by Janet Lowe
They paid around $4.60 to $4.80 per troy ounce for the silver in the summer of 1997. By February 1998, the price was up to $7 per ounce, its 9-year-high, but by the end of the year it was trading at around $5 per ounce, and the price has been relatively flat since then. Munger would not say what Berkshire's position in silver was at that time, but said that based on the current price, it was "perfectly obvious" that their expectations of silver price performance had not yet been realized.
MONGER AND B[UFFETT CAN STILL startle the investment world now and then, and as he did in the past Munger sometimes goes forward with his own ideas, even if Buffett isn't fully aboard. Such was the case with Costco, the Issequah, Washington-based warehouse store.
"I admired this place so much that I violated my rules [against sitting on outside boards," said Munger. "It's hard to think of people who've done more in my lifetime to change the world of retailing for good, for added human happiness for the customer.""
Munger contends that by selling quality merchandise very close to cost, the stores built such a loyal customer base that it qualifies as a franchise. "If you get hooked on going to Costco with your family, you'll go for the rest of your life," he said."
One of the reasons Munger likes Costco is because of Jim Sinegal, the company's president, whose office has no walls separating him from passing employees. Sinegal, chairman of Costco, studied at the feet of Sol Price, the San Diego, California, entrepreneur who originated the warehouse store concept. Price first opened the California-based Fedmart stores, then sold the chain to a German company, who apparently didn't understand the concept and couldn't keep the stores going. Price then took the plain-wrap-shopping concept a level higher with his Price Club warehouse stores. Price Club eventually was acquired by Costco, which now is the second-largest warehouse store chain behind Wal-Mart's Sam's Clubs.
Charlie absolutely crows at the story of Costco's paper towels, a story that to Munger represents an admirable example of business ethics. Costco produces its own line of Kirkland products, which it guarantees to be as good or better than the top selling product in its field. When Costco's paper towels didn't live up to the promise, they were withdrawn until a suitable towel could be sold.
"He truly believes in our business," says Sinegal, adding that the 76-year-old Munger has never missed a board meeting. "He loves it."
Buffett was asked why he hadn't bought more Costco shares, considering that Munger owns shares and is on the board of directors.
"Yeah, you hit on a good one here," Buffett replied. "We should've owned more Costco, and probably if Charlie had been sitting in Omaha, we would've owned more Costco. Charlie was constantly telling me about this terrific method of distribution, and after 10 years or so I started catching on to what he was saying, and we bought a little of Costco at Berkshire.
"We actually negotiated to buy more. I made the most common mistake that I make ... We started buying it, and the price went up, and instead of following it up and continuing to buy more.... If Costco had stayed at $15 a share or so, where we were buying it, we would've bought a lot more. But instead it went to 15'H and who could pay 1518 when they'd been paying $15-it wasn't quite that bad. But I have made that mistake a lot of times, and it's very irritating."23
In February 1999, Munger made a related investment when he and several family members bought 8 to 9 percent of San Diego-based Price Enterprises Inc. Price Enterprises is a real estate investment trust formed with real estate retained from the old Price Club retail empire. It owns 31 shopping centers, some of which are anchored by Costco stores. The Munger group holds around 2 million of Price's 23.7 million preferred shares.2,
Buffett also makes independent investments for his own account. Such was the case in the summer of 1999 when he bought a 5.3 percent stake in Bell Industries, a small California electronics business. In January 2000, a month after it was disclosed that Buffett bought shares in the company, he quietly sold for a profit of $1 million-a 50 percent return on investment.
BUFFETT AND MUNGER HAVE WARNED that Berkshire Hathaway, like so many other businesses, could go through a negative cycle. They've said this for so long that shareholders and analysts alike stopped believing them. They were, however, telling the truth. In 1998, Berkshire reported that its earnings slipped 24 percent from 1997, as gains from investments fell by more than half. That didn't mean Berkshire actually lost money. Net earnings were just down, $1.902 billion or $1,542 per share in 1997, compared to $2.489 billion or $2,065 per share for the previous year.25
Throughout its history, Berkshire's short-term earnings have been volatile-partly because insurance results are notoriously bumpy and partly because Munger and Buffett are willing to forego short-term results for longer-term gains. At the end of the century, Gen Re was being reorganized to better fit the Berkshire philosophy, and GEICO was being primed for a growth spurt.
