In my near 3 decades in Stock markets, I have seen many busts come, each getting replaced by an even bigger one.
The Harshad fix of 1992 repeated in 1994, the tech bust of 2000 that continues till date and much before these two were the drought linked bust-ups of Rajiv Gandhi's tumultous 5 years as PM.
The latest, fuelled by foreign and God knows which source of money is the Indian Real Estate bust. Just think, a 300-500 sq feet shop now sells for roughly Rs 1 crore and over in the Malls of Ludhiana, the same may sell for over Rs 3 to 5 crore in Bombay.
What returns would you need to sustain an investment of such magnitude for so small an office space? What type of business could have margins that would justify investment into Reality this expensive and which are the guys who are forking out money to buy them?
On the flip side, what kind of a Rental Income is this outrageously valued asset earning? About 1 per cent per annum, this type of asset was earning roughly 8 per cent three years ago, 6 per cent two years ago and now virtually nothing.
At the cost of sounding trite I think HDFC chairman Deepak Parekh has got Wool in his head or he is demented. Here is one guy who talks down Real Estate everywhere he goes, but his company keeps funding Real Estate. So either everyone at HDFC is equally lost or this nation has seriously run out of shrinks..anyway.
In 2008 your financial world is going to change... dramatically
For a decade it's been so simple for property investors. All they've had to do is buy property, and then sit back and watch it soar in value.
It's been so easy to make money that people have started treating their houses as a bank and a pension, as well as somewhere to live.
They've taken out loans against their homes on the basis they'll make a big profit in the future. They've bought houses they can't afford on the basis - again - that they'll make a big profit in the future. They've planned their retirement around property on the basis that - you've guessed it - they'll make a big profit in the future.
And every time that someone predicts a property crash, and nothing happens, those same people have become more and more convinced they're doing the right thing.
But they're making the most expensive mistake of their lives.
No bubble lasts forever. That's a FACT. There is a mountain of evidence that the property market is in a sick, sick state. FACT.
A property slump is coming....And, crucially, it's going to start very soon...
2008 Investment death-trap
#1: Buying property
According to the housing bulls, panicky estate agents and other crash deniers, house prices won't slump in 2008 because:
a] the supply of property can't cope with demand and...
b] the economic fundamentals are still strong
We don't agree. It's perfectly possible to have falling house prices even if GDP growth is respectable and employment is strong - as the American property market is proving right now.
And if supply and demand really was the crucial factor, rents would have gone up at the same rate as house prices. They haven't. In fact, house prices are now overvalued compared to rents by at least 50%.
No, the real reason why house prices have boomed is that interest rates have been low and lenders have been excessively lax. And that has allowed people to pay prices they really can't afford.
Now the gravy days are over. Interest rates rose 4 times in 2007 alone. And lenders, spooked by the US subprime disaster and worried about a repeat over here, are turning off the supply of cheap credit.
The result? The housing market is left without the two crutches - low interest rates and easy credit - that were keeping it upright. Right now, it's teetering alarmingly. Eventually it has to collapse. And when it does, it could have a long way to fall...
"The extent of house price over-valuation may be considerably larger in some national markets in Europe than in the
United States," - IMF Report, Oct 2007
House prices are set to fall. Almost every objective observer says so. But by how much?
Last October the International Monetary Fund warned that homes were overpriced by up to 40%.
That's far more than the overpricing in the US before the current property slump began there. Credit agency Fitch reckons that prices are overvalued by 20%; HSBC by 30% or more. Global banking group ABN-AMRO puts the figure at almost 50%.
Ed Stansfield, of Capital Economics, forecasts an overall decline in prices in 2008 of 3%. Henry Pryor, CEO of property website PrimeMove.com predicts a fall of 15% this year. Economist and MoneyWeek contributor James Ferguson thinks prices will go down by 3-5% in 2008, and by 41% in the longer term.
We're predicting a fall of 20% in real terms over the next 3 years.
So what should you do?
Well, if you already own a house, you're happy there and you're comfortable with your mortgage debt, don't do anything. You can think about selling at the top and investing elsewhere but why not just relax and enjoy your home.
But if you're thinking about getting onto the ladder, or of upsizing, then I'd urge you to think again.
Just look at the figures...
The average price of a detached house in the UK is now £323,000. The average price of all property is now £211,000. If we're right, and property is set to come down by 20%, people who buy the average detached house now could see £64,600 wiped off their assets in the next 3 years.
Plus you'll be paying higher and higher mortgage fees to cover the original cost.
We believe the solution is obvious. If you absolutely must buy a house to live in, then make sure you have a decent deposit and a sensible mortgage. And that means no interest-only mortgages, no 'lie-to-buy' deals, no sharing with friends and definitely no 50 year life sentences.
But if you don't really need to buy, why not rent? You'll save money in the short term. You'll protect yourself from the spectre of negative equity. And you'll be perfectly placed to grab a bargain when house prices come crashing down.
You'll also have more money to invest in alternative, lucrative sectors.
I'll introduce you to MoneyWeek's 3 favourite investments for 2008 later. But first let's move on to the next investment death-trap.. .
2008 Investment death-trap
#2: Buy-to-let
At the start of a raging bull market, buy-to-let seems close to the perfect investment. You buy a property, tenants queue up to pay the mortgage for you and then, when you decide to sell, you bank a massive capital gain.
But when interest rates are rising, rental yields are plunging and house prices are all set for a long downturn, it's a sure-fire way to lose money.
According to the industry hype, buy-to-let landlords rake in 8.5% each year from their tenants. In the real world the gross rental yield is more like 5.5%.
After fees, maintenance and other costs that figure slumps further, to 3.5% (and we haven't even mentioned stamp duty and other buying costs yet).
With interest rates just below 6%, many buy-to-let landlords are already swallowing big losses. And the fallout from the credit crisis means it's going to get worse and worse.
Why the credit crunch is set to wipe out Buy-to-Let
Many people think that mortgages are priced off the Bank of England's base rate. In fact they're normally priced off the rate at which banks can borrow from each other. And since the Northern Rock crisis, when the banks became more reluctant to lend to each other, that rate has shot up.
And this is the crucial bit. Interest rates for buy-to-letters and subprime buyers, which started off higher anyway, have risen particularly quickly. In September 2007, for example, two buy-to-let lenders, Advantage and Edeus, increased their average rates by 0.75% and 0.65%.
In the circumstances it's no surprise that people are starting to jump off the buy-to-let bandwagon. The number of buy-to-let investors selling their property leapt by 27% in the first quarter of 2007.
By December 2007, the proportion of landlords choosing to sell up at the end of the lease had jumped to 6.5%. I'd urge you to steer clear of this dead investment too. It could easily cost you £20,000 in the next 3 years.
And if you already own a second property I'd urge you to sell it soon.
This is why...
"Revealed: the 231 year-old 'secret' of perfect property market timing"
You probably won't have heard of the economist Fred Harrison.
But that's all set to change. After analysing 231 years of business cycle statistics, Harrison has made a discovery that's enabled us, for the first time ever, to predict when housing bubbles start and end.
I'm not going to get into the complex details of it here. But basically Harrison has discovered that the housing market operates on a cycle that's based around land prices.
As an economy grows, so does the demand for land. Because the supply of land is fixed, it becomes more expensive. As prices go up, corporate profits and wages are squeezed. Finally there comes a point when prices simply can't go any higher because people can't afford to pay them any more.
And this is the really interesting bit. In every single case the cycle lasts the same time - 18 years, which consists of 14 years of stable or rising prices and 4 years of recession.
The last UK housing bubble burst in 1990...
Which means that the value of your property investments could start to plummet right now in 2008.
There are a huge number of scary stats and facts that scream that a crisis is on the way. Here are just a few...
The average house is now worth an extraordinary 9 times average earnings. The long-term average is just 3.5!
Last month (January 2008) the Royal Institution of Chartered Surveyors (RICS) announced that December 2007 was the worst month for the housing market since the aftermath of Britain’s last recession in 1992.
In 1993 first-time buyers made up 55% of the market. That figure has now slumped to 29%.
According to the Empty Homes Agency, there are 850,000 empty properties in England alone. So the 'supply v demand' argument used by crash deniers might not be such a factor after all?
Individual insolvencies are up 225% in the last 2 years as a nation of debt junkies struggles to cope.
In May 2007 Jon Hunt, founder of Foxtons, sold the UK arm of the business. A smart move from the first big rat to jump ship?
For the first time ever, personal debt is higher than the entire value of the economy. GDP is forecast to hit £1.33 trillion for 2007 - less than the £1.35trn which was outstanding on mortgages, credit cards and personal loans in June. [5]
A study from ABN-AMRO found the UK is even more vulnerable to a housing slump than the US. Sales of existing homes now stand at their lowest rate since records began.
In December 2007 Halifax reported the biggest biggest three-month fall in house prices since 1995.
One million debt-ridden householders are using credit cards to pay their mortgage or rent.
Here's what we think will happen.
Investors will do the maths on buy-to-let and then rush to sell up.
People who've overstretched themselves won't be able to meet the higher mortgage payments. They'll either lose their homes or have to sell up.
People will scramble to sell their property. For sale signs will dominate streets. Repossessions will rocket.
And first-time buyers, the traditional lifeblood of the market, won't be around to take up the slack. Instead they'll wait and see if prices go lower.
But as panic hits the markets, and unprepared investors scramble to save themselves from devastating losses, a wave of profit opportunities will open up.
Traps like this...
2008 Investment death-trap
#3: Commercial Property
The era of easy credit and low interest rates didn't just spark the housing bubble, it also fuelled a spectacular boom in the commercial property sector.
Prices for shops and offices went through the roof. Overall the retail sector achieved a whopping 60.5% gain in the three years to 2007 alone.
But now the boom is officially over. The price of commercial property has been pushed so high that the average yield (the amount of rent paid compared with the purchase price) now stands at just 4.5%, well below the UK base rate.
Investors can now get a better return from buying risk-free government bonds than they can get from investing in the increasingly volatile retail sector.
Commercial property funds, including the market-leading schemes run by New Star and Norwich Union, have all seen their values dive in the last 12 months.
Between December 2007 and January 2008 alone 3 of Britain’s biggest property funds – Friends Provident, Scottish Equitable and ScottishWidows – were forced to shut their doors to withdrawals by small investors after an outbreak of panic selling.
Other fund managers, including Schroders and UBS, have already put a block on withdrawals by institutional clients.
The UK’s commercial property market is now in a worse state than at any time since the early 1990s.And there is little hope of things getting any better soon. In fact they’re going to get a lot worse. Investment bank Morgan Stanley predicts a market fall of 50%.
Economics consultancy Capital Economics predicts that commercial property prices will fall by 18% in real terms by 2010.
