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As ever, we at Biznews are all ears when Berkshire Hathaway’s duo Warren Buffett and Charlie Munger take the podium to talk business, investments and life while fielding questions from 40 000 assembled shareholders. Veteran Fortune magazine editor had the honour of posing the first question of the 2017 Berkshire AGM. It focuses on the scandal that hit Warren Buffett’s biggest individual investment – the banking group Wells Fargo. The lessons begin……..
CAROL LOOMIS: Thank you from all of us journalists up here. I know that there are many people out there who have sent us questions that aren’t going to get answered and I just want to say that it’s very hard to get a question answered. The one thing I could suggest, is you follow Warren’s thought in the annual report that he wants everybody to go away from this meeting more educated about Berkshire than they were when they came and one way you can do that is keep your questions quite directly Berkshire related or relating to the annual letter. Even then, it will be hard to get your question answered. The three of us only have 18 questions in total, but I encourage you to think in the Berkshire related direction when you’re submitting your question next year.
Now, my first question; it’s about Wells Fargo, which is Berkshire’s largest equity holding, $28bn at the end of the year and this question comes from a shareholder who did not wish to be identified. “In the wake of the sales practices scandal that last year engulfed Wells Fargo, the company’s independent directors commissioned an investigation and hired a large law firm to assist in carrying it out.
The findings of the investigating, which were harsh, had been released in what is called the Wells Fargo Sales Practices report (you can find it on the internet). It concludes that a major part of the company’s problem was that, and I quote, “Wells Fargo’s decentralised corporate structure gave too much autonomy to the community bank’s senior leadership”. Mr Buffett, how do you satisfy yourself that Berkshire isn’t subject to the same risk with its highly decentralised structure and the very substantial autonomy given to senior leadership of the operating companies?”
Yes, it’s true that we at Berkshire probably operate on this. We certainly operate on a more decentralised plan than any company that’s remotely our size and we count very heavily on principles of behaviour rather than loads of rules. That’s one reason that every annual meeting you see that Salomon description and that’s why I write very few communiques to our managers, but I send them one once every two years and it basically says that we have all the money we need, we’d like to have more, but it’s not a necessity, but we don’t have one ounce of reputation more than we need and that our reputation at Berkshire is in their hands. Charlie and I believe that if you establish the right sort of culture and that culture, to some extent self-selects who you obtain as directors and as managers, that you will get better results.
So that way in terms of behaviour, then if you have a thousand page guide book, you’re going to have problems regardless. We have 367 000, I believe, employees. Now if you have a town with 367 000 households, which is about what the Omaha Metropolitan area is, people are doing something wrong as we talk her today, there’s no question about it and the real question is whether the managers are worrying and thinking about finding and correcting any bad behaviour and if they fail in that, whether the message gets to Omaha and whether we do something about it. At Wells Fargo, yes, there were three very significant mistakes, but there was one that dwarfs all of the others. You’re going to have incentive systems in almost any business.
There’s nothing wrong with incentive systems, but you have to be very careful what you incentivise and you can’t incentivise bad behaviour and if so, you had better have a system for recognising it. Clearly at Wells Fargo, there was an incentive system built around the idea of cross selling and a number of services per customer and the company and every quarterly investor presentation highlighted how many services per customer. So, was the focus of the organisation, a major focus and undoubtedly people were paid, graded, and promoted based on that number or at least partly based on that number. Well, it turned out that was incentivising the wrong kind of behaviour. We’ve made similar mistakes.
Any company’s going to make some mistakes in designing a system, but it’s a mistake and you’re going to find out about it at some point and I’ll get to how we find out about it, but the biggest mistake was, and I obviously don’t know all the facts as to why the information got passed up the line at Wells Fargo, but at some point if there’s a major problem, the CEO will get wind of it. At that moment, that’s the key to everything because the CEO has to act.
#BRK2017: Buffett on Wells Fargo scandal: "We count very heavily in principles rather than rules. You can't incentivise bad behaviour."
