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OMORROW
morning, Warren E. Buffett and his board will gather in Omaha to
consider the merits of three executives he considers likely to succeed
him one day as Berkshire
Hathaway's
chief executive. Their names are still a closely guarded secret, but
all the candidates work for Berkshire and none are older than 60.
The directors' conclave is routine, part of an assessment of potential successors that Mr. Buffett conducts after Berkshire's annual meetings, the most recent of which was yesterday. But as Mr. Buffett approaches his 75th birthday, the financial powerhouse he began assembling 40 years ago confronts challenges that are anything but routine.
Berkshire has amassed a $43 billion stockpile of cash and other liquid assets that it has been unable to unleash. Its core insurance operation is emerging from an unusually tumultuous period. And then there is the General Re Corporation, its largest acquisition - and its biggest black eye. Not only has the payoff from that 1998 purchase failed to materialize, but General Re has also been swept up recently in regulatory investigations of insurance industry abuses.
Berkshire is expected to overcome each of these challenges, some sooner than others. And Mr. Buffett, whose personal fortune exceeds $40 billion, has a rare combination of discipline and insight that has allowed him to produce stellar returns for decades. But in the unforgiving argot of insurance actuaries, there is now both mortality and morbidity risk surrounding this legendary money manager. This year, perhaps more than in others of recent memory, his longevity looms large.
"A lot of what makes Berkshire tick is Mr. Buffett," said Keith Buckley, a managing director at Fitch Ratings, a firm that monitors insurers. "They are one of the only companies I can think of where they can have that much cash and can say to investors to be patient because they know when the time will come to use it properly. That's entirely because of Mr. Buffett's presence."
Fitch recently downgraded Berkshire's credit outlook to "negative" from "stable," noting in a research report that Fitch "does not believe that Mr. Buffett's talents can be easily replaced, or that Berkshire's current strategies would be sustainable in his absence."
Like a veteran poker player with deep pockets, Mr. Buffett is known for pushing in his chips whenever he believes he holds great cards - and for simply folding until he sees a deal that meets his standards. But what happens to the game, and to a company that so directly reflects its founder's fertile imagination, when the champion no longer sits at the table?
While there are many avenues for exploring Mr. Buffett's storied career, the $22 billion General Re acquisition is instructive for what it says about Berkshire's operations, strategic goals and future.
"I think Buffett's had a remarkable track record as an acquirer, and I don't think it's one that should or will be overwhelmed by what's happened at General Re," said Robert F. Bruner, a finance professor at the University of Virginia's Darden School of Business. "But how is it that the world's greatest investor would buy such a Pandora's box of problems?"
INSURANCE is an industry with about as much outward magnetism as drying paint. It is loosely regulated, prone to lax underwriting standards and, of course, cash rich. But Mr. Buffett saw many years ago that if he could get his hands on the torrents of money washing through an insurer, while cautiously managing the underlying business to prevent losses, he would have hefty sums to do what he loves most: buy great stocks and companies.
"The typical 'entrance' strategy for acquisitions at Berkshire is to buy a company with great economic characteristics: no debt, a robust balance sheet and positive cash flow," he writes in the foreword to "The Pampered Chef," a soon-to-be-published book about the company of the same name that was one of his recent small acquisitions. "That's important because here at Berkshire we have no 'exit' strategies. We buy great businesses to keep. My job is to stay out of the way."
Mr. Buffett has already made long-term investments in an assemblage of well-known companies: Gillette, Coca-Cola, American Express, the Washington Post Company, Moody's, Wells Fargo and H&R Block, among others. When Anheuser-Busch announced 10 days ago that Berkshire had bought a stake in it, the company's shares jumped.
Mr. Buffett's scorecard as an investor-manager is so statistically anomalous as to be almost freakish. Since 1965, Berkshire's stock has annually outperformed the Standard & Poor's 500-stock index in all but six years (and Mr. Buffett had already racked up huge returns as a private money manager starting in 1956). No other thoroughbreds of modern investing - including Peter Lynch and William H. Miller III - have come close to that achievement. Mr. Buffett is the industry's Secretariat.
Despite the passage of time, Mr. Buffett, who has said he enjoys his craft so much that he tap-dances to work, remains sharp-witted, and he is clearly itching to leap into the fray again. "What Charlie and I would like is a little action now," Mr. Buffett said in Berkshire's annual report this year, referring to the company's vice chairman, Charles T. Munger, who is 81. "We don't enjoy sitting on $43 billion of cash equivalents that are earning paltry returns. Instead, we yearn to buy more fractional interests similar to those we now own or - better still - more large businesses outright.
"We will do either, however, only when purchases can be made at prices that offer us the prospect of a reasonable return on our investment," Mr. Buffett added.
