B000U5KFIC EBOK (37 page)

"It's not by accident that recent acquisitions at Berkshire Hathaway
have been with stock. It's hard to make cash transactions in this market,"
said Munger.

"Berkshire's ability to instantly commit capital to ideas-no committee process or elaborate prospectus required-means that good investment ideas go to Omaha first," wrote Schroeder and Lapin. "We believe
that (1) Berkshire generally approaches businesses it wants to buy only
once, and (2) no one ever gets a better price from Berkshire the second
time around. This also gives the company a strong advantage in buying
businesses. "5

HIGH QUALITY INSURANCE IIIJSINESSES WITH massive float continued to be the
rocket fueling Berkshire's vertical ascent. As mentioned earlier, Buffett
first started learning about insurance at Columbia University when he
discovered that his professor, Ben Graham, was chairman of GEICO. Berkshire first entered the insurance business in 1967 with an investment of
$8.6 million. By the late 1990s, the insurance capital had topped $10 bil-
lion.6 Munger said the insurance companies have done well because of a
conservative business approach. Asked at Wesco's 1993 annual meeting
why Berkshire didn't write more insurance policies, considering its size,
Munger replied:

People are always saying to Berkshire, `Gee, why don't you write a lot more
volume in relation to capital? Everyone else is doing it. The rating agencies
say that you can write twice as much in annual volume as you have capital.'
And they look at our $10 billion in insurance capital and say, `That's $20 billion a year. What are you doing writing only $1 billion?' But then ... somebody else comes in and asks, 'Why did everybody get killed last year but
you?' Maybe the questions are related.

Munger admitted that Berkshire's huge "supercat," or catastrophic
event insurance unit, makes the company somewhat vulnerable, but he
thinks they've become experts at evaluating the risk and dealing with it
appropriately. A big loss from a California earthquake might cause an
insurance loss as high as $600 million for the company, and that would be
"irritating," Munger said. The 1994 Northridge, California, earthquake,
produced a significant loss, though the company didn't say how much.
Nevertheless, that year Berkshire's insurance division reported earnings
of $129.9 million from insurance plus $419.4 million from investments.-

"If we have a real disaster-if you had Hurricane Andrew followed
one week later by another one just like it-Berkshire would have a very
unpleasant year," said Munger.

Both Munger and Buffett have repeatedly warned shareholders that
as the company grows in assets, it will have more difficulty maintaining
an earnings growth rate, and thus share price growth, at the levels of the
past two decades.

"Size, at a certain point, gets to be an anchor, which drags you
down," explained Munger. "We always knew that it would. You get $10
billion in marketable securities. Show me unbelievable compound rates
when people get $10 billion."'

They did, however, find places to put their money. In August 1994,
Warren Buffett had in his pocket about $2 billion from the sale of Capital
Cities/ABC Inc. to Walt Disney Company. He began negotiating that same month with Louis A. Simpson, GEICO's co-chairman to buy the 50 percent
of the insurance company Berkshire didn't already own. There were several thorny issues to be resolved, including how to fairly manage a stock
trade when GEICO paid a dividend and Berkshire did not.

Negotiations continued for seven months and the New York investment banking firm Morgan Stanley was brought in to help set it fair price
for GEICO. Using cash flow and other yardsticks, Morgan Stanley said
GEICO's value could be as low as $50.80 or as high as $73.43 a share. Ultimately, Morgan Stanley suggested $70 as a fair price. Buffett said he
wanted to talk to Munger about the deal. Later the same day, he offered
$70 per share in cash to GEICO shareholders.'

It cost Berkshire $2.3 billion to buy the second half of GEICO at that
price. With GEICO, Berkshire got the full-time services of Lou Simpson,
who is believed by many to be Buffett's heir apparent. The shy, Princetoneducated Simpson had been in charge of investing GEICO's float and continues to do so after the acquisition. GEICO's fixed income portfolio is
now managed from Berkshire headquarters. Simpson had been beating
the market since at least 1980 and has an investment record nearly as
good as Buffett's. In 1997, 1998, and 1999, however, Simpson's return
failed to match the return on the Standard and Poor's 500, which meant
that instead of earning a bonus, Simpson owed Berkshire money.