In the circumstances our advice is simple. If you're thinking of sinking money into commercial property schemes, please don't.
The idea of swallowing substantial losses in the short-term in the hope of cashing in sometime in the unknown and distant future doesn't make a lot of sense to us.
'Cut your losses and run your profits' is the general advice given to investors in shares. We see no reason why you shouldn't do exactly the same for asset classes, particularly commercial property.
If you've already sunk money into a 'lame duck' retail scheme our advice is to get it out if you can - even if there are exit charges to pay.
And don't get back into commercial property till there are clear signs that the market is bottoming out.
The Warren Buffett You Don't Know
Warren Buffett is returning to the U.S. from Europe in a private jet. As his plane nears its destination, the flight attendant gives out landing cards and a warning to all eight passengers aboard. ''The customs inspector here is utterly humorless,'' she says, ''so no wisecracks or he will tear the plane apart from fore to aft.'' Buffett, who quips as reflexively as he breathes, takes his card without comment.
In the terminal, a surly looking man with a crewcut and a pistol on his hip sits behind a small table. Buffett hands over his passport and landing card to the inspector, who does not seem to realize that the professorial-looking 68-year-old standing before him is America's second-richest man. Or perhaps he just gets a kick out of trying to take the high and mighty down a peg. ''You left some things blank,'' the inspector says peevishly. ''Do you have $10,000?''
The question could have launched a dozen snappy retorts, but Buffett restrains himself. ''I have what I left with,'' he says carefully. The inspector furrows his brow--was that some kind of joke?--but does not press the issue. He asks Buffett if he has any anything to declare. ''I was given two books,'' Buffett says. ''Well, you have to put it down, then,'' snaps the agent, who fills in the blank himself.
Buffett shows not a flicker of annoyance at being treated like a misbehaving child. He stands mute and impassive before the inspector, who, after a few more curt remarks, can think of nothing else to do but let ''the Oracle of Omaha'' be on his way.
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Has there ever been a less pompous billionaire than Warren Edward Buffett? Hollywood might cast him in the role of an amiable teacher at a Midwestern college or a sweet-tempered, wisecracking inventor who eventually wins a Nobel prize and gets the girl besides. To hear Buffett sing his beautifully artless rendition of Ain't She Sweet to his own ukulele accompaniment is to wonder not only how such a man came to measure his net worth in billions but also whether he might not be a time-traveler from a more innocent age.
If Buffett had a business card, it would identify him as chairman and chief executive of Berkshire Hathaway Inc. (BRK.A) But he is far better known--indeed, world-famous--as the greatest stock market investor of modern times. The figures, though often cited, still astound: Had you put $10,000 into Berkshire when Buffett bought control of it in 1965, you'd have $51 million now, vs. just $497,431 if the money were invested in the Standard & Poor's 500-stock index.
The numbers don't lie, but the story they tell is out of date. Buffett has not added a major position to Berkshire's bulging stock portfolio since amassing 4.3% of McDonald's Corp. (MCD) in 1995. In the meantime, he has transformed what long has been a sideline at Berkshire--the acquisition of entire companies--into the main event. Over the past three years, Berkshire has spent $27.3 billion to buy seven companies in industries as disparate as aviation, fast food, and home furnishings. The $22 billion purchase of reinsurer General Re Corp., which closed late last year, was Buffett's largest ever.
The effect has been dramatic: In short order, Berkshire has been transformed from a closed-end fund in corporate drag to a bona fide operating company. At the start of 1996, the company's famous stock portfolio accounted for fully 76% of Berkshire's $29.9 billion in assets. But by the end of 1999's first quarter, the figure had plummeted to 32% as assets quadrupled, to $124 billion. Today, Buffett's company employs 47,566 workers, double the number in 1995.
And he isn't done yet. ''I'd love to make a $10 billion to $15 billion acquisition, and we could go bigger than that if I really like the company,'' says Buffett, who holds $15 billion in cash and is sitting on top of an additional $30 billion in unrealized gains in Berkshire's stock portfolios.
It's all there in black and white in Berkshire Hathaway's famously literate annual reports, but somehow the company's transformation has gone not just unheralded but unnoticed. Berkshire is ''possibly the most talked about and the least understood company in the world,'' contends Alice Schroeder, a PaineWebber Inc. insurance analyst who in January published one of the few comprehensive studies of the company ever undertaken by a brokerage house.
MISUNDERSTOOD. The common view is that Berkshire shares fetch a premium because of Buffett's reputation as a latter-day Midas. The ''Buffett premium'' undoubtedly is real in the sense that if the man died today, the stock would plunge tomorrow. In Schroeder's view, though, Berkshire's stock is already trading at a sizable discount to its true value, which she estimates at $91,000 to $97,000 per A share. The A shares lately have been trading at about $70,000. The basic problem, Schroeder says, is that the world continues to misperceive Berkshire as little more than the sum of the stocks it holds in its $37 billion portfolio. In other words, the market tends to overreact to news about the seven stocks that form the core of Berkshire's holdings (table). Over the past 12 months, Berkshire has fallen by about 17%, from a high of $84,000 in June, 1998. In Schroeder's view, the main cause of this decline is the plunging value of Buffett's colossal stakes in Coca-Cola Co. (KO) and Gillette Co (G).
The radical recent shift in Berkshire's corporate profile does not reflect a radical change in Buffett's thinking. In most ways, he remains true to the conservative precepts of value investing. In essence, Buffett continues to prefer today's sure thing to the next big thing, no matter how spectacular its potential. Forget Internet stocks: Buffett still will not invest in even such well-seasoned high-tech companies as Microsoft Corp. (MSFT) or Hewlett-Packard Co. (HWP) because he doesn't believe that anyone can predict how much they will earn over the next decade or two. ''I can't do it myself,'' he says. ''And if I don't know, I don't invest.''
Even in his stock-picking heyday, Buffett preferred owning businesses to passive minority investment. Until recently, though, Berkshire's acquisitions have been few and far between because Buffett insisted on buying top-quality businesses at discount prices. What has changed is that he is now willing to pay a premium for one-of-a-kind businesses.
Why this is so is not completely clear. The Buffett psyche is notoriously labyrinthine. ''I could easily spend a lot of time trying to analyze Warren if I didn't consciously try not to,'' says Olza M. Nicely, CEO of auto insurer GEICO Corp., one of Berkshire's largest subsidiaries. ''There are certain mysteries you just have to accept.''
In Buffett's view, he is putting the finishing touches on his masterpiece. ''Berkshire is my painting, so it should look the way I want it to when it's done,'' he says.
In an era in which most CEOs at least mouth the platitudes of good corporate governance and shareholder rights, Buffett, in his good-natured way, is a throwback to a time when a mogul was a mogul and did as he damn well pleased. ''Berkshire is the company I wanted to create. It's not the company Alfred P. Sloan wanted to create. It fits me,'' he says. ''I run it with our investors and managers in mind, but it is designed to fit me.'' To be blunt, Buffett stands revealed as a driven, even monomaniacal corporate empire-builder.
For all his offhand charm, Buffett is pretty much all business all the time. Aside from an addiction to luxury air travel, he is a man of simple tastes and frugal habits. He neither spends his money nor gives much of it away. Philanthropy, the renascent vogue of America's superrich, interests him peripherally at most. Buffett intends to take his fortune to the grave--and to keep adding to it until the day he dies. ''The problem I've got with doing anything else except what I'm doing is that there is nothing remotely as fun as running Berkshire,'' he says. ''I'm selfish that way.''
So far, Berkshire's legendarily devoted shareholders would not have it any other way. In May, some 15,000 of them flocked to Omaha to sit at the feet of the master during Berkshire's three-day festival of an annual meeting, which Buffett calls ''Woodstock for Capitalists.'' Of course, Buffett and his wife, Susan T. Buffett, are the largest Berkshire shareholders by far: Their 38.4% stake is worth about $40 billion.
The highest circle of management power at Berkshire has always been tight, but it has shrunk in recent years--to Buffett alone. Charles T. Munger, Buffett's longtime vice-chairman and business alter ego, continues to enliven the annual meeting by playing the part of drolly laconic sidekick to Buffett's ebullient master of ceremonies. Behind the scenes, though, his influence has waned. ''Charlie and I don't talk a lot anymore,'' acknowledges Buffett, who says he did not even bother to consult his vice-chairman before making the epochal Gen Re acquisition.
By all accounts, including their own, Munger and Buffett have not fallen out. But while Buffett is wholly devoted to building Berkshire, Munger, 75, now spends his time chairing a not-for-profit hospital and serving as a trustee of a private high school. ''Charlie is broader in his interests than I am,'' Buffett says. ''He doesn't have the same intensity for Berkshire that I have. It's not his baby.'' Munger concurs: ''Warren's whole ego is poured into Berkshire.''
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In mid-April, Buffett led a small entourage on a whirlwind European tour to promote one of Berkshire's latest acquisitions, Executive Jet Aviation. I went along for the ride (on one of EJA's Gulfstream IV-SP jets) and got an unusual chance to observe the notoriously press-shy Buffett at close range against a kaleidoscopic backdrop of private airports, luxury hotels, and banquet halls stretching from London to Frankfurt to Paris.
Buffett survived a demanding regimen of midmorning coffees, two-hour luncheons, 90-minute press conferences, and four-course banquets. ''I never get tired,'' he told reporters in London, ''except for my voice.'' Actually, Buffett was ashen with fatigue midway through the third day but soldiered gamely on, answering even the lamest questions with the same expansiveness and wit the fifth time he heard them as he did the first.
Only once did Buffett show annoyance. During a press conference at the Frankfurt airport, Richard Santulli, EJA's normally understated chief executive, let his admiration of Buffett overflow. ''People say that he's the most astute investor of the 20th century,'' he said. ''I say ever.''
Buffett, who was sitting at Santulli's side, gave a little snort. ''Why not?'' he said sourly. ''I'm sitting right here.''
Like any mogul, Buffett has his special needs. On this trip, he indulged two of them, listed here in reverse order of importance: red meat (at lunch and dinner) and Coca-Cola (all the time).
Whenever I lost track of Buffett, Coke often appeared to guide me--a carbonated version of the proverbial trail of crumbs. In London, our party went from airport to hotel in separate cars. When I arrived at the Berkeley Hotel, I did not have to wonder for long whether Buffett had preceded me. A bellhop approached with a shopping bag. ''Is this yours?'' he asked. Inside were two six-packs of Cherry Coke. Two days later, I was in the crowded lobby of the Schlosshotel Kronberg near Frankfurt, following a white-gloved waiter bearing aloft a single bottle of Coca-Cola on a silver tray.