Berkshire's share price declined 19.9 percent in 1999, the first time in nearly a decade, and the price kept falling in the early part of 2000. But so be it. Munger tells investors to conduct their financial affairs so that no matter what crazy things happen in the markets, they can stay in the game. He cautioned that if you can't afford for your Berkshire Hathaway stock (or any stock, for that matter) to drop 50 percent, you probably shouldn't own it. The share price decline could tarnish the pairs image with the public, but any wane in his and Buffett's personal popularity might come as a welcome relief. Both men are constantly badgered to make speeches, give personal advice, or contribute money to hundreds of different charities.
Nevertheless, in 1999 Berkshire was still a powerful company. Operating revenues gave it a rank of 75 on the Fortune 500. When measured by earnings, excluding investment gains, it ranked fifty-fourth. But some investors were worried that in the last year to start with the number one, Berkshire would have a substantial earnings decline. Net earnings were strong, although at $1.5 billion they were less than half 1998 net earnings. Per-share book value rose only .5 percent and relative to the S&P 500, results were down 20.5 percent.
Overall and for the long-term, Munger is optimistic about the future of Berkshire Hathaway, for very simple reasons. "Basically, we have a wonderful hunch of businesses. We have float that keeps increasing and a pretty good record of doing well in marketable securities. None of that has gone away." Indeed, in the first quarter, 2000, Berkshire's net income rose by 49 percent.
As the company has grown and taken shape, the relationship between Munger and Buffett has changed somewhat. In the 1970s and 1980s, they conferred several times every day.
"We don't talk as often," says Buffett. "We talked about more prospective ideas 25 years ago. There was a time when we averaged well over once a day. They were long conversations. The hospital is his main occupation now-Harvard School and Mungerville. Those aren't things for us to talk about. Charlie is just a fraction less involved in Berkshire than I am, but if anything big comes along and is specific, then we talk. He understands the business and the principles very well. Charlie doesn't have his ego wrapped up in Berkshire the way I do, but he understands it perfectly."2'
Though Buffett is nearly 70 years old and Munger is six and a half years his senior, they show no signs of retiring.
"Warren likes the game," said Munger. "I like the game. And even in periods that are thought of as a tough times for other people, it's a lot of fun.-2-
C H A P T E R S E V E N T E E N
SALOMON
BROTHERS
Charlie says as you get older you tolerate more and more in your old friends and less and less in your new friends.
Warren Buffett.
HEN WARREN Bt1FFETT GOT THE call that something was amiss at Salomon Brothers, it was 10:30 am. and he was standing at a noisy pay phone kiosk inside a Lake Tahoe restaurant. Charlie Munger, Berkshire Hathaway's vice chairman and a Salomon board member, received the message a few hours earlier as he was having dinner with his family at his summer cabin in Minnesota.'
Ordinarily, noth
ing interrupts Munger's time at the lake. The summer of 1991 was different. Charlie's swift reaction to the telephone call told the family that something serious was afoot.
"He doesn't show that he's under pressure to his kids," said Wendy Munger. But "he was totally absorbed by it and engaged, and it was the first time we ever saw him in a suit on Star Island."
This was the beginning of the most traumatic and public of Berkshire's troubles. The news was out about an illegal $12.2 billion Treasury notes "short squeeze" at Salomon, a New York investment banking firm in which Berkshire owned a considerable stake of preferred shares.
At the core of the widely reported episode was managing director Paul W. Mozer, a 34-year-old bond trader who in December 1990 and February 1991, made Treasury securities trades above the legal limit allowed for any one institution. Additionally, Mozer made secret and unauthorized trades in the accounts of some Salomon clients, then switched the transactions onto Salomon's own books.
