Berkshire AGM transcribed – Buffett lays into executive pay “shell game”

Executive remuneration is an issue guaranteed to get the Oracle of Omaha hot under the collar. So not surprisingly, he uses the opportunity presented by an AGM question to beat this particular drum really hard and visit in some detail what he believes is an ever escalating shell game. He suggests that simplicity works best and offers an alternative to the status quo where the CEO appoints expensive remuneration consultants who are themselves incentivized to devise complex systems that reward the one who hired them. As ever, Warren Buffett and Charlie Munger offer a rational alternative. Also in this segment, Buffett struggles to defend Berkshire’s hefty historical investment in American Express; dismisses speculation that the group’s insurance wizard Ajin Jain has been anointed as his successor and offers advice to a cattle farmer. – Alec Hogg 

This segment starts off on a popular theme at the AGMs – succession planning. The questioner implies there is now a greater likelihood of Berkshire’s insurance guru Ajit Jain eventually replacing Warren Buffett – when the head of General Re retired, instead of him being replaced, the responsibility was added to Jain’s already full card……. 

WARREN BUFFETT: Well Tad Montross, after 39 years, has done an absolutely sensational job for Berkshire. Gen Re was a problem child for a while, as you know, some brought on by itself and some external. Tad is sensational, and I tried several times to get him to stay longer. It makes sense to have the reinsurance operation under Ajit who has the ability to handle more in insurance. He oversees a company called Guard, which most of you have never heard of, and we bought it a few years ago. It’s doing terrifically. It’s based in Wilkes-Barre, Pennsylvania. It’s doing a great job, with small business policies, primarily Workers Comp around the country and it’s flourished. It’s being put under Ajit. He started the speciality operation a couple of years ago and under Peter that is going gangbusters.

I have found with really able people, they can handle so much. Well just, take Carrie who put this meeting together. If you have some preconceived notion that an annual meeting that’s going to have 40 000 people needs to spend millions of Dollars with all kinds of organisational planning and meetings.  But really, able people – my assistant, Debbie Bosanek, she can do anything – there’s just no limit what talented people can accomplish. If I had something in insurance tomorrow that needed doing, I would probably call Ajit on that too.

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You know, in terms of my succession that is something….we’ll have a board meeting on Monday but we’ll talk about it as we always do at every meeting and our thoughts are as one on that. And everybody knows why it makes the most sense. But five-years from now something different could make sense. That’s one reason for not announcing any names. I mean, who knows what happens in terms of the time when it happens, or what happens to the person involved maybe their situation changes. There are no tea leaves to read in the fact that Ajit is supervising Gen Re from this point forward. Charlie?

CHARLIE MUNGER: Well, there’s an obverse side to that. Not only can the able people usually do a lot more, but the unable by and large you can’t fix. I think you’re forced to use our system if you have your wits about you.

WARREN BUFFETT: We don’t feel the need to follow any kind of organisational common view as to ‘you do this’ and ‘you have only so many only so many people can report to you’ or any of that sort of thing. At Berkshire, every decision that comes up we just try to figure out the most logical thing to do at that time. We don’t have some grand design in mind, like an Army organisational chart or something to the sort, and we never will.

CHARLIE MUNGER: Warren and I once reached the decision we wouldn’t pay more than X Dollars for something and the man who was subordinate to both of us who was working on it said, “You guys are out of your minds. This is really, stupid. This is a quality operation. You ought to pay up for it.” We just looked at one another and did it his way. We don’t pay any attention to titles.

WARREN BUFFETT: He was right too.

CHARLIE MUNGER: He was right, yes, of course. Is a charwoman gave us a good and we’d accept it cheerfully.

WARREN BUFFETT: Actually, one time the woman who does clean my office came in and I think she’d been kind of wondering what I did. I’d see her frequently, her name was Ruby. Finally, one day she decided to get to the heart of the matter and she said, “Mr Buffett, do you ever get any good horses?” Apparently, she thought I was really making my money at the track.

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With Berkshire Hathaway being so well-managed why, doesn’t it have a highest credit bond rating? 

CHARLIE MUNGER: I’m going to take that one. The rating agencies are wrong and set in their ways.

WARREN BUFFETT: And we don’t fit their model very well. I mean, we don’t look like anything exactly, they see otherwise. I’ll say this though. When they come in the door I always say, “Let’s talk quadruple A.” I believe in starting the negotiation from that angle. I never get any place.

