The haunting blue light illuminating the impact zone of the Pentagon came into view, making the headlamp I use for pre-dawn runs unnecessary. As I paused to pay tribute early on the morning of September 11, 2021, I heard taps being played on an unseen bagpipe somewhere near the memorial, a precursor of the ceremonies that would occur later in the day. Two miles into my twenty mile run on the twentieth anniversary of the terrorist attacks, it was still pitch dark as I continued running toward the Air Force Memorial and Pentagon City.
At some point between the tenth and twentieth anniversaries, the terrorist attacks of September 11, 2001 transformed from an event that took place relatively recently to an event that feels more like a part of history. Nearly a third of the population of the United States is under the age of 25, meaning that over a hundred million people in this country have little or no direct recollection of the attacks. They know of these events only through history books and media coverage, as well as what older friends and family members might share with them.
It is exceedingly difficult to explain September 11, what it felt like on that awful day, how everyone alive at the time knew that the world had changed forever, and the sense of national unity that pervaded the country in a way that is nearly unimaginable today. Like Pearl Harbor sixty years earlier, September 11, 2001 marked a turning point in history, a date that lives in infamy, and an event seared into the minds of everyone who remembers it.
My clock radio was set for 4:55 am, but my real wakeup time was always five o’clock, when I heard the CBS radio chime signaling the top of the hour. But on that day, I silenced the radio and slept another half hour. Then I started the coffee and took a shower. At the time, I lived in the rural outskirts of Sacramento, which is in the Pacific time zone, three hours behind New York and Washington, DC. I remember that I was shaving when I heard the first bewildered accounts of a plane hitting the north tower of the World Trade Center. In the seventeen minutes between 8:46 am and 9:03 am, I don’t think anyone understood what was really happening, but at 9:03 am, when the south tower was hit, everyone instantly understood.
For some reason, I kept listening to the radio and did not turn on the television, stunned at what I was hearing. Eventually, I got into my truck, drove through the rural pre-dawn landscape, through the small town of Penryn, and merged onto the interstate heading toward my suburban Sacramento office. I heard about the Pentagon a couple of minutes later, arrived at my office just as the sun was rising, and just sat in my truck, totally stunned for well over an hour listening to the radio. I recall almost nothing about the time I spent in the office that morning, only that I spoke to a few people there and eventually everyone decided to go home. It was only when I returned home in the early afternoon that I turned on the television and saw the horror unfold for myself, the towers collapsing, the people running for their lives, and it was unimaginably worse than I could have possibly imagined.
Unlike so many others, I did not know anyone who died or was injured in the attacks and cannot imagine the horror of not knowing if your friends, family, and coworkers had made it out of Manhattan or the Pentagon safely. There was nothing I could do but watch the news coverage for hours. The United States was under attack and the fact that it was happening nearly three thousand miles away did not make it feel remote.
America’s response to the attacks began at 9:57 am when passengers of hijacked Flight 93, after learning about the attacks on the World Trade Center and Pentagon through cell phone calls, decided that they would revolt rather than allow the hijackers to use the plane to attack Washington DC. Six minutes later, the plane crashed into a field near Shanksville, Pennsylvania. The likely targets included the United States Capitol and the White House.
In today’s fractured society, it is almost impossible to describe the unity of purpose that followed September 11, 2001. I was in my late 20s at the time and had never experienced the level of social cohesion that existed in the weeks that followed. The county was hardly united prior to that point and had just gone through massive political turmoil with the Clinton impeachment and the contested election of 2000, yet the attacks on the country overrode all of that for several months. I imagine that this level of cohesion existed sixty years earlier as well after the Pearl Harbor attacks. When a country is under assault by enemies, and particularly when punched in the gut by cowards in an undeclared war, as was the case in both events, people have a way of coming together.
It is also difficult to describe the prevailing sense that the other shoe was yet to drop. Talk of dirty bombs, chemical warfare, and biological warfare dominated the news. I cannot personally imagine what that was like for people in major cities who had to use public transit and work and live in large buildings in the days and weeks that followed. However, I do know that this fear existed for several years and was pervasive when I moved to the Washington DC area a year after the attacks. And it still existed when I started weekly commutes between Washington and New York City a few years later.
It is strange to try to explain September 11 to young people who have no recollection of it, as I discovered in late 2015 when I walked through the streets of lower Manhattan with my niece and nephew. I was simply unable to explain it, and just could not put the words together. During my work trips to Manhattan, I visited the site several times and followed the agonizingly slow process of rebuilding, and yet I could not articulate what had taken place. But it is important for those who have recollections, even those like me who were thousands of miles away from the attacks, to explain what happened, to articulate our recollections as citizens, and to ensure that September 11, 2001 is not forgotten.
