The reasoning behind the purchase seemed sound, though. NetJets was dominant in its market; it was too late for any serious competitor to catch up. Buffett figured that it was not unlike the newspaper business, where there were no red ribbons. Eventually, the competitors would fall away.12 And, indeed, NetJets was outgrowing the competition. Buffett was intrigued with its CEO, Richard Santulli, an entrepreneurial mathematician who had formerly spent his days at Goldman Sachs figuring out trading patterns using chaos-theory mathematics. Now he used those same skills to schedule plane flights on six hours’ notice for a database full of celebrity clients whom he entertained at private events. Buffett met a whole new set of famous people, including Arnold Schwarzenegger and Tiger Woods.
Investors cheered Buffett’s purchase of NetJets but were shocked when he almost simultaneously announced that Berkshire was buying General Re, a huge insurance wholesaler, or “reinsurer,” which bought excess risk from other insurers. At $22 billion, this deal was almost thirty times larger than NetJets. It dwarfed by multiples his largest deal ever, GEICO.13
When he met with the Gen Re management team, Buffett told them, “I’m strictly hands-off. You guys run your own business. I won’t interfere.” Then he suddenly started spouting numbers from GEICO. “Well, you know, their hit ratio has dropped a bit.*32 Last week their numbers were…” Holy cow! thought Tad Montross, General Re’s chief underwriter. This is hands-off? He knows more about GEICO than we know about General Re.14
Buffett did not know much about the inner workings of General Re. He had made the decision to buy based on studying the company’s results, and he liked its reputation. General Re was sort of the Grace Kelly of the sometimes-shady insurance business. General Re wore white gloves and historically had acted more ladylike and respectable than the average company. Still…given the pattern of Buffett’s purchases of insurers—in almost every case they plunged straight into the ditch shortly after he bought them—and given the size of this deal, the distant rumble of the tow truck’s engine warming up could be heard, barely audible, over the next hill.
But it was the high price paid for General Re that attracted most of the attention, and the fact that Buffett had paid in stock, not cash—in effect, swapping twenty percent of Berkshire Hathaway for General Re in a deal announced on the day that Berkshire hit its then-all-time high of $80,900 per share. People wondered if Buffett’s willingness to give away his stock when it was trading at such an unheard-of price meant that he, too, thought BRK was overvalued.15 Buffett had spent his career tightening his stranglehold on Berkshire. Giving stock to General Re’s shareholders diluted his own personal voting interest in Berkshire from forty-three percent to less than thirty-eight percent. The last time he had paid stock for a major purchase, it was GEICO, and investors had believed then that Berkshire was overpriced. So they speculated about the message Buffett’s new deal might be sending.
The price of BRK swung up and down based partly on the prices of the stocks that Berkshire owned. It was especially high at that moment because Berkshire owned 200 million shares of Coca-Cola, which now traded at an astronomical price. So, if Buffett was subtly signaling through his purchase of General Re that BRK was overvalued, did that mean that its underlying stocks—like Coca-Cola—were overpriced? If so, this could have implications for the entire market. It might mean the whole market was overpriced.
The king of the soft-drink world, Coca-Cola ruled with an aggressive swagger, a fizzy-dizzy arrogance. Buffett’s stake in KO had multiplied fourteenfold over a decade, to $13 billion, and he had gone so far as to declare the company an “inevitable” to his shareholders, as if it were a stock he would never sell.16 He reasoned that Coca-Cola would send more swallows down more throats in each passing decade “for an investing lifetime,” which made it about as close to immortal, for a brand, as you could get. Berkshire now owned more than eight percent of the company. Coca-Cola stock was trading as high as forty times its estimated 2000 earnings—a multiple that said investors believed the stock would keep rising by at least twenty percent a year. But to do that, it would have to increase earnings twenty-five percent a year for five years—impossible. It would have to almost triple sales, to a number nearly as large as the entire soft-drink market in 1999—again impossible.17 No amount of bottler sales or accounting finagles could produce results like that. Buffett knew it. Nevertheless, he did not sell his Coca-Cola stock.
