Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In May 2003, I was fortunate enough to to attend the Berkshire Hathaway annual meeting in Omaha, Nebraska. (Full disclosure: I attended the meeting because I was then and remain now a Berkshire shareholder.) While at the meeting I struck up a conversation with some other attendees, who turned out to be a group of doctors who had attended medical school together, and who now invest together, and who every year have a reunion of sorts at the Berkshire annual meeting.

There are many people like these investing docs who hang on Buffett’s every word, perhaps hoping to replicate in some small way Buffett’s phenomenal investing success. The good news is that it isn’t necessary to go to Omaha to get Buffett’s own words about his approach to investing and business, as all of his Berkshire shareholders’ letters from 1977 to 2007 can be found on the Berkshire website, here.

But while the shareholder letters are available online, they are presented chronologically and are not indexed. There is not even a search function on the website, so other than going through a lot of words written over a lot of years, it is very difficult to find what Buffett has written about, say, zero coupon bonds, and difficult to see how his views on any given topic have changed over the years.

The great news for Buffett devotees is that there is a terrific alternative to laboring through 30 years' worth of Buffett’s letters to Berkshire shareholders. George Washington University Law Professor Lawrence Cunningham has read through all of them for us, and has distilled 30 years’ worth of Buffett’s commentary into a thematically arranged, absolutely wonderful book entitled “The Essays of Warren Buffett: Lessons from Corporate America,” which was recently released in a second edition (here). Professor Cunningham has added a brief introductory essay and afterword, but otherwise the book consists of the essence of Buffett. (It does also include an excerpt from one of Berkshire Vice Chairman Charlie Munger’s Letter to Wes.co shareholders and an amusing parody written by Buffett’s mentor, Ben Graham.)

Cunningham has done a masterful job distilling Buffett’s writings and organizing them according to topic. This arrangement not only facilitates a quick reference to Buffett’s comments on any given topic, but it also provides insight into how Buffett’s views on the topic may have evolved over time.

One thing that clearly emerges from a sustained reading of Buffett’s writing is that he is not only interested in developing the right investments and the right assets, he also wants to have the right sort of owner. Indeed, the reason Buffett has written the letters over the years is to develop and maintain “rational owners”; in the 1988 shareholders' letter, Buffett makes this explicit when he says that “all of our policies and our communications are designed to attract the business-oriented long-term owner and to filter out possible buyers whose focus is short-term and market-oriented.” From his essays about stock splits and dividends, it is also clear that the reason Berkshire has never split its shares and does not pay dividends is because of Berkshire wants to “avoid policies that attract buyers with a short-term focus on our stock price.” He wants investors focused on business values, not the company’s short-term share prices, and while a stock split or dividend might increase trading in Berkshire shares, “a hyperactive stock market is the pickpocket of enterprise.”

Buffett’s writings about the kind of owners he wants also dovetails with his extensive writings about the kind of managers owners should want. He is particularly concerned about the widespread practice of announcing earnings targets, noting the “many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings target they had announced.’ He also says that investors should

beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they will are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

He adds that “managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.”

This thematic arrangement of Buffett’s writings facilitates insight into the many ways his past experience unquestionably continues to inform his decision making. For example, we might well wonder about Buffett’s view on the current subprime crisis, but when you read his commentary from the late 80s about junk bonds and the Wall Street wizards who created them, you don’t have to wonder very much about what he might think about, say, CDOs backed by subprime mortgages. In his 1990 letter, Buffett wrote about junk bonds that “as usual, the Street’s enthusiasm for an idea was proportional not it its merit, but rather to the revenue it would produce.” Buffett also commented:

In the final chapter of The Intelligent Investor Ben Graham [wrote]:"Confronted with a challenge to distill the secret of sound investment into three words, we venture a motto, Margin of Safety.” Forty-Two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses.

Buffett went on to write later:

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failure we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.

Buffett’s prescience on the problems with derivates has already been the matter of commentary on this blog here.

Anyone who needs persuasion that Buffett truly is a financial master who has the added gift to be able to explain complicated things simply should review the segments of the book discussing zero coupon bonds and the difference between accounting goodwill and economic goodwill.