Buffett bought Executive Jet in mid-1998 for $725 million. Although this is a pittance compared with what Berkshire paid for General Re, the EJA deal was no less a milestone in its way. EJA, which pioneered the fractional ownership of business jets, is the first true emerging-growth company that Buffett has ever owned. What's more, the very idea of investing in business aviation would have been considered downright sacrilegious throughout most of Berkshire's history.
For years, Buffett mocked corporate ownership of jets as a wasteful executive perk. But in 1986, he bought a small used plane for Berkshire, then traded up to a more expensive model a few years later. He named the jet ''The Indefensible'' and made sport of its purchase in his 1989 report to shareholders: ''Whether Berkshire will get its money's worth from the plane is an open question, but I will work at achieving some business triumph that I can (no matter how dubiously) attribute to it.''
The truth is, Buffett had fallen in love with his plane but could not yet admit it. In 1995, he was introduced to Santulli by the head of one of Berkshire's operating companies and bought a one-quarter share of a Hawker for personal use. His wife, who has become a frequent flier, called the new plane ''The Richly Deserved.'' (Not to be outdone, Buffett renamed Berkshire's jet ''The Indispensable.'') Santulli offered to sell his company to Buffett when Goldman, Sachs & Co. (GS), a founding minority investor, began pressuring him to float a public stock offering.
Executive Jet in no way resembles the sort of business on which Buffett cut his teeth as an apprentice to the late Benjamin Graham, co-author of the value-investing bible, The Intelligent Investor. Graham's method emphasized creating a ''margin of safety'' by investing only in stocks trading at two-thirds of net working capital. He called them ''cigar butts''--companies the stock market had discarded but that still held a puff or two of value to extract.
Buffett was Graham's most accomplished disciple. But as the pupil established himself, he began to feel constrained by the mentor's method. For Graham, a business was an abstraction wholly defined by a set of numbers on a page; he had no interest in its products, its management, its personality. But Buffett's boundless curiosity and enthusiasm were not satisfied by the ghoulish exercise of profiting from the last dying gasps of derelict companies. Buffett's yearnings and dissatisfactions did not begin to coalesce into an investment philosophy of his own until he met the blunt-spoken Munger in 1959. The two, closely matched in intellect and outlook, quickly became the closest of partners. Munger urged his friend to leave the cigar butts in the gutter and think of value in more expansive terms. Says Buffett: ''Charlie kept pushing me back to the idea that what we really needed to own was the wonderful business.''
Even so, it took Buffett a long time to tailor Graham's straitjacket conservatism to the more generous dimensions of his own personality. His $11 million purchase of Berkshire Hathaway in 1965 was a costly case in point. Initially, Buffett saw the floundering old-line company as a classic Graham play. But then the textile manufacturer rallied unexpectedly, and Buffett sank more money into it on the belief that this cigar butt had a future after all. It did indeed, but not in textiles.
Buffett did not come fully into his own until he and Munger collaborated on the $25 million acquisition of See's Candies in 1972. The San Francisco maker of boxed chocolates was the first business of any sort for which Buffett paid more than book value--three times book, in fact.
What, in Buffett's view, makes a business wonderful? It starts with ''a sustainable competitive advantage.'' Underline sustainable. Buffett will not invest in a business unless he feels reasonably certain how much it will earn over the next 20 to 25 years. But for all of Buffett's cerebration, he does not feel truly comfortable unless a business ties into his own everyday experience. His favorite companies tend to traffic in elementally appealing brand-name products that Buffett not only uses himself but also invests with almost totemic meaning: a bottle of Coca-Cola, a Gillette razor blade, a box of See's candy, and, yes, even a Gulfstream jet.
Buffett has always been especially partial to companies that can sustain a competitive edge without tying up much capital. Consider Scott Fetzer, which makes a variety of industrial and consumer products, including Kirby vacuum cleaners and Quikut knives. Since 1986, when Berkshire paid $315 million for Scott Fetzer, its earnings have risen by only 5.5% a year on average. Yet Buffett repeatedly has praised it as a model of capital efficiency. In 1998, Scott Fetzer netted $96.5 million after taxes on its $112 million in equity, a return on equity of 86%. This is all the more breathtaking considering that Buffett has been milking it for 13 years, extracting more than $1 billion all told.
Ever since Berkshire's 1967 acquisition of National Indemnity Co., insurance has held double appeal for Buffett. Not only does he like the economics of the business--or parts of it, anyway--but a well-run underwriter also generates a steady flow of low-cost investment dollars, or ''float,'' as a matter of course. The 1996 acquisition of GEICO, now the sixth-largest U.S. auto insurer, doubled Berkshire's float at one stroke, and the Gen Re buy nearly tripled it, to $21 billion.
In Buffett's view, the quality of a company's management is integral to its value as a business. And when acquiring companies, Buffett is as concerned with the motives of the selling CEOs as he is with their abilities. ''What I must understand is why someone will continue to get out of bed in the morning once they have all the money they could want,'' Buffett says. ''Do they love the business, or do they love the money?''
No less an authority than John F. Welch, CEO of General Electric Co., considers Buffett a superb judge of managerial talent. Buffett and Welch have gotten to know each other over the years as golf partners and as rivals in auto insurance and other businesses. ''Take 20 people you know quite well but Warren has just met casually,'' Welch says. ''If you ask Warren his opinion about them, he'll have each one nailed. He's a masterful evaluator of people, and that's the biggest job there is in running a company.''
In 34 years, Berkshire has never lost an operating chief except to death. In fact, the great majority of its subsidiaries are still run by the same executive who brought them to Berkshire in the first place. The operating head of longest tenure is Charles N. Huggins, who has been president of See's Candies since Buffett acquired it. Huggins is 74 years old now, but he's not Berkshire's oldest manager. That would be 85-year-old Harold Alfond, who founded Dexter Shoe Co. in 1956 and sold to Buffett in 1993 for Berkshire shares now worth $1.5 billion.
Berkshire's operating ranks contain a second octogenarian billionaire: 82-year-old Albert L. Ueltschi, chairman and CEO of FlightSafety International Inc., a pilot-training concern Berkshire bought for $1.5 billion in 1996. An ex-pilot, Ueltschi founded the company in a LaGuardia Airport hangar in 1951. ''I'm like Warren,'' says Ueltschi, who has no plans to retire. ''I like what I do so much that I don't consider it work.''
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Somewhere between Frankfurt and Paris, Buffett gets up and walks back to the airplane's pantry to fetch a box of Swiss Sprungli chocolates an admirer had given him in Germany. Buffett makes his way slowly up the aisle of the plane in his shirtsleeves, offering the candy to each passenger aboard.
A half-empty box of See's chocolates rests on the table where I'm sitting. Buffett pops a piece in his mouth. I ask him whether he thinks he could identify See's in a blind taste test against other brands. ''Of course,'' he says. ''I can also tell Coke from Pepsi. The thing is, most Americans prefer Pepsi to Coke because it is 4% sweeter, but Coke still outsells Pepsi by a huge margin.''
As Buffett continues in this vein, he starts staring at the box of Sprungli he carries. He shifts it to one hand as if he were about to choose a piece, then seems to change his mind. ''It's a showy sort of candy, isn't it?'' he says and then falls silent. He gazes raptly at the Sprungli for a full 45 seconds as the conversation continues around him. Then he abruptly sets the box down and returns to his seat without a word.
Later, I recount this to Chuck Huggins, See's president, who chuckles knowingly. ''Yeah, that's Warren. Brand-loyal.''
The office next to Buffett's is occupied by Michael Goldberg. A former McKinsey & Co. consultant, Goldberg was hired in 1981 to bring order to Berkshire's far-flung insurance interests and essentially functioned as chief operating officer for the next 11 years. The single-minded intensity Goldberg brought to the job created friction in the ranks--and gave him a bad case of burnout. In 1993, Buffett reassigned Goldberg to ''special projects'' and eliminated his old position.
The line managers who once reported to Goldberg, now 53, have reported directly to Buffett ever since--as do the chiefs of all 22 of Berkshire's operating companies. Buffett essentially lets the chiefs of the companies that Berkshire acquires run their businesses as before, except that he requires them to transfer their excess cash to Omaha and clear capital-spending plans with him. Buffett, who thinks of his role as Berkshire's ''capital allocator,'' collects the enormous cash flow that the subs produce--$13.4 billion last year--and uses the money to buy more businesses, either in whole or in part, through the stock market.
Buffett tends not to initiate contact with his operating executives: He waits for the phone to ring. ''Let me know about any bad news as soon as possible,'' he tells his subordinates, ''but otherwise, you are free to call me as often or as seldom as you like.'' Buffett's managerial passivity should not be mistaken for indifference. Some operating chiefs say he nearly memorizes the monthly reports they send to Omaha.
During holiday seasons, Buffett requests daily sales reports from See's and Borsheim's, Berkshire's huge upscale jeweler in Omaha, because the ebb and flow of retailing hold an enduring fascination for him. Year-round, he speaks to two execs almost every day: Richard Santulli and Ajit Jain, who runs Berkshire's reinsurance business in Stamford, Conn.
Berkshire's homegrown insurance group offers a variety of property-and-casualty coverage in certain U.S. markets. But its chief business is a high-risk, high-reward specialty that Jain developed over the past decade in reinsuring ''super-catastrophes''--earthquakes, hurricanes, floods, and such. Buffett found the economics of ''super-cat'' seductive: Berkshire has made at least $865 million pretax in underwriting profits since 1991. But it was the complexities of analyzing super-cat risk that hooked him. Says Jain, 47: ''Warren and I might have had a 30-second conversation or a 30-minute one, but he has been involved in every piece of business I have done.''
As for Santulli's business, Buffett is intrigued not just by the novel challenges posed by EJA's rapid growth but also the logistical complexities of the fractional-shares business. ''He likes the mental challenge of it,'' says Santulli, a former mathematics professor. ''He calls it 3-D chess.'' Even so, Buffett is careful not to impinge on Santulli's operating authority. EJA's chief once asked Buffett for advice in making a decision and was rebuffed. ''Don't bother with that,'' Buffett told him. ''Just decide.''
Buffett's laissez-faire management style has been tested most severely in recent years by Berkshire's misadventures in shoes. From 1991 to 1993, Buffett laid out $650 million to buy three old-line makers of midprice shoes: H.H. Brown, Lowell, and Dexter. In essence, he was betting that his companies would benefit as the appeal of imports waned and U.S. consumers returned to home brands. Buffett hasn't made many fundamental strategic errors, but this was a doozy: Imports now account for 95% of domestic shoe purchases, vs. 70% in the early 1990s. Since 1994, operating profits of Berkshire's shoe group have plummeted 57% on an 18% decline in revenues.
