviously, some is a factor on capital expenditures but I would say that it’s very likely that we will spend more than depreciation, unfortunately, quite a bit more than depreciation, to stay in the same place for a long time, as will other railroads.
That is a negative in the picture. We will always be looking for ways to use capital expenditure money to develop additional business and we get that opportunity regularly. It is just a question of the size of it and we did a lot of that in The Bakken and we reckon we got benefits from it. We’re not getting benefits as much as we thought we would at this point, when the price of oil was falling, but that was very sensible capital expenditure, and I hope we get the opportunity to do more. What’s happening in coal with the decline, that doesn’t really have anything to do with our overall capital expenditure budget, except we won’t be spending a whole lot of money to expand in that arena. Does that answer your question okay?
I was just thinking maybe with intermodal as well, if that’s the longer-term opportunity to invest more heavily there?
WARREN BUFFETT: We’re always open to it but you have to see a fair amount of revenue coming. We had a proposition very recently, which we worked on for many years, in terms of making the Port Long Beach Intermodal Facility considerably more efficient and we spent a lot of money on that and spent a lot of time. We would have spent a lot more money, a whole lot more money, if it had been approved. Recently the court came out with the decision that was negative on it, and whether that kills the chance to do that or we look someplace else – we’ll have to look at the situation.
CHARLIE MUNGER: Our competitors there pretend to be environmentalists. It’s a common practice now.
WARREN BUFFETT: Yeah, in any event we thought we had something that made a lot of sense for both the area and the transportation system of the country, but…
CHARLIE MUNGER: We were trying to do the right thing and so far, we’ve lost.
WARREN BUFFETT: But we’re still willing to spend a lot of money. If we can find things that make the railroad more efficient or make it larger either way.
Do you believe major fluctuations in the supply of crude oil influence the US’s future monetary policy decisions?
CHARLIE MUNGER: Well, my answer would be ‘not much’.
WARREN BUFFETT: It’s an important industry obviously, and the decline in the price of oil has had a lot of effects, very good for the consumer, hundreds of millions of consumers, and very bad for certain other businesses, like the one we bought in Lubrizol and some others, to a degree. Net, it should be good for the United States overall that low prices for oil or a net oil importer. Just like it’s good for the United States to have low prices for bananas, we’re a banana importer. Anything we net buy is a plus when prices fall but oil is big enough and extends into so many areas that it also hurts plenty when the price of oil falls and it particularly hurts capital values.
The consumer gets the benefit. He or she goes to the filling station every two or three weeks or something like that and it comes in relatively small increments. The capital value contraction, which is huge if you project out lower price oil for a while, hits immediately. An oilfield that was worth X, maybe worth half-X or a third of X or no X overnight. So there are certain big factors – in terms of our chemical operation people just stop ordering – so you have this big impact on capital values immediately and you have the benefits moved in over time. Net – the United States is better off and Saudi Arabia is worse off when prices of oil are lower. Oil is a big part of the economy but our economy has continued to make progress overall, during the oil price decline but obviously, given regions suffered disproportionately. Just like they got a real boom during the period when oil was at $100 and when fracking came in big time. Charlie…?
CHARLIE MUNGER: Well, I think that will do it for this subject.
Why is it necessary for Berkshire businesses to have so much working capital, particularly so much cash? More generally, how do you think about efficiently managing the working capital of a business segment so large, sprawling, and decentralised as this one?
WARREN BUFFETT: We have accessible cash every place at Berkshire, so at present it really doesn’t make any difference whether we have it at certain subsidiaries or other subsidiaries. As I’ve pointed out in the past, we’ll never go below $20bn in cash and we’ll actually stay comfortably above it, but allowing for the preferred that’s going to, at times, be over $60bn of consolidated cash. We don’t really worry much about what pocket it’s in. It’s not making anything anyway, at these levels. Now, if rates move higher we’ve actually got the mechanics in process to do sweep accounts and that sort of thing. So I would pay no attention to the particular cash that’s been held in that category there.