In addition to Buffett's business wisdom and the clarity of his prose style, the other thing that comes through in these essays is how funny Buffett is, and in that respect Cunningham is to be complimented for managing to capture within a volume devoted to Buffett’s business writings the basic humorousness of the shareholder letters. I’m sure everyone has their favorite Buffett humor stories, but mine include the story told in the  1986 letter about the tailor who went to see the Pope, whose friends asked him what the Pope is like. Buffett writes that “our hero wasted no words: ‘He’s a forty-four medium.’” Another favorite that also makes it into this collection is the story about the man who asked his vet what to do for his horse that limped sometimes but seemed fine at other times. Buffett states that “the vet’s reply was pointed: ‘No problem – when he’s walking fine, sell him.’”

Cunningham’s book also captures my own personal favorite, from the 1985 letter. I have actually quoted this story previously on this blog, but I like it so much, I am reproducing it again here:

An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

In any compendium, there are necessarily going to be some omissions, and while Cunningham’s inclusions are comprehensive and the overall product deserving of praise, I think the volume would be even more complete were it to include selections from Buffett’s writing over the years about insurance. The insurance business has been the segment on which Buffett has concentrated the most, and his reasons for his focus on this industry convey a lot about his approach to investing and his understanding of how business cycles work. In particular, Buffett’s many comments about “float” and the insurance “cycle” convey a lot about what his overall approach to investing and business. Greater inclusion of his insurance writings would also provide greater context for Buffett’s comments about September 9/11, which is included in this volume.

This volume also excludes Buffett’s writing about his investment in Gen Re. This is a serious omission in my view. Gen Re was by far Buffett’s largest investment, and the company lost over $7 billion dollars in the early years that he owned it. Buffett’ trenchant comments about the losses represent a very public statement about what he learned from the experience, clearly one of the more significant of the losses he faced. His pointed comments about the reason for the losses underscore some of his most important business principles.

It is also a personal gripe that though this volume omits Buffett’s writings generally about insurance, somehow the book manages to include every single instance where Buffett has said that his company does not carry D&O insurance. I have always thought that these statements are dangerous for mere ordinary mortals. It is fine for Buffett and his billionaire board members to disdain D&O insurance, but persons of more ordinary means can ill afford to run the risk of uninsured board service. Every time I read Buffett’s comments about D&O insurance, I feel like they should include a warning that “Readers should be cautioned to recall that he is one of the wealthiest people on the planet and his personal net worth is greater than the policyholders' surplus of most insurance companies’; readers should not attempt this trick at home.”

While I think this volume of essays is a worthy introduction to Buffett’s views and business philosophy, a lot of the writing will lack context for many readers. To know why Buffett quotes Ben Graham, and what he means by it, it is really necessary to understand more about Buffett’s days in graduate school and his early days working for Graham. His comments about many of his investments, such as Capital Cities/ABC or Solomon Brothers, require a great deal of prequel and sequel in order to appreciate fully what Buffett is saying. So I would recommend as a companion to this volume of essays Roger Lowenstein’s excellent biography of Buffett (here). Even though Lowenstein’s book is now 13 years old, it still conveys a lot about how Buffett got there, which is of course what most people – like those investing docs who attend the Berkshire annual meeting every year – are interested in.

But these last quibbles with the content, such as they are, are minor. The book itself is quite an accomplishment; it is that rare business book that is worthwhile and entertaining and enjoyable to read.

Special thanks to Professor Cunningham for calling my attention to the book.

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Warren Buffett’s annual letter to Berkshire Hathaway shareholders has become a capitalist cult classic, eagerly awaited each year not only by Berkshire shareholders but also by a broader audience of readers keen to read Buffett’s observations about both his company and the larger business and economic environment. This year’s letter (here), issued after market close on February 29, 2008, does not disappoint, as it brims with commentary on a variety of matters, as well as about the performance of Berkshire itself. But to an unusual extent, this year’s letter may be as noteworthy for what it omits as for what it includes, as I discuss further below. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

Buffett’s letter is of course a part of the Berkshire 2007 annual report, and the letter does contain quite a few interesting nuggets about Berkshire. Even though Buffett seemingly goes out of his way to detail his past investing errors (particularly emphasizing his failed Dexter Shoes investment as well as his failure to buy a Dallas TV station), the overall effect is to reinforce Buffett’s astonishing investing success. For example, after documenting his lapses at length, he almost parenthetically mentions the company’s 2007 sale of its 1.3% interest in PetroChina, acquired during 2002 and 2003 for $488 million, for which Berkshire received $4 billion – a staggering 820% gain in approximately five years.

