Buffett Gives A Seminar On Risk, Cash, Debt, Discipline

And The Future Of Berkshire

seekingalpha.com/article/4342835-buffett-gives-seminar-on-risk-cash-debt-discipline-and-future-of-
berkshire

Jim Sloan May 4,

2020

Summary

Buffett's Q&A at Berkshire's virtual annual meeting addressed risk, cash, debt, discipline
and Berkshire's future.

Buffett explained that Berkshire's calculable risks were very manageable but that a large
incalculable risk hung over the economy; he suggested that this required a larger cash
set-side than previously.

Berkshire's cash set-aside for emergencies has a message for ordinary investors: start
with a bucket for cash you need to sustain your lifestyle for the foreseeable future.

Buffett explained his reasons for dumping the airlines in a way that should focus
investors on the true risks of many industries.

In February the world changed to a degree which may not have been fully recognized;
Buffett showed that he is in the process of learning and changing with it.

"In times of change learners inherit the earth while the learned find themselves beautifully
equipped to deal with a world that no longer exists." - Eric Hoffer

Buffett has never been in better form than answering questions at Berkshire's (BRK.A)
(BRK.B) virtual annual meeting on Saturday afternoon. He began with a civics lesson on
America's growth into a richer, but also better, nation and detailed its long painful
journey to realize the "aspirational" ideals of its founders. He also expressed the view
that capitalism was the greatest vehicle for meeting human needs but required
supervision, and that Schumpeter's "creative destruction" was necessary but greatly
damaged many individuals who deserved some form of rescue.

Sitting an adequate social distance away Greg Abel, the overall manager of Berkshire's
non-insurance businesses, commented with the brevity usually supplied by Charlie
Munger but also fleshed out answers having to do with operational issues. His command
of facts and strategy made him look like a suitable successor when the occasion arises.
He will be among the upper 1% of all CEOs.

While answering call-in questions Buffett fully dealt with the inquiries bearing upon his
"silence." He was silent during the crash and the rally that has followed because his best
judgment was that the future path of the economy was unknowable. That being the
case, he had also been silent in terms of actions taken except for the selling of his four
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airline positions. This sort of silence spoke volumes.

Measuring his words carefully, and declining to speculate on future scenarios, he

nevertheless managed to give an outline of his views of the range of business problems
presented by the virus and lock down. In the process he provided a rare gift for his
followers - a seminar on risk, cash, debt, discipline and the future of Berkshire Hathaway.

Risk First, Always

As an insurance man, Buffett is an expert in risk - risk that can be quantified, risk that is a
matter of broad judgment, and risk that is simply unknowable. He addressed all three.
He expressed confidence that the insurance side of Berkshire had priced risk properly in
the property and casualty area and that it had very little exposure to business
interruption risk, although it would undoubtedly incur meaningful costs of litigation. He
alluded particularly to the risk of several mega-cat events in succession.

It was also clear that Buffett had spent some of his "silent" time doing a careful review of
risk in all of Berkshire's nearly 100 businesses. He acknowledged that a few small units
are at risk of being closed, but in general Berkshire's wholly owned businesses are in
good shape. He also confirmed that Berkshire headquarters had provided its
subsidiaries with a modest amount of cash. If you follow Berkshire as I do, you will have
anticipated hearing exactly this.

The risks that Buffett considered the most meaningful but unknowable involved worst
case scenarios for the future of the economy. Much of his active inaction arose from this
sort of risk. While he felt that Berkshire was in very good shape compared to other
businesses, he did note that under the most extreme negative outcomes the cash hoard
of $137 billion (more after the sale of the airlines) would be pressed to be enough. This
was perhaps the single most interesting piece of information he provided.

Cash And Its Uses

Buffett has often mentioned that $20 billion of Berkshire's cash and near cash hoard
must be held back for availability in the event of one or more very major mega-cat
insurance events. As the current crisis unfolded I suspected that this number had
increased materially as Buffett anticipated possible need for cash to support Berkshire
businesses in the event of a very extended and deep business downturn. He confirmed
my suspicion.