The cash in Berkshire Hathaway Energy, the cash in the railroad, we have independent levels that we don’t guarantee their debt and they run with ample cash and we would not look at sweeping that down to a minimum. If you talk about 40 to 50 of our miscellaneous subsidiaries we will go to a sweep account when rates gets to where it really makes any difference to do it. Right now, when you’re getting zero interest rate, there’s not much difference where you get zero. I think the fellows over-analyse it a little bit but I understand why he did it.
CHARLIE MUNGER: Warren, one of his ideas is why don’t we imitate some of these other people and pay our suppliers a lot more slowly, so that we have more working capital.
WARREN BUFFETT: That’s a big thing in business now and last year, Walmart for example, went to almost all of their suppliers, as I understand it, and certainly the companies that we supply, and they basically, had a list of half a dozen things that they wanted present suppliers to agree to. One of those things was more extended terms. Each of our companies made their own decisions but my guess is they got more extended terms from most of their suppliers, maybe a very high percentage of their suppliers. And they may have gone from, I don’t remember the exact request, from 30 to 60 days, or what it was – they got a meaningful extension. In a couple of years (it takes time to implement) you will see higher payables relative to sales at Walmart, than you saw a year or two ago. They are under a lot of pressure, competing with Amazon and others, and that’s one of the ways they expressed it.
I’ve seen it done at other places and it’s conceivable that one of our subsidiaries might deem it wise to do it but I don’t think they will. I think that the pressure for cash at Berkshire is not that high and I think that the pressure for the desire for great relations with suppliers would probably overcome, in most of our manager’s minds, any desire to start extending terms.
CHARLIE MUNGER: I think it’s hard to do that brutally, when you’re rich and your supplier isn’t, and think that your supplier is going to love you. I think there is something to be said for leaning over backward to have a win-win relationship with both suppliers and customers – always.
WARREN BUFFETT: It’s never been pushed at Berkshire. You can argue we’ve got a pretty, good thing going on in float anyway.
CHARLIE MUNGER: Yeah and we don’t need it. Let somebody else set the record on that one.
Most American corporations separate out supposedly, onetime restructuring costs, whereas Berkshire doesn’t. Berkshire’s reported operating earnings are therefore of higher quality. Have you ever calculated how much higher operating earnings on average would be if Berkshire separated out plant closing costs, product line exits, severance pay, and similar items? Is it a material number or does Berkshire not incur much in the way of these types of costs, typically, because most of your acquisitions are standalone?
CHARLIE MUNGER: Let me take that one. That’s a question like asking, “Why don’t you kill your mother to get the insurance money?” We don’t do it. We’re not interested in manipulating those numbers. We haven’t had a restructuring charge ever, and I don’t think we’re about to start.
WARREN BUFFETT: We don’t do that. The numbers would not be huge. There could be a year, I suppose when they might be for some reason, but there are more conservatively stated at most companies and I think they have higher quality, but I pointed out also that I think our depreciation expense at the railroad, which is standard, and which all the other railroads use, is inadequate as a measure of true, operating earnings.
CHARLIE MUNGER: You’re talking about… We like to advertise our defects.
WARREN BUFFETT: Not all of them. There’s no question that I think we will have more amortisation of certain intangibles, which reduce earnings, and reported earnings, which in reality are not expenses. We’ll have more of that than some companies and I’ve pointed that out. I never want to report one of these things where I have the whole adjusted earnings set out and say, “This is what you’re supposed to pay attention to,” because everyone of those I’ve seen virtually results in some inflation of figures. Things are good enough at Berkshire. We don’t need to inflate the figures.
The premium on your CDS is about 31 bases points at the end of the year, so market-to-market, it’s probably at the high teens or twenties, so would you consider unwinding this position? Are you allowed to do it in your annual report you say no, but probably you can make exactly the contrary trade on it. That means you are buying protection, is that a philosophy, which you stand behind, could you do that when the premiums are extremely low?
