Challenges Of Analyzing Profitable Financial Companies
(April 30, 2005) Bill Ackman of Pershing Square asks Warren Buffett and Charlie Munger to justify why they are comfortable to invest in financial companies when the financial companies are difficult to analyze than other companies. Warren Buffett admits that financial companies are difficult to evaluate because the financial reporting is based on the assumptions (e.g. loss reserves) and financial companies are highly leverage. Charlie Munger added that while financial institution is difficult to evaluate, the complexity also provides amble opportunities for financial savvy investors.
Challenges Of Analyzing Profitable Financial Companies
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Thank you Bill Ackman from New York New York. For the handful of triple-A rated companies AIG, Fannie Mae, Freddie Mac and MBIA are under formal investigation for accounting shenanigans and are in the process of restating their financials. Like Charlie said before I think of a triple-A rated company as an exemplar a company that should behave with the highest accounting and ethical standards. My questions this leads me to are how can investors comfortably invest in any financial service company when even when a decent percentage of the triple-A rated companies have false or misleading financials and it gets the follow up question is why don’t the rating agencies do some independent due diligence from an accounting standpoint so that they can help serve as a watch on this issue.
Well financial companies are more difficult to analyze than the many companies. I mean the it is more if you take the insurance business you know the biggest single element that is very difficult to evaluate. Even if you own the company is the loss and loss adjustment expense reserve and that has a huge impact on reported earnings of any given period and the shorter the period the more the impact can be from just small changes in assumptions that we carry will say 45 billion of loss reserves but enough if I had to bet my life on whether forty five billion turned out to be a little over a little under I may be I think a long time and you could just as easily have a figure of forty five and a half billion or forty four and a half billion and then if you were concerned about reporting given earnings in a given period that would be an easy game to play. In a bank. You know what that basically is whether the loans are any good. And I’ve been on the boards of banks and that’s you know I’ve gotten surprises it’s tough to tell it’s financial companies if you’re analyzing something like WD40 in our See’s Candy here our brick business whatever that they may have good or bad prospects but you’re not likely to be fooling yourself much about what’s going on currently but with financial institutions it’s much tougher than you get at throwing derivatives on top of it. And you know it’s it’s no one probably knows perfectly what some of that or even within a reasonable range the exact condition of some of the biggest banks in the world and but that brings you back to the due diligence question of the agencies you had very high grade very smart financially smart people on the boards of both Freddie and Fannie and yet no one was 5 billion and one was apparently 9 billion. Those are big numbers and I don’t think those people were negligent and it’s just it’s very very tough to know precisely what’s going on in a financial institution. Charlie and I were directors of Solomon and Charlie was on the audit committee and I forget the size of a few of those things that that you’ve found but you know what that you’ve found. But you know what wasn’t found and that isn’t that doesn’t mean the people below are crooks or anything like that it just means that it’s it’s very tough with thousands and thousands and thousands of complicated transactions sometimes involving the computations involving multiple variables.
It can be it can be very hard to figure out where things stand at any given moment. And of course when the numbers get huge on both sides and you get small changes in these huge numbers they have this incredible effect on quarterly or yearly figures because it all comes lumped in those adjustments come lumped in a short period of time. So I just think you have to accept the fact that insurance. Banking finance companies we’ve seen all kinds of finance company both frauds and and just big big mistakes over time. Just one after another over the years. And it’s just a more dangerous field to analyze that doesn’t mean you can’t make money and we’ve made a lot of money on it. But but it’s it’s difficult now. Obviously a Geico. Where you’re insuring pretty much the same thing. Auto drivers and you get your statistics are much more valid in something like that than they will be if you’re if you’re taking something that like asbestos liability. You’re subject to far greater errors in estimation. Doesn’t mean that people aren’t operating in good faith. But you know I would take just take the asbestos estimates of the 20 largest insurance companies. I will bet you they’re way off but I don’t know in which direction and that’s that’s sort of the nature of financial companies. I wouldn’t fault the rating agencies in terms of not being able to dig into the the financials and find things that that you know all of the companies that you’ve talked about have had big name auditors and our auditors at Berkshire. How many hours did they spend last year. And I don’t know whether what it would be probably 60 70 thousand hours and I’m sure another you know if you take major banks they spending more than that but you know can they be certain of the numbers. I doubt it. Charlie.
Yeah. Warren is obviously correct that where you’ve got. Complexity which by its very nature provides better opportunities to be mistaken and not have it come to notice or to be fraudulent and I have not been found out. You’re going to get more fraud and mistakes than you are. If you’re selling a business where you shovel sand out of the river and sell it by the truckload. And just as a business that sells natural gas is gonna have more explosions than a business that sells sand. A business like these major financial institutions by its nature is going to have way more problems and that will always be true and it’s true when the financial institutions are owned by governments. In fact. Some of the worst financial reporting in the world is done by governments and governments institutions like government banks in China etc.. So if you don’t like. The lack of perfect accounting and financial institutions you’re in the wrong world.
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