People often take for granted the gift of life, the fact that for a brief time, we exist on earth and are blessed with all of the possibilities of life. That was taken away from nearly three thousand people twenty years ago and life was forever altered and tarnished for their loved ones. The same is true for the soldiers who have died or suffered life changing injuries over the endless wars of the past two decades, and it is true for their families. I find it repugnant when I see a lack of appreciation for the gift of life and for the sacrifices that have been made by those who have served. Through all the vicissitudes of life, one must never forget that we have something that so many others have lost.
As I continued my run from the Pentagon into Washington DC, the sun rose as I passed sights including the United States Capitol and the White House, both spared from attack by the heroes of Flight 93. I could not help but think about the fact that it will not be very long before a majority of Americans have no recollection of that terrible day. I have nothing particularly profound to share beyond what I have written here, but it is still better than writing nothing at all.
“The dots are not a great forecaster of future rate moves. And that’s not because—it’s just because it’s so highly uncertain. There is no great forecaster of the future—so dots to be taken with a big, big grain of salt.”
Once upon a time, Federal Reserve policy-setting meetings were not followed by press conferences or even explicit statements regarding changes in policy. Ben Bernanke began the practice of holding press conferences in April 2011. This followed a significant enhancement in policy setting disclosures announced in November 2007. If sunlight is the best disinfectant, the hope was that allowing market participants to gain better insight into the Fed’s thinking would have salutary effects on market function. There would be fewer instances of miscommunication leading to market volatility and, more importantly, less risk to the real economy since everyone would know what to expect in advance.
The level of disclosure and commentary from the Federal Reserve has gone into overdrive in recent years and especially over the past year as the economy suffered the effects of the COVID-19 pandemic. Aside from the Fed’s self-imposed “quiet period” in the days leading up to policy meetings, rarely a day goes by when a Fed official does not appear on financial television or makes a speech to some audience. Those unfortunate enough to pay attention to financial news during the trading day are presented with schedules of Fed officials appearing in various venues along with charts of the S&P 500 as traders react to the latest utterances.
The Federal Reserve appears more and more to be the genesis of market-moving news rather than a dispassionate observer of economic indicators and market sentiment. It is as if the Federal Reserve wishes to test its theories and trial balloons out on the market to see how it reacts and uses this information to set policy. Make no mistake, financial market participants have long been obsessed with Fed policy but prior to the new hyperactive communication strategy, much had to be inferred and the obsessing was concentrated during the periods surrounding policy meetings. Now, the obsession is constant. If the goal of the Fed since 2007 has been to reduce market volatility by being more transparent, has anyone bothered to study whether this goal has been achieved?
Nassim Nicholas Taleb’s books are some of the few that I have re-read from cover to cover multiple times. While recently reading The Black Swan, I kept thinking about the Federal Reserve.
Taleb’s concept of epistemic arrogance involves the hubris we have regarding the limits of our knowledge. It is not that we know nothing or that our knowledge about the world does not increase over time. The trouble is that people tend to consistently overestimate what they know and, more importantly, what it is possible to know.
This problem appears to be endemic in human society. For example, Taleb cites a study where the researcher asked a room full of people to estimate a range of possible values for some statistic, such as the population of a country, with 98 percent confidence. The study was not attempting to test knowledge, but what people thought about the accuracy of their knowledge. One would expect the error rate from such an experiment to be around 2 percent, but in reality it is far higher:
“This experiment has been replicated dozens of times, across populations, professions, and cultures, and just about every empirical psychologist and decision theorist has tried it on his class to show his students the big problem of humankind: we are simply not wise enough to be trusted with knowledge. The intended 2 percent error rate usually turns out to be between 15 and 30 percent, depending on the population and the subject matter”
If the problem is severe in society at large, it is at epidemic levels in the world of finance and economics. It is trivially easy to create a set of assumptions about the world and build spreadsheets that use these assumptions to project, with seemingly precise accuracy, the state of a company or an economy years or decades into the future. The trouble is not only that we are likely wrong about the future but that small variances in key inputs can result in radically different outcomes in non-linear systems that compound over time.
A modern market economy is an extremely complex system and we only see the results retrospectively. If we do not replace epistemic arrogance with epistemic humility, we will pay the consequences. For market actors with money on the line, the consequences involve financial gain and loss. It is less clear what the consequences are for Federal Reserve officials.
Chairman Powell’s Attempt at Epistemic Humility
Am I beating a dead horse here? Isn’t the quote at the beginning of the article a sign that the Chairman of the Federal Reserve in fact does have a healthy level of epistemic humility? It is not my intent to vilify Jay Powell or to be unfair to the Federal Reserve, so let’s take an extended excerpt from the press conference transcript and read the full question and response that included the “grain of salt” quip:
QUESTION: Thanks, Chair Powell. Your economic projections today forecast 7 percent growth in 2022, unemployment at 4 ½ percent, and core inflation of 3 percent. If those conditions are achieved by the end of the year, would that constitute substantial further progress, in your mind?