Dexter has fared much worse than Brown, which absorbed Lowell and has buoyed itself by shifting much of its production offshore. Although Dexter now does some manufacturing in Puerto Rico, it has placed overriding emphasis on maintaining full employment at its four factories in its home state of Maine. By all accounts, Buffett has played no part in this divergence in basic strategy--and performance--between H.H. Brown and Dexter except to countenance it by his silence. ''It's amazing how little he bothers you,'' says Francis Rooney, chairman and CEO of H.H. Brown. ''He never even comments.''
The deference Buffett shows Berkshire's subsidiaries is all the more remarkable because it does not come naturally to him. ''With almost every one of the companies Berkshire owns, I think I would do something different if I was running them--in some cases, substantially different,'' Buffett says. The reason he doesn't impose his views, he adds, ''is simply that I am not inclined to make myself unhappy. I sort of accept things as they come.''
It's not that simple. Buffett knows the sort of self-motivated, hands-on exec he covets wouldn't tolerate being pushed around by Omaha. And Buffett's respectful treatment of his managers has instilled in them an ambition to ''make Warren proud,'' as one puts it. ''Somehow, Warren has been able to keep a diverse cast of characters working harder for him than they did for themselves,'' Goldberg says. ''I see it every day--and I still don't know how he does it. But I do know that all of us feel this incredible responsibility to him.''
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We arrive late to Paris, touching down in a freakish, near-gale-force windstorm that both thrills and alarms our pilot. In four cars, we race as fast as rush-hour Paris traffic allows from Le Bourget to Dassault Aviation Group's magnificent 19th century chateau--familiarly known as Le Rond Point--on the Champs Elysees. EJA is the largest commercial customer of Dassault Aviation, Europe's leading manufacturer of business jets. Serge Dassault, the company's chairman, is hosting tonight's gala reception and dinner in Buffett's honor. By the time we arrive, the reception is in full swing. But Buffett takes a few steps into the foyer and hustles up a flight of stairs. It will be a good 35 minutes until he descends and joins the party.
Downstairs, the guest of honor's whereabouts is Topic A among Dassault's distinguished guests. It might puzzle them to learn that Buffett is on a transatlantic call to one of his employees. The matter he is discussing with Ajit Jain this evening is not urgent. But it is Buffett's custom to speak with Jain every evening. If that means keeping 200 of France's richest people waiting, then c'est la vie.
In mid-May, Buffett moderated a panel on Internet commerce at Microsoft's annual CEO summit in Seattle. As Buffett tells it, the assignment reflected William H. Gates III's sense of humor. But the Microsoft chairman and CEO, a friend of Buffett's since 1991, says it was no joke: ''Every principle that Warren holds about business and business value will still apply in this new world we're going into.'' Gates, who owns Berkshire stock in his personal account, adds that he has learned more about business from Buffett than from anyone else. ''People really underestimate what he has created in Berkshire,'' he says.
Unlike most megacorporations, Berkshire was not erected on the foundation of a single great business. Buffett began with a dying textile maker and parlayed its dwindling cash flow into ownership of a massive portfolio of enduringly profitable operating businesses. By the end of 1998, Berkshire had amassed shareholder equity worth $57 billion. This is a staggering sum, putting Berkshire well ahead of General Electric, Microsoft, and every other U.S. corporation and ranking it second in the world to Royal Dutch/Shell Group. Buffett could retire tomorrow and be confident of his place in business history not only as stock investor extraordinaire but as a corporate builder of the first rank.
LIMITS OF SCALE. Instead, of course, he is still in there pitching, to borrow one of the baseball metaphors that so delight him. From 1965 through 1998, Berkshire's book value per share rose 24.7% a year on average--trouncing the 12.9% average annual gain in the S&P 500. For some time now, Buffett has warned that the company's sheer bulk will prevent it from matching its breathtaking historical average in the future. His avowed goal is to increase its worth at an average of 15% a year. It's a modest aspiration only by comparison, for it implies adding $58 billion of shareholder equity over the next five years.
Except for the shoe group, Berkshire appears to be in fine fettle. Executive Jet is by no means its only hope for growth. GEICO, Berkshire's largest subsidiary in terms of revenue, has been wresting market share from rivals at an impressive rate and yet still has only 3.5% of the vast U.S. auto-insurance market. Like EJA, Gen Re is planning to expand in Europe and around the world. At the same time, Borsheim's, Scott Fetzer, See's Candies, and other Berkshire companies are experimenting with E-commerce. ''The No. 1 topic Warren and I talk about now is whether retail selling is going to move over to the Internet,'' says Ralph E. Schey, Scott Fetzer's chairman and chief executive.
The pursuit of accelerated growth carries added risk. In 1998, Berkshire had a banner year, posting a 48% increase in net earnings, to $2.8 billion, on revenues of $13.8 billion. But net income dropped 25%, to $541 million in the first quarter, largely because of earnings declines at GEICO and Gen Re. While both insurers were hurt by intensifying price competition, a German subsidiary of Gen Re's also took an embarrassing $275 million pretax loss on a workers' compensation pool. The down quarter did not seem to faze Buffett, who is famous for taking the long view.
If Berkshire were in fact a painting, it would look like a Jackson Pollock: an idiosyncratic product of inspired improvisation. In building his company virtually from scratch over the past quarter-century, Buffett conjured no overarching strategic vision, followed no master plan other than to buy good businesses at the right price. Even when he erred--a rare occurrence--he enfolded his purchases in an embrace intended to be permanent. ''We buy everything, even a stock, with the idea that we will hold it forever,'' he says.
It is hugely important to Buffett that his corporate handiwork outlast him. In fact, it is his hope that Berkshire--his masterpiece in progress--survive him in exactly the form it exists upon his death, like a painting framed and hung on a museum wall. But might there not come a time when his successor might be smart to sell some of Berkshire's weaker units? ''I don't think so,'' Buffett says. ''I hope whoever follows me would behave pretty much as I would if I were to live forever. I feel I owe it. I owe it to the people who sold me their businesses. They didn't have to sell to me. If I die tonight, I want them to get what they were expecting.''
MYSTERY HEIRS. Buffett says he already has picked a successor--two of them, actually: one to manage the stock portfolio, the other to oversee the operating companies. Their identities have not been disclosed to shareholders or, for that matter, to the heirs apparent themselves, because Buffett reserves the right to change his mind. He says he might eventually settle on a single successor.
Munger, who has most of his own billion-dollar net worth in Berkshire stock, professes optimism about the company's post-Buffett prospects. ''The corporate culture of Berkshire is more durable than that of the average corporation. That will go on,'' Munger says. ''The one place a death will hurt us is we're not likely to get as good an allocator of capital as Warren in the next CEO, whoever that is. But it will still be one hell of a business.''
In a company as decentralized as Berkshire Hathaway, the operating businesses need not suffer an immediate loss of momentum from Buffett's passing. On the other hand, it is not clear that a holding company with a grand total of 12 employees can be said to have a corporate culture. Without question, Berkshire's operating chiefs are united in their admiration of Buffett and his principles. But most of them barely know one another, and none is remotely Buffett's equal in terms of breadth of knowledge or personal authority. With its challengingly eccentric mix of businesses and its loose, informal structure, Berkshire Hathaway fits Buffett to a T but might well prove unwieldy for lesser mortals--especially ones constrained by loyalty to Buffett's preservationist credo.
The outlook for Buffett's personal fortune is no less problematic. His wife is his sole heir, but she is 67 years old and might not outlive him. The Buffetts have three children--Susan, 46; Howard, 44; and Peter, 41. Howard and Susan are directors of Berkshire, but none of the Buffett progeny is involved in the management of the company.
FAMILY PLAN. Buffett has said that it is his wish that 99% of the money he has made eventually go to the Buffett Foundation, to be distributed to worthy causes under the direction of Allen Greenberg, 42, the ex-husband of his daughter Susan A. Buffett. Greenberg works out of a one-person office in the same building that houses Berkshire. The foundation was set up in the mid-1960s but operates with a scanty endowment. Currently, it disburses $11 million to $12 million a year, with the bulk of the funds going to groups that provide family-planning services, including abortions. When the foundation comes into its full endowment, it is likely to rank as the world's largest philanthropy.
Buffett is often criticized--privately, to be sure--as a tightwad. But he insists that he is holding tight to his Berkshire stock not out of greed but out of a desire to ensure that control of the company passes to his heirs. ''I think I could control it with as little as 1% of the stock,'' Buffett says. ''With 35%, my wife could carry on, but not with 1%. I'd view it as a tragedy if someone whose achievement was issuing the most junk bonds or having the silliest stock price took over the company and all that we've built evaporated.''
It would indeed be a tragedy in the classical sense if the specialness of Buffett's great gifts contains the seeds of his empire's eventual undoing. For just as no one other than Buffett could have created Berkshire Hathaway, it may well come to pass that no one other than Buffett can make it work.
In the terminal, a surly looking man with a crewcut and a pistol on his hip sits behind a small table. Buffett hands over his passport and landing card to the inspector, who does not seem to realize that the professorial-looking 68-year-old standing before him is America's second-richest man. Or perhaps he just gets a kick out of trying to take the high and mighty down a peg. ''You left some things blank,'' the inspector says peevishly. ''Do you have $10,000?''
The question could have launched a dozen snappy retorts, but Buffett restrains himself. ''I have what I left with,'' he says carefully. The inspector furrows his brow--was that some kind of joke?--but does not press the issue. He asks Buffett if he has any anything to declare. ''I was given two books,'' Buffett says. ''Well, you have to put it down, then,'' snaps the agent, who fills in the blank himself.
Buffett shows not a flicker of annoyance at being treated like a misbehaving child. He stands mute and impassive before the inspector, who, after a few more curt remarks, can think of nothing else to do but let ''the Oracle of Omaha'' be on his way.
***************
Has there ever been a less pompous billionaire than Warren Edward Buffett? Hollywood might cast him in the role of an amiable teacher at a Midwestern college or a sweet-tempered, wisecracking inventor who eventually wins a Nobel prize and gets the girl besides. To hear Buffett sing his beautifully artless rendition of Ain't She Sweet to his own ukulele accompaniment is to wonder not only how such a man came to measure his net worth in billions but also whether he might not be a time-traveler from a more innocent age.
If Buffett had a business card, it would identify him as chairman and chief executive of Berkshire Hathaway Inc. (BRK.A) But he is far better known--indeed, world-famous--as the greatest stock market investor of modern times. The figures, though often cited, still astound: Had you put $10,000 into Berkshire when Buffett bought control of it in 1965, you'd have $51 million now, vs. just $497,431 if the money were invested in the Standard & Poor's 500-stock index.