General Re, a large insurance concern, certainly seemed to fit that bill when Mr. Buffett bought it seven years ago. It specializes in reinsurance, which is what larger insurers buy to protect themselves from outsized losses on risky policies. Mr. Buffett knew General Re well: it had helped to bail out Geico when that company was on verge of bankruptcy and Mr. Buffett had begun accumulating Geico stock.
Mr. Buffett's rationale for buying General Re centered on the company's "float" - the difference between policy premiums it collected and payments it had to make on claims. As long as the underwriting business could produce float at a break-even cost, the excess cash could land in Mr. Buffett's hands and be put to work, ideally for outsized returns.
In 1998, the year it bought General Re, Berkshire had earnings of $2.8 billion on revenue of about $13.8 billion, a clear indication that it had swelled into a much larger enterprise than the tiny textile maker it was in the 1960's. And it would balloon even more: last year, the company earned $7.3 billion on revenue of $74.4 billion.
Many money managers can be strangled by success. As they chalk up large gains, they have more money to put to work. But as their portfolio blossoms, it becomes more difficult to find investments that deliver big enough returns to have much effect on overall performance. They become victims of size, forced to steer an aircraft carrier when they once maneuvered a destroyer.
Mr. Lynch, after a heady 13-year run at the Fidelity Magellan fund, gave up the reins in 1990 because he found it infinitely harder and more exhausting to be at the top of the charts than when he began. (Those who have run Magellan after him haven't matched his performance.)
Mr. Buffett first confronted that kind of quandary years ago but stayed in the game, adding to his legend by continuing to post strong results. His ability to pick winning stocks and well-run companies did not falter, and General Re appeared to be a large acquisition that would make good use of Berkshire's resources. General Re's buoyant float and its pristine, conservative reputation seemed to match up well with Mr. Buffett's skills.
But little went right at General Re after Berkshire took over.
The insurer was slammed by an almost ceaseless series of underwriting losses, totaling about $7.5 billion from 1999 to 2002. Troubles that began with a thorny debacle involving workers' compensation claims culminated with the collapse of the World Trade Center towers in the September 2001 terrorist attacks. General Re, a major insurer of the twin towers, absorbed nearly $2 billion in claims on the tragedy.
As dowdy as the insurance business may seem, beneath the surface it can often be a financial chess match that engages gifted oddsmakers like Mr. Buffett. The borders of high-stakes insurance matches are defined by catastrophes like hurricanes and earthquakes. For companies to play the match well, however, requires accurate assumptions about the likelihood of various disasters and the proper pricing of policies and establishment of reserves to reflect those assumptions.
At the time Mr. Buffet bought it, General Re was playing a bad game of chess. It priced policies poorly, set inadequate reserve levels and had bloated expenses because of the desire of the company's chief executive, Ronald E. Ferguson, to grow the business relentlessly, according to analysts and insurance industry executives. Mr. Ferguson declined repeated interview requests.
Instead of enhancing Berkshire's performance, General Re inflicted financial damage on it. Berkshire earnings fell to $795 million in 2001 from $3.3 billion a year earlier. And Mr. Buffett, while not the primary author of many of General Re's operating woes, accepted responsibility for some of them in his 2001 letter to Berkshire shareholders.
"We had either overlooked or dismissed the possibility of large-scale terrorism losses," he wrote. "Why, you might ask, didn't I recognize the above facts before Sept. 11? The answer, sadly, is that I did, but I didn't convert thought into action.
"I violated the Noah rule: Predicting rain doesn't count; building arks does. I consequently let Berkshire operate with a dangerous level of risk, at General Re in particular."
While General Re's huge losses hurt Berkshire, they did not wipe out the company, as they might have any other franchise that lacked its thick financial armor.
But other standards at General Re were also slipping. The company is now under regulatory investigation in the United States and abroad for possible financial manipulation several years ago involving the American International Group and other insurers. Australian regulators have banned several executives of General Re from the insurance market there; none of its United States executives have been charged with wrongdoing.
Mr. Buffett is not a target of those investigations, but he has cooperated as a witness. People with direct knowledge of the inquiries say that there is no evidence Mr. Buffett had prior knowledge of any questionable transactions involving General Re or other Berkshire insurance subsidiaries.
Mr. Buffett has weathered other Berkshire insurance scandals, including a dust-up in the 1970's involving rogue salesmen selling bogus policies. That episode rattled Mr. Buffett, who values his reputation as much as he does his stock-picking prowess. There have been other bad acquisitions, too, including loss-plagued buyouts in the early 1990's of shoe companies that ignored the threat of competition from abroad.
NONETHELESS, Mr. Buffett has astute faculties for assessing the financial promise of companies he screens and well-developed antennas for evaluating more intuitive matters, like market dominance, customer loyalty and quality of management.
