We have maintained a roughly 10% commitment to Berkshire on behalf of the Oak Value Fund since the late 1998 acquisition by Berkshire of General Re. We have done so at prices ranging from the $70,000 price at the Gen Re deal's closing to Berkshire's nadir in the low $40,000s in the cold winter of 2000. We have done so because throughout that time, from the low price to the high, the shares have represented compelling value to us. We still can't predict the timing for value recognition in the stock market, but our opinion remains that Berkshire's business is extremely valuable vis-à-vis what is reflected in its recent share price.

We believe that if you owned the entire company outright, there is no way you would rationally part with the entire thing at a price equivalent to that which the market is currently valuing individual pieces. We plan to own Berkshire for as long as its value makes sense. Irrespective of considerations of valuation, just looking at Berkshire's competitive strengths in the abstract make it a fascinating case study, one worthy of enshrinement in the pantheon of American business establishments.

Summary

We came away from the latest annual meeting as excited as we have been in some time about Berkshire's business. In brief, Berkshire has created: 

1. an immense capacity to generate low cost funds, 
2. that can be invested at high rates of return, 
3. on a vast (billions of dollars) scale.

Our research effort generally falls into two broad categories: 1) looking for competitive advantages and 2) attempting to arrive at reasonable values for companies where we can find those advantages. Our ongoing research, including the most recent visit to Omaha, reinforced our opinion that Berkshire's operation includes as unique a collection of competitive advantages as we have ever seen; we believe they should inure to the benefit of Berkshire shareholders for decades to come. Moreover, in our view those advantages are structurally inherent in the organization and exist irrespective of who occupies the chairman's position, i.e., they are NOT solely dependent on Mr. Buffett or his partner, "I'm no slouch myself - but also no spring chicken," Charlie Munger. We think this helps to mitigate perhaps the largest downside risk for Berkshire - the perception of its dependence on Warren Buffett.

From the perspective of evaluating what Berkshire's competitive advantages are worth, we use, among other measures, realistic to conservative assumptions about the growth rate of insurance float, its cost, and the returns Berkshire can expect to earn on its investments. That valuation methodology has helped us to gain comfort that a large margin of safety currently exists for Berkshire's shareholders. Additionally, in our view the occurrence of optimistic, but not unrealistic, future conditions could lead to the creation of even more value. For example, Charlie Munger indicated at the Berkshire meeting - and reiterated (see quote below) the same the next week at the (80% Berkshire-owned) Wesco annual meeting - a much higher pre-tax return assumption for Berkshire's investments than we currently allow for in valuing Berkshire.

Of course downside risk exists at Berkshire, both for the stock and the business. Risks include insurance and reinsurance pricing, the lack of predictability of the macro investing environment into which Berkshire will be reinvesting its mammoth cash flows, ability to find attractive investment opportunities for all that cash, execution risk on those investments, and of course the nearly inevitable short term psychological blow and we suspect attendant stock price weakness that would accompany Mr. Buffett's death or incapacity. [We note that we do not account for any kind of "Buffett premium" in our valuation work; obviously every year that passes and every acquisition that occurs with access to Mr. Buffett's formidable investment prowess represents continued opportunity for him to add value to Berkshire's business.] Based on current assumptions and conditions, we would view stock price weakness related to Mr. Buffett's death or illness as more related to short term or other technical factors rather than as a reflection of business fundamentals. But we recognize that our opinion would be in the minority on that issue and would be little consolation for those who might need to sell into potential price weakness. Therefore, in our view, Berkshire remains an investment for long time horizon (greater than five years) investors.

What Did We Hear To Our Liking?

We took away much to like about Berkshire's prospects from the late April gathering in Omaha and our subsequent deliberations on the information we gathered. Our ongoing analysis and positive comments over the recent Berkshire shareholder weekend as detailed herein indicate to us that business momentum is building at Berkshire and that its competitive advantages are as fearsome as ever. We noted three main areas gleaned from the weekend's events that we find are most important to and illustrative of Berkshire's business.