The numbers don't lie, but the story they tell is out of date. Buffett has not added a major position to Berkshire's bulging stock portfolio since amassing 4.3% of McDonald's Corp. (MCD) in 1995. In the meantime, he has transformed what long has been a sideline at Berkshire--the acquisition of entire companies--into the main event. Over the past three years, Berkshire has spent $27.3 billion to buy seven companies in industries as disparate as aviation, fast food, and home furnishings. The $22 billion purchase of reinsurer General Re Corp., which closed late last year, was Buffett's largest ever.
The effect has been dramatic: In short order, Berkshire has been transformed from a closed-end fund in corporate drag to a bona fide operating company. At the start of 1996, the company's famous stock portfolio accounted for fully 76% of Berkshire's $29.9 billion in assets. But by the end of 1999's first quarter, the figure had plummeted to 32% as assets quadrupled, to $124 billion. Today, Buffett's company employs 47,566 workers, double the number in 1995.
And he isn't done yet. ''I'd love to make a $10 billion to $15 billion acquisition, and we could go bigger than that if I really like the company,'' says Buffett, who holds $15 billion in cash and is sitting on top of an additional $30 billion in unrealized gains in Berkshire's stock portfolios.
It's all there in black and white in Berkshire Hathaway's famously literate annual reports, but somehow the company's transformation has gone not just unheralded but unnoticed. Berkshire is ''possibly the most talked about and the least understood company in the world,'' contends Alice Schroeder, a PaineWebber Inc. insurance analyst who in January published one of the few comprehensive studies of the company ever undertaken by a brokerage house.
MISUNDERSTOOD. The common view is that Berkshire shares fetch a premium because of Buffett's reputation as a latter-day Midas. The ''Buffett premium'' undoubtedly is real in the sense that if the man died today, the stock would plunge tomorrow. In Schroeder's view, though, Berkshire's stock is already trading at a sizable discount to its true value, which she estimates at $91,000 to $97,000 per A share. The A shares lately have been trading at about $70,000. The basic problem, Schroeder says, is that the world continues to misperceive Berkshire as little more than the sum of the stocks it holds in its $37 billion portfolio. In other words, the market tends to overreact to news about the seven stocks that form the core of Berkshire's holdings (table). Over the past 12 months, Berkshire has fallen by about 17%, from a high of $84,000 in June, 1998. In Schroeder's view, the main cause of this decline is the plunging value of Buffett's colossal stakes in Coca-Cola Co. (KO) and Gillette Co (G).
The radical recent shift in Berkshire's corporate profile does not reflect a radical change in Buffett's thinking. In most ways, he remains true to the conservative precepts of value investing. In essence, Buffett continues to prefer today's sure thing to the next big thing, no matter how spectacular its potential. Forget Internet stocks: Buffett still will not invest in even such well-seasoned high-tech companies as Microsoft Corp. (MSFT) or Hewlett-Packard Co. (HWP) because he doesn't believe that anyone can predict how much they will earn over the next decade or two. ''I can't do it myself,'' he says. ''And if I don't know, I don't invest.''
Even in his stock-picking heyday, Buffett preferred owning businesses to passive minority investment. Until recently, though, Berkshire's acquisitions have been few and far between because Buffett insisted on buying top-quality businesses at discount prices. What has changed is that he is now willing to pay a premium for one-of-a-kind businesses.
Why this is so is not completely clear. The Buffett psyche is notoriously labyrinthine. ''I could easily spend a lot of time trying to analyze Warren if I didn't consciously try not to,'' says Olza M. Nicely, CEO of auto insurer GEICO Corp., one of Berkshire's largest subsidiaries. ''There are certain mysteries you just have to accept.''
In Buffett's view, he is putting the finishing touches on his masterpiece. ''Berkshire is my painting, so it should look the way I want it to when it's done,'' he says.
In an era in which most CEOs at least mouth the platitudes of good corporate governance and shareholder rights, Buffett, in his good-natured way, is a throwback to a time when a mogul was a mogul and did as he damn well pleased. ''Berkshire is the company I wanted to create. It's not the company Alfred P. Sloan wanted to create. It fits me,'' he says. ''I run it with our investors and managers in mind, but it is designed to fit me.'' To be blunt, Buffett stands revealed as a driven, even monomaniacal corporate empire-builder.
For all his offhand charm, Buffett is pretty much all business all the time. Aside from an addiction to luxury air travel, he is a man of simple tastes and frugal habits. He neither spends his money nor gives much of it away. Philanthropy, the renascent vogue of America's superrich, interests him peripherally at most. Buffett intends to take his fortune to the grave--and to keep adding to it until the day he dies. ''The problem I've got with doing anything else except what I'm doing is that there is nothing remotely as fun as running Berkshire,'' he says. ''I'm selfish that way.''
So far, Berkshire's legendarily devoted shareholders would not have it any other way. In May, some 15,000 of them flocked to Omaha to sit at the feet of the master during Berkshire's three-day festival of an annual meeting, which Buffett calls ''Woodstock for Capitalists.'' Of course, Buffett and his wife, Susan T. Buffett, are the largest Berkshire shareholders by far: Their 38.4% stake is worth about $40 billion.
The highest circle of management power at Berkshire has always been tight, but it has shrunk in recent years--to Buffett alone. Charles T. Munger, Buffett's longtime vice-chairman and business alter ego, continues to enliven the annual meeting by playing the part of drolly laconic sidekick to Buffett's ebullient master of ceremonies. Behind the scenes, though, his influence has waned. ''Charlie and I don't talk a lot anymore,'' acknowledges Buffett, who says he did not even bother to consult his vice-chairman before making the epochal Gen Re acquisition.
By all accounts, including their own, Munger and Buffett have not fallen out. But while Buffett is wholly devoted to building Berkshire, Munger, 75, now spends his time chairing a not-for-profit hospital and serving as a trustee of a private high school. ''Charlie is broader in his interests than I am,'' Buffett says. ''He doesn't have the same intensity for Berkshire that I have. It's not his baby.'' Munger concurs: ''Warren's whole ego is poured into Berkshire.''
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In mid-April, Buffett led a small entourage on a whirlwind European tour to promote one of Berkshire's latest acquisitions, Executive Jet Aviation. I went along for the ride (on one of EJA's Gulfstream IV-SP jets) and got an unusual chance to observe the notoriously press-shy Buffett at close range against a kaleidoscopic backdrop of private airports, luxury hotels, and banquet halls stretching from London to Frankfurt to Paris.
Buffett survived a demanding regimen of midmorning coffees, two-hour luncheons, 90-minute press conferences, and four-course banquets. ''I never get tired,'' he told reporters in London, ''except for my voice.'' Actually, Buffett was ashen with fatigue midway through the third day but soldiered gamely on, answering even the lamest questions with the same expansiveness and wit the fifth time he heard them as he did the first.
Only once did Buffett show annoyance. During a press conference at the Frankfurt airport, Richard Santulli, EJA's normally understated chief executive, let his admiration of Buffett overflow. ''People say that he's the most astute investor of the 20th century,'' he said. ''I say ever.''
Buffett, who was sitting at Santulli's side, gave a little snort. ''Why not?'' he said sourly. ''I'm sitting right here.''
Like any mogul, Buffett has his special needs. On this trip, he indulged two of them, listed here in reverse order of importance: red meat (at lunch and dinner) and Coca-Cola (all the time).
Whenever I lost track of Buffett, Coke often appeared to guide me--a carbonated version of the proverbial trail of crumbs. In London, our party went from airport to hotel in separate cars. When I arrived at the Berkeley Hotel, I did not have to wonder for long whether Buffett had preceded me. A bellhop approached with a shopping bag. ''Is this yours?'' he asked. Inside were two six-packs of Cherry Coke. Two days later, I was in the crowded lobby of the Schlosshotel Kronberg near Frankfurt, following a white-gloved waiter bearing aloft a single bottle of Coca-Cola on a silver tray.
Buffett bought Executive Jet in mid-1998 for $725 million. Although this is a pittance compared with what Berkshire paid for General Re, the EJA deal was no less a milestone in its way. EJA, which pioneered the fractional ownership of business jets, is the first true emerging-growth company that Buffett has ever owned. What's more, the very idea of investing in business aviation would have been considered downright sacrilegious throughout most of Berkshire's history.
For years, Buffett mocked corporate ownership of jets as a wasteful executive perk. But in 1986, he bought a small used plane for Berkshire, then traded up to a more expensive model a few years later. He named the jet ''The Indefensible'' and made sport of its purchase in his 1989 report to shareholders: ''Whether Berkshire will get its money's worth from the plane is an open question, but I will work at achieving some business triumph that I can (no matter how dubiously) attribute to it.''
The truth is, Buffett had fallen in love with his plane but could not yet admit it. In 1995, he was introduced to Santulli by the head of one of Berkshire's operating companies and bought a one-quarter share of a Hawker for personal use. His wife, who has become a frequent flier, called the new plane ''The Richly Deserved.'' (Not to be outdone, Buffett renamed Berkshire's jet ''The Indispensable.'') Santulli offered to sell his company to Buffett when Goldman, Sachs & Co. (GS), a founding minority investor, began pressuring him to float a public stock offering.
Executive Jet in no way resembles the sort of business on which Buffett cut his teeth as an apprentice to the late Benjamin Graham, co-author of the value-investing bible, The Intelligent Investor. Graham's method emphasized creating a ''margin of safety'' by investing only in stocks trading at two-thirds of net working capital. He called them ''cigar butts''--companies the stock market had discarded but that still held a puff or two of value to extract.
Buffett was Graham's most accomplished disciple. But as the pupil established himself, he began to feel constrained by the mentor's method. For Graham, a business was an abstraction wholly defined by a set of numbers on a page; he had no interest in its products, its management, its personality. But Buffett's boundless curiosity and enthusiasm were not satisfied by the ghoulish exercise of profiting from the last dying gasps of derelict companies. Buffett's yearnings and dissatisfactions did not begin to coalesce into an investment philosophy of his own until he met the blunt-spoken Munger in 1959. The two, closely matched in intellect and outlook, quickly became the closest of partners. Munger urged his friend to leave the cigar butts in the gutter and think of value in more expansive terms. Says Buffett: ''Charlie kept pushing me back to the idea that what we really needed to own was the wonderful business.''
Even so, it took Buffett a long time to tailor Graham's straitjacket conservatism to the more generous dimensions of his own personality. His $11 million purchase of Berkshire Hathaway in 1965 was a costly case in point. Initially, Buffett saw the floundering old-line company as a classic Graham play. But then the textile manufacturer rallied unexpectedly, and Buffett sank more money into it on the belief that this cigar butt had a future after all. It did indeed, but not in textiles.
Buffett did not come fully into his own until he and Munger collaborated on the $25 million acquisition of See's Candies in 1972. The San Francisco maker of boxed chocolates was the first business of any sort for which Buffett paid more than book value--three times book, in fact.