WARREN BUFFETT: Because we have one position left over from six or seven years ago, or thereabouts that involves us selling protection on zero coupon, municipal bonds with a nominal value, maturity value, which is, since there are zero coupons is far off and not present value at all – I think $7.7bn or something like that. We’re just sitting with that position because we like the position. Our CDS, that’s an insurance premium against our debt that people buy, there’s a fair amount of activity in it from time to time. I think that’s partially caused by the fact that we neither collateralise that municipal contract, but we don’t collateralise with minor exceptions the equity puts that are still out there. So the counterparties have to buy protection on Berkshire’s credit through CDS’s.
Now, the people they buy it from, their credit probably isn’t as good as Berkshire’s, but it’s probably an internal rule at some of these firms that are on the other side of the contract. But that really doesn’t make any difference to us. Back in 2008 and 2009, our CDS prices went up to a crazy level and I even commented here at the annual meeting that I would love to be selling them myself, except I wouldn’t be allowed to. What goes on at the CDS market really isn’t of any particular interest to us and it’s too bad for the other guys. They didn’t get collateral from us and we wouldn’t have given it to them, so they have to buy these things that, like I say from our standpoint, they are wasting their money but they probably have internal rules that make them. Charlie, do you think I’ve addressed his question?
CHARLIE MUNGER: Well, the truth of the matter is we don’t pay much attention to trying to get an extra two bases point by being gamey on our short-term things and that credit fault position is a weird, historically accident. We don’t pay much attention to it either. It will go away in due course.
WARREN BUFFETT: Yes, all of our contracts are just going to expire. Now, we do a few operational contracts in our energy company. I mean there’s a couple of places where they, for their own reasons and sometimes because the Utility Commissions want them to, they do certain things but its peanuts. The positions that I instituted six or seven years ago are basically all in a run-off position and the first big run-offs will be in 2018, in a couple of years.
CHARLIE MUNGER: We’re basically, not in that. We don’t fool around with our own credit default swaps at all….
WARREN BUFFETT: No, never but I would have liked to have sold them in 2008. They actually got up.
CHARLIE MUNGER: I know. It was crazy.
WARREN BUFFETT: People were paying 500 basis points, five percent, in terms of betting that Berkshire would go broke, which was totally crazy. But I couldn’t take advantage of it. I wanted to though.
Please comment on the impact on National Indemnity in Berkshire if something happened to Ajit Jain..
WARREN BUFFETT: There’s not another Ajit in the house. If we lost him the impact would be very significant and that would be true of some other managers at some other subsidiaries. It’s quite dramatic with Ajit’s operation because literally there were a few years when we had like 30 people where that operation – it was an unusual period at the end – where it’s earning potential under Ajit was fantastic. That probably won’t happen to that degree again. I wish it would but he’s done a tremendous amount for Berkshire. But I could, you know, starting with Tony Nicely….There’s been a lot of managers that have created billions and billions of Dollars of value for Berkshire. Maybe you can even get into the tens of billions. It’s having a fantastic manager that has a large potential business available to them, and whom makes the most of it – it’s huge over time and you don’t see it necessarily in a week or a month.
When you’re building capital value, I mean think of the value of Jeff Bezos to Amazon. I mean, it wouldn’t have happened without him. You’re looking at huge values. I can name other situations. The value of Tom Murphy and Dan Burke was the difference between a zero and what they ended up with. They built that thing from a bankrupt UHS station in Albany. They didn’t invent television or anything of the sort. They just managed it so well. Really outstanding managers – they’re invaluable and Charlie and I can’t do it ourselves but we want to align ourselves with them, and then have them feel about Berkshire the way we feel about it. If we do that then we have an enormous asset and we do have, in Ajit and a number of the other managers. Charlie…?
CHARLIE MUNGER: Yes, Ajit has a longer shelf life than we do. He’d be particularly missed.
WARREN BUFFETT: Well, let’s not give up here Charlie. I reject such defeatism.
