Sokol’s Lubrizol Trades Sure Look Illegal, And Buffett Needs To Change Berkshire Hathaway’s Internal Trading Policies Immediately

I would not go as far as some people have and suggest that Warren Buffett’s Berkshire Hathaway has lost its way, but there have certainly been some developments in recent months that should give people pause. First, a young, unknown investor is named as one of Buffett’s likely successors, and now we learn that one of the firm’s most highly regarded internal candidates has resigned from the company over what appears to possibly be insider trading accusations.

After looking at the timeline of events surrounding Berkshire’s discussion to acquire Lubrizol (announced March 14th) and Sokol’s trading in the stock while he was serving as the point person for those talks, it is hard to argue that Sokol’s trades are not illegal. Not only that, it appears that Berkshire Hathaway has no internal controls regarding how managers trade stocks they may have inside information about, which is also troubling. Although it is reasonable to assume that high level people at the company should know what would fall under insider trading and what would not, given the fact that Berkshire’s main source of growth is through acquisitions, the firm should have a specific personal trading policy in place for all of its employees. If anything, to avoid situations like this, where it appears that Sokol made a big mistake and Buffett is pretty much defending him by saying he didn’t see anything wrong with the trades.

So why is it most likely insider trading? According to a timeline of the Lubrizol deal compiled by the Wall Street Journal, Sokol met on behalf of Berkshire Hathaway, with their investment bankers (Citigroup), on December 13th. At this meeting the two parties discussed a list of 18 companies that the bankers had put together as a possible deal targets for Berkshire and Sokol told Citigroup that Lubrizol was the only company on the list that he found interesting.  Sokol also told them to contact Lubrizol’s management to inform them of Berkshire’s interest in exploring a possible deal.

At that point it should be obvious to anyone, including Sokol, that he and the bankers are in possession of material, non-public information. Sokol has decided that Berkshire Hathaway would like to explore the possibility of buying Lubrizol and he has instructed his bankers to inform Lubrizol of their interest. It is painfully clear that a deal could result from these discussions, and only a few people are aware of these private plans. Now remember, this meeting occurred on December 13th.

So when did Sokol first buy Lubrizol stock for his personal account? On December 14th. Seriously? Seriously. Sokol bought 2,300 shares of the stock the day after telling Citigroup to call them and express interest in a deal. Interestingly, Sokol sold those shares on December 21st. He didn’t wait very long to buy them back though. During the first week of January Sokol bought 96,060 shares of Lubrizol. Lubrizol’s board met to discuss the interest from Berkshire Hathaway on January 6th and Sokol met with Lubrizol’s CEO face-to-face on January 25. The deal was approved on March 13th and announced March 14th. The purchase price was 30% above where Sokol bought the stock for his own account.

Not only is Sokol going to have trouble on his hands here, but Buffett’s reputation is also on the line. Even though Warren didn’t know about these trades as they were happening, the very fact that Sokol is allowed to trade in the same companies that he is looking at as possible acquisition targets for Berkshire Hathaway (and at the same time!) screams of lax oversight.

Hiring of Todd Combs at Berkshire Hathaway Does Little to Solidify Warren Buffett Succession Plan

Maybe I am way off base on this, but given that Warren Buffett is the greatest investor we have ever seen (or even if you disagree with me, he has to be in the top few, right?) I would have expected more when Berkshire Hathaway decided to start hiring outside investment managers to eventually replace him. Given Buffett’s knowledge and connections in the industry, coupled with the fact that this job opening has to be one of the most intriguing ones for a value investor anywhere on the planet, it seems as though they should have been willing (and able) to hire someone who we have at least heard of before. The addition of Todd Combs, an unknown 39-year old hedge fund manager who graduated business school just eight years ago, is not only baffling but I doubt that it instills all that much confidence for Berkshire shareholders.

Let’s review some facts about Combs and the hiring process, according to an article recently published in the Wall Street Journal:

1) Combs graduated from Columbia Business School in 2002, and worked as an equity analyst for 3 years before being seeded with $35 million in 2005 to start a new hedge fund, Castle Point Management, focused exclusively on financial services companies.

2) While assets have grown to about $400 million during the five years Combs has been an investment manager, his cumulative returns over that span are 34%, less than 7% per year. Depending on the risk profile of the fund, which is unclear, this may or may not be very impressive, but it is interesting that Castle Point returned 6% in 2009 (when the S&P 500 rose by more than 26%), and in 2010 has actually lost 4% of its value (despite the S&P 500 rising by 6% during that time). Combs’ five-year track record is not only extremely short, but it also doesn’t scream “Berkshire Hathaway.”

3) It is also interesting that Combs sent Buffett a letter in 2007 to apply for the job as Berkshire’s next investment manager but Buffett was unimpressed (his resume “didn’t distinguish itself” according to the WSJ article). Only recently did Combs send a second letter to Charlie Munger, which impressed Munger enough to advance the process and resulted in him being hired shortly thereafter.

To me, none of this information taken on its own can prove whether or not Combs is ready for the prime time or not. I have no doubt he is a very smart guy and his personality seems to fit with Buffett, Munger, and Berkshire well. His focus on financial services is important as Berkshire has a large insurance operation and invests in a lot of banks and other financial companies. That said, if I were a Berkshire shareholder I would be asking why this is the best they could do. Hiring an young, unknown fund manager with a five-year track record seems risky given how many more well known, established, and proven people are out there and would likely have been honored to join the Buffett team. In the case of Combs, it will be years before we find out exactly how good he is at picking stocks and managing tens of billions of dollars.