Business Strategy - Charlie Munger provided a succinct summary investment case for Berkshire: a business that generates loads of investable cash (via insurance float) at a current 3% cost (absent a mega catastrophe payout) and reinvests those funds at 13% returns (a number Mr. Buffett notably didn't quarrel with) is "a pretty good thing." There is of course more to think about in evaluating Berkshire, but this very high level viewpoint is a good start. There is much that we include in our evaluation of any company - competitive positioning, business strategy, management quality - and high scores in these areas support our confidence in Berkshire's ability to actually be able to execute such a simple sounding, incredibly powerful (and difficult to achieve) objective. We are already comfortable with a higher valuation for Berkshire than recent share prices using much more conservative assumptions for returns than13%. If Mr. Munger's number is closer to Berkshire's true investment earnings than our lower assumption, we have an increased margin of safety in our appraisal.

Insurance Pricing Discipline - Berkshire's value will be largely determined by the effectiveness of their insurance operation (it is the source of funding to feed the investing machine). As Mr. Buffett has often noted, size and growth of float are important, but its cost is critical. Much of Berkshire's ability to generate float is based on reinsurance, generated largely through Gen Re and National Indemnity.

It has become clear through both improvement of visible financial metrics and from management comments that reinsurance pricing discipline is absolutely religious fervor at Berkshire. They will not write insurance business that does not represent compelling economic sense (though Mr. Buffett will continue his hallmark of writing policies that may have negative short term accounting impact as a trade off for favorable long term financial benefit). Berkshire is indicating to reinsurance buyers its disciplined willingness to write fewer contracts and walk away from business if it simply doesn't make fundamental financial sense. We are quite confident that the senior management compensation systems at Gen Re are aligned with achieving this simple but powerful goal.

We plan to add some additional thoughts in a future Berkshire communication dedicated specifically to insurance, but in general, we like what we've seen and heard about in this important area for Berkshire. Prices are firming in reinsurance in general, an overall market phenomenon over which Berkshire has limited influence. But clearly Gen Re will not participate in irrational pricing in ways that hurt 1999s underwriting results. The vast distribution system of Gen Re (see Mr. Munger's comments below) is a great competitive advantage, but it is only useful to Berkshire if policies are priced profitably, i.e, in a way that generates low cost funds via float. Mr. Buffett has no use for badly priced insurance, and much better uses of capital than chasing unprofitable business, and it appears that message will be reflected in improved results when Berkshire reports its underwriting performance for the full year 2001.

Cash Flow Production - At the end of the day, investing is about laying out cash today for the promise of greater cash tomorrow. Mr. Buffett indicated that Berkshire would generate roughly $5 billion of free cash flow after all capital expenditures and taxes in 2001, a number that we think is almost certain to grow over time. A recent price of $67,000 for Class A shares is just over 20 times this '01 cash flow. Using conservative growth of 7% equates to paying less than 15 times for 2006 cash flow. For a high quality asset such as Berkshire, we'd call that a bargain. And in no other case we can think of can we have such a high level of confidence that such sizable cash flows will be put to good use, i.e., retained for reinvestment at high rates of return. We have noted in the past a high propensity for stock prices to respond over time to the visibility of strong and growing reported cash flow.

Acquisitions and Investment Activity

Mr. Buffett continued running his personal commercial that Berkshire will be a buyer for business owners who are interested in Berkshire's culture, even widening the circle a bit to include possibly European acquisitions, "if the phone rings." He indicated that shareholders could expect 2-3 outright purchases of whole business on average per year, or 40 or so in roughly the next decade and a half (importantly, Mr. Buffett indicated he planned no meaningful increase in shares outstanding to do so). In several instances during the annual meeting weekend, Mr. Buffett made clear that his criteria for evaluating business opportunities, and skill in doing so, are as sharp as ever. To state what we believe is obvious, the longer he's around to engage in this activity, the better for Berkshire shareholders.

Mr. Buffett also reiterated his preference for buying businesses outright versus stock market purchases. We'd go so far as to say that absent any significant break in the equity market and exclusive of small (anything less than $1 billion) purchases (more likely than not initiated by Lou Simpson at GEICO), Berkshire is essentially out of the marketable securities investing business in any way that is meaningful to its future financial results. Making intelligent choices about purchasing whole businesses is where Berkshire's capital will primarily be spent, and acumen in that endeavor will be the driver of results for Berkshire going forward.