Simpson became known to investors in the mid-1990s when shareholders pressured Buffett, then in his mid-60s, to reveal his succession
plan. Warren mentioned somewhat casually that there was plenty of backup, including Simpson. However, Munger says Buffett did not mean to
imply that Simpson would replace him, merely that Simpson was immediately available if necessary. "We could have clone the job of naming a replacement directly and not in some crazy, indirect way," Munger insisted."'

A few years after the GEICO purchase, Berkshire surprised the insurance world and nailed down its position as an insurance leader with a $22
billion acquisition of General Reinsurance (Gen Re). This huge acquisition was described as a "watershed event" in Berkshire's history by some
analysts, and Buffett himself said, "We are creating Fort Knox.""

Berkshire Hathaway's stock was trading near an all-time high when
in 1998 Buffett acquired the reinsurance giant in a stock swap deal.

"Warren's timing is uncanny," said Otis Booth. "He bought out
Gen Re when Berkshire's stock was trading at around $80,000 in a stockfor-stock merger."

Munger points out, however, that Gen Re's stock, too was trading at
a high price. These overall high valuations in the market, however, were
about to go through some adjustments.

In the Gen Re transaction, a substantial number of institutional investors were added to Berkshire's mix of shareholders, since 70 percent of
Gen Re was held by mutual funds, insurance companies and pension plans.

Berkshire had trending in that direction, but now it was primarily a
property-casualty insurer, with 79 percent of its revenues and operating
earnings from insurance. Based on premiums, it is the fourth largest U.S.-
based casualty insurance company. With revenues of $4 billion, GEICO is
the seventh largest auto insurer in the United States, and the eighteenth
largest insurer overall. But Gen Re focuses on insuring the risks on insurance companies themselves, thus it's name, General Reinsurance.
Based on premiums and surplus, Gen Re is the largest direct-writing reinsurance provider in the United States and third largest in the world,
with 1997 revenues of $8.3 billion. Added to that, National Indemnity,
headed by Buffett's bridge-playing friend Ajit Jain, is the most prominent
supercat underwriter in the nation.

The purchase of Gen Re gave Berkshire a net worth of $56 billion,
the highest of any company in the United States, and a stock market capitalization of $120 billion. At the start of 1999, Schroeder and Lapin estimated Berkshire's intrinsic, or actual per-share value at $91,253 (for B
shares, that would be $3,041 per share). And of course, Berkshire's insurance float kept growing. It is estimated that Berkshire's float from all of
its insurance operations in 1998 was just under $23 billion, and would
escalate to nearly $53 billion a year by 2008.

However, there was a set-back. Almost immediately after Berkshire acquired Gen Re, it was discovered that the insurance company had made an
underwriting error that would affect its short-term profits. But Munger
and Buffett were undaunted. Their experience told them that long-term,
the re-insurer remained an excellent purchase.

THE PUBLIC HOLDS MIUNGER AND Buffett to exceptionally high standards.
They get more attention for their difficult deals than they do their troublefree deals.

Such was the case when in 1990, Buffett and Munger bought a $358
million stake in USAirways preferred stock that could be converted into a
12 percent ownership of the airline. Both men joined the airline's board
of directors. USAir's motive in selling the shares to Berkshire was to bring
much-needed funds into the company and at the same time make itself
less vulnerable to an unwelcome takeover by someone else.

USAir, cobbled together from mergers over time of Lake Central,
Mohawk, Piedmont, and Pacific Southwest Airlines, had made itself a contender for top national carrier. Then, after an impressive start, USAir
ran into serious problems.

Munger and Buffett had stepped into a real mess. At Berkshire's 1991
annual meeting. Munger describe an airline as "marginal cost with wings."
Charlie's gripe was against the now defunct Eastern Airlines which
brought other carriers down with it as it fought for survival. He believed a
bankruptcy judge should have shut Eastern down earlier than he did.
Munger explained that once an airline files for bankruptcy, it is then operating debt free, thus it can be more competitive than a solvent one.

Just as S&L deregulation had unsettled that industry, airline deregulation was underway, leading to a scramble for industry dominance. In addition to competing with Eastern's low fares, USAir suffered a series of
fatal crashes between 1991 and 1994 which devastated both employee
morale and passenger loyalty. In its eerily scientific objectivity, the National Transportation and Safety Board described a 1994 USAir accident in
Pennsylvania in which 132 people died, as "an uncontrolled descent and
collision with terrain."''

