NEW YORK (
faced plenty of catastrophes in the first quarter, most in the Asia Pacific region, from the Japanese earthquake and tsunami to a New Zealand quake and massive flooding in Australia. As one of the world's biggest catastrophe insurers, Berkshire Hathaway's first-quarter results may be impacted by catastrophe losses. Nevertheless, it's the unquantifiable catastrophe in
own Omaha backyard, the resignation of former top lieutenant David Sokol, that rises above the natural world's devastation.
Berkshire Hathaway tried to pre-empt the firestorm that its CEO Buffett is sure to face at this weekend's Berkshire annual meeting when results of a Berkshire board audit committee's review of the trades made by Sokol, the former Berkshire senior officer, in shares of
( LZ) were made public, slamming Sokol. Berkshire's board said Sokol didn't just violate company policy, but that
Sokol intended to deceive Buffett
specifically about the trades, and made misleading disclosures to Berkshire.
on Thursday night, Buffett said that Berkshire shareholders can ask any and all questions about Sokol at the annual meeting, and that if his lawyers try to stop him from answering or wrestle him to the ground, he will go on talking. For Berkshire Hathaway shareholders, though, the board's condemnation of Sokol still leaves unanswered several critical questions about the future of Berkshire Hathaway, questions that have been highlighted by the Sokol resignation and relate more directly to the future opportunities for shareholders of Berkshire Hathaway. These are questions that investors who come to the annual meeting to focus on the stock's future might be more interested in than the mud-slinging between Berkshire Hathaway and Sokol.
In the same way that the hiring of hedge fund manager Todd Combs seemed to heighten investor awareness of how little they know about the future of Berkshire Hathaway, the Sokol resignation has opened a "can of worms" in the words of Morningstar analyst Greggory Warren, about the future of America's flagship investment enterprise.
For Meyer Shields, analyst from Stifel, the biggest point of the Sokol affair relates to the fact that Sokol was assumed to be in the pole position for Buffett's job, and it highlights the level of "ignorance" that all Berkshire Hathaway watchers and shareholders must confront in trying to assess the future of the company.
In light of this and the fact that it is annual meeting time for Berkshire Hathaway shareholders, here are four key questions not related specifically to Sokol, and arguably more important to the future of Berkshire Hathaway as an investment that continues to reward shareholders.
Does Anyone Want Warren Buffett's Job?
Succession planning at Berkshire Hathaway is the most obvious issue over which Berkshire shareholders can plead nothing but "ignorance" in light of the Sokol resignation. If Sokol is to be believed -- a big if -- he never wanted Buffett's job in the first place, and twice tried to resign in recent years.
The short list of candidates to replace Buffett is now shorter, like the plot of an Agatha Christie novel, and yet, analysts are divided over whether any of the top candidates even want to take the reins from Buffett. "The public had a comfort level with Sokol as the top candidate, and with Sokol removed from the picture, none of the other candidates have the breadth of experience," said Morningstar analyst Warren.
Ajit Jain, Berkshire's head of national indemnity, is on the short list, and Buffett has remarked that Jain would make a great CEO, but Berkshire Hathaway watcher (and shareholder) Paul Howard, founder of Solstice Investment Research, doesn't even think Jain wants the job.
"I think Jain is happy running his smaller operations in Connecticut. He's making plenty of money and doing what he has been doing for decades," Howard said. "Whoever it is, institutional investors will pound the new CEO," Howard said.
Alongside Jain, the name of
CEO Matthew Rose is often mentioned, as well as
insurance chief Tony Nicely. Above the speculation, though, analysts now wonder if the Sokol resignation has exposed a lack of board knowledge of what's really occurring at the operating companies of Berkshire Hathaway, and if that is an important hurdle for succession planning with Sokol out of the picture. It's back to the corporate governance structure issue. Does the Berkshire Hathaway board have a firm grasp of the management teams within Berkshire and at marquee properties like
and Burlington Northern where looking for a successor would be logical?
Morningstar's Warren said the Sokol resignation has left Berkshire with one key question to answer: Is it now approaching the succession process differently than in the past? "I want confirmation that they are looking at it differently and ensuring us that candidates are engrossed in different businesses," he said.
The Sokol resignation also raises a derivative question about succession: Is the "bench" deep enough at Berkshire Hathaway? Morningstar analyst Warren differentiated between a conglomerate like
, which has as part of its core strategy developing a deep bench and allowing managers to rise through the ranks, and Berkshire Hathaway. The Morningstar analyst is skeptical that the GE organic succession planning process is an approach that Berkshire Hathaway cultivated.
As a result, "There's the chance for an outside the box candidate as opposed to internal Berkshire operating entity executive," said Howard, the Berkshire shareholder.
Shields, the Stifel analyst, agreed with the shallow bench assessment, but in a left-handed compliment to whoever does succeed Buffett, said, "Somebody wants this job ... there are people who want to be president of the U.S."
"You couldn't pay me enough money to take it. The new CEO will be under so much scrutiny," said Morningstar's Warren.
How Significantly Has the S&P 500 Inclusion Changed Berkshire's Shareholder Base?
The comment from Berkshire shareholder Howard that whomever takes Buffett's CEO spot will be "pounded" by institutional shareholders highlights how quickly the Berkshire Hathaway shareholder base has changed.