And kind of more broadly, when you look at the sort of median forecast for interest rates in 2023 showing not one but two interest rate increases at the time, I mean, is this kind of—can you describe the sort of tone of the—of the discussion in the committee? And are we really moving towards sort of a post-pandemic stance? Is there greater confidence that, you know, the recovery will be a—you know, a full recovery sooner than expected?
MR. POWELL: Well, on your first question, the judgment of when we have arrived at substantial further progress is one that the committee will make, and it would not be appropriate for me to lay out particular numbers that do or do not—that do or do not qualify. That is, you know, the process that we’re beginning now. At the next meeting, we will begin meeting by meeting to assess that progress and talk about what we—what we think we’re seeing, and just do all of the things that you do to sort of clarify your thinking around the process of deciding whether and how to adjust the pace and composition of asset purchases.
In terms of the two hikes, so let me say a couple things first of all, not for the first time, about the—about the dot plot. These are, of course, individual projections. They’re not a committee forecast. They’re not a plan. And we did not actually have a discussion of whether liftoff is appropriate at any particular year because discussing liftoff now would be—would be highly premature. It wouldn’t make any sense.
In our—if you look at the transcripts from five years ago, you’ll see that sometimes people mention their rate path in their interventions. Often, they don’t.
And the last thing to say is the dots are not a great forecaster of future rate moves. And that’s not because—it’s just because it’s so highly uncertain. There is no great forecaster of the future—so dots to be taken with a big, big grain of salt.
However—so let me talk about this meeting. The committee spelled out, as you know, in our FOMC statements the conditions that it expects to see before an adjustment in the target range is made. And it’s outcome-based. It’s not time-based. And as I mentioned, it’s labor-market conditions consistent with maximum employment, inflation at 2 percent, and on track to exceed 2 percent. And the projections give some sense of how participants see the economy evolving in their most likely case.
And honestly, the main message I would take away from the SEP is that participants—many participants are more comfortable that the economic conditions in the committee’s forward guidance will be met somewhat sooner than previously anticipated. And that would be a welcome development. If such outcomes materialize, it means the economy will have made faster progress toward our goals.
So the other thing I’ll say is rate increases are really not at all the focus of the committee. The focus of the committee is the current state of the economy. But in terms of our tools, it’s about asset purchases. That’s what we’re thinking about. Liftoff is well into the future. The conditions for liftoff—we’re very far from maximum employment, for example. It’s a consideration for the future.
So the near-term thing is really—the real near-term discussion that we’ll begin is really about the path of asset purchases. And as I mentioned, we had a discussion about that today and expect to, at future meetings, continue to see—think about our progress.
I suspect most readers know what Chairman Powell is referring to when he mentions the “dots”, but for the benefit of others, here is the latest “dot plot” released by the Fed. Each circle indicates the value of an individual committee member’s judgment of the midpoint of the appropriate target range for the federal funds rate at the end of the specified calendar year or in “the longer run”:
Why does the Fed release this dot plot, along with the other assumptions in the Summary of Economic Projections document that is released after each policy meeting? The idea is that this information provides market participants with guidance regarding what interest rate policy will look like during the years in the graph as well as in the undefined “longer run”.
Since interest rates are a crucially important variable that impacts the valuation of all financial assets in the economy and also has major impacts on capital investment decisions, the Fed is hoping to give market participants the confidence to make decisions with greater insight into the likely progression of the Fed funds rate. The progression of the Fed funds rate over time also helps to guide market participants when it comes to the market clearing rate for other fixed income securities. For example, the two year treasury note yield is heavily influenced by what market participants think the Fed funds rate will be over the course of the next two years.
Those who review the Summary of Economic Projections document will see forecasts for many additional economic variables, most notably the expected rate of inflation, real GDP growth, and unemployment. Each member of the policy setting committee provides estimates for these variables and the committee as a whole presumably is informed by a composite of these individual estimates. The two-day meeting is ostensibly meant to refine these forecasts as the Fed’s army of staff economists furnish more detailed economic data and projections to committee members.
As Chairman Powell admits, the dot plot cannot really be used to estimate the future course of interest rate policy and indeed must be taken not only with big grains of salt, but with heaps of salt. Let’s see what the dot plot revealed after the December 15-16, 2020 policy meeting just six months ago:
Clearly, the strength of the economy over the first half of 2021 caught the Fed by surprise. The Fed was certainly not alone. The degree to which the economy has come roaring back as COVID-19 vaccines have rolled out was not expected by most market participants. The strength of the economy and a resurgence in inflation has led committee participants to anticipate increases in the Fed funds rate much sooner than they expected just six months ago.
Everyone’s a Critic
Who am I to write an article criticizing expert economists who happened to be wrong about the course of economic growth and inflation over the past six months? Could I have done any better?
The answer is no!