In several instances, Mr. Buffett made what we consider to be uncharacteristically (though still well within his gift for understatement) bullish comments about several of Berkshire's prior acquisitions, even managing to make shine the attractive economics and protected competitive position of something as seemingly mundane as the brick business. We view this specific example of Acme Brick as significant for two reasons:

1. It points to the power of the Berkshire model, which can be patient with cyclical but high returning businesses because it is so well capitalized and cares not at all for smoothness of earnings. Berkshire's low cost of funds means businesses may in some instances have more value inside of Berkshire than outside.

2. It indicates that the economics of even pedestrian sounding businesses are solid and subject to the investment model of protected competitive advantage that Mr. Buffett loves so well. He isn't lowering the bar in favor of unattractive but steady returns, but rather is opportunistically selecting niche pockets of attractive economics wherever they may exist, as long as they are of size. Mr. Buffett indicated that the building-products related investment "motif" that was supposed in the wake of acquisitions of Acme Brick, Johns Mansville, and Shaw Carpet, was coincidental rather than strategic.

In a similar positive note, Mr. Buffett was fairly gushing (in a Midwestern way, with quiet dignity and grace, of course) about the opportunity for the Executive Jet fractional aircraft leasing business, where the only limit he sees is the capacity to get new planes built (Berkshire is already buying 7% of worldwide capacity). He indicated he didn't think that business would be mature "for decades," an important statement given its high 40+% revenue growth rate for two years running and the capital-intensive nature of the business.

Places to put capital to work profitably are exactly what the Berkshire machine feeds on, so its shareholders should be delighted by Mr. Buffett's optimism for this capital-hungry business.  Additionally, he was conspicuously un-worried about announced competition from traditional airlines, detailing on the fly (in a way that is fascinating to watch for its purity and clarity of thought) several important distinctions between traditional passenger air carriers and Executive Jet's business, including labor costs, service differences, customer perception, and safety. Not a man given to overstatement, he went so far as to say that "No one is going to catch us in fractional ownership," then quipped: "What will their sales pitch be? Give up your first class seat and start flying right?"

Berkshire as "The Perfect Storm" of Investments

In his book The Perfect Storm, Sebastian Junger described a unique set of weather conditions that combined to create an unusual tempest that doomed the fishing vessel the Andrea Gail. Looking back over the Berkshire shareholder weekend and filtered through our prism of long study of the company, it occurred to us that Berkshire could be viewed in an analogous fashion. Various circumstances have come together at this particular point in the company's history to create a condition wherein the business model resembles a "perfect storm" of investment behavior, though in a positive sense of advantageous conditions combining for cash creative purposes rather than destructive ones. Though the analogy of a perfect storm might appear a bit ironic for an insurer that is meaningfully exposed to the whims of weather, it seems clear to us that Berkshire's overall business executes a virtuous cycle of cash production and reinvestment opportunities that support each other, in a fashion that may be viewed in some ways "self organizing," a virtual perpetual motion machine of investing.

A (Brief) History

Much of Berkshire's strength today can be encapsulated by dual traits: size and stability. Briefly, the shrewd pricing of risk, both investment and insurance, over a long time has allowed the company to amass a prodigious pool of capital, far beyond that which is required as reserves for insurance payouts. The financial strength embodied in that capital base, coupled with Mr. Buffett's sterling reputation for both intellectual and personal integrity, provides a panoply of investment opportunities and a decision making flexibility that is in many cases literally available to no other investor of size. How do you get that kind of advantage? The same way you get to Carnegie Hall: practice.

Liabilities & Stuff That Looks Like Them (But Aren't)

How did Berkshire come to its current esteemed position? In short, it has for decades executed an operation that has generated cheap (for many years, free) investment capital and substantial operating cash flow, and has always funneled that growing capital to good if not great uses. We think today's enviable position is the culmination of a well-executed strategic direction by Berkshire's management and its cultivation of the rewards of its own unique culture that have accrued over many decades. Messrs. Buffett and Munger practiced an intelligent, conservative business plan, and were fortunate enough to have been served up some amazing opportunities over the years - opportunities for which their practice, patience and discipline had well prepared them. But it's the structure and the attitude that got them where they are today.