Low to negative interest rates are something that’s been discussed a few times today, and you’ve mentioned its implications for a return on float. I was wondering how should shareholders value the 25 percent of the float that’s been created where the business is booked at an underwriting loss and, at times, has adversely developed.
WARREN BUFFETT: Cliff brings up some of our business in the insurance business. We take with either the probability of some underwriting loss, in order to get to use the money for a very, long period of time. It would look, under today’s interest rates, like we can’t do much with that. There’s two answers to that. We don’t think for the duration of the kind of contracts we have, we don’t expect these rates but we could be wrong. The second one also is that we do think that occasionally we will get chances, even in periods of low interest rates, to do things that will produce very reasonable returns. We are not measuring it against double A corporate or anything of the sort. We’re measuring it in the potential utility to us with our pretty unusual flexibility in respect to the deployment of funds and this long period, when we’ll have an opportunity perhaps to come up with one or two things where we can deploy money at a rate that maybe quite a bit higher than other people. Charlie…?
CHARLIE MUNGER: Yeah, we’re willing to pay a little money now to have just the certainty of having a lot of money available, in case something really attractive comes up, in a bit of a difficult time.
WARREN BUFFETT: It’s an option cost.
CHARLIE MUNGER: It’s an option cost, right.
WARREN BUFFETT: That option came in handy in 2008 and 2009, for example.
CHARLIE MUNGER: Did it ever.
How do you feel about the real estate market today?
WARREN BUFFETT: It’s not as attractive as it was in 2012. We’re not better at predicting real estate markets than we are stock markets or interest rate markets but there’s certainly – and it’s driven to some extent by these low interest rates – there is certainly properties that are being sold at very low cap-rates that strike me as having more potential for loss than gain. Again, if you can borrow money for very little and you think you’re getting it at a very, safe asset, at 100 bases points or 150 bases points higher, there’s a great temptation to do it. I think it’s a mistake to do that but I could be wrong. I don’t see a nationwide bubble in residential real estate now, at all. I think in a place like Omaha and most of the country you are not paying bubble prices for residential real estate. But it’s quite different than it was in 2012, and I don’t think the next time around the problem is going to be a real estate bubble. I think that it certainly was the cause, in a very large part of what happened in 2008 and 2009, but I don’t think it will be a replica of that. Charlie…?
CHARLIE MUNGER: Nothing to add.
Portfolio managers Todd Combs and Ted Weschler have now been at Berkshire for several years – what have been their biggest hits and failures, specifically? What are the biggest differences between you and them?
WARREN BUFFETT: Each has a $9bn portfolio and one of them has, perhaps seven or eight positions and the other one has maybe 13 or 14. They have a very, similar approach to investing. They’ve both been enormously helpful in doing several things, including important things, for which they don’t get paid a dime and which they’re just as happy working on as working on the things as they are when they’re working on things that do pay off for them financially. They’ve got perfect cultural fits for Berkshire. They’re smart at what they do and they’re a big addition to Berkshire. Charlie…?
I would say they have a bigger universe to work with because they can look at ideas, in which they can put $500m and I’m trying to think of ways to put billions. They certainly have a more extensive knowledge of certain industries and activities in business that have developed in the last 10 or 15 years. They’d be smarter on that than I am. Their approach to investing – they’re looking for businesses that they understand and, through the stocks of those businesses that they can buy at a sensible price, even if they think it will be earning significantly more money five or ten years from now. It’s very similar to what I’m thinking about, except that I’d add another zero to it.
CHARLIE MUNGER: And we don’t want to talk about specific hits and failures.
WARREN BUFFETT: Yeah, we will never get into disclosing, I mean we file reports every 90 days that show what Berkshire does in marketable securities but I may identify whether it’s mine or theirs, but we don’t get into identifying what they do individually.
Cyril Ramaphosa: The Audio Biography
Listen to the story of Cyril Ramaphosa's rise to presidential power, narrated by our very own Alec Hogg.