Prior to making the pilgrimage to Omaha, Nebraska, this year for the Berkshire Hathaway (BRK.A) (BRK.B) Annual Meeting, we had laid out a series of questions we'd like to hear asked during the main question-and-answer segment. For those unfamiliar with the structure of Berkshire's annual meeting, Warren Buffett and Charlie Munger spend upward of five hours answering questions from a trio of financial journalists, intermixed with questions from Berkshire's shareholders (who are picked via a lottery).
On the day after the annual meeting, Buffett and Munger allot a few hours to answer questions from the press directly. Morningstar has traditionally been allowed one question during this meeting and this year used to it glean more insight into the succession-planning process at Berkshire following the resignation of David Sokol last month. Despite releasing the findings late last week of Berkshire's own internal investigation into Sokol's trading activity in Lubrizol (LZ), Buffett and Munger were subjected to a host of questions about the impact that the transgression has had on everything from succession planning to Berkshire's reputation. We were also encouraged to see that many of the key themes and questions we had highlighted prior to the meeting were actually covered during the weekend.
The Sokol Affair
Buffett did not even wait for the question-and-answer period to begin to start discussing the Sokol affair, bringing the topic up immediately after releasing Berkshire's preliminary first-quarter earnings. He alluded to a clip shown during the annual meeting movie of his testimony before Congress in the early 1990s, following the trading scandal that had engulfed Salomon Brothers, where he referred to Salomon's activity as "inexcusable and inexplicable."
Buffett then applied those very same words to David Sokol's trading activity in Lubrizol. He further noted that it has been 20 years since the events at Salomon Brothers and yet he still cannot explain or excuse what happened. Buffett anticipates that it will be the same with the Sokol affair 20 years from now. Most surprising of all for Buffett was the fact that Sokol didn't even try to cover his tracks, even though the details of his trades would be disclosed before the acquisition was completed.
In general, we were encouraged to see Buffett toughen up his rhetoric on Sokol, especially given the odd press release he released in late March to announce the resignation of his top lieutenant, which sung Sokol's praises despite obvious indiscretions. At this point, it seems clear that Buffett views what Sokol did as unethical. Whether it is illegal is yet to be determined, but Buffett stated that he not only called the head of the enforcement division at the SEC to brief them on Sokol's trades but that Berkshire has passed the details of its own internal investigation along to the SEC, as well.
Although Buffett may believe that he was ruthless in his handling of the affair, and that the firm avoided a lengthy legal dispute, as well as any severance compensation, by having Sokol resign, we continue to believe that Berkshire needs to conduct a serious re-evaluation of its trading policies and compliance procedures, especially for its top managers. Buffett stated that the board is looking closely at these rules in the aftermath of the Sokol affair, but he noted that expanding the size of the compliance department isn't going to prevent this type of activity from occurring.
Succession Planning
Believing that succession planning is one of the two major hurdles facing Berkshire longer term, we used our allotted question at the Sunday press conference to clarify a few points on what Buffett and Munger were looking for in their next CEO. Noting that one of the biggest attractions of David Sokol was the fact that he had experience across several of Berkshire's operating subsidiaries, we asked what the board was doing to ensure that the remaining candidates for the top job get the exposure they need to the firm's operating subsidiaries--and, most importantly, the insurance, railroad, and energy businesses--to handle the CEO responsibilities once Warren Buffett departs. We also wondered, given the two men's preference for someone steeped in Berkshire's culture to run the show longer term, whether they (or the board) would ever consider an outside candidate for the top job.
In his response, Buffett stated that it would be nearly impossible for the future CEO to come from outside of Berkshire because of the uniqueness of the corporate culture. He also said it would not be necessary for the next chief executive to have direct experience in a number of Berkshire's business lines and, in fact, it could be a disadvantage. Both he and Munger would like someone who will be an "intelligent shareholder" in Berkshire's businesses. Buffett explained that he personally would not know how to be the CEO of many of Berkshire's key subsidiaries, but, at the same time, he knows enough about these companies to know when they are succeeding if there is a problem. Therefore, he does not believe that rotating managers around through Berkshire's subsidiaries would be necessary before they can be ready to be CEO. In fact, he thinks this would be disruptive as a group of potential successors would likely be hoping for the failure of one another.
This was the first time we had heard Buffett and Munger describe the characteristics of the next CEO this way. Although we had not originally anticipated their answer, after further consideration the response makes sense. In order to preserve the culture of Berkshire, which is a key component of the firm's moat, it will be essential to choose a CEO who believes in the company's ideals rather than someone who is skilled in day-to-day operations of a specific business. Unfortunately, many candidates at Berkshire fit Buffett's criteria of having a large amount of business sense and the potential to act as intelligent investors, making the prediction of an eventual successor difficult.
Morningstar senior stock analyst Greggory Warren contributed to this article.