Berkshire has always been more conservative - in insurance reserves, in investment behavior, in financing - than was necessary from a regulatory or business policy perspective, but those characteristics have served to avoid the serious mishaps - to which the insurance business is especially susceptible - that can destroy capital and from which rebuilding is doubly hard. Berkshire has consistently made money selling insurance and reinsurance. They did so on an incrementally increasing scale, and those insurance profits (and importantly the associated and growing float) financed highly profitable investment activities. We note that doing so is no easy task, particularly over many years and market environments and with ever-larger sums. That it is not easy becomes obvious when one looks at how badly some competitors mismanaged the same responsibility. Just ask Reliance shareholders.

As an illustration, consider that hedge funds do essentially the same thing that Berkshire does, except they get the money either from investors, who implicitly have high return requirements on their equity investment (in the form of limited partnership interests). Hedge funds also add capital via leverage by borrowing, an activity that adds risk, (sometimes asymmetrically so, as in the case of Long Term Capital Management) and is also not free and certainly higher cost than 3% for anyone who isn't the U. S. Government. Another large public company might also raise capital to invest in high return opportunities, though the great propensity among them has historically been to use their own stock for acquisitions, a funding method that often proves dilutive - the cost is borne by existing shareholders - and one that Mr. Buffett has indicated he specifically attempts to limit to instances where Berkshire gets as much or more than it gives by issuing stock.

In thinking about it, it occurred to us that the only other collective group who we know of that raised cheaper funds than Berkshire was the various and sundry dot-com companies during the late 90s frenzy in which essentially free capital was sloshing around everywhere for the taking. But of course that was diffused widely over a number of business "opportunities," many of which seem to have put the capital to rather poor use. While the, forgive us, post-mortem on that once-in-a-lifetime event is still being written, we point out that Berkshire Hathaway has gotten funds in none of these traditionally costly methods. (They have issued some new shares along the way for acquisitions, but the dilution has not been meaningful.)

Instead, Berkshire's capital has been created, over decades, almost as if it was conjured from thin air, by a business model that, if run correctly, seems destined to continue to do so. The value of free capital, invested profitably, is hard to overstate. (If you don't believe it, think about it this way: if your bank credit card would advance you money at 3% if you promised to keep those funds in a bank account earning 13%, how quickly and for how much would you sign up?) Berkshire continues to generate gobs of low cost money to invest. While not as cheap as when it was free, it's still a good deal, if Mr. Munger is even half right on his math. And while Berkshire takes on risk in a way that our simple example above does not, its management has a long and enviable track record of managing those risks intelligently, to the benefit of many of its shareholders over time. In fact, the only real challenge, which Mr. Buffett has acknowledged for anyone who will listen, is finding, and executing, good investment opportunity "homes" for all those dollars being created.

Investments, Anyone?

In the wrong hands, such a huge investment pool often spells trouble in terms of bad acquisitions, ill conceived business expansion into less profitable business, and other wealth destroying activities (Peter Lynch, of Fidelity Investments aptly labeled such spending by a typical company as di-worse-ification). But Berkshire management's focus, while eclectic in implementation, has been singular in focus on generating non-dilutive growth in aggregate. This has allowed Berkshire to periodically ratchet up and expand its massive capital, adding even more heft to its already solid infrastructure.

Along the way, big payoffs from large (and dirt cheap) investments in Washington Post, Coke, Gillette (and others, including half of GEICO, purchased practically out of receivership in 1978) early in its history were combined with cash flows from operating businesses such as candy, furniture, and even shoes and provided further capital, and financed the company's continued forays into insurance. The other half of GEICO was acquired in 1993 and then General Re in 1998. The Gen Re transaction in our view forever moved Berkshire into the realm of operating business, albeit in a highly decentralized structure. More importantly the Gen Re transaction was both indicative of, and accretive to, the symbiotic relationship between the generating funds "input" side of Berkshire - primarily insurance - and the opportunistic deployment of those funds on the investment "output" side - traditionally marketable securities investments but more recently operating businesses, eight of them, to the tune of roughly $8 billion in 2000.