Munger first heard of the situation on Thursday, August 8, from Salomon's president Thomas Strauss and its inside attorney Donald Feuerstein. From the very first telephone call, Munger harbored suspicions that Salomon's official story was incomplete.
Buffett was having dinner at Lake Tahoe with the executives of one of Berkshire's subsidiaries when he talked to Strauss and Feuerstein. From the sketchy details and matter-of-fact tone, the matter didn't strike Buffett as an extreme crisis. It was Saturday before Buffett called Munger at Star Island, and only then did he realize how serious the infraction was. Salomon's lawyer had read to Munger their talking points, an internal document Salomon executives would use during media interviews regarding a news release that was about to be distributed. The talking points noted that "one part of the problem has been known since late April." Munger objected to the use of the passive voice, and demanded to be told who exactly knew.'
Though Munger challenged the wording of the talking points, the attorney explained that management and its lawyers were worried that different wording would threaten the firm's funding, its ability to roll over the billions of dollars of short-term debt that became due daily. This was dangerous because Salomon was highly leveraged, with only $4 billion of equity. In addition to the short-term debt, Salomon was relying on $16 billion in medium-term notes, bank debt, and commercial paper.
In her account of the Salomon affair in Fortune magazine, Carol Loomis wrote, "So Salomon's play was to tell its directors and regulators that management had known of Mozer's misconduct, but to avoid saving this publicly. Munger didn't like it, finding this behavior neither candid nor smart. But not considering himself an expert on `funding,' he subsided."'
Munger was indignant at the attempt to brush over personal culpability, but perhaps because Charlie and Warren thought highly of Salomon's Chief Executive Officer John Gutfruend and had a congenial relationship with him, Munger admits that "Warren and I didn't see John's downfall" that first evening.'
Nevertheless, Munger was certain from the very outset that Salomon had stepped in a pile of horse manure. After all, Treasury securities, a $2.2 trillion business, is the foundation of the United States financial system. Salomon is a primary dealer in U.S. government treasury securities, one of only about 40 companies with the privileged status that allows them to buy bills, notes, and bonds from the federal government and resell them to customers. Individuals in America and abroad, businesses, and other governments invest in U.S. Treasury securities because they trust the U.S. government and its public finance system. However, the system itself operates on a delicate balance of trust, and some experts feared that the Salomon breach of conduct would ruin the reputation of American securities markets worldwide and raise the government's cost of debt financing.'
Munger and Buffett continued to communicate about the problem, and planned a board meeting by conference call the next Wednesday, August 14. During that conference call, the board was read a second press release, which included three pages of details. The hoard members exploded in unified objection to a phrase stating that management had failed to go to the regulators for nearly four months due to the "press of other business." That lame excuse, the board felt, would not fly. The wording was changed, and in time, Munger and Buffett learned that management had met the previous April and agreed that something criminal had occurred and it should be reported to regulators immediately. For some inexplicable reason, nobody in the group did so.'
By late summer, the New York Times and the Wall Street Journal were broadcasting the story on their front pages and tension escalated. The securities markets reacted with a run on Salomon's own corporate securities. On Friday, Charlie donned a suit and caught a flight from Bimidji to New York for one of the most hectic episodes of his life.
SALOMON WAS FOINDSll IN 1910 and became one of the largest, most profitable and most admired brokerage houses in the United States. Buffett and Munger's connection with Salomon went back many years during which Salomon performed investment banking and brokerage services for Berkshire. Berkshire bought into Salomon in 1987, when the firm became the target of a hostile takeover by corporate marauder Ronald O. Perelman, chairman of Revlon Inc. Gutfruend dodged that bullet by approaching Buffett and asking that Berkshire take a financial position to stave Perelman off.