What, in Buffett's view, makes a business wonderful? It starts with ''a sustainable competitive advantage.'' Underline sustainable. Buffett will not invest in a business unless he feels reasonably certain how much it will earn over the next 20 to 25 years. But for all of Buffett's cerebration, he does not feel truly comfortable unless a business ties into his own everyday experience. His favorite companies tend to traffic in elementally appealing brand-name products that Buffett not only uses himself but also invests with almost totemic meaning: a bottle of Coca-Cola, a Gillette razor blade, a box of See's candy, and, yes, even a Gulfstream jet.
Buffett has always been especially partial to companies that can sustain a competitive edge without tying up much capital. Consider Scott Fetzer, which makes a variety of industrial and consumer products, including Kirby vacuum cleaners and Quikut knives. Since 1986, when Berkshire paid $315 million for Scott Fetzer, its earnings have risen by only 5.5% a year on average. Yet Buffett repeatedly has praised it as a model of capital efficiency. In 1998, Scott Fetzer netted $96.5 million after taxes on its $112 million in equity, a return on equity of 86%. This is all the more breathtaking considering that Buffett has been milking it for 13 years, extracting more than $1 billion all told.
Ever since Berkshire's 1967 acquisition of National Indemnity Co., insurance has held double appeal for Buffett. Not only does he like the economics of the business--or parts of it, anyway--but a well-run underwriter also generates a steady flow of low-cost investment dollars, or ''float,'' as a matter of course. The 1996 acquisition of GEICO, now the sixth-largest U.S. auto insurer, doubled Berkshire's float at one stroke, and the Gen Re buy nearly tripled it, to $21 billion.
In Buffett's view, the quality of a company's management is integral to its value as a business. And when acquiring companies, Buffett is as concerned with the motives of the selling CEOs as he is with their abilities. ''What I must understand is why someone will continue to get out of bed in the morning once they have all the money they could want,'' Buffett says. ''Do they love the business, or do they love the money?''
No less an authority than John F. Welch, CEO of General Electric Co., considers Buffett a superb judge of managerial talent. Buffett and Welch have gotten to know each other over the years as golf partners and as rivals in auto insurance and other businesses. ''Take 20 people you know quite well but Warren has just met casually,'' Welch says. ''If you ask Warren his opinion about them, he'll have each one nailed. He's a masterful evaluator of people, and that's the biggest job there is in running a company.''
In 34 years, Berkshire has never lost an operating chief except to death. In fact, the great majority of its subsidiaries are still run by the same executive who brought them to Berkshire in the first place. The operating head of longest tenure is Charles N. Huggins, who has been president of See's Candies since Buffett acquired it. Huggins is 74 years old now, but he's not Berkshire's oldest manager. That would be 85-year-old Harold Alfond, who founded Dexter Shoe Co. in 1956 and sold to Buffett in 1993 for Berkshire shares now worth $1.5 billion.
Berkshire's operating ranks contain a second octogenarian billionaire: 82-year-old Albert L. Ueltschi, chairman and CEO of FlightSafety International Inc., a pilot-training concern Berkshire bought for $1.5 billion in 1996. An ex-pilot, Ueltschi founded the company in a LaGuardia Airport hangar in 1951. ''I'm like Warren,'' says Ueltschi, who has no plans to retire. ''I like what I do so much that I don't consider it work.''
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Somewhere between Frankfurt and Paris, Buffett gets up and walks back to the airplane's pantry to fetch a box of Swiss Sprungli chocolates an admirer had given him in Germany. Buffett makes his way slowly up the aisle of the plane in his shirtsleeves, offering the candy to each passenger aboard.
A half-empty box of See's chocolates rests on the table where I'm sitting. Buffett pops a piece in his mouth. I ask him whether he thinks he could identify See's in a blind taste test against other brands. ''Of course,'' he says. ''I can also tell Coke from Pepsi. The thing is, most Americans prefer Pepsi to Coke because it is 4% sweeter, but Coke still outsells Pepsi by a huge margin.''
As Buffett continues in this vein, he starts staring at the box of Sprungli he carries. He shifts it to one hand as if he were about to choose a piece, then seems to change his mind. ''It's a showy sort of candy, isn't it?'' he says and then falls silent. He gazes raptly at the Sprungli for a full 45 seconds as the conversation continues around him. Then he abruptly sets the box down and returns to his seat without a word.
Later, I recount this to Chuck Huggins, See's president, who chuckles knowingly. ''Yeah, that's Warren. Brand-loyal.''
The office next to Buffett's is occupied by Michael Goldberg. A former McKinsey & Co. consultant, Goldberg was hired in 1981 to bring order to Berkshire's far-flung insurance interests and essentially functioned as chief operating officer for the next 11 years. The single-minded intensity Goldberg brought to the job created friction in the ranks--and gave him a bad case of burnout. In 1993, Buffett reassigned Goldberg to ''special projects'' and eliminated his old position.
The line managers who once reported to Goldberg, now 53, have reported directly to Buffett ever since--as do the chiefs of all 22 of Berkshire's operating companies. Buffett essentially lets the chiefs of the companies that Berkshire acquires run their businesses as before, except that he requires them to transfer their excess cash to Omaha and clear capital-spending plans with him. Buffett, who thinks of his role as Berkshire's ''capital allocator,'' collects the enormous cash flow that the subs produce--$13.4 billion last year--and uses the money to buy more businesses, either in whole or in part, through the stock market.
Buffett tends not to initiate contact with his operating executives: He waits for the phone to ring. ''Let me know about any bad news as soon as possible,'' he tells his subordinates, ''but otherwise, you are free to call me as often or as seldom as you like.'' Buffett's managerial passivity should not be mistaken for indifference. Some operating chiefs say he nearly memorizes the monthly reports they send to Omaha.
During holiday seasons, Buffett requests daily sales reports from See's and Borsheim's, Berkshire's huge upscale jeweler in Omaha, because the ebb and flow of retailing hold an enduring fascination for him. Year-round, he speaks to two execs almost every day: Richard Santulli and Ajit Jain, who runs Berkshire's reinsurance business in Stamford, Conn.
Berkshire's homegrown insurance group offers a variety of property-and-casualty coverage in certain U.S. markets. But its chief business is a high-risk, high-reward specialty that Jain developed over the past decade in reinsuring ''super-catastrophes''--earthquakes, hurricanes, floods, and such. Buffett found the economics of ''super-cat'' seductive: Berkshire has made at least $865 million pretax in underwriting profits since 1991. But it was the complexities of analyzing super-cat risk that hooked him. Says Jain, 47: ''Warren and I might have had a 30-second conversation or a 30-minute one, but he has been involved in every piece of business I have done.''
As for Santulli's business, Buffett is intrigued not just by the novel challenges posed by EJA's rapid growth but also the logistical complexities of the fractional-shares business. ''He likes the mental challenge of it,'' says Santulli, a former mathematics professor. ''He calls it 3-D chess.'' Even so, Buffett is careful not to impinge on Santulli's operating authority. EJA's chief once asked Buffett for advice in making a decision and was rebuffed. ''Don't bother with that,'' Buffett told him. ''Just decide.''
Buffett's laissez-faire management style has been tested most severely in recent years by Berkshire's misadventures in shoes. From 1991 to 1993, Buffett laid out $650 million to buy three old-line makers of midprice shoes: H.H. Brown, Lowell, and Dexter. In essence, he was betting that his companies would benefit as the appeal of imports waned and U.S. consumers returned to home brands. Buffett hasn't made many fundamental strategic errors, but this was a doozy: Imports now account for 95% of domestic shoe purchases, vs. 70% in the early 1990s. Since 1994, operating profits of Berkshire's shoe group have plummeted 57% on an 18% decline in revenues.
Dexter has fared much worse than Brown, which absorbed Lowell and has buoyed itself by shifting much of its production offshore. Although Dexter now does some manufacturing in Puerto Rico, it has placed overriding emphasis on maintaining full employment at its four factories in its home state of Maine. By all accounts, Buffett has played no part in this divergence in basic strategy--and performance--between H.H. Brown and Dexter except to countenance it by his silence. ''It's amazing how little he bothers you,'' says Francis Rooney, chairman and CEO of H.H. Brown. ''He never even comments.''
The deference Buffett shows Berkshire's subsidiaries is all the more remarkable because it does not come naturally to him. ''With almost every one of the companies Berkshire owns, I think I would do something different if I was running them--in some cases, substantially different,'' Buffett says. The reason he doesn't impose his views, he adds, ''is simply that I am not inclined to make myself unhappy. I sort of accept things as they come.''
It's not that simple. Buffett knows the sort of self-motivated, hands-on exec he covets wouldn't tolerate being pushed around by Omaha. And Buffett's respectful treatment of his managers has instilled in them an ambition to ''make Warren proud,'' as one puts it. ''Somehow, Warren has been able to keep a diverse cast of characters working harder for him than they did for themselves,'' Goldberg says. ''I see it every day--and I still don't know how he does it. But I do know that all of us feel this incredible responsibility to him.''
***************
We arrive late to Paris, touching down in a freakish, near-gale-force windstorm that both thrills and alarms our pilot. In four cars, we race as fast as rush-hour Paris traffic allows from Le Bourget to Dassault Aviation Group's magnificent 19th century chateau--familiarly known as Le Rond Point--on the Champs Elysees. EJA is the largest commercial customer of Dassault Aviation, Europe's leading manufacturer of business jets. Serge Dassault, the company's chairman, is hosting tonight's gala reception and dinner in Buffett's honor. By the time we arrive, the reception is in full swing. But Buffett takes a few steps into the foyer and hustles up a flight of stairs. It will be a good 35 minutes until he descends and joins the party.
Downstairs, the guest of honor's whereabouts is Topic A among Dassault's distinguished guests. It might puzzle them to learn that Buffett is on a transatlantic call to one of his employees. The matter he is discussing with Ajit Jain this evening is not urgent. But it is Buffett's custom to speak with Jain every evening. If that means keeping 200 of France's richest people waiting, then c'est la vie.
In mid-May, Buffett moderated a panel on Internet commerce at Microsoft's annual CEO summit in Seattle. As Buffett tells it, the assignment reflected William H. Gates III's sense of humor. But the Microsoft chairman and CEO, a friend of Buffett's since 1991, says it was no joke: ''Every principle that Warren holds about business and business value will still apply in this new world we're going into.'' Gates, who owns Berkshire stock in his personal account, adds that he has learned more about business from Buffett than from anyone else. ''People really underestimate what he has created in Berkshire,'' he says.