Here, too, size matters. Berkshire's ability to commit large amounts of capital, and quickly, is a leg up on competition in a way that is impossible to quantify but nonetheless very real. Johns-Manville became available when a large buyout firm couldn't get financing. The deal collapsed on a Friday. That Monday morning Berkshire agreed to terms - at a price considerably lower than what had been on the table - which the sellers apparently gladly took since they knew, as Mr. Buffett puts it, "that the check would clear." Difficult financing environments, should the future offer any, will only serve to increase the attractiveness of Berkshire as a stalwart partner that can get the deal done. Quick: name another large investment pool, hedge fund, or public entity that committed $8 billion of capital (by itself; syndications or large single merger transactions don't count) in a twelve month period. If you come up with one, let us know.

So, What About Mr. Buffett?

The ability to be patient and wait for exactly the right investment opportunities to come along, and to vet them with extreme prejudice, is admittedly rare and highly refined between Messrs. Buffett and Munger. We do not diminish them or their achievements is any way in our view to point out that this is not, however, a skill set reserved only to them. They have done it better than most, but the structure that exists in Berkshire whereby there is an immense capacity (via huge cash production and solid capitalization), but no over-riding need to make acquisitions will survive both men. Part of Berkshire's beauty going forward in our view is that even without its current chairman and vice chairman, its structural advantages should allow even a much less gifted investment successor the opportunity to do well given the financial flexibility and other advantages they will someday inherit.

As one example, part of the intangible attraction of Berkshire as a buyer of businesses outright is its stated desire to be a permanent owner. Many enterprises, built by a founding family over generations, desire protection from the split-up that may occur during an auction or sale to financially oriented buyers. While he is alive this behavior comes with Mr. Buffett's not-to-be-understated personal commitment, though there is every reason to believe that the advantage this conduct creates is a real one, not simply a folksy slogan. As such it could be continued by any successor, unearthing investment purchase opportunities that might not otherwise materialize and are perhaps unavailable elsewhere.

We look forward to Mr. Buffett's longevity as much as the next Berkshire shareholder, we just don't rely solely on it to make an investment case. [Perhaps Berkshire shareholders can take heart from his quip at the annual meeting that when Mr. Buffett heard that the longevity of one's parents correlated highly with one's own, "I bought my 80-year-old mom an exercise bike."] In all seriousness, our view is that Mr. Buffett has been as forward thinking about allowing Berkshire to succeed in his absence as he has in crafting the advantages we've highlighted above. After Mr. Buffett, the top job will be split between investments and other activities.

The person in charge of investments after Mr. Buffett will have less to worry about and can focus solely on investment activity. This will be an important job, and they aren't going to run a Ben-and-Jerry's style essay contest for the post ("Why I Should Invest Berkshire's $Billions in 250 Words or Less"). We are quite confident that anyone tapped for the investment role will have the requisite skills to evaluate and select investments successfully. In our opinion, even if they (almost surely) do it less well than has been the case up to now, the compelling economics of Berkshire's business as described herein are such that they can accommodate much less than perfection and still allow value to accrue over time. We consider that opinion to be a credit to Mr. Buffett, not a slight.

A Word About Stock Price

Several, actually. Last year at this time, Berkshire's stock price weakness was foremost on many peoples' minds. 2000's price recovery (see chart on page 1) somewhat quelled investor unrest, but has left many wondering if there is any remaining upside in a stock that was up 26% in 2000 and over 60% in ten months from its February price bottom (from roughly $44,000 per A share to $71,000 per last December). We think the opportunity for misunderstanding is compounded by the high dollar per share price of even Berkshire's B shares. Some people simply maintain a visceral hurdle in trying to grasp the value in something attached to such a high absolute price tag.

We can also point to some level of confusion apparently created by Berkshire's dual share class structure. The dual share structure and the high share price based on not splitting the stock are both ideas with a firm foundation in straightforward arithmetic. For example, if Microsoft had not chosen in the past to split its stock eight times since 1986 - an "event" that is the economic equivalent of choosing the same pizza delivered in four slices or eight - its recent $69 stock price would have been roughly $9,957. But considering Berkshire as an investment takes some thinking, an activity that we find many people (even some investment professionals, most of whom are people) choose to avoid.

We are of the opinion that investors should not be misled into underestimating future prospects of any investment because of its high absolute price or its strong performance from a previously irrational low. Just as we have cautioned against simplistically thinking that stocks with prices that have come way down off their prior highs are bargains, so we remind investors that even a significant run up in price can leave a high quality, growing business at a discount to its long-term intrinsic value.