— Alec Hogg (@alechogg) May 6, 2017
That Salomon situation that you saw happened because on April, I think 28th the CEO of Salomon, the president of Salomon, the general council of Salomon sat in a room and they had described to them by a fellow named John Meriwether, there’s some bad practice, terrible practice that was being conducted by a fellow named Paul Mozer who worked for them and Paul Mozer was flimflamming the United States Treasury, which is a very dumb thing to do and he was doing it partly out of spite because he didn’t like the Treasury and they didn’t like them. So, he put in phoney bids for US Treasuries and all of that, so on April 28th roughly, the CEO and all these people knew that they had something that had gone very wrong and they had to report it to the Federal Reserve Bank in New York.
The CEO, John Gutfreund said he would do it and then he didn’t do it and he undoubtedly put it off because it was unpleasant thing to do and then on May 15th another Treasury auction was held and Paul Mozer put in a bunch of phony bids again and at this point, it’s all over because the top management had known ahead of time and now a guy that was a pyromaniac had gone out and lit another fire and he lit it after they’d been warned that he was a pyromaniac, essentially and it all went downhill from there. It had to stop when the CEO learns about it and then they made a third mistake actually, but again, it pales in comparison to the second mistake.
They made a third mistake when they totally underestimated the impact of what they had done once it became uncovered because there was a penalty of $185m and in the banking business, people get fined billions and billions of Dollars for mortgage practices and all kinds of things. The total fines against the big banks, I don’t know whether it totals, $30bn or $40bn or whatever the number may be. So, they measured the seriousness of the problem by the dimensions of the fine and they thought $185mn fine signalled a less offensive practice than something that involved $2bn and they were totally wrong on that, but the main problem was they didn’t act when they learned about it. It was bad enough having a bad system, but they didn’t act.
At Berkshire, we have, the main source of information for me about anything that’s being done wrong at a subsidiary is the hotline. Now we have 4 000 or so hotline reports that we get, communications on the hotline, perhaps 4 000 times a year and most of them are frivolous. You know, the guy next to me has bad breath or something like that, but there are a few serious ones and the head of our internal audit Becky Amick, looks at all those. Many of them come in anonymous, probably most of them and some of them she refers back to the companies, probably most of them, but anything that looks serious, I will hear about and that has led to action, we’ll put it more than once and we spent real money investigating some of those, we put special investigators sometimes on them and like I say, it has uncovered certain practices that we would not at all condone at the parent company.
I think it’s a good system, I don’t think it’s perfect. I don’t know what, I’m sure that they have an internal audit at Wells Fargo and I’m sure they have a hotline and I don’t know the facts, but I would just have to bet that many communications came in on that and I don’t know what their system was for getting them to the right person and I don’t know who did what at any given time, but that was a huge error, if they were, and I’m sure they were, getting some communications and they ignored them or they just sent them back down to somebody down below. Charlie, you follow, what are your thoughts on it?
Well, put me down as sceptical when some law firm thinks they know how to fix something like this. If you’re in a business where you have a whole lot of people under incentives, it’s very likely to cause a lot of misbehaviour, of course you need a big compliance department. Every big warehouse stock brokerage firm has a huge compliance department and if we had one, we would have a big compliance department too, wouldn’t we, Warren?
Absolutely, but does it mean that everybody should try and solve their problems with more and more compliance. I think we’ve had less trouble over the years by being more careful in whom we pick to have power and having a culture of trust. I think we have less trouble, not more.
But we will have trouble from time to time.
Yes, of course, we’ll be blind sighted someday.
#BRK2017: Buffett – Biggest mistake at Wells Fargo was they ignored the communications on issues that caused the scandal and didn't act.
— Alec Hogg (@alechogg) May 6, 2017
Charlie says, “An ounce of prevention” he said, “When Ben Franklin”, who he worships said, “An ounce of prevention is worth a pound of cure”, he understated it and I would say, “A pound of cure properly applied is worth a ton of cure that’s delayed and problems don’t go away”. John Gutfreund said that problem originally was, he called it a traffic ticket. He told the truth there that Salomon was a traffic ticket and it almost brought down a business. Some other CEO that described the problem that he had encountered as a footfall and it resulted in incredible damage to the institution and so on.