The point of this article is not to criticize the Federal Reserve for being wrong about the course of economic activity during a pandemic that has no historical parallel in a modern economy but to question whether the Fed is suffering from epistemic arrogance. When questioned about this, Chairman Powell seems to express some humility but his organization seems addicted to continuing to produce overly precise forecasts that everyone should know will have no bearing on reality.
Why do they do this?
One reason is the institutional imperative that exists when you have armies of highly educated experts armed with PhDs who need to justify their existence. But it appears that the problem is more insidious than that. I will point to a comment at the end of Chairman Powell’s answer regarding “asset purchases”. What was he referring to?
The Federal Reserve will continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage‑backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee’s maximum employment and price stability goals. These asset purchases help foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses.
During the depths of the pandemic crisis last year, the Federal Reserve embarked on an unprecedented effort to ensure that financial markets would not freeze up and part of the program involved massive purchases of treasury securities and mortgage-backed securities. Despite the fact that the economy has been booming in recent months and shows no signs of illiquidity, the Fed has insisted on continuing these asset purchases at a rate of $80 billion per month of treasury securities and $40 billion per month of mortgage-backed securities.
The Fed claims that it is doing this in order to “help foster smooth market functioning” which implies that the goal is to ensure that markets do not freeze up. However, anyone who has followed financial markets even superficially this year understands that the system is awash in liquidity. Rather than attempting to ensure liquidity, the Fed is a major actor in the treasury and mortgage-backed securities markets. There is no doubt that by doing so the Fed is attempting to influence longer term interest rates.
Warren Buffett has likened the effect of interest rates to “financial gravity” because the level of interest rates influences the valuation of all other financial assets. The Federal Reserve’s actions, whatever their motivation, has had some impact on asset prices over the past year. One can argue about the extent to which the Fed has caused asset prices to increase or whether we have asset price bubbles, but it is hard to argue that there has not been a directional impact.
But You Have to Have Models…
I am not advocating that the Federal Reserve fire its economists and give up on making economic projections entirely. However, I do question the utility of communicating these projections through countless speeches, policy statements, and press conferences that give the appearance of jawboning the market. For one thing, anyone who looks at the Fed’s track record can see that the projections have no particular credibility. We have more transparency than ever before, but more and more it looks like the “man behind the curtain” resembles the Wizard of Oz.
The Federal Open Market Committee is made up of twelve members who meet eight times per year and are supported by the army of economists I keep referring to. No matter how brilliant these minds are or how aligned their intentions are with fulfilling the mandates given to them by Congress, I will suggest that the forecasts of these individuals are next to useless when it comes to what they are trying to do which is “set market expectations”.
Rather than obsessing over setting market expectations, the Federal Reserve might want to invert their process and observe the market — a free and un-manipulated market. The Fed should stop interfering in the treasury and mortgage backed security markets — the argument of fostering liquidity and smooth market functioning is long past. Then, the Fed can observe the level of longer term rates that are being set by actual market participants with skin in the game.
Are market participants any better at forecasting than the Fed? Perhaps not individually, and maybe not even collectively. However, I would rather observe the level of interest rate and inflation expectations by looking at a free and un-manipulated yield curve and infer what thousands of market participants are thinking because they have their skin in the game. In free markets, participants who consistently have bad judgment will exit the game while more competent individuals take their place. There is no such self-correcting mechanism for the Federal Reserve, either among FOMC committee members or their staffs.
Risk takers with capital on the line will exit the game due to incompetence. Federal Reserve officials who appear on financial television constantly might exit their particular game after a period of time, but they will not suffer negative effects from their inaccurate views. Career academics, especially well-spoken ones of the type who appear on financial television, will always have career opportunities in the lucrative world of Wall Street. And if not, there are always speaking fees and board seats.
Epistemic humility is in short supply in general and I would suggest that despite Chairman Powell’s seeming humility, the actions of the entity he runs suffers from chronic epistemic arrogance and is in need of significant reform.
“If you get to my age in life and nobody thinks well of you, I don’t care how big your bank account is, your life is a disaster.”
— Warren Buffett
Warren Buffett did not achieve his success in the business world by worrying about what others thought of his investment decisions. He has never sought the external validation that addicts so many investors. He does not care about winning the approval of media pundits or analysts chattering about stocks on a daily basis. For someone like Warren Buffett, success is measured in years and decades, not hours or days.
There is a fundamental mismatch between the frequency of the feedback an investor gets from market quotations and the time required to determine whether a specific investment or a strategy is working. There will always be critics who are not shy about second guessing your decisions. The concept of discarding the transient opinions of others and breaking the addiction to external validation is known as living by an inner scorecard.
What is the lesson we should take from the concept of living by an inner scorecard, by marching to the beat of own’s own drummer rather than being subject to the judgment of others?