Because Mr. Buffett has been right so many more times than he has been wrong, he tends to have an unshakable faith in his own judgment when making an acquisition. Unlike other big acquirers, he doesn't send in swarms of investment bankers and auditors to evaluate a target. Berkshire bought General Re without exhaustively scrubbing the company for potential problems, people with direct knowledge of the transaction say.
Munger, Tolles & Olson, Berkshire's law firm, represented the company in the General Re transaction. Ronald L. Olson, a Munger, Tolles partner, is a Berkshire board member and is said by people close to the company to play an influential role in helping Mr. Buffett anoint a successor. Mr. Olson, who also represents Berkshire in the various regulatory investigations, did not return calls seeking comment.
Kevin Lampo, an insurance analyst at Edward D. Jones & Company, said: "Warren Buffett's due diligence is about having faith in the management of the team he acquires. But I'm not sure they could have done the kind of due diligence at General Re that they needed to do anyway because it took a number of years for these problems to come out."
Insurance executives with direct knowledge of the matter say Mr. Buffett may have faltered in the General Re acquisition by placing too much faith in Mr. Ferguson. According to three people with direct knowledge of the events, Mr. Ferguson, who has a reputation for Calvinistic rectitude, was not running his business as conservatively as he appeared to be and had a clearer understanding than Mr. Buffett that some of General Re's highflying sales representatives and executives had been granted too much latitude.
Even after problems began to surface, Mr. Buffett stood by Mr. Ferguson, in keeping with his belief in total loyalty to the management of companies he acquires. When Mr. Ferguson suffered a brain hemorrhage in 1999, Mr. Buffett chose not to use the occasion to relieve him of his responsibilities. Instead, he waited until Mr. Ferguson offered to step down in early 2001 before replacing him with Joseph P. Brandon.
Since Mr. Brandon took the helm, General Re has been running its business more cautiously. The company has booked strong underwriting gains in the last two years and is poised to deliver on the potential it held when Mr. Buffett acquired it. But that reintroduces another wrinkle: Mr. Buffett's advancing years.
The market conditions that have prevented Mr. Buffett from deploying Berkshire's mountain of cash have also prevented him from taking advantage of General Re's $23 billion float. Unless a crop of big bargains emerges relatively soon, it may be Mr. Buffett's successor who has to go shopping with Berkshire's billions.
For as large as Berkshire is, it is run almost like a sprawling family business, and a successor will inherit that structure as well. "It's an unusual company because so much of what Buffett does is on the investment side; he has people who report to him but he doesn't run the businesses," said David Schiff, an insurance analyst who publishes a newsletter, Schiff's Insurance Observer. "It's hard to say what the corporate model is because it's been unique to him. It's run by nice, honest people who don't care about earnings per share and do care about the long-term creation of value."
So far, Berkshire's model has not been flawless, but it has worked enormously well. Nell Minow, editor of the Corporate Library, a group that analyzes corporate governance issues, gives Berkshire top marks for its compensation, accounting and decision-making practices. She gives the company's board, which includes one of Mr. Buffett's sons, low marks for having too many directors who are close to Mr. Buffett. (One son, Howard, is designated to become nonexecutive chairman when Mr. Buffett dies.) But she said Berkshire's overall performance trumps cronyism on its board.
"You can't apply the same standard to Berkshire that you use for almost every other company, because Berkshire's primary asset is Warren Buffett's brain," said Ms. Minow, who owns three Berkshire shares her father gave her years ago. "I think he is as committed to creating shareholder value as anyone who's ever lived. I'd be happy to clone him and make him C.E.O. of every company."
WHETHER Berkshire can create an actual clone of Mr. Buffett is doubtful, but analysts and others close to the company speculate that there are three well-regarded executives who are front-runners to succeed him: Mr. Brandon; Ajit Jain, who runs Berkshire's other core insurance operations; and David L. Sokol, chief executive of another Berkshire subsidiary, MidAmerican Energy Holdings.
Among the three, Mr. Jain has drawn the most lavish public praise from Mr. Buffett over the years, but regulators in Australia are examining one of Mr. Jain's insurance units in connection with possible regulatory problems there. It is unclear whether that investigation could complicate Mr. Jain's ascent. Mr. Buffett is said by people close to him to retain an unwavering confidence in Mr. Jain's integrity and abilities.
A more realistic complication for Mr. Jain or others who may step into Mr. Buffett's shoes is that they will inevitably have their investing performance measured against Mr. Buffett's. Perhaps to dampen expectations, Mr. Buffett suggested four years ago that given how much both Berkshire and the world had changed, even Warren Buffett would have trouble competing with Warren Buffett.
"One final thought about Berkshire: In the future we won't come close to replicating our past record," he wrote in his 2001 letter to shareholders. "To be sure, Charlie and I will strive for above-average performance and will not be satisfied with less. But two conditions at Berkshire are far different from what they once were: Then, we could often buy businesses and securities at much lower valuations than now prevail; and more important, we were then working with far less money than we now have."