While 3G has been very successful in cutting costs and increasing margins at Kraft Heinz, the company has seen volumes and revenues decline. As a long-term investor, how do you judge when a management is cutting muscle as well as fat? Can a business increase revenues, while cutting costs? 

WARREN BUFFETT: Well, the answer is yes that sometimes you can cut costs that are a mistake to cut; and sometimes you can keep costs that are a mistake to keep. Tom Murphy had the best approach. He never hired a person they didn’t need, and therefore they never had layoffs. You might say that at headquarters at Berkshire, we followed a similar approach. We just don’t take on anybody. Now, I think it is totally crazy when companies are in a cyclical business – you may have to cut a workforce because there aren’t as many carloads of freight moving or something like that, so you cut back on crane crew and all that. The idea that you give up your staff or whatever it maybe an economist or something like that because business has slowed down, if you don’t need them now then you didn’t need them in the first place. People that are there just because somebody started a department and they hired more people and so on, I would argue that since we’ve forgotten to insult this group so far, I would suggest that happens in investor relations departments perhaps, or something of the sort. You get a department going and they are always going to want to expand.

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The ideal method is not to do it in the first place but there are all kinds of American companies that are loaded with people that aren’t really doing anything or doing the wrong thing, and if you cut that out it should not really have any significant effect on volume. On the other hand if you cut out the wrong things, it can have a big effect. It can be done in dumb or a smart way. My impression with everything I’ve seen, and I’ve seen a fair amount so far, is that 3G, in terms of the cost cuts that they’ve made, they’ve been extremely intelligent about it and have not done things that will cut volume. It is true that in the package goods industry, volume trends for everybody, whether there are fat or lean in their operation, volume trends are not good.

The test will be over time, (three or five years) are the operations which have had their costs cut, do they do poor in terms of volume than the ones that in my judgement look very fat. So far I see no evidence of that whatsoever. I do think at Kraft Heinz for example, we’ve got certain lines that will decline in volume. I think we’ve got certain lines that will increase but I think overall, the package goods industry is not going to go any place, in terms of physical volume and it may decline just a bit. I’ve never seen anybody run anything more sensibly than 3G has, in terms of taking over operations where costs were unnecessarily high and getting those costs under control in a hurry. The volume question we’ll look at as we go along. But believe me, I look at those figures every month, and I look at everybody else’s figures every month. I’m always looking for any signs of underperformance because of any decisions made, and I’ve seen none. Charlie?

Commemorative items for sale are on display at the Kraft Heinz booth during the Berkshire Hathaway Annual Shareholders Meeting at the CenturyLink Center in Omaha, Nebraska, U.S. April 30, 2016. REUTERS/Ryan Henriksen
Commemorative items for sale are on display at the Kraft Heinz booth during the Berkshire Hathaway Annual Shareholders Meeting at the CenturyLink Center in Omaha, Nebraska, U.S. April 30, 2016. REUTERS/Ryan Henriksen

CHARLIE MUNGER: Yeah and sometimes when you reduce volume it is very intelligent because you’re losing money on the volume you’re discarding. It’s quite common for a business not only to have more employees than it needs, but it sometimes has two or three customers that could be better off without. It’s hard to judge from outside, whether things are good or bad just because volume is going up or down. Generally, speaking I think the leanly staffed companies do better at everything, than the ones that are overstaffed. I think overstaffing is like getting to weigh 400lbs when you’re a normal person. It’s not a plus.

WARREN BUFFETT: Yes, sloppy thinking in one area probably indicates there may well be sloppy thinking elsewhere. I have been a director of 19 public corporations. I’ve seen some very sloppy operations and I’ve seen a few really outstanding business operators, and there’s a huge difference. If you have a wonderful business, you can get away with being sloppy. We could be wasting a billion Dollars a year, at Berkshire, you know $640m after tax, that would be four percent of earnings, and maybe you wouldn’t notice it….


Barbarians at the Gate WARREN BUFFETT: Charlie would notice it… It’s the really prosperous companies that well….the classic case were the tobacco companies many years ago. They went off into this thing and that thing, and it was practically play money because it was so easy to make. It didn’t require good management, and they took advantage of that fact. You can read about some of that in ‘Barbarians of the Gate’.

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Berkshire paid $4.1bn for Van Tuyl’s auto retailing business and consolidated its earnings for nearly ten months for last year – could you explain the difference between the likely economics of the deal and what can be inferred from the annual report figures? 