When it comes to investing, there are massive benefits that accrue to those of us who only manage our own capital. The individual investor’s enduring edge is that one can totally ignore short term market movements. Professional managers must provide quarterly and annual updates to investors no matter how much they may wish to create their own scorecard. While they can attempt to attract investors who share their broad philosophy regarding long-term investing, it is well known that many self-professed long-term investors shift to a short term focus when markets are going down.
The question of the inner scorecard gets more interesting when the concept is extended beyond the narrow realm of judging investment performance. When it comes to living a good life, at some point the opinion of your family, friends, business associates, and peers has to matter.
When Warren Buffett says that your life is a disaster if no one thinks well of you when you reach old age, he is implicitly acknowledging the importance of an outer scorecard in life.
In the business world, how do you ultimately gain the approval of others? Is it by the empty virtue signaling that comes from adopting a policy statement regarding environmental, social, and governance matters, known today as “ESG”? Or are you more likely to win the approval of others by acting in an ethical manner and, most importantly, adding value to all of your relationships?
Zero-sum thinking says that for one side of a relationship to win, the other must lose. Positive-sum thinking involves creating win-win relationships across the spectrum. From a business perspective, lasting positive relationships are built when there is economic surplus enjoyed by all parties to the relationship. The value customers receive from buying your products and services should greatly exceed what they must pay. Employees should stick around for decades without the need for employment contracts. When one evaluates a business, these are the factors that count, not some vapid ESG statement written up by consultants for a disengaged board of directors.
But Warren Buffett was not thinking only of business relationships. Here is the full context of the quote that appears at the beginning of this article:
“I know people who have a lot of money, and they get testimonial dinners and hospital wings named after them. But the truth is that nobody in the world loves them. If you get to my age in life and nobody thinks well of you, I don’t care how big your bank account is — your life is a disaster. That’s the ultimate test of how you have lived your life.”
Living by an inner scorecard is a good policy in many ways. But that begs the question of what factors should appear on the scorecard!
A sociopath has an inner scorecard … one that is unconstrained by the judgment of his family, business associates, and society at large. The hallmarks of narcissistic sociopaths include an elevated sense of self-importance and a lack of empathy for the experience of other individuals. Someone with a good moral compass will have an inner scorecard congruent with getting to old age and having people think highly of their accomplishments and who they are as human beings. The sociopath will have an inner scorecard that leads to isolation and scorn. And, of course, there are many gradients in between.
The lesson to take away from the inner scorecard concept is to be fiercely independent when it comes to exercising your professional judgement in areas where you are well within your circle of competence. At a personal level, the inner scorecard is of critical importance when it comes to what type of career to pursue and the types of people to associate with. But, ultimately, no life can be well-lived without eventually subjecting yourself to an outer scorecard. The good news is that an inner scorecard that is consistent with win-win outcomes is highly likely to lead to a favorable outer scorecard in the long run.
The question of who will succeed Warren Buffett as Chief Executive Officer of Berkshire Hathaway has finally been answered. Although Mr. Buffett has no intention of stepping down anytime soon, Vice Chairman Greg Abel is the current “name in the envelope” who is expected to take the reins of managing the company when the time comes. If Mr. Abel is not available when succession occurs, then Vice Chairman Ajit Jain is expected to be named as CEO.
Prior to the annual meeting on May 1, the question was whether Greg Abel or Ajit Jain would take over the top job. Both men were named Vice Chairmen in January 2018 with Mr. Jain put in charge of insurance operations and Mr. Abel overseeing non-insurance businesses. Mr. Abel, at 58, is a decade younger than Mr. Jain and more likely to be able to serve as CEO for a long period of time. As Berkshire Hathaway Energy’s longtime Chairman, Mr. Abel also has extensive capital allocation experience.
Warren Buffett and Charlie Munger have long taken only a token salary of $100,000 per year. This is due to their large ownership interest in Berkshire as well as their desire to act as exemplars. However, it would be unrealistic and unreasonable to expect that their successors would also elect to only take token pay. After all, Berkshire Hathaway is one of the largest companies in the world with a market capitalization of over $650 billion. The difference between an excellent CEO and a merely average one obviously can add up to billions of dollars of wealth for shareholders. It is logical to expect Mr. Abel’s compensation to be commensurate with his responsibilities.
What can we expect Mr. Abel’s compensation to look like? One clue might be how he has been paid over the past three years since his appointment as Vice Chairman in charge of non-insurance operations. The following table appears in Berkshire’s latest proxy statement:
Readers who are familiar with compensation tables in proxy statements but not familiar with Berkshire might look at this table and wonder if the stock based compensation has been omitted. It hasn’t been omitted — Berkshire pays executives in cash comprised of salary and bonus. Other than retirement account contributions and, in the case of Mr. Buffett, security services, there is no other compensation provided to executives.