It has always been my assumption that in his own head Buffett had two numbers for
cash - two separate buckets - the cash needed in the event of catastrophes and the cash
available for investment opportunities. Though he did not put it exactly that way, it
became evident that this is exactly his thinking on cash. I also had strong expectation
that the amount of cash needed for defensive purposes had risen sharply during the
virus lock down such that his cash available for investment was not nearly as high as
many observers assumed.
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Buffett indirectly confirmed that his two cash buckets had tilted materially toward
potential defensive needs in worst case scenarios. There may have been a hint in his
mention that Berkshire was prepared to make a large acquisition up to the area of $50
billion. It's likely that this is the highest amount he feels comfortable in investing at this
moment.

This two-bucket view of cash is in fact the way I run my personal financial life, and I think
it suggests a helpful approach for many investors. If your ratio between cash and risk
assets is 50/50, for instance, but 20% of your cash is mentally assigned to the
emergency/defensive bucket, the effective asset allocation of your investable assets is not
50/50 but 62.5% risk assets and 37.5% cash.

There's a more important way to look at this, however, and it is pretty clear to me that it
is Buffett's way. You must start with the emergency bucket. As a result the present crisis
does an interesting thing to the way you think about investable cash. I personally started
with an upgrade of the family cash bucket to the level that would support our lifestyle for
the foreseeable future if every risk asset went to zero. This actually raised total cash to a
bit over 60%. If the market collapsed entirely, but left the economic system bruised but
intact, I would probably invest half of that - in effect going all in on the total available
cash.

Berkshire is Buffett's life, his friends, and his family. The way he now thinks of Berkshire's
cash appears to be similar to what I describe above. If it's possible for you to think that
way, his actions and lack of action suggest that you should consider the above thinking
for your own money.

Better To Be A Debtor Than A Creditor

Buffett spoke of debt in in two ways which appear contradictory. In a personal anecdote
he told of a friend who had very recently come into a modest sum and sought his advice
for investing it. He inquired as to whether she had any credit card debt, and when she
said yes he estimated the rate she was paying at 18%. He then told her that the best
investment choice was paying off that debt. She wasn't happy with this answer, so he
explained that he knew of no way to get that return elsewhere.

From a personal standpoint, debt is poison. As he said at other points in the Q&A it has
also become poison to many companies which hadn't foreseen anything like an
economic lock down. The survivors, he implied, would be companies with low debt and
adequate cash.

In terms of investment value, however, he took the other view, saying that it is far better
to be a debtor than creditor. Rates on debt of any kind are simply inadequate for the
various risks. On the other hand, the present moment is a good time to borrow if you

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anticipate any kind of future need. He put his money where his mouth was, he said,
mentioning that Berkshire had taken the opportunity to borrow at the current low rates
just in case.

The two sides of his argument fit together perfectly. Both are pieces of valuable advice
for ordinary investors.

Buffett Is A Man Of Discipline, And Proved It

Buffett proved to be the dog that didn't bark. He bought nothing. The fact that he bought
nothing is a powerful indicator. This morning on CNBC before the market open Jim
Cramer appeared to be in virtual despair on what Buffett's view implied for the airline
industry, several other industries, and the economy as a whole.

The explanation Buffett gave was that he hadn't found anything attractive to buy. This
sentence expands in multiple implications. For one thing, as discussed above, the cash
available in his investable bucket was smaller than many observers assumed. For that
reason, his standard for attractiveness are higher than they might be otherwise. He
partially explained why he didn't then do buybacks, saying that although Berkshire
traded 30% below a recent buyback price, it was not more attractive at the recent low
than it had been at that time. That being the case, with overall risks higher, it made
sense to wait.

Imagine, though, what that means when estimating the correct price for the entire
market. Has its fair value dropped 30%? The more you think of the damage to the
economy the more sense that makes.

The clearest takeaway from Buffett's expressed views was that we had come to the end
of an era and entered into a new era in which everything had changed. There is no clarity
on the economic path forward. The course of the pandemic is important, but even if the
pandemic is defeated in a reasonable period of time there is still very little visibility on
what consumers and businesses will do as the virus ebbs and the lock down ends.