The reason was partly inertia. Buffett liked to say he made most of his money by “sitting on his ass.” Like the investors who kept their GEICO stock when it fell to $2 a share, inertia had protected him from many mistakes—both of commission and of omission. He also owned too much Coke to sell without creating a major headache. The symbolism of Warren Buffett—the “world’s greatest investor” and a board member—dumping Coca-Cola stock would be unmistakable. The price of Coca-Cola could plunge as a result. Besides, with its effervescent mix of profit, product, nostalgia, show business, and likable people, Coca-Cola was Buffett’s favorite stock. “The Real Thing” wasn’t a slogan to him, it was an incredible cash machine that could grind out money forever, like the mill in the old fairy tale that endlessly ground out rivers of porridge, mountains of gold, or an ocean’s-worth of salt.
Buffett carefully sidestepped these questions about the market and Coca-Cola when he used Berkshire stock to buy General Re, saying, “It is not a market call whatsoever.”18 BRK, he said, was “fairly valued” before the merger, and the combined companies would create “synergy.” When Charlie Munger was asked, he stated that Buffett had consulted him about this deal very late in the game. In effect, he disowned the deal.19 Not unexpectedly, investors began to reprice BRK as if either Berkshire and its holdings in stocks like Coca-Cola were overpriced or the deal’s synergies would prove illusory.20 Or both.
Buffett’s explanation later that summer at Sun Valley was that “we wanted to buy Gen Re, but coming with Gen Re was $22 billion dollars of investments.” Many were stocks; Buffett promptly sold them. Adding $22 billion of bonds “changed the bond/stock ratio at Berkshire, which I was not unhappy with. It did have the effect of a portfolio allocation change.”
So Buffett—who sat on the Coca-Cola board with Herbert Allen—was “not unhappy with” swamping BRK’s stocks, including Coca-Cola, in an ocean of General Re’s bonds. This statement in context made all kinds of sense. In his previous shareholder letter, Buffett had written that stocks were “not overvalued”—if interest rates stayed below average, and if businesses kept delivering “extraordinary” returns on capital—in other words, if the unlikely continued to occur. This statement was oblique enough to avoid looking like a forecast. Buffett thought those who were always out prophesying some turn in the market’s direction usually wound up being wrong ten times out of two. So he rarely made statements about the market, and often played coy when he did. Still, it was unusually clever of him to work the words “not overvalued” into a sentence that said that the market was overvalued. People could read this message any way they wanted, but if they were smart, they got it.21
Likewise, Buffett was “not unhappy with” diluting his stock portfolio in the same Sun Valley speech, where he faced an audience filled with Internet CEOs at a time when Internet stocks were parthenogizing faster than naked mole rats. He accompanied his “not unhappy with” remark with the same warnings as in his letter: that interest rates must stay well below average and the economy stay unusually hot for the market to meet investors’ expectations. This was also the same Sun Valley speech where Buffett had used his place at the pulpit to explain that investing is laying out money today to get money back tomorrow, like Aesop’s bird in the hand versus the birds in the bush; that interest rates are the price of waiting for the birds in the bush; that for periods sometimes as long as seventeen years the market had gone exactly nowhere; and that at other times—such as the present—the value of stocks grows much faster than the economy. And, of course, he had closed this speech by comparing investors to a bunch of oi
l prospectors who were going to hell.
Thus, if Buffett was reshuffling his portfolio and focusing on bonds, perhaps it meant that he thought that it was now easier to make a living in bonds than stocks, and it was going to get easier still.22
The following October, he made another move that was just the opposite of what most people were doing—strikingly conservative by the standards of the market. He bought MidAmerican Energy Holding Company, an Iowa-based utility company with some international operations and a presence in alternative energy. He put in enough capital to buy just over seventy-five percent of MidAmerican for about $2 billion plus $7 billion of assumed debt, with the other twenty-five percent owned by his friend Walter Scott; MidAmerican’s CEO, Scott’s protégé David Sokol; and Sokol’s number two, Greg Abel.
Investors were mystified. Why would Buffett want to buy a regulated electric company? Admittedly, the business was growing moderately, was well-managed, and had attractive embedded returns that were relatively certain and would be so for as long as could reasonably be imagined.