On the other hand, Buffett’s letter also emphasizes that although Berkshire’s insurance businesses had another “excellent year” in 2007 (producing underwriting profit of $3.37 billion, on top of $3.8 billion in 2006), it is “a certainty that insurance industry profit margins, including ours, will fall significantly in 2008.” Buffett’s bases for this conclusion are that “prices are down and exposures inexorably rise.” If natural catastrophes occur, “results could be far worse.” Buffett warns Berkshire’s shareholders “to be prepared for lower insurance earnings during the next few years.”

Buffett also provides a detailed explanation of Berkshire’s growing derivatives exposure. The existence of these contracts in Berkshire’s portfolio may strike some as contradictory, as Buffett has for years railed against derivatives as, among other things, “financial weapons of mass destruction” (as he called them in his 2002 shareholders’ letter). He has bemoaned for years the losses Berkshire sustained in winding down Gen Re Securities derivatives operation (on which Buffett reported in his 2006 letter that Berkshire had sustained a cumulative pre-tax loss of $409 million).

Buffett nevertheless reports in this year’s letter that Berkshire had entered a total of 94 derivative contracts (up from 62 in 2006), apparently in the form of credit default swaps and futures put options on four stock indices. (The stock indices put represents a bet that these indices will close at far-forward dates at levels above where they stood when Berkshire entered the contracts.) While Buffett’s willingness to enter these contracts seems surprising given his long-standing and often-expressed hostility to derivatives generally, he emphasizes that with respect to each of the contracts, Berkshire is holding the cash – which means not only that Berkshire has no counterparty risk, but also that Berkshire has the opportunity to earn investment income in the interim. It is also important to contrast Berkshire’s current portfolio of 94 derivative contracts with the 23,318 contracts that were formerly held by Gen Re Securities. 

Buffett does warn that the mark-to-market accounting required on the derivative contracts “will sometimes cause large swings in reported earnings.” Buffett compares this exposure to Berkshire’s catastrophe insurance exposure and Berkshire’s long-standing willingness to “trade volatility in reported earnings in the short run for greater gains in net worth in the long run.” I have more to say below about Buffett’s comparison between the derivatives portfolio and Berkshire’s catastrophe reinsurance business.

Buffett’s commentaries about Berkshire’s performance are interesting, but Buffett’s letters are valued for far more than their observations on Berkshire’s own performance. Most readers scour Buffett’s letters for his discourse on larger topics, and his most recent letter has much to offer in that regard. In this year’s letter, Buffett returns to some of his familiar themes and also launches into some new topics.

The first familiar theme Buffett sounds relates to problems in the residential mortgage sector. Buffett commented on this topic in last year’s letter, where he decried “weakened lending practices” and mortgage loan structures that subjected borrowers to potentially escalating repayment obligations. In this year’s letter, Buffett has a “told-you-so” tone when he references the “staggering problems” that “major financial institutions” have recently experienced. He comments that “our country is experiencing widespread pain” because of the “erroneous belief” that “house price appreciation” would “cure all problems.” Buffett notes that

As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide does out – and what we are witnessing at some of our largest financial institutions is an ugly sight.

Another recurring theme Buffett revisits in this year’s letter is the U.S. trade deficit and its impact on the dollar’s valuation. In last year’s letter, while reporting on Berkshire’s direct foreign exchange gains, he bemoaned the U.S.’s transformation into a net debtor country as a result of which the country is now shipping “tribute” overseas in the form of an interest income burden that finances what he called U.S. “over-consumption.” Buffett returns to this topic in this year’s letter, specifically commenting on how these circumstances have led to the emergence of sovereign wealth funds:

There has been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot of foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here.  Why should we complain when they choose stocks over bonds?

In last year’s letter, Buffett did note that Berkshire had “come close to eliminating our direct foreign exchange position,” on which Berkshire had earned roughly $2.2 billion between 2002 and 2006 in investments in 14 different currencies. In this year’s letter, Buffett notes that in 2007 Berkshire had only one direct currency position, in the Brazilian real. Buffett also noted that Berkshire had invested in bonds denominated in currencies other than dollars, citing as a specific example euro-denominated Amazon.com bonds Berkshire purchased in 2002 for $162 million, that were redeemed in 2007 for $253 million (having paid 6 7/8 % interest in the interim).