Unlike most megacorporations, Berkshire was not erected on the foundation of a single great business. Buffett began with a dying textile maker and parlayed its dwindling cash flow into ownership of a massive portfolio of enduringly profitable operating businesses. By the end of 1998, Berkshire had amassed shareholder equity worth $57 billion. This is a staggering sum, putting Berkshire well ahead of General Electric, Microsoft, and every other U.S. corporation and ranking it second in the world to Royal Dutch/Shell Group. Buffett could retire tomorrow and be confident of his place in business history not only as stock investor extraordinaire but as a corporate builder of the first rank.
LIMITS OF SCALE. Instead, of course, he is still in there pitching, to borrow one of the baseball metaphors that so delight him. From 1965 through 1998, Berkshire's book value per share rose 24.7% a year on average--trouncing the 12.9% average annual gain in the S&P 500. For some time now, Buffett has warned that the company's sheer bulk will prevent it from matching its breathtaking historical average in the future. His avowed goal is to increase its worth at an average of 15% a year. It's a modest aspiration only by comparison, for it implies adding $58 billion of shareholder equity over the next five years.
Except for the shoe group, Berkshire appears to be in fine fettle. Executive Jet is by no means its only hope for growth. GEICO, Berkshire's largest subsidiary in terms of revenue, has been wresting market share from rivals at an impressive rate and yet still has only 3.5% of the vast U.S. auto-insurance market. Like EJA, Gen Re is planning to expand in Europe and around the world. At the same time, Borsheim's, Scott Fetzer, See's Candies, and other Berkshire companies are experimenting with E-commerce. ''The No. 1 topic Warren and I talk about now is whether retail selling is going to move over to the Internet,'' says Ralph E. Schey, Scott Fetzer's chairman and chief executive.
The pursuit of accelerated growth carries added risk. In 1998, Berkshire had a banner year, posting a 48% increase in net earnings, to $2.8 billion, on revenues of $13.8 billion. But net income dropped 25%, to $541 million in the first quarter, largely because of earnings declines at GEICO and Gen Re. While both insurers were hurt by intensifying price competition, a German subsidiary of Gen Re's also took an embarrassing $275 million pretax loss on a workers' compensation pool. The down quarter did not seem to faze Buffett, who is famous for taking the long view.
If Berkshire were in fact a painting, it would look like a Jackson Pollock: an idiosyncratic product of inspired improvisation. In building his company virtually from scratch over the past quarter-century, Buffett conjured no overarching strategic vision, followed no master plan other than to buy good businesses at the right price. Even when he erred--a rare occurrence--he enfolded his purchases in an embrace intended to be permanent. ''We buy everything, even a stock, with the idea that we will hold it forever,'' he says.
It is hugely important to Buffett that his corporate handiwork outlast him. In fact, it is his hope that Berkshire--his masterpiece in progress--survive him in exactly the form it exists upon his death, like a painting framed and hung on a museum wall. But might there not come a time when his successor might be smart to sell some of Berkshire's weaker units? ''I don't think so,'' Buffett says. ''I hope whoever follows me would behave pretty much as I would if I were to live forever. I feel I owe it. I owe it to the people who sold me their businesses. They didn't have to sell to me. If I die tonight, I want them to get what they were expecting.''
MYSTERY HEIRS. Buffett says he already has picked a successor--two of them, actually: one to manage the stock portfolio, the other to oversee the operating companies. Their identities have not been disclosed to shareholders or, for that matter, to the heirs apparent themselves, because Buffett reserves the right to change his mind. He says he might eventually settle on a single successor.
Munger, who has most of his own billion-dollar net worth in Berkshire stock, professes optimism about the company's post-Buffett prospects. ''The corporate culture of Berkshire is more durable than that of the average corporation. That will go on,'' Munger says. ''The one place a death will hurt us is we're not likely to get as good an allocator of capital as Warren in the next CEO, whoever that is. But it will still be one hell of a business.''
In a company as decentralized as Berkshire Hathaway, the operating businesses need not suffer an immediate loss of momentum from Buffett's passing. On the other hand, it is not clear that a holding company with a grand total of 12 employees can be said to have a corporate culture. Without question, Berkshire's operating chiefs are united in their admiration of Buffett and his principles. But most of them barely know one another, and none is remotely Buffett's equal in terms of breadth of knowledge or personal authority. With its challengingly eccentric mix of businesses and its loose, informal structure, Berkshire Hathaway fits Buffett to a T but might well prove unwieldy for lesser mortals--especially ones constrained by loyalty to Buffett's preservationist credo.
The outlook for Buffett's personal fortune is no less problematic. His wife is his sole heir, but she is 67 years old and might not outlive him. The Buffetts have three children--Susan, 46; Howard, 44; and Peter, 41. Howard and Susan are directors of Berkshire, but none of the Buffett progeny is involved in the management of the company.
FAMILY PLAN. Buffett has said that it is his wish that 99% of the money he has made eventually go to the Buffett Foundation, to be distributed to worthy causes under the direction of Allen Greenberg, 42, the ex-husband of his daughter Susan A. Buffett. Greenberg works out of a one-person office in the same building that houses Berkshire. The foundation was set up in the mid-1960s but operates with a scanty endowment. Currently, it disburses $11 million to $12 million a year, with the bulk of the funds going to groups that provide family-planning services, including abortions. When the foundation comes into its full endowment, it is likely to rank as the world's largest philanthropy.
Buffett is often criticized--privately, to be sure--as a tightwad. But he insists that he is holding tight to his Berkshire stock not out of greed but out of a desire to ensure that control of the company passes to his heirs. ''I think I could control it with as little as 1% of the stock,'' Buffett says. ''With 35%, my wife could carry on, but not with 1%. I'd view it as a tragedy if someone whose achievement was issuing the most junk bonds or having the silliest stock price took over the company and all that we've built evaporated.''
It would indeed be a tragedy in the classical sense if the specialness of Buffett's great gifts contains the seeds of his empire's eventual undoing. For just as no one other than Buffett could have created Berkshire Hathaway, it may well come to pass that no one other than Buffett can make it work.
Investment approach of Warren Buffet
Buffett's philosophy on business investing is a modification of the value investing approach of his mentor Benjamin Graham. Graham bought companies because they were cheap compared to their intrinsic value. He was of the belief that as long as the market undervalued them relative to their intrinsic value he was making a solid investment. He reasoned that the market will eventually realize it has undervalued the company and will correct its course regardless of what type of business the company was in. In addition he believed that the business has to have solid economics behind it. Buffett's investment style is also heavily influenced by Phil Fisher.
The following are some questions to determine what business to buy, based on the book Buffettology by Mary Buffett:
- Is the company in an industry with good economics, i.e., not an industry competing on price. Does the company have a consumer monopoly or brand name that commands loyalty? Can any company with an abundance of resources compete successfully with the company?
- Are the Owner Earnings on an upward trend with good and consistent margins?
- Is the debt-to-equity ratio low or is the earnings-to-debt ratio high, i.e. can the company repay debt even in years when earnings are lower than average?
- Does the company have high and consistent Returns on Invested Capital?
- Does the company retain earnings for growth?
- The business should not have high maintenance cost of operations, high capital expenditure or investment cash outflow. This is not the same as investing to expand capacity.
- Does the company reinvest earnings in good business opportunities? Does management have a good track record of profiting from these investments?
- Is the company free to adjust prices for inflation?
Buffett also concentrates when to buy. He does not want to invest in businesses with indiscernible value. He will wait for market corrections or downturns to buy solid businesses at reasonable prices, since stock market downturns present buying opportunities.
He is known for being conservative when speculation is rampant in the market and being aggressive when others are fearing for their capital. This contrarian strategy is what led Buffett's company through the Internet boom and bust without significant damage, although critics have also noted that it may have led Berkshire to miss out on potential opportunities during the same period.
He also asks at what price is the business a bargain, and his answer typically is when it provides a higher rate of compounded return relative to other available investment opportunities.
Warren Buffett's letters to shareholders are a valuable source in understanding his investment style and outlook.[13]
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Chidambaram: Sivaganga's Robin Hood Or Houdini
March 3 (Bloomberg) -- Indian Finance Minister Palaniappan Chidambaram' s annual budget is one part Robin Hood and another part Houdini. It's hard to say which one is worse.
In his Feb. 29 budget speech in parliament in New Delhi, Chidambaram announced a 600 billion-rupee ($15 billion) debt waiver for farmers.
This sum, which amounts to a staggering 10 percent of the government's tax revenue in the current fiscal year, would have sufficed to create 15,000 megawatts of new power-generation capacity, enough to significantly reduce the country's perennial and debilitating electricity shortages.
There's no denying that farming in India is facing a crisis. Productivity gains have stalled. The overall economy has grown an average of 8 percent per annum since 2002, adjusting for inflation. In this six-year period, real agricultural output has expanded 2 percent annually with high year-to-year volatility.
Reports of indebted farmers committing suicide have dominated newspaper columns and political debates, putting pressure on the government to take drastic measures.
With general elections very likely to be held later this year, Chidambaram didn't disappoint the ruling coalition. It is, after all, impossible for any government to be returned to power in India without the support of rural voters.
So Chidambaram decided to play Robin Hood.
Playing Robin Hood
He even defended the debt-forgiveness plan as a bonanza for the banking industry, which, he said at a post-budget press conference, would now be rid of potential bad loans.
The least the finance minister could do was to acknowledge the ``moral hazard.''
Voters in India have been known to shun the incumbent party.
So if the ruling Congress Party-led coalition manages to return to power, debt forgiveness will be equated with political nirvana. From time to time, the weather and commodity-price risks inherent in the farming business would shift to the hapless taxpayers. No political party will object because none of them can afford to be seen as anti-farmer.
Chidambaram' s performance was so subtly masterful that the taxpayers aren't even sure if they have been robbed.
The budget left the corporate-tax rate unchanged and cut the excise levy on manufacturers to 14 percent, from 16 percent. The income-tax burden on individuals will also be somewhat lower now. Only the charge on short-term capital gains -- profit on securities sold within a year of purchase -- was raised to 15 percent from 10 percent.
Touch of Houdini
As for the write-off, it doesn't even show up as a budgetary expenditure.
And that's nothing short of a Houdini trick.
Analysts aren't yet sure just how the financial system will be compensated. One possibility is that banks will be given government bonds with which they can replace their impaired assets. Chidambaram himself has been evasive.
All he said is that the government would provide liquidity to the banking system as loans to the farmers are written off over three years.
``You must allow me that I have some intelligence, '' he said. ``I have done my homework.''
Investors certainly would hope so. This penchant for keeping large increases in expenditure ``off-budget' ' has already assumed odious proportions.
Oil companies are being compensated through special government bonds for keeping retail fuel prices low. This has a clear, known fiscal cost, which is nonetheless not included in the budget deficit. A similar strategy has been adopted to tackle food inflation.