You have to act promptly and frankly, I don’t know any better system that hotlines and anonymous letters to me, I get anonymous letters and I’ve gotten three or four of them, probably in the last six or seven years that have resulted in major changes and very occasionally they’re signed, almost always they’re anonymous, but it wouldn’t make any difference because there will be no retribution against anybody obviously if they call our attention to something that’s going wrong, but I will tell you, as we sit here, somebody is doing, quite a few people, are probably doing something wrong at Berkshire and usually it’s very limited, I mean it may be stealing small amounts of money or something like that, but when it gets to some sales practice like was taking place at Wells Fargo, you can see the kind of damage it would do. We will now shift over to the analyst and Johnny Brandt.
Hi Warren, hi Charlie, thanks for having me. You’ve addressed the risk of driverless cars to GEICO’s business, but it strikes me that driverless trucks could narrow the cost advantage of railroads even if the number of crew members in a locomotive eventually declines from two to zero, is autonomous technology more of an opportunity or more of a threat for the Burlington Northern?
I would say that driverless trucks are a lot more of a threat than an opportunity to the Burlington Northern and I would say that if driverless cars became pervasive, it would only be because they were safer and that would mean that the overall economic cost of auto related losses had gone down and that would drive down the premium income of GEICO, so I would say both of those and autonomous vehicles widespread, would hurt us if they spread to trucks and they would hurt our auto insurance business.
My personal view is that they will certainly come. I think they may be a long way off, but that will probably frankly depend on experience in the first early months of the introduction in other than test situations and if they make the world safer, it’s going to be a very good thing, but it won’t be a good thing for auto insurers and similarly if they learn how to move trucks more safely, there tend to be driver shortages in the truck business now, it obviously improves their position visa vie the railroads, Charlie?
Well, I think that’s perfectly clear, finally approval, all these years. Okay, station one, the shareholder.
Hi Warren and Charlie, my name is Brian Martin and I’m from Springfield Illinois on. An HBO documentary becoming more and more on Buffett, you had a great analogy comparing investing to hitting a baseball and knowing your sweet spot, Ted Williams knew his sweet spot was a pitch right down the middle. When both of you look at potential investment, what attributes make accompanying pitch in your sweet spot that you’ll take a swing at and invest in?
Well, I’m not sure I’d define it in exactly the terms you would like, but we sort of know it when we see it and it would tend to be a business that for one reason or another, we can look out five or ten or twenty years and decide that the competitive advantage that it had at the present would last over that period and it would have a trusted manager that would not only fit into the Berkshire culture, but that was eager to join the Berkshire culture and then it would be a matter of price, but the main, you know, when we buy a business, essentially we’re laying out a lot of money now based on what we think that business will deliver over time and the higher the certainty with which we make that prediction, the better we feel about it.
You can go back to the first, it wasn’t the first outstanding business we bought, but it was kind of a watershed event which was a relatively small company, See’s Candy and the question when we looked at See’s Candy in 1972, was would people still want to be both eating and giving away that candy in preference to lower priced candies and it wouldn’t be a question of people buying candy for the little bit and we had a manager we liked very much and we bought a business that we paid $25mn for and that of cash and it was earning about $4mn pre-tax then and we must be getting close to $2bn or something that pre-tax that we’ve taken out of it, but it was only because we felt that people would not be buying necessarily a lower priced candy.
I mean, it does not work very well if you go to your wife or your girlfriend on Valentine’s Day (I hope they’re the same person) and say, you know, “Here’s a box of candy honey, I took the low bid”, you know it doesn’t, it loses a little as you’re going through that speech and we made a judgement about See’s Candy, that it would be special and probably not in the year 2017, but we certainly thought it would be special in 1982 and 1992 and unfortunately, we were right on it and we’re looking for more See’s Candies, only a lot bigger, Charlie?
Yes, but it’s also true that we were young and ignorant then.
Now we’re old and ignorant.
Yes, that’s true too and the truth of the matter is that it would have been very wise to buy See’s Candy at a slightly higher price and if they’d asked it, we wouldn’t have done it, so we’ve gotten a lot of credit for being smarter than we were.