WARREN BUFFETT: It is better than it looks. For one thing, we got a billion Dollars of securities, roughly, with the $4.1bn and those securities we’re basically carrying at a quarter of a percent, but that billion is available to us. That came with the deal. There are some very significant acquisition accounting charges that will continue for a couple of years and I’m happy to have taken that way. The economics of Van Tuyl, I would say have worked out almost exactly. If you had me a year ago layout a projection – I don’t do it but if I had – it would look very much like things have turned out. Jeff Rachor, who runs that organisation, really fits the Berkshire mould. We’ve got a first class CEO there. Take a billion off the purchase prices for openers and then there are some amortisation charges of items that are allowable that make you correctly see a fairly low figure, against what it appears the acquisition price was. So far, it’s exactly on schedule, and the schedule was perfectly satisfactory.

Incidentally, we haven’t had much luck so far in acquiring other auto dealerships, based on the same metrics that we bought Van Tuyl and I think to a small degree that’s because people think we paid more for Van Tuyl than we did. They’re not seeing certain factors in it, so they think we paid X and, therefore they’re entitled to X, and we didn’t pay X, so we haven’t made or we’ve bought very, little so far. I hope that changes in the future but we’re not going to change our metrics, in terms of how we value auto dealerships.

When interest rates go from zero to negative in a country, how does that change the way that you value a company or a stock? 

WARREN BUFFETT: Going from zero to minus a half is really, no different from going from four to three and a half. It has a different feel to it obviously, if you have to pay a half a point to somebody. If you have your yield or your base rate reduced by half a point, it’s of some significance but it isn’t dramatic. What’s dramatic is interest rates being where they are, generally. I mean whether it’s zero plus a quarter or minus a quarter, or plus a half or minus a half, we’re dealing with a situation that’s essentially very close to zero interest rates and we  have been for a long time, longer than I would have anticipated. The nature of it is that you’ll pay more for a business when interest rates are zero, than if they were like 15 percent when Volker was around and you can take that up and down the line.

We don’t get too exact about it because it isn’t that exact to science. But very cheap money makes me pay a little more for businesses than when money was at what we previously thought was normal rates, and very tight money would cause me to pay somewhat less. We had a rule for 2600 years that Aesop lived around 600BC but he didn’t happen to know what was BC – he can’t know everything – and it was that a bird in the hand is worth two in the bush. But a bird in the hand now is worth about nine-tenths of a bird in the bush in Europe. It depends on how far out of the bush it is, but it keeps getting a little less as you go along. These are very unusual times. If you ask me whether I paid a little more for Precision Castparts because interest rates were zero, than if they had been six percent. The answer is yes. I try not to pay too much more but it has an effect. If interest rates continue at this rate for a long time, if people ever really start thinking this is normal that will have an enormous effect on asset values. It already has had some effect. Charlie…?

CHARLIE MUNGER: I don’t think anybody really knows much about negative interest rates. We’ve never had them before and we never had periods of stasis, except for the ‘Great Depression’. We didn’t have things like happened in Japan – a great, modern nation playing all un-monetary tricks, Keynesian tricks, stimulus tricks, and mired in stasis for 25 years. None of the great economists who studied this stuff and taught it to our children understand it either, so we just do the best we can.

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WARREN BUFFETT: And they still don’t understand it.

CHARLIE MUNGER: No, and our advantage is that we know we don’t understand it.

WARREN BUFFETT: It’s interesting though. It makes for an interesting movie and it does modestly affect what we pay for businesses. I don’t think anybody expected it to last this long, do you Charlie?

CHARLIE MUNGER: I don’t think so. If you’re not confused then you haven’t thought about it correctly.

WARREN BUFFETT: I thought about it correctly then.

Credit cards of American Express are photographed in this illustration picture in this March 17, 2016, file photo. REUTERS/Kai Pfaffenbach
Credit cards of American Express are photographed in this illustration picture. At the AGM, Warren Buffett had a tough time explaining why Berkshire remains heavily invested in the company. REUTERS/Kai Pfaffenbach

American Express seems to be a company that doesn’t have alternative businesses and its brand doesn’t seem to have the cache as it once did. Shouldn’t Berkshire reassess its reasons for owning Amex? 

WARREN BUFFETT: We reassess our reasons for owning all investments on almost a continuous basis. Both Charlie and I do that, and we’re usually in a general range of agreement. But sometimes we are a fair distance apart, perhaps. There’s no question that payments are an area of intense interest to a lot of smart people, who’ve got a lot of resources.

CHARLIE MUNGER: …and rapid change.