Today's headaches are merely being transferred to tomorrow.
Off-Budget
One day the bonds will have to be redeemed; when cash leaves the exchequer, the expenditure will have to be brought on budget. By then, it may be another finance minister's problem.
To be sure, Chidambaram did, in his budget last week, say that this particular accounting practice needed to be reconsidered. But any such review is still about two years away.
There are other problems with Chidambaram' s most recent budget. The minister hasn't made any provision for the hefty salary increases for civil servants that he may announce after the Pay Commission, which resets the wages of government workers every 10 years, submits its report by March 31.
The panel's recommendations are widely expected to be generous, jeopardizing several years of fiscal consolidation.
``Recent fiscal gains, a cornerstone of the sovereign's improved creditworthiness, could not only come under threat but be severely reversed by this pay review,'' says Standard & Poor's analyst Sani Hamid in Singapore.
Enough `Headroom'
In all fairness, the budget ought to have given investors a chance to gauge the risk.
The state-owned Indian Railways, which has had a separate budget since 1925, did just that last week by acknowledging that its wage bill for the next fiscal year may get bloated by as much as 50 billion rupees.
Chidambaram chose not to make the adjustment.
The finance minister's response is that he has enough ``headroom'' in the budget to meet any salary increases that the pay panel may recommend.
Investors would have preferred to see evidence of that headroom because his projections for tax collections appear to be rather optimistic.
As an increasingly important part of the global economy, India needs to gain credibility for its budgets. That means making them more transparent, and less magical.
In his Feb. 29 budget speech in parliament in New Delhi, Chidambaram announced a 600 billion-rupee ($15 billion) debt waiver for farmers.
This sum, which amounts to a staggering 10 percent of the government's tax revenue in the current fiscal year, would have sufficed to create 15,000 megawatts of new power-generation capacity, enough to significantly reduce the country's perennial and debilitating electricity shortages.
There's no denying that farming in India is facing a crisis. Productivity gains have stalled. The overall economy has grown an average of 8 percent per annum since 2002, adjusting for inflation. In this six-year period, real agricultural output has expanded 2 percent annually with high year-to-year volatility.
Reports of indebted farmers committing suicide have dominated newspaper columns and political debates, putting pressure on the government to take drastic measures.
With general elections very likely to be held later this year, Chidambaram didn't disappoint the ruling coalition. It is, after all, impossible for any government to be returned to power in India without the support of rural voters.
So Chidambaram decided to play Robin Hood.
Playing Robin Hood
He even defended the debt-forgiveness plan as a bonanza for the banking industry, which, he said at a post-budget press conference, would now be rid of potential bad loans.
The least the finance minister could do was to acknowledge the ``moral hazard.''
Voters in India have been known to shun the incumbent party.
So if the ruling Congress Party-led coalition manages to return to power, debt forgiveness will be equated with political nirvana. From time to time, the weather and commodity-price risks inherent in the farming business would shift to the hapless taxpayers. No political party will object because none of them can afford to be seen as anti-farmer.
Chidambaram' s performance was so subtly masterful that the taxpayers aren't even sure if they have been robbed.
The budget left the corporate-tax rate unchanged and cut the excise levy on manufacturers to 14 percent, from 16 percent. The income-tax burden on individuals will also be somewhat lower now. Only the charge on short-term capital gains -- profit on securities sold within a year of purchase -- was raised to 15 percent from 10 percent.
Touch of Houdini
As for the write-off, it doesn't even show up as a budgetary expenditure.
And that's nothing short of a Houdini trick.
Analysts aren't yet sure just how the financial system will be compensated. One possibility is that banks will be given government bonds with which they can replace their impaired assets. Chidambaram himself has been evasive.
All he said is that the government would provide liquidity to the banking system as loans to the farmers are written off over three years.
``You must allow me that I have some intelligence, '' he said. ``I have done my homework.''
Investors certainly would hope so. This penchant for keeping large increases in expenditure ``off-budget' ' has already assumed odious proportions.
Oil companies are being compensated through special government bonds for keeping retail fuel prices low. This has a clear, known fiscal cost, which is nonetheless not included in the budget deficit. A similar strategy has been adopted to tackle food inflation.
Today's headaches are merely being transferred to tomorrow.
Off-Budget
One day the bonds will have to be redeemed; when cash leaves the exchequer, the expenditure will have to be brought on budget. By then, it may be another finance minister's problem.
To be sure, Chidambaram did, in his budget last week, say that this particular accounting practice needed to be reconsidered. But any such review is still about two years away.
There are other problems with Chidambaram' s most recent budget. The minister hasn't made any provision for the hefty salary increases for civil servants that he may announce after the Pay Commission, which resets the wages of government workers every 10 years, submits its report by March 31.
The panel's recommendations are widely expected to be generous, jeopardizing several years of fiscal consolidation.
``Recent fiscal gains, a cornerstone of the sovereign's improved creditworthiness, could not only come under threat but be severely reversed by this pay review,'' says Standard & Poor's analyst Sani Hamid in Singapore.
Enough `Headroom'
In all fairness, the budget ought to have given investors a chance to gauge the risk.
The state-owned Indian Railways, which has had a separate budget since 1925, did just that last week by acknowledging that its wage bill for the next fiscal year may get bloated by as much as 50 billion rupees.
Chidambaram chose not to make the adjustment.
The finance minister's response is that he has enough ``headroom'' in the budget to meet any salary increases that the pay panel may recommend.
Investors would have preferred to see evidence of that headroom because his projections for tax collections appear to be rather optimistic.
As an increasingly important part of the global economy, India needs to gain credibility for its budgets. That means making them more transparent, and less magical.
America's Economy Risks Mother Of All Meltdowns
America’s economy risks mother of all meltdowns By Martin Wolf
Published: February 19 2008 18:21 | Last updated: February 19 2008 18:21
“I would tell audiences that we were facing not a bubble but a froth – lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.” Alan Greenspan, The Age of Turbulence.
That used to be Mr Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor.
Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*.
At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”**. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.”
Prof Roubini is even fonder of lists than I am. Here are his 12 – yes, 12 – steps to financial disaster.
Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.
Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Prof Roubini.
Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.
Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.
Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.
Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.
Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.
Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.
Step nine would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.
Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.
Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.
Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.
These, then, are 12 steps to meltdown. In all, argues Prof Roubini: “Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe.”
This, he suggests, is the “nightmare scenario” keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.
Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about “decoupling”. If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late.
Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot***.
(He really loves lists!) These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions- oriented financial system is itself in deep crisis.
The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law.
Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government.
The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.
The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.
*A Coming Recession in the US Economy? July 17 2006, www.rgemonitor. com; **The Rising Risk of a Systemic Financial Meltdown, February 5 2008; ***Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not, February 8 2008
martin.wolf@ ft.com
Published: February 19 2008 18:21 | Last updated: February 19 2008 18:21
“I would tell audiences that we were facing not a bubble but a froth – lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.” Alan Greenspan, The Age of Turbulence.
That used to be Mr Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor.
Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*.
At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”**. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.”
Prof Roubini is even fonder of lists than I am. Here are his 12 – yes, 12 – steps to financial disaster.
Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.
Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Prof Roubini.
Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.
Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.
Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.
Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.
Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.
Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.
Step nine would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.
Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.
Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.
Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.
These, then, are 12 steps to meltdown. In all, argues Prof Roubini: “Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe.”
This, he suggests, is the “nightmare scenario” keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.
Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about “decoupling”. If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late.
Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot***.
(He really loves lists!) These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions- oriented financial system is itself in deep crisis.
The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law.
Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government.
The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.
The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.
*A Coming Recession in the US Economy? July 17 2006, www.rgemonitor. com; **The Rising Risk of a Systemic Financial Meltdown, February 5 2008; ***Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not, February 8 2008
martin.wolf@ ft.com
Warren Buffett-"Investors Should Not Rule Out A Significant Economic
Warren Buffett on Monday said the U.S. economy is in recession and that "stocks are not cheap."
Speaking on CNBC television, Buffett also said he is no longer offering to guarantee $800 million of municipal bonds backed by MBIA Inc (MBI.N), Ambac Financial Group Inc (ABK.N) and FGIC Corp, three large bond insurers.
Buffett said that "from a common-sense standpoint right now, we're in a recession," though the U.S. economy has not yet recorded two straight quarters of declining gross domestic product, a traditional indicator of recession.
He said, though, that the environment is "nothing like '73 or '74 yet," referring to a deep economic downturn also marked by rising oil prices and falling stocks. Buffett said investors should not rule out the possibility of a significant economic downturn.
On Friday, Buffett's insurance and investment company Berkshire Hathaway Inc (BRKa.N) (BRKb.N) reported an 18 percent decline in fourth-quarter profit.
This stemmed in part from weakness in businesses linked to housing, including units that make bricks and carpet, and that offer real estate brokerage services.
Bond insurers, which normally insure relatively safe municipal bonds, came under pressure in late 2007 after they also guaranteed billions of dollars of riskier debt, often tied to subprime mortgages.
On Feb 12, Buffett offered to reinsure $800 billion of municipal bonds, but only at a steep premium. The offer didn't include the riskier debt. Bond insurers rejected the offer, and have been seeking new sources of capital or possibly breaking themselves up.
Buffett on Monday said his earlier offer is "not on the table." In December, Buffett started its own bond insurer, Berkshire Hathaway Assurance Corp.
Speaking on CNBC television, Buffett also said he is no longer offering to guarantee $800 million of municipal bonds backed by MBIA Inc (MBI.N), Ambac Financial Group Inc (ABK.N) and FGIC Corp, three large bond insurers.
Buffett said that "from a common-sense standpoint right now, we're in a recession," though the U.S. economy has not yet recorded two straight quarters of declining gross domestic product, a traditional indicator of recession.
He said, though, that the environment is "nothing like '73 or '74 yet," referring to a deep economic downturn also marked by rising oil prices and falling stocks. Buffett said investors should not rule out the possibility of a significant economic downturn.
On Friday, Buffett's insurance and investment company Berkshire Hathaway Inc (BRKa.N) (BRKb.N) reported an 18 percent decline in fourth-quarter profit.
This stemmed in part from weakness in businesses linked to housing, including units that make bricks and carpet, and that offer real estate brokerage services.
Bond insurers, which normally insure relatively safe municipal bonds, came under pressure in late 2007 after they also guaranteed billions of dollars of riskier debt, often tied to subprime mortgages.
On Feb 12, Buffett offered to reinsure $800 billion of municipal bonds, but only at a steep premium. The offer didn't include the riskier debt. Bond insurers rejected the offer, and have been seeking new sources of capital or possibly breaking themselves up.
Buffett on Monday said his earlier offer is "not on the table." In December, Buffett started its own bond insurer, Berkshire Hathaway Assurance Corp.
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