Yes, and to be more accurate, if it had been $5m more, I wouldn’t have bought it. Charlie would have been willing to buy it, so fortunately, we didn’t get to the point where we had to make that decision that way, but he would have pushed forward when I probably would have faded. It’s a good thing that the guy came around. Actually, the seller was the grandson, [Larry See’s son, if I’m correct or Larry See’s brother, but he was not interested in the business. He was more interested in girls and grapes actually and he almost changed his mind. We did change his mind about selling. I wasn’t there, but Rick Errand told me that Charlie went in and gave an hour talk on the merits of girls and grapes over having a candy company. This is true folks and the fellow sold to us, so that… I pull Charlie out in emergencies like that.
We were very lucky that early in the habit of buying horrible businesses because they were really cheap. It gave us a lot of experience trying to fix unfixable businesses as they headed downward toward doom and that early experience was so horrible fixing the unfixable that we were very good at avoiding it thereafter, so I would argue that our early stupidity helped us.
Yes, we learned that we could not make a silk purse out of a sow’s ear, so we went out looking for silk after that.
Well, you have to try it for a long time and fail and have your nose rubbed in it to really understand it.
BECKY QUICK: This question comes from a shareholder named Mark Blackley in Tulsa Oklahoma, who says, “There has been more news than usual in some of Berkshire’s core stockholdings. Wells Fargo, and the incentive and new account scandal. American Express losing the Costco relationship and playing catch up in the premium card space, United Airlines and customer service issues, Coca-Cola and slowing soda consumption, how much time is spent reviewing Berkshire stockholdings and is it safe to assume if Berkshire continues to hold these stocks that the thesis remains intact?”
Well, we do spend a lot of time thinking, those are very large holdings. If you add up American Express, Coca-Cola, and Wells Fargo, I mean, you’re getting up well into the high tens of billions of Dollars and those are businesses we like very much. There are different characteristics and the cases that you mentioned, United Airlines, we actually are the largest holder of the four largest airlines and that is much more of an industry thought, but all businesses have problems and some of them have some very big plusses. I personally, you mentioned American Express.
— VV Investing (@Vintage_Value) March 20, 2017
If you read American Express’s first quarter report and talk about their platinum card, in fact, their platinum card is doing very well, the games around the world, I think there were 17% or something like that in buildings in the UK and 15% is original currency or the local currency, Japan, Mexico, and in the United States. There’s competition in all these businesses. If we thought we did not buy American Express or Wells Fargo or United Airlines, but Coca-Cola with the idea that they would never have problems or never have competition, why we did buy them is we thought they had very strong hands and we liked the financial policies in the case of many of them and we liked their position.
We bought a lot of businesses and we do look to see what we think they have, durable, competitive advantage and we recognise if you have a very good business, you’re going to have plenty of competitors that are going try and take it away from you. Then you make a judgement as to the ability of your particular company and product and management to ward off competitors. They won’t go away, but we think, I’m not going to get into the specific names on it, but those companies generally are very well-positioned. I’d liken it essentially, if you have a wonderful business, even if it’s a small one like See’s Candy, you basically have an economic castle, and in capitalism, people are going to try and take away that castle from you.
So you want a moat around it protecting it in various ways that can protect it and then you want a knight in the castle that’s pretty darn good at warding off marauders, but there are going to be marauders and they’ll never go away. If you look at, I think Coca-Cola was 1886, American Express was 1851 or 1852, starting out with an express business, Wells Fargo, I don’t know what year they were started, and incidentally American Express was started by Wells & Fargo as well. So, these companies had many challenges and many more challenges and the companies we own have had challenges. Our insurance business has had challenges, but we started when the actual indemnity was an $8mn purchase in 1968.
Unfortunately, we’ve had people like Tony Nicely at Geico. We’ve had Ajit Jain who has added tens of billions of value and we have some smaller companies that you probably don’t even know about, but really have done a terrific job for us, so there’ll always be competition in insurance, but there’ll always be things to do that are really intelligent man with a decent distribution system, various things going for him, can do to ward off the marauders, so there’s a specific question, how much time is spent reviewing the holdings, I would say that I do it every day, I’m sure Charlie does it every day, Charlie?
Oh, I don’t think I have anything to add to that either.
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