A letter a day!

A letter a day!

Letter #56 2002

Key learning :

1. To be a winner, work with winners.

Buffett has written this in context of employment of excellent managers. He has often stated in his letters that his only task is identifying business with good economic characteristics run by good managers.

2. Acquisition of Northern natural gas.

From its beginnings in the 1930s, Northern Natural was one of Omaha’s premier businesses, run by CEOs who regularly distinguished themselves as community leaders. Then, in July, 1985, the company – which in 1980 had been renamed InterNorth – merged with Houston Natural Gas, a business less than half its size. The companies announced that the enlarged operation would be headquartered in Omaha, with InterNorth’s CEO continuing in that job.
Within a year, those promises were broken. By then, the former CEO of Houston Natural had taken over the top job at InterNorth, the company had been renamed, and the headquarters had been moved to Houston. These switches were orchestrated by the new CEO – Ken Lay – and the name he chose was Enron.
Fast forward 15 years to late 2001. Enron ran into the troubles and borrowed money from Dynegy, putting up the Northern Natural pipeline operation as collateral. The two companies quickly had a falling out, and the pipeline’s ownership moved to Dynegy. That company, in turn, soon encountered severe financial problems of its own.
MEHC received a call from Dynegy, which was looking for a quick and certain cash sale of the pipeline.

“When 2001 began, Charlie and I had no idea that Berkshire would be moving into the pipeline business. But upon completion of the Kern River expansion, MEHC will transport about 8% of all gas used in the U.S. We continue to look for large energy-related assets, though in the electric utility field PUHCA constrains what we can do.”

3. In this letter, Buffett has discussed in detail about derivatives. Those of you interested can give it a read.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.
Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

4. Corporate governance.
   The directors should behave as if there was a single absentee owner, whose long-term interest they should try to further in all proper ways. This means that directors must get rid of a manager who is mediocre or worse, no matter how likable he may be.

“ Directors must react as did the chorus-girl bride of an 85-year- old multimillionaire when he asked whether she would love him if he lost his money. “Of course,” the young beauty replied, “I would miss you, but I would still love you.”

The current cry is for “independent” directors. It is certainly true that it is desirable to have directors who think and speak independently – but they must also be business-savvy, interested and shareholder- oriented. In my 1993 commentary, those are the three qualities I described as essential.

5. Audit committees can’t audit. Only a company’s outside auditor can determine whether the earnings that a management purports to have made are suspect.

6. Three suggestions for investor’s

1. beware of companies displaying weak accounting.

2. unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to.

3. be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly .

“Charlie and I not only don’t know today what our businesses will earn next year – we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future – and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.”