Buffett saw this as a second cornerstone for Berkshire alongside the insurance business. He felt that he was working with excellent managers who could potentially put a lot of money to work in utilities and energy at predictable rates of return, which compensated for the limited growth. However, Buffett was already being ridiculed for his refusal to buy technology stocks. Now he had bought the light company. How dull!
But this was not how he thought. When it came to investing, the kind of electricity he sought was not the thrill of trading, but rather, kilowatts.
Buying MidAmerican and General Re significantly diluted the impact of Coca-Cola on Berkshire’s shareholders, but Berkshire still owned 200 million shares of Coke. Buffett never stopped thinking about Coca-Cola, where matters continued to go awry. By late 1999, the value of his KO stock was down to $9.5 billion, dragging down the price of BRK with it. A short-term wobble didn’t worry him—it never did—but thanks in large part to Coca-Cola, one share of BRK stock could no longer buy a top-of-the-line luxury sports car. Buffett kept turning over and over in his mind an incident back in June. Reports had trickled in that Coke products were poisoning children in Belgium and France. It was not hard to figure out what to do. The late Goizueta would have let “Mr. Coca-Cola,” Don Keough, handle it: Fly over right away, visit the kids, shower the parents with free soft drinks, make compassionately clever remarks to the press. Instead, Ivester—who was actually in France at the time—returned to the U.S. without comment, leaving the local bottlers to deal with the mess.
Herbert Allen, never one to sit patiently on the sidelines, called Ivester and asked, Why on earth don’t you get over there and show your face? And Ivester said, I’ve sent a team over, plus, those kids aren’t really sick. Allen exploded in frustration. Look, he said, these aren’t kids who marched around and said, “I’m going to ‘get Coca-Cola’ by saying I’m sick.” They think they’re sick. Whether they’re sick or not, what harm would it do to go over and sit down with their parents and give them a lifetime supply of Coke?23
But it seemed to him that Ivester didn’t understand any of that. As he saw it, Coca-Cola was not at fault. And that was that.
For weeks, the local bottlers kept trying to reassure the public that Coca-Cola products were safe. But then it turned out that maybe they weren’t. The company admitted it had found mold and chemical contaminants in the bottling plants. But it insisted these were aberrations, surely not serious enough to sicken children. Buffett was horrified. The arrogant response played right into Coca-Cola’s vainglorious image. Ivester had already had difficulty dealing with the European Union. Coca-Cola’s über-American style and the company’s strategy of seeking exclusive marketing deals had earned it a reputation for extraordinary hubris. Over and over, European government officials slapped around Coca-Cola representatives in a Punch and Judy show. All over the world, headlines blared, and customers’ trust in their beloved product dwindled.24
Weeks later, Ivester showed up in Europe and apologized in finely crafted legalese that never actually said, “We’re sorry.” The headlines died, and the Coke machines were plugged back in all over the continent. But the incident cost more than a hundred million dollars and impossible-to-measure damage to Coke’s reputation. Buffett stewed.
Herbert Allen was stewing as well. Closer to the day-to-day management of the company, he questioned whether Coca-Cola was running off the rails. Despite the declining sales, at least 3,500 new employees had marched into Coca-Cola Plaza in Atlanta in the last two years. Allen looked at the burgeoning payroll and saw “a cancerous growth on the company.”25 The company’s strategy of adding on the periphery, growing by acquisition, and hiring thousands of new staff was not working. Quarter after quarter, Ivester promised to improve growth rates; quarter after quarter, Coca-Cola fell short. One day in Ivester’s office, Allen asked him, What are you going to do? And Ivester said he didn’t know; had no solution.26 “It had just overwhelmed him. Everything together had overwhelmed him. He did not know what to do,” Allen says.
Floating above it all like the Goodyear blimp was Coca-Cola’s millennially named Project Infinity. This “was one of those projects where everybody’s computer would be linked up to the men’s room so they’d know how much soap they were taking out of the dispensers,” says Allen. Even the name, Project Infinity, seemed to refer to out-of-control spending in pursuit of ever-diminishing returns.27 It drove Allen nuts. He wanted to know what Coca-Cola was getting for its billion dollars. How was Infinity going to solve the company’s basic problems?