Both Mr. Abel and Mr. Jain have been paid identical amounts since taking on their current roles. At $19 million in total cash compensation, both men are compensated well with the vast majority of pay in base salary. How is their pay determined? This is what the proxy has to say:
The [Compensation] Committee has established a policy that neither the profitability of Berkshire nor the market value of its stock are to be considered in the compensation of any executive officer. Under the Committee’s compensation policy, Berkshire does not grant stock options to executive officers. The Committee has delegated to Mr. Buffett the responsibility for setting the compensation of Mr. Abel, Vice Chairman-Non Insurance Operations, Mr. Jain, Vice Chairman-Insurance Operations and Marc Hamburg, Berkshire’s Senior Vice President/Chief Financial Officer and Secretary.
Berkshire’s policy is highly unusual in that Berkshire’s profitability and market value are not considered when setting pay. Instead, Mr. Buffett sets that pay of Mr. Jain, Mr. Abel, and Marc Hamburg who serves as Berkshire’s Chief Financial Officer. How does Mr. Buffett come up with these compensation figures? The proxy does not say and the company has occasionally been criticized for lack of transparency in this area. Presumably, pay for Mr. Abel and Mr. Jain is set based on their respective responsibilities and performance. However, the pay figures are identical, most likely due to a desire that both are perceived as occupying the same level in the organization and not tipping Berkshire’s hand in who will emerge as the next CEO.
Once Mr. Buffett and Mr. Munger are no longer involved with the company and a new CEO is named, the Board of Directors and the Compensation Committee will be in charge of setting the pay of the CEO. Presumably Mr. Buffett has communicated his rationale for pay to the Board and the committee will continue his approach in the future. However, it is possible that the Board may elect to begin using some form of stock based compensation in the future, although I don’t view that as likely.
We cannot consider incentives at Berkshire by just looking at compensation alone. One might think that not incorporating stock in compensation will result in a misalignment of incentives between management and shareholders. Of course, this has not been true in the past since Mr. Munger and Mr. Buffett both have billions of dollars and the majority of their net worths invested in Berkshire. They do not need stock based compensation to feel a profound alignment of incentives with shareholders because they are both major shareholders themselves.
So, we need to look at the amount of stock owned by Greg Abel to fully understand his incentives, both now and in the future. A look at Berkshire’s proxy statement reveals that Mr. Abel controls 5 shares of Class A stock and 2,363 shares of Class B stock, in both cases as a fiduciary for trusts held for family members. Based on quoted stock prices on May 11, 2021, this amounts to slightly more than $2.8 million. Is a $2.8 million ownership interest in Berkshire meaningful for a man who has earned between $18 million and $19 million in each of the past three years? Most people would say that this ownership interest is not a meaningful enough incentive.
But wait, there’s more!
A careful reader of Berkshire’s proxy will notice this statement:
Mr. Abel, a director of and the holder of approximately 1% of the voting stock of BHE, also has an agreement with Berkshire with terms similar to the terms of the agreement with Mr. Scott. The major difference between the agreement with Mr. Scott and the agreement with Mr. Abel is that Mr. Abel can also put his shares to BHE (“BHE Put”) and BHE can call Mr. Abel’s shares (“BHE Call”). The purchase price under either a BHE Put or BHE Call shall be payable in cash and determined in the same manner as the purchase price under Mr. Scott’s agreement.
Mr. Abel came to Berkshire two decades ago when the company acquired MidAmerican Energy. Along with Walter Scott, who serves on Berkshire’s Board of Directors as well, Mr. Abel owns a minority interest in Berkshire Hathaway Energy (BHE). As of the date of the proxy, Mr. Abel owned approximately 1 percent of BHE.
That sounds like a significant ownership interest, and indeed it is. What is it worth?
Fortunately, we can estimate the value of Mr. Abel’s BHE ownership interest based on recent transactions in which BHE purchased part of Mr. Scott’s holdings for cash. These transactions required the agreement of Warren Buffett, Walter Scott, and Greg Abel and, given the incentives and reputations of all parties, we should be confident that the price represents a close approximation of intrinsic value. The proxy gives us the details of the latest purchase:
On March 5, 2020, Berkshire Hathaway Energy repurchased 180,358 shares of its common stock from certain family interests of Mr. Scott for an aggregate cost of $126 million. The per share purchase price was based on a price deemed to represent fair market value and agreed upon by Berkshire, Mr. Abel and Mr. Scott and approved by the Audit Committee. Berkshire is not aware of any other Transaction entered into since January 1, 2020 that is required to be disclosed under Item 404(a) of Regulation S-K.
This implies that BHE had an intrinsic value of $698.61 per share as of March 2020. According the BHE’s latest 10-Q report, there were 76,368,874 shares of BHE outstanding as of April 29, 2021. This implies that BHE’s intrinsic value, as of March 2020, was approximately $53.4 billion. As an aside, there were previous transactions with Mr. Scott in February 2019 at a valuation of $654.44 per share and in 2018 at $603.22 per share.
