Revisiting Warren Buffett's Criteria for Selecting Corporate Directors

Given the recent outrage about the high compensation for executives who did poor jobs running their companies, and given the role corporate boards of directors play in setting executive compensation, it's worth revisiting Warren Buffett's comments on selecting corporate directors. Buffett wrote this in his 2006 Berkshire Hathaway Shareholder Letter (p.19 in the PDF):

In selecting a new director [Yahoo! CFO Susan Decker], we were guided by our long-standing criteria, which are that board members be owner-oriented, business-savvy, interested and truly independent. I say “truly” because many directors who are now deemed independent by various authorities and observers are far from that, relying heavily as they do on directors’ fees to maintain their standard of living. These payments, which come in many forms, often range between $150,000 and $250,000 annually, compensation that may approach or even exceed all other income of the “independent” director. And – surprise, surprise – director compensation has soared in recent years, pushed up by recommendations from corporate America’s favorite consultant, Ratchet, Ratchet and Bingo. (The name may be phony, but the action it conveys is not.)

Charlie [Munger, Berkshire's Vice Chairman] and I believe our four criteria are essential if directors are to do their job – which, by law, is to faithfully represent owners. Yet these criteria are usually ignored. Instead, consultants and CEOs seeking board candidates will often say, “We’re looking for a woman,” or “a Hispanic,” or “someone from abroad,” or what have you. It sometimes sounds as if the mission is to stock Noah’s ark. Over the years I’ve been queried many times about potential directors and have yet to hear anyone ask, “Does he think like an intelligent owner?”

The problem of corporate executives or directors not acting in the interests of shareholders is a prime example of an agency conflict. We touched on this in a post last summer ("Agency Conflicts").

Berkshire Hathaway's Annual Shareholder Letter

Berkshire Hathaway's annual shareholder letter (PDF) was released today. Berkshire's decline in book value in 2008 was less than I would have expected, 9.6%. Below are a few brief excerpts.

Buffett On Some of his Mistakes in 2008:

I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.

I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

On Why Berkshire Sold Some of its Stakes in JNJ, PG, and COP:

On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three
purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations.

On Treasury Securities:

When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.

On the limits of Regulation:

For a case study on regulatory effectiveness, let’s look harder at the Freddie and Fannie example. These giant institutions were created by Congress, which retained control over them, dictating what they could and could not do. To aid its oversight, Congress created OFHEO in 1992, admonishing it to make sure the two behemoths were behaving themselves. With that move, Fannie and Freddie became the most intensely-regulated companies of which I am aware, as measured by manpower assigned to the task.

On June 15, 2003, OFHEO (whose annual reports are available on the Internet) sent its 2002 report to Congress – specifically to its four bosses in the Senate and House, among them none other than Messrs. Sarbanes and Oxley. The report’s 127 pages included a self-congratulatory cover-line: “Celebrating 10 Years of Excellence.” The transmittal letter and report were delivered nine days after the CEO and CFO of Freddie had resigned in disgrace and the COO had been fired. No mention of their departures was made in the letter, even while the report concluded, as it always did, that “Both Enterprises were financially sound and well managed.”

In truth, both enterprises had engaged in massive accounting shenanigans for some time. Finally, in 2006, OFHEO issued a 340-page scathing chronicle of the sins of Fannie that, more or less, blamed the fiasco on every party but – you guessed it – Congress and OFHEO.

"Buffett's Strategy is Stale"

That was the title of Doug Kass's column yesterday on TheStreet.com. Excerpt:

Over the past week, I have outlined the potholes in Berkshire Hathaway's investment portfolio and the sharp drop in market value in some of Warren Buffett's largest holdings.

It was not my intention to overly dramatize the short-term miscues nor was it my intention to understate the remarkable long-term investment achievements of Warren Buffett. It was my intention to underscore that the strategy of investing in companies that have apparent moats to protect their business -- and these moats have been so dear to Buffett's investment strategy over multiple decades -- could either:

* have been abandoned by the Oracle of Omaha, owing to his reluctance to alter/sell off his strategic and principal holdings and maintain a tax-efficient portfolio approach; or

* have been influenced by his mistaken analysis of the changing competitive landscape facing some of his portfolio companies (in other words, the moat has been flooded!).

Kass goes on to offer American Express as an example of a Berkshire holding with a putative moat whose product has become commoditized, and he estimates Buffett's long term average annual return on his American Express to be about 2% per year. In his previous column (the same one he links to in the above excerpt), Kass argued that the banks in which Berkshire holds large positions no longer have moats either.

Subprimes and The Efficient Market Theory

Many active investors who don't believe that markets are fully efficient (if they did, of course, they wouldn't be active investors) nevertheless believe that markets are mostly or frequently efficient (see, for example, Warren Buffett making this point in his 1988 Berkshire Hathaway Chairman's Letter). How then to explain the yawning gap between the market prices of certain mortgage-backed securities and their supposed hold-to-maturity or intrinsic values?

Brian Wesbury, chief economist of First Trust, reiterated on CNBC today a point he made in a recent Forbes column: if 100% of the mortgages in a subprime mortgage CDO defaulted, owners of the security would recover something -- perhaps 40 cents on the dollar -- from the sale of the houses. And yet, two months ago, Merrill Lynch unloaded some CDOs for about 22 cents on the dollar (Barry Ritholtz argued at the time that, since Merrill was financing about 75% of the sale itself, the actual sale price for the assets was about 5.47 cents on the dollar).