Yet, Buffett emphasizes, Berkshire’s assets “will always be concentrated in the U.S.,” citing as justification “America’s rule of law, market-responsive economic system, and belief in meritocracy,” which Buffett contends, “are almost certain to produce ever-growing prosperity for its citizens.”

One standard feature of Buffett’s annual letter is a penultimate portion in which he skewers some particular foible of the financial scene. Last year, Buffett targeted the “2-and-20 crowd” of hedge fund “helpers” whose fees enrich themselves at their clients’ expense. This year, in a section of the letter captioned “Fanciful Figures – How Public Companies Juice Earning,” Buffett targets “the investment return assumption a company uses in calculating pension expense.”

Buffett notes that the 2006 average assumed pension return among the 363 S & P companies that have pensions is 8%. Buffett compares this assumed 8% return to the 5.3% average annual increase in the Dow Jones average during the 20^th century. In order for the Dow Jones average to continue to grow at just a continued 5.3% annual rate in the 21^st century, the Dow Jones average would have to close at 2,000,000 on December 31, 2099. And the companies that are projecting a 10% return “are implicitly forecasting a level of about 24,000,000 on the Dow by 2100.” Buffett characterizes the “helpers” who make these kinds of assumptions as “direct descendants of the Queen in Alice in Wonderland” who has “believed as many as six impossible things before breakfast.”

The reason for these high investment return assumptions, Buffett notes, “is no puzzle,” as they allow CEOS to “report higher earnings,” securing the knowledge that “the chickens won’t come home to roost until long after they retire.”

Having disparaged corporate pension fund accounting, Buffett then moves on to “public pension promises” for which “funding is woefully inadequate.” The “fuse on this time bomb is long,” but the promises that politicians find so easy to make “will be anything but easy to keep.”

Buffett’s annual letter is always entertaining and informative, and this year’s letter is no exception. But it strikes me that there are omissions from this year’s letter, some of which seem to me to be particularly conspicuous.

First, Buffett’s letter makes absolutely no reference to the recent “finite reinsurance” criminal trial that resulted in guilty verdicts against four former Gen Re officials (as well as one former AIG officer). Buffett’s silence on this matter is at one level understandable, as his name did arise in trial testimony, and as news reports suggest (here) that the criminal investigation is continuing. But given the fact that the former CEO and former CFO of Berkshire’s largest subsidiary were found guilty of criminal wrongdoing, Buffett’s lack of any reference to the verdicts (even to say that he could not comment) seems like a significant omission.

Buffett did implicitly draw a seeming contrast between prior Gen Re management (the ones on trial) and current Gen Re management; Buffett said that current management is doing “first-class business in a first-class way” despite “costly and time consuming legacy problems.” Buffett also commented that he learned to his regret that when he acquired Gen Re in 1998, it was no longer the “Tiffany of reinsurers” as it had been previously. Buffett made similar comments in the 2001 and 2002 Berkshire annual reports. (Full disclosure: I was for ten years an employee of a Gen Re operating subsidiary, and for that reason I feel obliged to forebear from any further commentary on these circumstances.)

Second, other than commenting on the mortgage lending industry’s lamentable shortcomings, Buffett provides no further commentary on the subprime crisis. Other insurers reporting their earnings in recent weeks have felt compelled to address both their potential insurance loss exposure to subprime-related liabilities and their companies’ investment portfolio vulnerability to subprime investment losses. On the one hand, Buffett’s credibility is such that if Berkshire had significant exposure in these areas, we would all expect him to have said something about it. On the other hand, given the prominence of these issues, it does not seem too much to have expected him to address these issues, and, again, his failure to comment on these topics seems like an omission.

Third, and related to the topic of subprime, Buffett’s letter makes no reference to Berkshire’s recent high profile entry into the municipal bond insurance business, in the wake of turmoil involving the traditional monoline insurers. While we may perhaps look forward to reading about this development in next year’s letter, this initiative did unfold in late 2007, and I would have expected some commentary about it in this year’s letter, especially given the high profile nature of the move.

But while Buffett did not mention Berkshire’s move into municipal bond insurance, his commentary on the problems public pension funds may face does put Berkshire’s move into providing municipalities with default guarantee protection in an interesting perspective. As Floyd Norris of the New York Times observes on his blog, Notions on High and Low Finance (here), “Why, you might wonder, would Mr. Buffett want to put Berkshire Hathaway into the business of insuring municipal bonds issued by such governments?”

