Comeback Crusader

By Daniel Kadlec

During investment banker Herb Allen's annual gathering for media moguls in Sun Valley, Idaho, last July--when locals were paid $20 an hour just to be available for baby sitting--Coca-Cola CEO Douglas Daft at one point turned for advice to investment legend Warren Buffett, who sits on Coke's board. What would happen, Daft wondered, if Coke suddenly stopped giving Wall Street quarterly earnings estimates? Buffett answered that Coke's shares would be more volatile and some investors would sell but that these were prices worth paying. Daft would forever "be free from that fiction," Buffett said, according to someone close to both men, and better able to focus on long-term goals. That did it for Daft. This past December, Coke made it official: no more advance earnings estimates. A month later, McDonald's followed suit, and a few days after that, AT&T made it a trend.

People are listening to the Sage of Omaha again. The man whom many consider to be the greatest investor of all time--Buffett once raised $210,000 at a charity auction for his 20-year-old wallet, with a stock tip inside--fell into disfavor in the late '90s. He was criticized for avoiding tech shares when they were soaring, and for clinging to big positions in stocks like Coke and Gillette after they had peaked and were driving down the market value of his company, Berkshire Hathaway.

But now Buffett, 72, is on a comeback. By avoiding fads and sticking to what he knows, the Nebraska native is finding ways to make money in a bear market that has ravaged many fortunes. His long-held stake in the Washington Post Co. has sparkled during the market downturn, and over the 30 years that Buffett has owned the stock he has turned an $11 million investment into $1.2 billion. More recently, he has been snapping up steady cash-producing private businesses like kitchen retailer The Pampered Chef.

Beyond adding to a personal wealth estimated at $30.5 billion--second only to Bill Gates'--Buffett is a man on a mission. He has been agitating for publicly traded companies to clean up their management, and this Saturday he will take that crusade up several notches in his eagerly anticipated annual letter to shareholders. Long a must-read among investors and executives, Buffett's folksy, insightful yearly musings on business and finance carry added credibility today, thanks to his early warnings about the dangers of overpriced stocks, gimmicky accounting and other new-era traps.

Much of Buffett's letter, to be released on his firm's website (berkshirehathaway. com), will expound on corporate reforms needed in the wake of scandals at the likes of Enron, Tyco and WorldCom. He will probably urge that boards hire independent directors who will ask tough questions and curb excessive executive pay. He will call on CEOs to focus more on the long term and provide investors with clear, complete and timely information.

Buffett will touch on what has long made his letter popular: how he is deploying Berkshire's $75 billion investment portfolio. He's less interested than he used to be in common stocks; he apparently finds their prices too high. Instead he's dabbling in junk bonds and acquiring private assets that range from apparel makers to gas pipelines. Buffett's book is no longer the model it once was: the investments he favors these days--specially constructed bonds and convertible preferred stock and private companies--aren't available to most investors. But they offer a clue as to how he views the investment landscape.

Most investors will appreciate Buffett's generalship of the battle for stronger measures to restore corner-office accountability and stock-market confidence. His penchant for keeping things simple is legendary, and the need for reform remains acute. Just last week two former executives at Kmart were charged with manipulating earnings (their lawyer says the prosecution is "wrong and unjust"), while Dutch retailer Ahold owned up to faulty bookkeeping at a U.S. subsidiary and restated the past two years' earnings, slashing them $500 million.

The last time Buffett took on "corporate governance" was in his 1993 report, in which he focused on the need for companies to hire outside directors for their business savvy, not "because they are prominent or add diversity," and asserted that directors must have the spine to root out unethical behavior and take their concerns directly to shareholders--or resign, if entrenched directors balk.

His biggest impact, though, has come fairly recently. A good example is Wall Street earnings guidance, the issue on which Coke just got real. Some 95% of public companies still provide guidance. But in part because of Buffett's stand, the trickle of dissenters is growing. A cynic might note that this trickle consists mainly of companies that have struggled in recent years. Mickey D's, Ma Bell and Coke may simply be taking Mother's advice: If you can't say something nice, say nothing at all. But others are sure to fall in line. Buffett has long asserted that spoon-feeding analysts quarterly guidance puts undue focus on short-term results and leads companies to avoid prudent risks that probably would pay off over time.

Stock options are another Buffett hot button. While that Sun Valley conference was under way last summer, Coke's board voted to begin treating the options it grants to executives and other employees as an expense that reduces reported earnings--which is how Buffett and increasingly others say they ought to be accounted for. Coke was just the third large company to make the change, preceded years earlier by Boeing and Winn-Dixie Stores. Since Coke made the move, about 150 others have piled on. The Financial Accounting Standards Board is widely expected to begin requiring such treatment of stock options within a year or two. Buffett "is so sound and so right about so many issues that eventually people catch up to what he's been saying," says Barry Diller, CEO of USA Interactive and a fellow director with Buffett on the boards of both Coke and Washington Post. As in his investing, Buffett sticks to his principles even during periods when they're unpopular, and expects to be proved correct in the long run. Then others follow.