When Berkshire acquired Burlington Northern and split its B shares as part of the deal, the liquidity led to its inclusion in the S&P 500 and the big boys of the institutional world -- from index funds to exchange-traded funds and actively managed funds that track the index by the trillions -- had to invest in Berkshire. While index fund giants like
and exchange-traded funds aren't likely to be activist in nature, they can ultimately lend their massive weight to any shareholder issues.
Morningstar's Warren said when he recently looked at the top holders of Berkshire Hathaway, seven of the top 10 are passive index funds and ETFs.
or Vanguard, the question longer term is as the shareholder mix features more activist investors, how many more people can the activists bring to the party, and in larger numbers?" Warren asked, adding that the biggest mutual funds in the world "can lend their vote once it gets to a proxy. "
Analysts said many of individual investors who have been with Buffett throughout their Baby Boomer adult lives are retirement age and could be looking at different investment options for their golden years, and Berkshire Hathaway has never offered a dividend.
"The long-term record is difficult to match and the company is going in the direction of a more institutional base. Pure ETFs and index funds aren't vocal, but actively managed funds will be," said Howard.
"The era of Warren Buffett not being questioned is behind us," concluded the Morningstar analyst Warren.
Does a new Berkshire Hathaway CEO Have to Pay a Dividend?
The idea that activist investors could pressure Berkshire Hathaway to get off its cash hoard and return money to shareholders raises another often debated question: If shareholders are to be rewarded, is a dividend or share repurchase plan the way to go?
"In two or three years time, if Berkshire is sitting on $70 billion to $80 billion in cash and investors are clamoring for a dividend or repurchase of shares, the big index funds and ETFs could lend their weight to a vote," Morningstar's Warren said.
David Rolfe, chief investment officer of Wedgewood Partners, which manages $1 billion in assets and has Berkshire in its top five holdings, said he wouldn't be surprised at the time of the new CEO announcement if a dividend is also implemented. Yet he doesn't see it happening any time soon. As other Berkshire shareholders have noted in the past, through Buffett's purchase of Burlington Northern and MidAmerican Energy, Berkshire is a capital intensive company that can reinvest more cash than historically it could in operating businesses.
"The railroad and utility soak up a ton of cash," Rolfe said.
The Wedgewood Partners CIO said a share repurchase could be tricky to pull off, even with the added liquidity of the B shares, especially if it is done while Buffett is still running the show.
"For someone like Buffett to go out and say 'we are going to initiate a buyback and have allocated $40 billion,' the stock will move so fast, how much will Berkshire even be able to buy back after that?" Rolfe asked. He noted that back in the spring of 2000 Buffett said if any investor of size wanted to sell Berkshire shares they should call Buffett directly. "If a buyback could be of size, I would love it, but I doubt it can be pulled off."
On the dividend issue, Meyer Shields of Stifel is among those who doubt the efficiency of a dividend since it would force shareholders to create a taxable event in their portfolios.
"I always thought a dividend was a bad use of money by creating a taxable transaction," Berkshire shareholder Howard said, adding that the company doesn't get to deduct it against revenue for tax purposes.
The Wedgewood Partners CIO took a more resigned view of the tax implications. "If you are a stock holder, the government is your partner whether you like it or not, so a dividend as a taxable event ... that's life."
Ultimately, the question is about what to do with the excess cash that Berkshire Hathaway generates and whether it can constantly reinvest at a level that generates its historically high returns. And ultimately, the excess cash issue leads into the biggest existential question of all for Berkshire Hathaway.
Should Berkshire Be Broken Up After Buffett Exits?
It's been asked before, and it will be asked again, especially if Berkshire's performance continues to trail the S&P, as it did last year and is doing so far year to date in 2011
though Buffett has always stressed five-year performance periods, and even when one looks at the long-term record, there are few individual years when Buffett did not beat the index on the book value basis which Buffett stresses-- only 8 years out of the last 45 year period, though 2009 and 2010 are two of those years.
Of course, Buffett can point to Berkshire's 409,000% book value increase from 1965 through 2010, versus the S&P at a mere 6,000%, but investors are looking to the future, and Buffett has famously remarked on the difficulty of outpacing the index the larger Berkshire becomes. In last year's annual letter to shareholders, Buffett described his stock's performance versus the S&P as "quite good" in earlier years and now only "satisfactory."
"The bountiful years, we want to emphasize, will never return," Buffett wrote.
"Investors will say if you have excess cash give it back, and over the long term, the conversation will go in the direction of a broader question about Berkshire, and feed into the argument that there is more value in breaking the company up," said Howard.
The Berkshire shareholder said that in the short term the existing conglomerate has value as a "hodgepodge" of companies, as the management teams enjoy the "long leash" provided by Buffett and the rating agency credit support for Berkshire's insurance operations give all the businesses under the Berkshire umbrella an extra "benefit of the doubt" brand.
"Lots of institutional investors don't know what to call this company. If it was just a railroad or just manufacturing it would be easier to make the sum is greater than the parts case, but the way it is now is confusing to investors," Howard said.
-- Written by Eric Rosenbaum from New York.
>>Will the Sokol Drama Linger for Berkshire Hathaway
>>Will the Sokol Drama Linger for Berkshire Hathaway (Part 2)
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