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Warren Buffett values personal relationships very highly.
Buffett III – Beyond Value Investing – Personal Relationships
Warren Buffett values personal relationships very highly. He views these relationships as an integral part of his investment process. Quite simply, he does not like to buy companies anonymously. Even when purchasing shares in publicly listed companies he is invariably on very friendly terms with senior management. Buffett understood very early in his career that he could learn a lot about a company’s prospects by talking to the people who run the company.
A great example of Buffett’s ‘personal’ approach to investing is his first investment in GEICO in 1951. GEICO is a major insurance company. The twenty-one-year-old Buffett was considering an investment in GEICO. His college lecturer Benjamin Graham was already a shareholder. Perhaps Grahams involvement aroused Buffett’s interest. Either way, the (wealthy)young man thought to visit the GEICO offices in Washington before investing. He got lucky and ended upspeaking with Lorimer Davison, the future CEO of the company. Warren put 65% of his considerable personal wealth into GEICO shares immediately after this meeting. The size of his investment is an early demonstration of his preference for focus over diversification. Buffett’s instinct to seek out and speak directly to the company served Berkshire very well throughout his decades of investing.
The sheer size of Berkshire Hathaway has always opened doors for Buffett. Remember Berkshire was ever a small company. Berkshire started large and got larger. One of Berkshire’s first investments was the purchase Of National Indemnity Company and National Fire and Marine Insurance Company in 1967. He paid (in today’s dollars) between $250m and $500m depending on how you wish to measure inflation. From the very beginning of establishing his Berkshire trading record, Buffett was making huge investments. A Berkshire investment in any publicly listed company was always going to be large.
Capitalizing Personal Business Relationships.
Berkshires size and Buffets personal connections allows Buffett to negotiate private deals with public companies. The best way to explain this is to look into one of his deals. In August 2011 Buffett gave Bank of America (“BAC”) $5 Billion. In return BAC promised to pay Berkshire $300m annually for as long as BAC remained in business. If for any reason BAC failed to make an annual payment it would owe it to Berkshire in the future. This is called a ‘6% Cumulative Perpetual Preferred Stock’. At this time, interest rates in the United States were effectively 0%. This special one-of-a-kind deal tailored to Berkshire Hathaway had one more benefit. At any time up to September 2021, (10 years later), Buffett could instruct the bank to convert his preferred shares into 700m ordinary shares, which equates to about 7% of the company, at a $7.14 share price.
Naturally, when the potential dividend payout on 700mordinary shares exceeded $300m, Berkshire converted. In August 2017 Buffett converted to ordinary shares. He started collecting dividends on his now ordinary shares. Today his annual dividends are $616m. I estimate that Berkshire’s $5 Billion preference / ordinary shares investment has received almost $5 Billion in dividends from BAC to date. In addition to this, Bank of America shares are now worth $32.00, which values Berkshires investment at $22.5 Billion.
This deal is testimony to Buffett’s charisma and persuasiveness. Bank of America did not need Berkshires investment. They were not seeking cash. I am drawing heavily on a Fortune Magazine article (Buffett-Bank-of America-deal) for this section, (see quote below).
Buffett called CEO Brian Moynihan and proposed an investment in his company. “Moynihan replied that Bank of America didn't need the capital. "I know, that's why I'm calling," Buffett responded, adding that accepting his money would provide stability, a stamp of approval, and a cash cushion.
Moynihan, an experienced dealmaker from his days making acquisitions for Fleet, wanted near-total secrecy. He declined to bring in investment bankers, didn’t consult with lieutenants, and initially discussed the deal only with his chairman, former DuPont CEO Chad Holliday.
The board voted by phone early Thursday morning. The $5 Billion deal had taken just 24 hours, a pace that could only happen in Buffett land.“ (Forbes Magazine)
This is a classic example of Buffett using his reputation and size to garner a sweetheart deal. He got this deal at the expense of existing shareholders. Not only did they payout ‘extra’ dividends for cash, that at least according to their chairman, they did not need ($5 Billion to date), but they also had their shareholdings diluted by the issuance of an extra 700m shares. For example, a shareholder that owned 1.00% of BAC saw their ownership reduced to about 0.93% after Buffett’s deal.