One final apparent omission from Buffett’s letter is that he does not mention Berkshire’s recent acquisition of 3% interest in Swiss Re, or Berkshire’s agreement to assume 20% of Swiss Re’s property and casualty reinsurance business for the next five years. (Refer here for background on these transactions.) On the one hand, the Swiss Re transactions represent 2008 business, and so I suppose we should just be patient and wait until next year’s letter to see what Buffett says about the transactions. But the particular reason that Buffett arguably ought to have discussed the Swiss Re transactions, and in particular the timing of the Swiss Re transactions, is his commentary in this year’s letter about the likely future prospects of the insurance industry. I agree with Buffett that we should all “be prepared for lower insurance earnings over the next few years.” Given these prospects, the timing of the Swiss Re transactions cries out for further explanation.

A Final Observation: Perhaps others might be unwilling to find any relation between the two companies’ respective positions, but I find Berkshire’s increased derivatives exposure somewhat disconcerting in light of AIG’s recent $11.2 billion mark-to-market derivatives portfolio write-down. It may also fairly be argued that Berkshire’s volatility exposure is much smaller than is AIG’s. But after years of Buffett’s lectures about the evils of derivatives, Berkshire’s growing derivatives exposure seem incongruous.

Questions may also be raised about the appropriateness of the analogy Buffett draws between Berkshire’s volatility exposure as a catastrophe reinsurer and the potential volatility from Berkshire’s growing derivatives portfolio. The Wall Street Journal’s March 1, 2008 Breaking Views column (here) put its finger precisely on the problem in its commentary on AIG’s write-down, by pointing out that logical shortcoming of insurers’ putative qualifications to assess and accept risk from these financial instruments:

Insurers say they are experts at managing just this sort of high-severity, low-probability risk. They argue that insuring against floods, hurricanes, and earthquakes has given them peerless expertise in managing it.

But since there’s no market in acts of nature, insuring against them can’t lead to massive mark-to-market write-downs, as financial exposures can. And there’s a big difference between acts of nature, which can be modeled statistically, and the behavior of complex structured-finance instruments packed with assets that have little historical performance data, which frequently confounds statisticians.

The Journal column ends with the observation that “AIG isn’t alone in falling for this false analogy.” 

To be sure, Buffett did not claim that Berkshire’s expertise in underwriting catastrophe reinsurance qualified the company to underwrite derivatives, only that Berkshire’s willingness to accept the volatile results of catastrophe reinsurance was comparable to its willingness to accept volatile impacts from its derivatives portfolio, in exchange for the long run net worth benefits.

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It is now a well-established part of the mythology of American capitalism that Warren Buffett still lives in the same modest brick colonial in Omaha, pictured above, that he bought in 1958 for $31,000. (According to Forbes magazine's annual survey of billionaires' houses, here, Buffett's home had a 2003 tax valuation of $700,000.) Intuitively, we believe that the relative modesty of Buffett's home tells us something about his values and priorities, just as we all probably make certain assumptions about the values and priorities of the occupants of the truly execrable miniature Versailles mansions that have sprouted in recent years on the far-flung fringes of most American cities --even Cleveland, for God's sake!

In one of the more interesting and entertaining articles I have read in a long time, Crocker Liu of the Arizona State University Business School and David Yermack of N.Y.U. Business School take a look at what else the size and valuation of CEOs' homes might tell us. In their March 2007 article entitled "Where Are The Shareholders' Mansions? CEOs' Home Purchases, Stock Sales, and Company Performance" (here), the authors' "central research question concerns the association between CEO real estate purchases and subsequent performance of their company."

The authors developed their hypotheses by questioning whether a CEO's home purchase more nearly indicates the CEO's commitment to their company and its community, or rather represents the CEO's "entrenchment," particularly if the CEO is unconcerned about liquidating their assets (especially their holdings in company shares) and investing in an expensive home so as to provide "a public signal about the executive's status and security."

In order to determine which hypothesis is accurate, the authors undertook some rather creative detective work to identify the homes of the CEOs of the S & P 500 companies (including, among other things, each home's location, size, valuation, date of acquisition, and method of financing). The authors ultimately were able to identify the homes of 488 of the CEOs, 164 of which the CEOs had acquired after taking office.