Bob Denham, Berkshire's main lawyer, remembers the weekend in September when he first became involved with Salomon. Denham got a telephone call on a Saturday morning. "I walked in the door from coaching a soccer game when they called to say they'd struck a deal to buy," said Denham. "They asked if I could work on it right away. I went to the office and got others in to work with me. An agreement was signed on Monday. That deal was more compressed than usual, but it is typical of working with Charlie and Warren, because they worked so closely together. They're two of the smartest and most creative businesspeople America has produced. They are always thinking of novel ways to slant investments. There is a high level of trust. They never try to undercut. They seldom disagree. If they do, they talk it out."
In the fall of 1987, Berkshire allocated $700 million of Berkshire's cash, the company's biggest investment to that time, to Salomon redeemable convertible preferred stock. The preferred securities paid 9 percent and were convertible after three years into common shares at $38. At that time Salomon's common stock was trading at around $30. If not converted, the shares would be redeemed over five years beginning in 1995. The deal also provided for a seven-year "standstill" during which Buffett agreed not to purchase any more Salomon shares.
In effect, Berkshire got a 12 percent stake in Salomon and became the company's largest shareholder. The deal was structured so that Berkshire's $700 million would be used to buy out a 12 percent stake in Salomon owned by Minerals and Resources Corp., Ltd. (Minorco) a subsidiary of the giant South African conglomerate Anglo-American Corp. Gutfreund worried that the Minorco interest would fall into the hands of Perelman or some other unfriendly takeover artist.?
The move angered some shareholders, who thought they should have had the opportunity to consider Perelman's proposition. Furthermore, some Salomon officers considered Berkshire's deal a sweetheart arrangement that took advantage of Gutfreund at a vulnerable time. But shareholders also got considerable benefits from the deal between Gutfreund and Buffett. The transaction increased Salomon's capital, provided a financial cushion for losses, and put Gutfreund into a relationship of his own choosing.'
As part of the deal, Buffett and Munger got seats on Salomon's board of directors.
"We had some pretty good foresight," said Munger. "When we bought big positions in ABC and in Salomon, Warren suggested I go on ABC's board. I said, `you never will need me (there).' Salomon could get into enough trouble that it would need both of us.'"
Wall Street veterans were surprised and puzzled at the Salomon investment, since Buffett and Munger often made disparaging remarks about the quality of work in the brokerage and investment industry as well as the high salaries and lavish lifestyles enjoyed by top exe
cutives. In Berkshire's 1982 annual report, Buffett scolded investment bankers for providing whatever advice would bring them the most income: "Don't ask your barber whether you need a haircut," he wrote.9
Buffett explained later that he knew the Salomon investment wouldn't be one of his famous "three baggers," but he was having a hard time finding suitable investments for his cash holdings, and he'd had good experiences working with Salomon in the past, especially from 1976 to 1981 when Berkshire was purchasing the first half of GEICO."
Nevertheless, there were always differences of perception between Buffett's and Munger's ideas of how business should be conducted, and those of Wall Street regulars. Salomon felt the sting of the Midwesterner's conservatism.
"When they went on the Salomon board, Salomon had a star chef on call," recalled Charles Munger, Jr., "The first time Warren sat down with a Coke and a hamburger, some changes in culture had been introduced."
Even before the Treasury scandal, there were early rumors that Buffett and Munger were unhappy with Gutfreund, but in Berkshire's 1987 Annual Report Buffett tried to lay those stories to rest: "We have no special insights regarding the direction or future profitability of investment banking. What we do have is a strong feeling about is the ability and integrity of John Gutfreund, CEO of Salomon, Inc.""
He said Gutfruend had at times advised clients to stay away from deals, even in cases where Salomon would have reaped huge fees. "Such service-above-self behavior is far from automatic on Wall Street," said Buffett. 12
Gutfruend impressed Warren and Charlie when in 1987 Salomon took a large trading loss, and then in a restructuring laid off 800 employees. That year Gutfreund declined a bonus worth about $2 million. Again in 1989, when profits were down, he took a $500,000 pay cut to $3.5 million."