If BHE had a total intrinsic value of $53.4 billion in March 2020 and Mr. Abel owns approximately 1 percent of BHE, it follows that his personal stake in BHE was worth about $534 million at that date. Since BHE retains all of its earnings and another year has passed, the value of Mr. Abel’s holdings is probably in the high $500 million range.
Is an ownership interest of over half a billion dollars meaningful to a man who is earning $19 million per year? The answer must be an unequivocal yes. Obviously, Mr. Abel has a major amount of skin in the game. His annual “look through earnings” attributable to his BHE stake is certainly far in excess of his $19 million of compensation as Vice Chairman of Berkshire.
However, there is a possible problem.
Mr. Abel’s ownership interest is in BHE, not in Berkshire Hathaway, the parent company. This was entirely appropriate when Mr. Abel was Chairman and CEO of BHE. But as the next CEO of Berkshire Hathaway, he will be responsible for the success of the entire conglomerate, not just BHE. It would seem desirable if Mr. Abel’s ownership interest was in the parent company rather than in a subsidiary.
By all accounts, Mr. Abel is a man of unimpeachable integrity and I believe that if he is charged with overseeing the parent company, he will do so to the best of his ability and allocate capital intelligently across all business units. However, it is still desirable for his direct financial incentives to be aligned with the parent company.
I am not suggesting that Mr. Abel would purposely favor BHE over other business units simply because of his ownership interest in BHE. But in order to put to rest any fears of this taking place and giving more confidence to shareholders at large, perhaps Mr. Buffett and Mr. Abel could come to some agreement to swap Mr. Abel’s interest in BHE for an interest in Berkshire Hathaway Class A or Class B stock. This would give Berkshire an opportunity to increase its interest in BHE by 1 percent and would more directly align Mr. Abel’s financial interests with the parent company. Also, it seems likely that it could be done in a tax efficient manner as a stock swap.
Mr. Buffett isn’t planning to go anywhere and seemed to be in top form at the annual meeting. At the age of ninety, his life expectancy is most likely considerably longer than the actuarial four years that a typical ninety year old male would expect. Nevertheless, life can throw curve balls and succession could be needed at any time. Berkshire’s stock price rose in the days following the annual meeting which might be partly related to the CEO succession choice. Incentives at Berkshire are already well aligned but I hope that they will be enhanced further by Mr. Abel’s ownership in BHE converting to Berkshire Class A or B shares before he takes over as CEO.
Derrick Rossi was born in 1966 in Toronto. He is the youngest child of Maltese immigrants who did not have a college education but worked hard to raise their five children. Rossi’s father worked in an auto body shop for fifty years and his mother was part owner in a Maltese bakery. Their son went on to develop an interest in molecular biology and made early discoveries in the field of messenger RNA. He founded ModeRNA Therapeutics in 2010 to commercialize his research.
Rossi never envisioned that his work would lead to vaccine development and he is no longer involved in the company. However, there’s no doubt that his early discoveries played a key role in making Moderna’s COVID-19 vaccine possible. Clinical trials indicate that the Moderna vaccine is 94.1% effective at preventing COVID-19 illness in people who received two doses and had no evidence of being previously infected. The FDA issued an emergency use authorization for the Moderna vaccine on December 18, 2020. The Pfizer-BioNTech vaccine, also utilizing mRNA technology, received an emergency use authorization on December 11, 2020.
Vaccine development was always a process measured in years, not months or weeks, and the most optimistic estimates early in the pandemic was that a vaccine may require a year to eighteen months to develop. But in a matter of weeks, Moderna had developed a vaccine and it rapidly entered clinical trials. The timeline is simply remarkable.
The federal government anticipates that all adults in the United States will be able to make appointments for vaccination by April 19, 2021, just two weeks from now. Both the Moderna and Pfizer vaccines require two doses and not everyone will be able to get immediate appointments. However, it is likely that everyone who wants a vaccine should have an opportunity to be fully vaccinated by the end of June.
One week after receiving the second Moderna vaccine shot, I am able to sit inside a coffee shop and write this article. That might not seem like a big deal, but it has been over a year since I last did something this mundane. And the mundane now seems like a milestone.
Slowly, but surely, the economy is reawakening from a long slumber. Over the weekend, outdoor dining was packed and more restaurants are opening up inside seating as well. Bolstered by stimulus payments, pent-up demand, and beautiful spring weather, people want to get back to their lives, and that’s a great thing to see.
Exactly a year ago, I observed that the world has no pause button, and it’s a useful personal exercise to reflect on how I thought the pandemic would evolve compared to what actually happened:
The speed and shape of the recovery is on everyone’s minds at this point, and much will depend on Keynes’s animal spirits. Will the boarded up businesses scattered through countless American cities open up again when governments give the all-clear to do so? Will the customers of these businesses be willing to again go out and spend money in person after weeks or months of self-isolation?