WARREN BUFFETT: Yeah, and rapid change and it will change. I personally feel okay about American Express. I’m happy to own it but their position has been under attack for decades, more intensively lately and it will continue to be under attack. It’s too big a business and it’s too interesting a business and too attractive a business for people to ignore it and it plays to the talents of some very smart people. I mean it’s a natural that a great many organisations that are really quite able think about it. And it’s big.

CHARLIE MUNGER: A lot of great businesses aren’t quite so great as they used to be. The package goods business for the Procter & Gambles and so forth, of the world, the General Mills. They are all weaker than they used to be at their peak.

WARREN BUFFETT: And the auto companies, I mean…

CHARLIE MUNGER: The auto companies, oh my God. When I think the power of General Motors, when I was young, and what happened. They wiped out all the shareholders. I would no more have predicted that. When I was young, General Motors loomed over the economy like a colossus. It looked totally invincible. Torrents of cash and torrents of everything…

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WARREN BUFFETT: They had to hold down market share….

CHARLIE MUNGER: Yes, because they were afraid they’d been too monopolistic. And so the world changes and we can’t make a portfolio change every time something is a little less advantaged than it used to be.

WARREN BUFFETT: But you have to be alert. You have to be thinking all the time. In order as to whether there has been something that really changes the game in a big way and that’s not only true for American Express. That’s true for other things we own, including things we own 100% of, and we’ll be wrong sometimes. We’ll be late sometimes, we’ll be wrong sometimes, but we’ll be right sometimes too. It’s not that we’re not cognisant of threats, but assessing the probabilities of those threats being a minor problem, or a major problem, or a life threatening problem – it’s a tough game but that’s what makes our job interesting.

CHARLIE MUNGER: I think anybody in payments, who’s an established long time player, with an old method, has more danger than used to exist. There is just more fluidity in it.

Is it wise to invest in cattle?

CHARLIE MUNGER: I think it’s one of the worst businesses I can imagine, for somebody like us. Not only is it a bad business but we have no aptitude for it.

WARREN BUFFETT: Some people have done well in there, Charlie.

CHARLIE MUNGER: Yeah, well they have one good year every 20 years or something.

I know you guys like steak….

WARREN BUFFETT: Very much, but not owning cattle. Actually, I know a few people who have done reasonably well in cattle, but they usually own banks on the side or something. But I wish you the best at it and I’m in Kiewit Plaza if you want to send anything along…..

CHARLIE MUNGER: Somebody has to argue about the tough natures in the economy. We need you.

Gorat's t-bone
The cattle farmer might not have gotten the answer he wanted, but Warren Buffett said he’s be quite happy to sample his products – Buffett loves steak like this T-Bone served at one of his favourite eateries, Gorat’s of Omaha,

Charlie, how do you apply incentives at Berkshire when designing the compensation formula – how do operating managers get paid for performance in different industries? Warren, can you describe exactly how you would remunerate the next Berkshire CEO? 

CHARLIE MUNGER: When it comes to assessing incentives, the systems are different and what they’re trying to adapt to is the reality of each situation. The basic rule on incentives is you get what you were awarded for, so if you have a dumb incentive system, you get dumb outcomes. One of our really interesting incentive systems is at GEICO, and I’ll let Warren explain it to you because we don’t have a normal profits type incentive for the people at GEICO.

WARREN BUFFETT: Yeah, well at GEICO we have two variables and they apply to well over 20 000 people who I think you have to be there a year. Beyond that point, everybody who has been there a year or more – and I could be wrong on the exact period – knows and understands that these two variables will determine bonus compensation. As you go up the ladder, it has a multiplier effect. It’s still the same two variables, but it gets to be larger and larger in terms of bonus compensation as a percentage of your base. But it’s always significant.

Those two variables are very simple. I care about growing the business and I care about growing it with profitable business. So we have a grid which consists of growth and policies in force, on one axis. Not gross in Dollars because that’s reflected by average premiums, which are outside their control, but growth in policies enforced. Then on the other grid, we have the profitability of seasoned business. It costs a lot of money to put business on the books. We spend a lot of money on advertising, and all of that, so the first year any business we put on the books is going to reduce profits significantly. I don’t want people to be worried about the profit that might be impaired by growing the business fast. Profitable seasoned business, growth of policies in force. Very simple. We’ve used it since 1995. We’ve put a tiny, little tweak or two in for new businesses or something, it’s overwhelmingly a simple system. Everybody understands it. In February or so, it’s a big day when the two variables are announced and people figure out how they come out on it. It totally aligns the goals of the organisation, in terms of compensation, with the goals of the owner. That’s a simple one.