In 1994, USAir stopped paying dividends on preferred shares. That
same year, Berkshire wrote down its investment in the company, taking a
$269.5 million pretax charge on the books. In 1995, Berkshire's stake,
which was acquired for $358 million, was valued at only $86 million.

Lawsuits, operating problems, and especially labor union troubles
were so intractable that the pair resigned from the hoard after two years.
Munger and Buffett stepped down in 1995 after the airline failed to win
cost-saving concessions from its unions.

When an investor asked Munger to explain the economics of Berkshire's involvement in USAir, Munger replied, "I'm glad you've given me
the opportunity to display my small share of humility.... We did not display our greatest brilliance."

In 1996, Buffett tried to sell the USAir shares, but luckily, lie was unsuccessful. The very next year, USAir reported the best quarterly profits
in the airline's history and, although it was as difficult as turning the
Titanic away from the iceberg, tiSAir made a reversa1.'3

"When Charlie and I left the board, the fortunes of USAir went
abruptly upward," quipped Buffett, suggesting that things work better if
they stay away.'' USAir finally was able to pay preferred dividends in arrears, and on February 3, 1998, USAir redeemed Berkshire's $358 million
in preferred stock.

"It was a humbling experience. To sit there and watch that net worth
melt away-$150 million, $200 million-to watch a lot of lovely money
that used to be yours and see it melt away.... And all those unions that could only think about reality from their own point of view. And the idiot
competition-including bankrupt competitors who stiff-armed their creditors while they lost money ruining our business. It was a very unpleasant
experience," Munger recalled. "All that said, it's a very leveraged business. So when the industry turned, it turned beautifully-for USAir included.... It worked out fine for Berkshire. But we're not looking for
another experience like it."

BUFFETT HAS ALWAYS SAID THAT the airline industry has been great for travelers, but a disaster for investors. And yet he is attracted again and again to
aviation-oriented stocks. The Berkshire investment that has puzzled people the most is its 20 percent stake in PS Group Holdings. The relationships surrounding this investment go back to when Munger was operating
out of the old Pacific Coast Stock Exchange and he introduced Buffett to
his friend Rick Guerin. Guerin had participated in the acquisition of Blue
Chip Stamps, See's Candy, and other investments with Munger and Buffett.

Guerin was a major shareholder and a director of Pacific Southwest
Airlines. PS Group is the residual company from PSA after it was sold to
USAir in 1987. With assets of $700 million, PS Group's main business was
leasing out the airplanes that USAir would not buy when it acquired the
airline. Some of those aircraft were leased back to USAir. PS Group also
had ownership in a travel agency, an oil and gas exploration concern, a
waste-recycling company, and a fuel trading and distribution company.''

In 1990, Berkshire acquired a 11.04 percent stake in PS Group, for
$18.68 million. The 603,275 shares were purchased for an average price
of $30.96. Four months after the original purchase, Buffett increased his
ownership to 22.5 percent."

Some experts believe that Buffett bought the shares to bail Guerin,
vice chairman of PS Group, out of a tight spot. Over the years, Guerin had
his financial ups and downs. At one point he was forced to sell 5,700
shares of Berkshire at a relatively low price to pay off bank debts.'-

"Warren bought his shares-about 20 percent of PS Group-because
a broker called from New York and said he had them," said Guerin. "They
looked cheap. He trusted me to be sensible. But PS Group is a meaningless asset to Berkshire, only about $20 million on the books. You can't
even find it. It's been one of his worst investments, and mine, for various
reasons."

Munger's former law partner Chuck Rickershauser also was involved
in PS Group. "We took money from the sale of the airline and invested it in
things that ranged from had to terrible," said Rickershauser.

Berkshire still owns the shares, and though business started looking
up for PS Group when USAir recovered its health, many of PS Group's
problems are unresolved. Earnings for PS Group have been spotty, following several disappointing attempts to diversify by investing its cash.18
In 1999, one PS Group board member and major shareholder, Joseph S.
Pirinea, resigned and protested the company's management policy.
Pirinea suggested the board put the company up for sale: "Just look at the
company's book value per share-$13," said the Seaford, New York,
accountant. "The stock sells for $8."