Much will depend on whether the coronavirus pandemic is viewed as a one-time event or as a potentially recurring feature of our lives going forward. If the pandemic is viewed as a horrible, but temporary, interlude in an era of prosperity, then the government’s efforts to induce a “medical coma” of the hardest hit sectors of the economy could well succeed. Sound businesses will emerge with muscle atrophy. Those that were weak even before the crisis may never reopen at all. But the overall system will rebound and regroup.
In early April 2020, few people believed that the lockdowns and related restrictions would last a year rather than weeks or months. I recall watching small businesses close, following the talk on Facebook and elsewhere, and the sentiment seemed to be that things would be back to normal by the summer, at the latest. The first stimulus bill had passed and the hope was that this temporary palliative would be able to staunch the bleeding for the time required to “stop the spread”. But the situation did not abate and the country endured month after month of constrained economic activity. The federal government responded with two additional stimulus bills funded by issuing trillions of dollars of new debt.
At the start of the pandemic, financial markets clearly did not anticipate that the federal government would step in as vigorously. Yet here we are in early April 2021 with stock markets at record highs. Who would have believed that in March 2020 when I was writing about how to cope with the massive market meltdown that was underway?
I was wrong about many aspects of the pandemic, but I was correct to not panic when stocks crashed. I don’t know how other investors handled that crash mentally, but I anchored on the actual businesses that are represented by the ticker symbols I own. For example, I took the time to examine Berkshire Hathaway as a business and tried to understand how the shutdowns would affect the company’s subsidiaries. I did the same for other companies that I own.
Make no mistake about it, I understood that, with few exceptions, all owners of American businesses were poorer due to the pandemic. It would be delusional to think that my portfolio had not declined in intrinsic value terms. The question was whether the market was appraising the situation accurately or acting with emotion. As usual, stock market participants reacted more emotionally than an owner of a privately held business that has no market quote. In panics, quotes are an emotional burden for those who do not understand the intrinsic value of what they own.
Conviction has to be built up during ordinary times if you want to fortify yourself mentally for the tough times. A market crash is not the time to begin to study the intrinsic value of your holdings. I made one major portfolio change during the pandemic, not because the price of the stock in question had declined but because my conviction in the business declined. Of course, I had studied the company in depth prior to owning it. But in retrospect, I did not have enough conviction to own that business at all. This lack of conviction did not manifest until tested by a crisis.
So where do we go from here? If we assume that all adults in the United States who want a vaccine can be fully vaccinated by the summer, will things go back to normal at that time?
I suspect that we will have several more months of restrictions before we are truly back to normal, but the reality is that no one can really predict the trajectory of the rest of the year. I’m not going to post any polls on vaccine acceptance because they seem to be changing all the time, but it is quite clear that a significant percentage of Americans view the vaccines with suspicion and may not be willing to get the shots. In May 2020, I wrote about the politicization of masks and the discourse regarding vaccines seems to be developing in the same way. Talk of “vaccine passports” and coercive measures to obtain compliance are likely to backfire.
Society has an interest in maximizing the percentage of the population accepting the vaccines because we want to reach “herd immunity” — the point at which the COVID virus will not find enough susceptible people to remain a threat to the population at large. Convincing as many people as possible to accept vaccinations will reduce the time required to reach herd immunity. However, in a free society, government should not compel people to accept vaccination through coercive methods.
A key question remains whether unvaccinated people represent a direct threat to vaccinated people. The CDC’s latest recommendations indicate that vaccinated people should continue taking precautions but can gather in small groups with other vaccinated people as well as with unvaccinated people who are not at risk of severe illness from COVID:
You can gather indoors with fully vaccinated people without wearing a mask or staying 6 feet apart. You can gather indoors with unvaccinated people of any age from one other household (for example, visiting with relatives who all live together) without masks or staying 6 feet apart, unless any of those people or anyone they live with has an increased risk for severe illness from COVID-19.
Will unvaccinated people pose any risk to vaccinated people? If not, should vaccine passports be required? Should masks be required after everyone who wants to be vaccinated has been able to get the vaccine?
These are the key questions that should guide policy in the months ahead. If the vaccine is available to everyone who wants it, we should be in a position to return to normal. It is reasonable for people to expect society to take precautions to protect them if there is no vaccine available, but not reasonable to expect continued restrictions if a vaccine is an option.
As I look back over the past year, I am amazed by the advances in science that led to vaccine development in record time. But I am dismayed by the politicization of the pandemic and the great divide between Americans. When political party affiliation is so tightly correlated with issues such as masks and vaccines, something has gone terribly wrong in our national discourse.
Politicians need to focus on getting society back to normal as soon as possible and resist the temptation to not let a crisis “go to waste”. The pandemic has cast a spotlight on many longstanding problems in America, but longstanding problems deserve reasoned debate and deliberation outside the context of an emergency.
It’s hard to be optimistic about politics, but right now it is hard to be a total pessimist on a nice spring day as I sit inside a coffee shop for the first time in thirteen months.