What the authors found out about the CEOs' homes is fascinating. The median CEOs' home is more than 5,600 square feet, and sits on over one and a quarter acres. The median 2006 market valuation of the CEOs' homes is $2.7 million (although this may be understated because some of the homes are sufficiently unique that there are no ready market valuations). 12% of CEOs' homes are on the waterfront, and 8.5% are on golf courses. The median distance from the office for CEOs' homes is 12.5 miles, but 16 of the CEOs live more than 1,000 miles from their company headquarters and another 16 live between 250 and 1,000 miles from their office.

With respect to the question about the correlation between the CEO's home purchase and company performance, the authors found that when a CEO buys a home, "future company performance is inversely related to the CEO's liquidation of company shares and options" to finance the transaction, even if the stock sales are small relative to the CEO's holdings. The authors also found that "future performance deteriorates when CEOs acquire extremely large or costly mansions or estates," regardless of the method of financing. The authors found a "significantly negative stock performance following the acquisition of very large homes by company CEOs," a negative trend that persists for several years after the home purchase.

The authors' assessment of this finding is that the CEO who purchases his or her home without selling shares is perhaps signaling their commitment to the company and expectation of future stock returns. The CEO who liquidates his or her shares to finance their home purchase , or buys a very expensive home, is signaling his or her perception of his or her status and security, and therefore the purchase represents a proxy for CEO "entrenchment."

The authors contend that these facts suggest an investment strategy, essentially shorting the shares of companies whose CEOs who acquire very large and expensive homes, but maintaining long positions on the companies whose CEOs acquired their homes without selling company shares. According to the authors, both ends of this strategy would substantially outperform the companies taken as a whole.

I find the authors' work intriguing, but I wonder whether the apparent link between the CEO's home valuation and corporate performance might not be a manifestation of what a former colleague of mine poetically calls "multicollinearity." That is, is the inverse correlation between CEO home valuation and corporate performance simply the quantification of another phenomenon - for example, the level of CEO compensation?

For the record, Buffett's home was not among the houses the authors studied, since Berkshire Hathaway inexplicably is not a part of the S & P 500. The authors' data set also does not include Bill Gates' $140 million, 66,000 square foot home, since he is no longer the CEO of Microsoft. Steve Ballmer's $8 million, 4,100 square foot home was included, however.

I am hoping that the authors' next article will compare the valuations of CEOs homes to those of the leading securities class action plaintiffs' lawyers. I suspect it would provide even more interesting analysis.

One of the Internet tools the authors used is the website, Zillow.com (here). If you have never visited the site, drop what you are doing immediately and go there. Just be prepared to spend the next few hours figuring out how much you neighbors', friends', and acquaintances' houses are valued for. Unless you really don't find things like that interesting at all. (Right...) Coincidentally, the April 4, 2007 Wall Street Journal reports (here, subscription required) that Zillow.com CEO Richard Barton is currently attempting to sell his Seattle home for $2.6 million (marked down from the intial asking price of of $3.475 million).

Special thanks to an alert reader (who prefers anonymity) for the link to the article.

Adults Only: When my oldest daughter was eight years old, she expressed an interest in reading The Hunchback of Notre Dame. (For reasons that no one who has actually read the book could possibly explain or understand, Disney had just released a childrens' cartoon movie based on the book.) I told her that I did not believe the book was appropriate for children. She of course asked why, and I told her that the book deals with "adult themes." She cocked her head at me and squinted her eyes and said, "You mean like real estate?"

Yes, like real estate. Exactly.

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For years, Warren Buffett's annual Letter to Berkshire Hathaway shareholders has been a trove of business insight and commercial wisdom, and this year's letter (here), released on March 1, 2007, is no exception. While the general focus of the letter is a year-end review of the various Berkshire businesses, Buffett still managed to work in some memorable observations about some larger topics. I review below several of his comments, as well as one substantial omission from the letter to shareholders. (Full dislosure: I own Berkshire shares, although not nearly as many as I wish I did.)

Executive Compensation: After noting that he has been on 19 corporate boards and that he sets the compensation for the CEOs of "around 40 significant operating businesses," he has nonetheless faced "ostracism" from the compensation committees of the boards on which he has served, perhaps because he takes a different view on executive compensation. His concern is that there is a pack mentality on executive compensation, driven by compensation consultants, which results in the following:

CEO perks at one company are quickly copied elsewhere. "All the other kids have one" may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees.