If what Wesbury says is right (and it seems reasonable), why aren't institutional investors lining up to bid on subprime-backed paper for 22 cents on the dollar?

The Credit Crisis a Year Later

Articles with similar titles are sprouting up in the financial media now, so I thought it would be worth posting a link to John Mauldin's excellent essay on this from last August, "The Panic of 2007". Mauldin's essay includes helpful charts such as the one above and offers a lucid explanation of CDOs comprised of mortgage backed securities.

One suggestion Mauldin had back then for ameliorating the crisis was for Warren Buffett to take over Moody's, which he owns about 20% of through Berkshire Hathaway (as he took over Salomon Brothers years ago), to restore faith in the rating agencies. Of course, that didn't come to pass (instead, Buffett later created a muni bond insurer, Berkshire Hathaway Assurance, to profit from the crisis in which Moody's and the other rating agencies played a supporting role) but I wonder if it would have helped anyway. At Salomon Brothers, the problems were regulatory violations (of Treasury auction rules) that Buffett wasn't aware of (and of course wouldn't have condoned) at the time they were committed; at Moody's the problem was the way it did business, awarding triple-A credit ratings to so many questionable mortgage backed CDOs. As an insider, one would think that Buffett would have been aware of this practice at the time, so he might not have had the same credibility coming in to clean the stables at Moody's that he had coming into Salomon.

Does Warren Buffett's Secretary Have a Higher Effective Tax Rate than Him?

On her Atlantic blog ("Tax talk"), Megan McCardle writes,

And [University of Chicago Economics Professor and erstwhile Obama economic adviser Austan] Goolsbee justly points out that under the current system, Warren Buffet's secretary has a higher average tax rate than he does.

To be precise, Megan writes "average" tax rate, but since the effective tax rate represents the percentage of one's income that one actually pays in taxes, I assume she meant effective tax rate¹. Does Buffett's secretary (I've also heard the claim made about his housekeeper) have a higher effective tax rate than him? I'm skeptical about this.

According to these data from the non-partisan Congressional Budget Office, effective federal tax rates in America (taking into account payroll taxes as well) are highly progressive. In 2005, the lowest quintile of earners had an average effective federal tax rate of 4.3%, and the highest quintile had an average effective federal tax rate of 25.5% (the top 1% paid 31.2%). It's possible that the ultra-wealthy such as Buffett have lower effective tax rates than the top 1%, because nearly all of the income of the ultra-wealthy comes from capital gains, but I doubt the ultra-wealthy have lower effective tax rates than housekeepers and secretaries. I'd be more inclined to believe that Buffett's physician has a higher effective tax rate than him than that his housekeeper does. Perhaps Buffett will make public his and his secretary's and housekeeper's tax returns so others can verify this.

In the meantime, the issue of Buffett's taxes versus his secretary's taxes raises a couple of meta-questions:

- Does it make sense to make tax policy based on a small number of outliers such as America's multi-billionaires?

- Would proposed changes in tax policy materially affect these billionaires?

The answer to both questions appears to be "no". Multi-billionaires have far more control over how and when they get paid -- and how and when they get taxed -- than any other tax payers. I doubt Buffett's taxes will be materially affected by any tax code changes made in Washington next year.

The real impact of any changes in tax policies will fall mostly on the "working rich": the surgeon, high-end salesman, or other worker making $250k-$500k+. There will be little if any impact on the Buffetts of this country. Buffett, I would think, knows this, but he is politically savvy enough to position this as an issue of the super-wealthy such as himself paying their 'fair share'. Whether Buffett really thinks he doesn't pay enough in taxes is another question. Two data points suggest otherwise.

The first is Buffett's occasional boasting in his annual letters to Berkshire Hathaway shareholders about how much Berkshire (of which Buffett remains the largest individual shareholder) pays in federal taxes. This, for example, is from his 2006 Letter:

Berkshire will pay about $4.4 billion in federal income tax on its 2006 earnings. In its last fiscal year the U.S. Government spent $2.6 trillion, or about $7 billion per day. Thus, for more than half of one day, Berkshire picked up the tab for all federal expenditures, ranging from Social Security and Medicare payments to the cost of our armed services. Had there been only 600 taxpayers like Berkshire, no one else in America would have needed to pay any federal income or payroll taxes.

The second data point that suggests Buffett isn't really worried that he pays too little in taxes is the method in which he makes his generous donations to the Gates Foundation. Currently, Buffett donates shares of Berkshire Hathaway to the foundation. If Buffett were truly concerned that he didn't pay enough in taxes, he could easily remedy this by selling his Berkshire Hathaway shares first, paying the capital gains taxes on the sales, and then donating the net cash proceeds to the Gates Foundation. Presumably, Buffett donates the shares instead because he feels he pays enough in taxes already, or because he feels that the Gates Foundation will spend his money more wisely than the federal government will. Whatever the reason, avoiding the capital gains tax by donating the shares is inconsistent with Buffett's lamentations about not paying enough in taxes.


¹Update: The phrase "average tax rate" is a synonym for the phrase "effective tax rate". Thanks to commenter Jason for indirectly pointing that out.