• Jeff Matthews

The Best of “Woodstock for Capitalists” Part 2: Least Logical Answer

In Part 1 of this two-part series we promised the following key disclosures from the Berkshire Hathaway annual shareholders meeting:

· Best Question Not on Our List, Answered · Best Question Not on Our List, Avoided · Sharpest Implied Put-Down · Mystery Revealed! · Least Logical Answer · Most Logical Answer · One Industry Not to Expect Buffett to Buy Into

And

· The Most Philosophical Start to Any Answer at Any Annual Meeting in History, Since the Beginning of Recorded Time

So without further ado, here goes: The Least Logical Answer

The question, by one Aaron Goldzimer, was straightforward and helpfully reprinted by New York Times ace Andrew Ross Sorkin—one of three reporters asking the questions—in his DealBook blog:

“Warren, in your General Electric and Goldman Sachs investments, do you think you’ve picked attractive businesses or simply attractive securities? Ben Graham’s Security Analysis suggest that the most frightening things management can do is manage earnings, which it could be argued both of these firms do. What’s your reaction to that?” —Andrew Ross Sorkin, DealBook, May 4, 2009 In assessing Buffett’s “reaction to that,” let’s be clear of one thing: nobody is going to make light of Warren Buffett’s capacity for logical thought.

It is, after all, the rational appraisal of investment ideas that accounts for Buffett’s quite literally unparalleled investment success—not to mention the fact that the man processes more financial information than probably any other human being on earth.

And that last clause was not a throw-away line. We didn’t stick it in there to merely conclude the primary thought, nor was it added merely to lend weight to the statement about Buffett’s rational thought process. Buffett has very likely read and absorbed more financial information in the last 78 years than any other human being on earth.

So when Buffett kicked off his response to the question of “managed earnings” at Goldman Sachs and GE with the whopper that “A large percentage of American businesses have managed earnings,” and “I wouldn’t know anything about that” at Goldman or GE—our reaction was, well, it’s a whopper.

GE, by any standard—and Wall Street has very low standards, we know—has to be one of the most earnings-conscious companies on earth.

This doesn’t mean GE is a bad company, or that it practices accounting gimmickry outside the bounds of Generally Accepted Accounting Principles. It’s just that GE plays up to Wall Street analysts the way World Cup soccer players play up to the refs—throwing themselves on the ground, grabbing a leg, writhing in pain, and then, once the yellow flag comes out, jumping up and running back to their position, smiling.

So too GE plays the Wall Street game, and anybody who’s ever listened to a GE earnings call knows it.

And surely Warren Buffett knows it.

He’s certainly read the GE proxy statement, which describes how the compensation committee arrives at the GE CEO’s compensation each year—compensation that is heavily dependent on not merely return on capital and cash flow from operations, but “earnings from continuing operations” and “earnings per share from continuing operations.”

He certainly knows that GE’s 2008 earnings would have been significantly lower than reported if not for a substantial reduction in GE’s income tax rate, from 15.6% in 2007 to all of 5.5% in 2008.

He also knows that GE’s tax rate is not even remotely comparable to other well-run conglomerates such as Honeywell, at 27%, and 3M Company, at 31%.

Consequently, we rate Buffett’s answer—that he “wouldn’t know anything about” earnings management, particularly at GE—as the “Least Logical Answer” we heard all day.

Interestingly, the balance of his response—as to whether GE and Goldman were “attractive investments” or “attractive securities”—was weighed towards the latter: “We were the low bid,” Buffett said. “The terms of the deals were overwhelming.” Indeed they were.

Up next: Most Logical Answer

Jeff Matthews I Am Not Making This Up © 2009 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.

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The content contained in this blog represents only the opinions of Mr. Matthews. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. The content herein is intended solely for the entertainment of the reader, and the author.

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