CHARLIE MUNGER: It’s simple but other people might reward something like just profits, so the people don’t take on new business that they should take it on because it hurts profit. So you’ve got to think these things through and, of course Warren is good at that, and so is Tony Nicely.

WARREN BUFFETT: Yes and just thinking about it. Somebody comes and says well, you’ll rewarded profits. I don’t want to reward profits. That alone would be the dumbest thing you could do. You would just quit advertising and start shrinking the business a little. Like I say, people there know that the very top person is getting based on those same two variables, so they don’t think the guys at the top have got a cushy deal, compared to them and all of that. It is just a very logical system. The interesting thing is, if we brought in a compensation consultant, they would start coming up with plans that would be designed for all of Berkshire and get us all pulling together.

CHARLIE MUNGER: And maybe an undertaking power. God knows where they get the plan.

WARREN BUFFETT: The idea of having a coordinated arrangement, for incentive compensation across 70 or 80 businesses or whatever is just totally nuts. And yet I would almost guarantee you that if we brought in somebody they would be thinking in terms of some master plan, or sub-plans and all this kind of thing, and explain it with all kinds of objectives. We try to figure out what makes sense in each business we’re in. There are some businesses where the top person is enormously important. There are some businesses where the business itself dominates the result. We try to design plans that make sense.

In certain cases, I asked one fellow that came to work for us, or he was selling me his business, the day I met him he came to the office and he had a business that he wanted to sell, but he also wanted to keep running it. I made a deal with him on it and then I said, “Tell me what the compensation plan should be.” He said, “I thought you told me that.” I said, “No, I don’t want a guy working for me that has a plan that he thinks doesn’t make sense or that he’s unhappy with it or it’s chewing at him or he’s complaining to his wife about it, or whatever it may be. You tell me what makes sense.” He told me what made sense and it made sense and we’ve been using it ever since. We never changed a word. We have so many different kinds of businesses. Some of them are very tough businesses and some of them are very easy businesses. Some of them are capital-intensive and some of them don’t take capital.

I mean, you can just go up and down the line and to think that you’ll have a simple formula that can be sort of stamped out for the whole place and then with some overall stuff for corporate results on top but you’d be wasting a lot of money and you’d be misdirecting incentives. We think it through one at a time and it seems to work out pretty well. In terms of the person that succeeds me – it’s true, I have sent a memo, in fact, and I’ve sent two memos to the board, with some thoughts on that. Maybe I’ll send a third one, but I don’t think it would be wise to disclose exactly what’s in those letters. But it’s the same principle as I’ve just gotten through describing.

CHARLIE MUNGER: He wanted more bad examples. A lot of the bad examples of incentives come from banking and investment banking. If you reward somebody with some share of the profits and the profits are being reported using accounting practices that cause profits to exist on paper that aren’t really happening, in terms of underlying economics then people are doing the wrong thing and it’s endangering the bank and hurting the country and everything else. That was a major part of the cause of the Great Financial Crisis – the banks were reporting a lot of income they weren’t making, and the investment banks were too. The accounting allowed for a long time a lender to use as his bad debt provision his previous historical loss rate. So an idiot could make a lot of money by just making loans on a high interest and accruing a lot of interest, and saying ‘I’m not going to lose any more money on these because I didn’t lose money on different loans in the past’. That was insane for the accountants to allow that. Literally insane. It’s not too strong a word. Yet, nobody is ashamed of it. I’ve never heard of an accountant that’s ashamed of it.

WARREN BUFFETT: Another thing that’s possible is when you get the very greedy chief executive, who wants an enormous pay-off for himself and to justify it designs a pyramid so that a whole bunch of other people down the line get overpaid or get paid in relation to something they have no control over, just so it doesn’t look like he’s all by himself, in terms of that fantastic pay-off he’s arranged for himself. There’s a lot of misbehaviour. You saw it in pricing of stock options. I’d literally would hear conversations in a boardroom where they hoped they were issuing the options at a terribly low price. Well, if you get people interested in having options issued at a terribly low price, they may even occasionally do something that might cause that. What could be dumber than a company looking for a way to issue shares at the lowest price? Compensation isn’t as complicated as the world would like to make it but that’s, if you were a consultant, you’d want to make people think it’s very complicated and that only you can solve this terrible problem for them.

CHARLIE MUNGER: We want it simple and right and we don’t want to reward what we don’t want. Those of you with children, just imagine how your household would work if you constantly rewarded every child for bad behaviour. The house would be ungovernable in short order.