This point was made most cogently in discussing the sale of his entire position in four
airlines, United Continental (UAL), American (AAL), Delta (DAL), and Southwest (LUV).
What Buffett did - what most investors find it very hard to do - was face up to the reality
of an investment which had been a mistake. To be sure, his premise on the airlines six
months ago had been fine, but the new circumstances made it wrong. He cited the
famous Keynes quote about changing your mind when the facts change. He bit the bullet
and exited the position at a loss.

The circumstances say quite a bit. It took a little time for the whole situation to sink in,
and as a result he did his selling as the market was coming off the lows. This said in part
that the rally was not cutting any ice with him. More importantly he reeled off the
problems airlines were going to have going forward under the best of circumstances -

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largely his strong doubts that airline travel was likely to approach its past level of seat
miles flown anytime soon. He noted the impact on Boeing (BA), a great company in his
opinion but likely not to have many customers for some time.

If those companies are going to be a disaster for years no matter what happens, you can
easily start to tick off a large list of similar companies. Within Berkshire both Buffett and
Greg Abel mentioned Precision Castparts which is doing fine in its military business but
taking a major hit in commercial aviation.

The takeaway here: despite his desire for an acquisition Buffett made a cool assessment
and did nothing. When he saw that his position was a mistake, he admitted it and took
decisive action. Another point that the headlines this morning didn't want to accept: it
wasn't the Fed's action rescuing troubled companies that stopped Buffett from making
deals. It was Buffett's judgment that the risks were too great for the possible rewards.

The Future Of Berkshire

Despite an overall tone of uncertainty - I was tempted to type pessimism, but I don't
think that quite fits the overall message - Buffett's view of Berkshire's future was
generally positive. Yes, his fortress of cash reserve may be pushed to the limit. Yes, some
of his smaller businesses may have to go. But Berkshire itself is a survivor and that will
mean something as we come out of this.

Buffett believes that over the long run Berkshire will continue to have a solid return on
capital. He believes it may or may not beat the S&P 500 but will be competitive. He noted
that Berkshire owns a lot of financials and gave an optimistic view of their future. They
will have loan problems with energy and consumers but were ready this time with
adequate capital and will survive and prosper.

His greatest concern is a cluster of second-order events which could greatly deepen and
lengthen the downturn. He has faith in the leaders of Berkshire's various units to deal
with the problems presented in their areas, and he had praise for Ajit Jain on the
insurance side and Greg Abel on the operating side, one of whom will one day be his
successor,

Conclusion
Sometime in February the world changed. It's arguable as to how radical the change will
be, and whether the change will be permanent, but there is no refuting the fact that we
have entered a different era. A large number of the investing rules accumulated over a
lifetime have had to be modified to a degree. Merely being cheap may not be enough.
What Buffett is doing and especially what he is not doing may contains lessons for you
and me.

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The first goal of every living entity is survival, and the novel coronavirus and attendant
lock down of the economy are separating those entities which prepared with sufficient
reserves from those whose preparations were more nominal than real. The fact that
survival is the first principle of life and investing is likely to be the major investment rule
that has been rediscovered in the course of this crisis.

It's okay to make a few mistakes. It's okay to underperform a benchmark. What's not
okay is to put your own or your own company's survival at risk. Older investors have
seen and survived many things, but no one has seen anything like this - not even Buffett.
As the above Eric Hoffer quote says, succeeding when everything changes is not so much
about being learned as about being a learner.

If you think Buffett is being a little slow to pick up the bargains available in the market,
you should consider the possibility that he is making sure he understands what the
survival qualities are in the new environment and how to be sure apparent bargains are
actual bargains. Like the rest of us Buffett has to get up to speed on the New Era. He has
to unlearn or modify a few rules, and learn what is likely to work in the future.

Like the rest of us he is starting from a zero base. When the world turned a corner in
February it left behind quite a bit of baggage. When Buffett does act, it will have a
powerful message about what he has learned. When he waits, that is also an important
message. Meanwhile don't hold your breath for a New York Times op-ed saying "Buy
American; I Am."

Disclosure: I am/we are long BRK.B. I wrote this article myself, and it expresses my own
opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have
no business relationship with any company whose stock is mentioned in this article.

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