Buffett is not optimistic about changing these practices, either; he says that "irrational and excessive comp practices will not be materially changed by disclosure or by an independent comp committee." Buffett asserts that true comp reform will take place only "if the largest institutional shareholders...demand a fresh look at the whole system." Buffett is skeptical that the fresh look will never take place as long as compensation is engineered by comp consultants who are "deftly selecting 'peer' companies," a practice that will only "perpetuate present excesses."

Hedge Funds: Using the example of the wealthy, fictitious Gotrocks family, Buffett examines the way that an investment industry of "helpers" is diverting (rather than creating) wealth through imposition of outsized management fees and other costs. Buffett has particular contempt for the "2-and-20 crowd" that charges 2% of principal and 20% of profit, ensuring enormous fees to the "helper" but inferior returns to investors:

The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these "hyper-helpers." Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.

Dollar Weakness and U.S. Indebtedness: After reviewing the $2.2 billion profit Berkshire earned between 2002 and 2006 from its direct foreign-exchange position (i.e., Berkshire was long on foreign currencies), Buffett reviewed the reasons why Berkshire will continue to attempt to gain from foreign currency exposure, either from "the ownership of foreign equities or of U.S. stocks with major earnings abroad." Buffett expects to gain as the dollar continues to weaken, which he expects because of the massive level of U.S. imports that are not reciprocated by export sales - as a result of which "the U.S. has necessarily transferred ownership of its assets or IOUs to the rest of the world." The U.S. can do this because "we are an extraordinarily rich country that has behaved responsibly in the past." But Buffett believes that this imbalance and outflow of assets and wealth has its consequences, some of which are potentially very dangerous:

our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won't be pleasant to work part of each day to pay for the over-consumption. of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual "tribute" so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict - but to expect a "soft landing" seems like wishful thinking.

PetroChina and Darfur: Consistent with Buffett's commitment going forward to foreign equities, Berkshire has a substantial investment in PetroChina, which is China's biggest producer of oil. According to his letter to shareholders, as of December 31, 2006, Berkshire owned 2.3 billion shares of PetroChina Class H shares (representing 1.3% of the company and making Berkshire the company's largest foreign shareholder), which have a cost basis of $488 million but a market value of $3.3 billion, or a current value of 670% of cost. (Buffett obviously has not lost his eye for a bargain.)

Interestingly, Buffett elected to say nothing in his letter to shareholders about Berkshire's investment in PetroChina, which has come under fire recently (refer here) for its 40 percent investment in a Sudanese oil venture. (The allegation is that the venture supports the Sudanese government, which is responsible for genocide in the Darfur region. Based on these concerns, Harvard and Yale, among others, have divested their shares in PetroChina.) Perhaps to avoid the necessity for Buffett to address this topic in his shareholder's letter, Berkshire released a statement (here) the week before the letter was published. Essentially, Berkshire's response is that it is not PetroChina, but PetroChina's controlling shareholder China National Petroleum Corporation (owned by the Chinese government) that has operations in Sudan. PetroChina itself does not, and the subsidiary can't control the parent.

A February 23. 2007 Salon.com column entitled "Warren Buffett Plays Dumb in Darfur" (here) criticizes Berkshire's response for ignoring the true relationship between PetroChina and CNPC - specifically, that the executive team for both companies consists of exactly the same individuals in the same functions with the same titles. The Salon.com article asserts that "to declare, as Berkshire does, that a subsidiary has no ability to control the policies of the parent, when the two entities are run by the exact same people, is an exercise in specious obfuscation."

The D & O Diary is in no position to judge the merits of the PetroChina dispute. But it has been my observation that commentators have been more hostile toward Buffett since he started his very public bet against the dollar a few years ago. As his investment approach has moved beyond foreign currencies to foreign equities and other foreign assets, media commentators, who idealized him for so long as the "Oracle of Omaha," are now likelier to demonize him. Buffett's strategy to go long on foreign assets because of his bearish views on the U.S. dollar will likely make him increasingly unpopular. Perhaps Buffett himself is experiencing his own form of "backlash" of the kind he anticipated in his shareholder's letter's comments about the fallout from U.S indebtedness. Unlike Buffett himself, many are unable (or unwilling) to regard his decision to invest in foreign assets as the neutral pursuit of superior investment returns. I suspect that going forward Buffett will find himself dogged by similar questions like those surrounding Berkshire's PetroChina investment.

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