It is difficult to measure the extra benefits that this ‘private sweetheart deal’ achieved for Berkshire. But we can make a start by breaking down his gains into two parts – Dividends and Capital Gains.
Dividends
Berkshire earned about $4.76 Billion in dividends from August 2011 until June 2023. If Buffett bought 700m ordinary shares in the public market Berkshire would have earned $3.55 Billion in dividends. This extra $1.2 Billion is a 33% gain on what Berkshire would have achieved via a normal public investment.
Capital Gains
We know that Berkshire received the right to buy 700m shares of Bank of America at $7.14 each in exchange for his preference shares. This right is called a warrant, and for our purposes here this behaves just like an ‘American style’ call option. The salient point about the strike price is that it was ‘at the money.’ In other words, BAC shares were trading at around $7.14 when Buffett struck his deal. These 10-year warrants were worth Billions of Dollars.
Buffett paid zero dollars for the warrants.
For valuation purposes, Buffett’s warrants were similar to American style call options. I estimate the real value of these ‘free’ warrants to be roughly $2 Billion. I have set out my calculations in the technical box below at the end of this commentary.
Berkshire Hathaway has made a total of $22.5 Billion from this Bank of America deal. Part of this profit is attributable to Buffett’s private negotiating skills and his personal relationships. If he chose to not speak with the BAC CEO Brian Moynihan and just bought shares on the open market his overall profits would be less than $22.5 Billion. He would have paid on average a good deal more than $7.14 per share and he would have received ordinary dividend payments only. His personal relationship skills accounted for about $3.2 Billion of Berkshires profits (made up of $1.2 Billion in extra dividends plus a $2Billion ‘free’ warrant).
The remaining $19.3 Billion in profits could be attributed to Buffett’s foresight in knowing that Bank of America had a bright and profitable future ahead of it. However, as we will see, his foresight was guided by another set of personal relationships. Which leads us onto Buffett's government contacts.
Capitalizing Personal Political Relationships.
In October 2008, in the midst of the financial crisis, Warren called his friend Hank Paulson. Hank, (pictured below),was the US Treasury Secretary. Like many others, Buffett believed that the US government should bailout the banks. Warren certainly wasn’t shy about letting his views be known in government circles. He worked hard to use his contacts and influence to make the bailouts happen.
Warren spoke to whomever he needed pretty much whenever he needed. Famously he woke Hank in the middle of the night to press his case. Paulson jokingly recalls waking from a deep sleep to answer his mobile phone to speak to Warren. He has dropped by for unscheduled meetings in the White House. In fact, the photo below is a photo of one such meeting.
Regardless of the rights and wrongs of bailouts they certainly helped Berkshire Hathaway in two ways. Initially the bailouts resuscitated Berkshires poorly performing financial stocks. But perhaps more importantly, Buffett gained insights into what was actually happening at government level. To be more specific, the general investing public had no idea exactly how much assistance or medicine was being applied, or to whom it was being applied. It has since been revealed that Bank of America received $3.3 Trillion in an alphabet soup of various government loan programs.
Buffett invested in a $100Bn company that had $3,300Bn of government backing. Buffett knew better than most that BAC was a safe bet with an almost 100% guaranteed future.
Warren’s connections go back decades. The BAC deal is by no means a ‘one-off’ relating to the Global Financial Crisis. An earlier example of Buffett’s political skill was his rescue of investment banking firm Salomon Brothers in 1990. He arranged a private $700m sweetheart deal with his friend John Gutfreund, (Salomon CEO), for Berkshire in 1987. In 1991 Salomon Brothers was caught trying to rigg the US Government Treasury Bond market. The US Treasury and the Federal Reserve combined were on the cusp of shutting down the company.
Warren Buffett swooped in and personally persuaded the government to give the bank a second chance. Playing the role of Salomon Brothers CEO for a while he helped turn Berkshires investment from zero to a handsome profit in the end. He capitalised on his status and reputation perfectly and saved his investors a fortune. Travelers Group Inc bought his Salomon interest for $1278m in 1997.
Conclusion.
A Berkshire Hathaway shareholder could not wish for a better chairman. Buffett has a lot of strings to his bow. He cares deeply about his company and has proven the value of his personal relationships. It is hard to value charisma. In the next and final analysis of Buffett we will ask the question – should you buy Berkshire Hathaway shares?