Conclusion

In short, we view Berkshire Hathaway as a phenomenon that produces low-cost cash, and lots of it, to be invested at high rates of return for long periods of time. The difference we see from the weather occurrence for which this piece is named is that those conditions came together in rare happenstance and wrought destruction, whereas we believe that similarly unique conditions have been purposely put in place by Mr. Buffett at Berkshire, toward ends that will wreak havoc only on its competitors - and ultimately we think to Berkshire shareholders' delight. That is Berkshire's "perfect storm." Picture a hurricane (we're partial to hurricanes here in North Carolina, including the professional hockey team), two sides of swirling winds moving around a center. Cheap insurance funds fueling one side, investment opportunities on the other. All of it on a grand (billions of dollars) scale. And, the world's most talented investor (arguably, we suppose, though we're not taking the other side of that argument) sitting comfortably in the calm eye of that storm.

Quotes

Float, as described by Mr. Buffett: "… float is money we hold but don't own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an "underwriting loss," which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money."

Mr. Munger on investment returns (at the Wesco shareholders meeting): "The businesses that Berkshire has acquired will return 13% pre-tax on what we paid for them, maybe more. With a cost of capital of 3% -- generated via other peoples' money in the form of float -- that's a hell of a business. Berkshire is not as good as it was in terms of percentage compounding [going forward], but it's still a hell of a business."

Mr. Munger on General Re: "It's one of the best reinsurance operations in the world. It has a strong distribution network and culture -- a culture of intelligence and discipline. It sees reinsurance opportunities that Berkshire doesn't. They have a huge advantage being there for so long. Gen Re's competitive advantage is that it's smarter and sees more opportunities." "I don't think its returns in the future will be as good, but a 2-3%/year advantage is a lot over time."

Mr. Munger on Reinsurance Pricing: "Reinsurance is interesting. A lot of people get into the business because of the money. Then, reinsurance brokers -- who are very well paid and can make dumb ideas look good -- pitch them business. Boy, is this dangerous! Very smart people can make very dumb investments. Even GEICO and Gen Re get caught sometimes."

Mr. Buffett on the Same Topic: "There is an unlimited market for dumb insurance policies."

Important Information

Authorized for distribution only if preceded or accompanied by a prospectus. We have presented this collection of information, opinions, interpretation, and conclusions gathered from our recent visit to the Berkshire Hathaway, Inc. ("Berkshire," or "Berkshire Hathaway") annual meeting in Omaha, Nebraska because we thought it would be useful and interesting to share some thoughts and ideas associated with this visit with, shareholders, prospective shareholders and other parties in the hope of communicating a greater understanding of the rational, research-based investing that we practice. While much of the discussion associated with the Berkshire meeting will be general in nature, some of it will be specific to Berkshire as an investment.

Where shown or quoted, recent company returns are stock price changes only, and reflect neither dividends nor any fees associated with an investment in the Oak Value Fund (the "Fund"). This discussion seeks to describe our current views of the market and to highlight selected activity in the Fund. Information concerning the performance of the Fund and our recommendations over the last year is available on request. Past performance is no indication of future performance.  You should not assume that future recommendations will be as profitable or will equal the performance of past recommendations. The discussion of specific securities is intended to help shareholders understand the Fund's investment style, and should not be regarded as a recommendation of any security.

Statements referring to future actions or events, such as the future financial performance or ongoing business strategies of the companies in which the Fund invests, are based on the current expectations and projections about future events provided by various sources, including company management. These statements are not guarantees of future performance, and actual events may differ materially from those discussed herein. References to securities purchased or held are only as of the date of this commentary. Although we focus on long-term investments, holdings are subject to change.

This commentary may include statistical and other factual information obtained from third-party sources. We believe those sources to be accurate and reliable; however, we are not responsible for errors by them on which we reasonably rely. In addition, our commentary is influenced by our analysis of information from a wide variety of sources and may contain syntheses, synopses, or excerpts of ideas from written or oral viewpoints provided to us by investment, industry, press and other public sources about various economic, political, central bank, and other suspected influences on investment markets.

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