Buffett is in fashion today--but that wasn't the case just a few years ago. In December 1999--about the same time Buffett presciently warned in FORTUNE that stock-market returns were on the verge of a dramatic and long-lasting slowdown--a writer at Barron's stated what many were thinking: "Warren Buffett may be losing his magic touch." As the Internet craze mounted through the '90s, Buffett had become a renowned technophobe. But consider this feat: during the past three grueling bear-market years, Berkshire stock has soared nearly 40%. Those remarkable returns came during a period when hundreds of companies went bankrupt and millions of investors, including honchos like Bernie Ebbers at WorldCom, were wiped out.

Buffett's investing savvy during those hard years has made his giant insurance businesses, Geico and General Re, the envy of their industry. While other insurers have lost billions investing the premium payments they receive, Berkshire's insurance units have benefited from Buffett's deft hand. For example, he got General Re to dump all its stocks before Berkshire bought the company in December 1998, ahead of the market's collapse. Now Geico and General Re have deep enough pockets to ride out the insurance industry's famously volatile cycles and capture more business in the long term as struggling firms fall away. "Over the past 18 months he's put his insurance business in a great position," says Thomas Russo, a money manager, long-time Buffett watcher and Berkshire shareholder at Gardner Russo & Gardner. "He alone has the capital, and I don't think Berkshire's stock price reflects that yet."

Buffett's influence over the influential is what gives his views so much currency. His position on an issue inspires strategy in places where he holds no board seat or investment stake. Look again at the earnings-guidance issue. Daft sought out Buffett. McDonald's made its announcement after CEO Jim Cantalupo had turned to one of his advisers--Don Keough, a former long-time Coke executive and FOB (Friend of Buffett). Keough had adopted Buffett's view. On the question of expensing stock options, Cathleen Black, president of Hearst Magazines, who sits with Buffett on the Coke board, has broached the idea at IBM, another firm at which she serves as a director. Diller says he intends to stop granting stock options altogether and look for another incentive plan. Doris Christopher, who sold The Pampered Chef to Berkshire, says she has been captivated by Buffett's willingness to lose money in the short run to preserve a firm's reputation--like, say, eating the cost of shipping a product express after a customer has had it on back order. She advocates that approach at three nonprofit groups at which she is on the board.

Buffett declined to be interviewed for this story lest, he says, he be besieged by follow-up media requests. No time for all that while he's hard at work saving American business from itself. Yet he doesn't view himself as any sort of caped crusader. "I've never seen him try to push an agenda," says Black. Buffett's efforts tend to be understated. But now that he's becoming more vocal about his beliefs, he can expect more opposition. In an op-ed article in the Wall Street Journal, Harvey Golub, a director at Dow Jones and former CEO of American Express, has already argued that stock options should not be regarded as an expense on a company's books. Intel chairman Andy Grove spoke for much of the tech world last September when he told the Conference Board that "stock options are a red herring. The real issue is excessive compensation for executives. [Expensing options] will not be an effective deterrent to abuse." Meanwhile, many investors who can't afford to hold a stock forever value quarterly guidance because it helps prevent nasty profits surprises that can whipsaw a stock's price.

Somewhat lost on Buffett's new stage of influence is the plight of the typical investor, who just wants to learn a thing or two about the market. Yes, Buffett still says plenty about how to find value, and his archive of letters on the Net amounts to a timeless library on the issue. Investors can piggyback Buffett by investing in Berkshire--if, that is, they can muster the $61,700 it takes to buy a single "A" share. Even the "Baby Berks," or "B" shares, which carry reduced voting rights and grant no say on the company's charitable giving, cost $2,065 apiece. Mimicking Buffett was much easier when he was buying common stocks like Coke, American Express, Gillette, Wells Fargo and Washington Post--his largest stock holdings today.

Buffett plainly warns against do-it-yourselfers' venturing, as he has, into concentrated positions in the junk bonds of individual companies. "These are not, we should emphasize, suitable investments for the general public," he wrote in last year's annual letter, in which he copped to having bought 13% of the debt of bankruptcy-bound financial-services firm Finova. But investors can approximate this kind of investment by buying a diversified junk-bond mutual fund.

So what's Buffett doing right now? He still picks up small stakes in the occasional common stock, like Best Buy and PNC last year. "I'd be surprised if he hasn't got more exposure to junk bonds," says Russo. "And what this tells us is, now is a good time to buy distressed assets." That message also seems clear in Buffett's recent investments in fiber-optic company Level 3 and energy firm Williams Cos., both strapped financially. These are public companies, but Buffett did not buy their common stocks. He holds non--publicly traded securities in each--convertible bonds in Level 3 and convertible preferred stock in Williams. Buffett also cherry-picked a prize gas pipeline from Williams and another from distressed energy company Dynegy. These investments do not necessarily point to broad value in any particular industry. Level 3, for example, is an unusual play on the world's vastly overbuilt fiber-optic networks. Buffett believes Level 3 will be one of the few left standing in this area. But he's collecting 9% annual interest while he waits. The common stock is far more risky.

Buffett's bigger plays have been in buying whole businesses, which suggests that he sees private-asset values as a bargain while the public markets have not yet become cheap. But take heart. Maybe after he cleans up how America's largest companies are run he will want to buy their common stocks again. --With reporting by Julie Rawe/New York

With reporting by Julie Rawe/New York