Buffett was displeased but resigned to being displeased. He had encountered this on some scale at almost every company where he sat on the board. Therefore, he sighed to himself, “They all do it. The people who run information-technology departments always want the latest and greatest whiz-bang thing. No matter how smart you are, no matter how much you know, who can challenge them?
“We probably aren’t going to sell any more Coca-Cola because of some computer project, and we will add more people instead of cutting jobs. The vendors have it rigged to make us update the software and hardware every couple of years or the system will stop working. So it isn’t even a onetime expense.
“Controlling technology spending is one of the toughest problems in management. And it’s particularly hard at Coca-Cola because a successful company is like a rich family. When you’re prosperous it’s very hard to instill discipline.” Buffett, of course, did not run his own company—or his own rich family—that way.
And there was more disturbing news, via Don Keough, who remained the bottlers’ best friend at Coca-Cola. He was now retired from the company and had become chairman of Allen & Co.—but Goizueta had kept him on as an adviser to the board. Keough was almost as much a part of Coca-Cola as he ever had been. Through Keough, Buffett heard that Ivester had been dictating terms to the bottlers in an unheard-of way. This troubled him, because so much of the good results produced by Ivester had come from reengineering the relationship between the bottlers and Coca-Cola. Now Ivester was pushing that same lever so hard that the century-long partnership between the company and the bottlers had broken down.28 Don Keough had become a sort of “father confessor to the disaffected” among the bottlers.29 They were in open revolt. Meanwhile, Ivester had snatched away Keough’s official role, a dumb move since Ivester needed Keough on his side. He might be King Arthur, but Keough was Coca-Cola’s Merlin and must be paid due respect.
This squeezing of the bottlers reiterated the question of whether Ivester really knew what to do about Coca-Cola’s slowing sales growth. The philosophy at Coca-Cola had always been that it was all about the relationship with the customer. Ivester favored a continuation of the accounting solutions to business problems, troweling more makeup on Coke when the CEO’s main job—as Keough and Allen and Buffett perceived it—was to make the Coke brand more popular around the world.
Since Goizueta had been engineering the com
pany’s earnings before he died, and Ivester was the engineer and reaped the rewards for doing so, why should he behave any differently now that he was CEO? As one board member put it, “The finance committee was the center of everything,” which was odd for a marketing company like Coca-Cola. In the end, the mistake was not Ivester’s. The board had deferred to Goizueta even after his death, when it followed his wishes and made the head of the financial engineering department the new CEO of Coke.
Still, Buffett was pretty sure that the problem so obvious to him was not so obvious to the whole board. As he ticked off marks against Ivester, Buffett spent the whole fall in a wrung-out state of anxiety. By Thanksgiving, the paralyzing limitations of his role as a board member, given the travails of Coca-Cola, had almost reached a breaking point.30
Then Fortune magazine, which had labeled Ivester “the 21st-century CEO” not two years earlier, published a highly critical piece blaming him for the company’s problems.31 That was a bad sign. Fortune rarely smiled on CEOs whom Fortune smacked around this way, especially if the CEO had previously been featured in a flattering profile on the cover of the magazine. Being knocked off one’s pedestal in public this way signaled that the powerful people whom Fortune’s reporters used as sources were displeased, and on the brink of tossing away the teddy bear they had once embraced.
Right after Thanksgiving, Herbert Allen put in a call to Buffett. “I think we have a problem with Ivester,” he said. “We picked the wrong guy,” Buffett agreed.32 “That’s about it,” said Allen. They began to lay their plans.
They both estimated that it would take more than a year for the board to come around to their point of view that Ivester had to go—and that, says Allen, “would have been devastating to the company. So I think we decided, just as two individuals, to tell him the truth about how we felt.”
Allen called Ivester and said he and Buffett wanted a meeting. They agreed to get together in Chicago, where Ivester would be stopping following a meeting with McDonald’s.
The Snowball Page 89