Full Disclosure: No position in Berkshire Hathaway at the time of writing, but positions may change at any time.

Sardar Biglari Mimicking Warren Buffett’s Berkshire Hathaway? The Proof is in the Web Site

Yesterday  wrote my second post about Sardar Biglari, the man who took over the Steak ‘n Shake restaurant chain and has since decided to change the company name to Biglari Holdings (BH) to signal his intention to branch out into other areas, a la Warren Buffett and Berkshire Hathaway (BRK). As you may know, Berkshire Hathaway probably has the most simple corporate web site of any publicly traded company. Simple text links to the documents investors would want to see and that is about it, along with a plug or two for some of his companies.

Here is a condensed screenshot of Berkshire Hathaway’s home page as of Monday:


Since the Steak ‘n Shake corporate name was changed recently, I decided to see if Biglari had published his own web site yet. Sure enough, here is a screenshot of the Biglari Holdings home page:

Needless to say, I was pretty stunned to see a design so obviously similar and simplified. But maybe the history of Biglari Holdings up to this point should have resulted in me being a lot less surprised. At any rate, it is pretty clear what to expect from this company going forward. Biglari definitely wants to follow in Warren Buffett’s footsteps.

Biglari Exchange Offer Signals Inflated Stock Price of Warren Buffet Follower

Biglari Holdings (BH), in the company’s first major move since changing its corporate name from Steak ‘n Shake (read my last post about Biglari and Steak ‘n Shake), has chosen an uncommon method for completing its next public market transaction. Rather than use the company’s cash to acquire a minority stake in Advance Auto Parts (AAP), Biglari has offered to exchange shares of his own stock for shares in AAP at a ratio of 0.1179. Such a move is rare, but more importantly, it signals to investors that Biglari feels that his stock is at least fully valued and at most overvalued. Otherwise, he would have preferred to use cash rather than stock to invest in AAP. Smart capital allocators such as Biglari only have a reason to dilute their ownership stake if they are using prime currency. In this case, BH shares at nearly $400 each were certainly on the expensive side, at nearly two times book value.

Unfortunately, the market has reacted appropriately to this move by shedding nearly 10% from Biglari Holdings’ market value. Trading down into the mid 350’s, the exchange offer to Advance Auto Parts shareholders went from being an attractive option (originally representing a premium of about $1 per share) to being very unattractive (about a $3 per share discount). The markets in general are quite smart and they appear to have sniffed out Biglari’s intention of swapping an expensive stock for a cheaper one.

Why he did not opt to make this offer privately to one or a handful of existing AAP shareholders is baffling. By going public with the offer, he essentially ensured that his stock would get hit hard and reduce any interest in his exchange offer. Of course, the more Biglari makes headlines the more investors might start to read up on him and decide to invest in his company. That exposure could result in a fairly quick rebound in the stock price of Biglari Holdings, prompting more offers like this one.

Full Disclosure: No position in AAP or BH at the time of writing, but positions may change at any time

KBW is Right, Berkshire Hathaway Stock No Longer Cheap

From MarketWatch

“Berkshire Hathaway was downgraded to market perform from outperform Monday by insurance analysts at Keefe, Bruyette & Woods who said a recent rally has left the shares fairly valued. Berkshire’s class B stock was included in the Standard & Poor’s 500 index this year and a lot of mutual funds that track the equity benchmark had to buy, pushing up the price. They also cut their price target on Berkshire’s class A shares to $125,000 from $135,000.”

I think this is a good sell-side call, and I am not one who typically praises Wall Street analysts. Since it was announced that Berkshire was being added to the S&P 500 on January 26th, the stock has surged nearly 20% in about a month. It now trades for 1.4 times book value and 1.8 times tangible book value. While neither ratio is extremely high, the stock does trade at a premium to both its peers (rightfully so) and near the upper end of its historical average. It appears the S&P 500 announcement has resulted in such a large surge in the share price that I would agree with KBW that buying at current levels is not a very attractive entry point.

Steak n Shake Company Quietly Shifting to Berkshire Hathaway Business Model

The Steak n Shake Company (SNS), an operator of 485 burger and shake focused casual dining restaurants in 21 states, has recently been quietly transformed by a new management team into a small Berkshire Hathaway type holding company. The move is very Warren Buffett-esque, with a 1-for-20 reverse stock split aimed at boosting the share price to well above normal levels (above $300 currently) and a bid to buy an insurance company among the noteworthy actions taken thus far.

What I find almost as interesting as the moves made by new CEO Sardar Biglari (a former hedge fund manager who has gained control of the firm and inserted himself into the top management slot) is the fact that this move has largely gone unnoticed by the financial media. Granted, Steak n Shake is a small cap regional restaurant chain ($450 million equity value) but the exact same strategy undertaken by Sears Holdings chairman Eddie Lampert garnered huge amounts of press.

Clearly Sears and Kmart are larger, more well known U.S. brands, but there seems to be a lot of interest from investors for any company trying to mimic the holding company business model that Buffett has perfected for decades. As a result, I would have thought Steak n Shake would have gotten some more attention.

Essentially, Biglari is using similar methods Lampert used when he took control of Kmart and later purchased Sears. Steak n Shake has dramatically cut costs, reduced capital expenditures, and will add to its store base going forward solely via franchising new locations, rather than building them with shareholder capital. The results have been impressive so far. During 2009, the first full year under new management, Steak n Shake’s free cash flow soared from negative $20 million to positive $31 million.

Biglari has made it clear that he plans to deploy the company’s capital into the best investment opportunities going forward, and that likely does not include heavy investments into the core Steak n Shake business. He has announced plans to rename the company Biglari Holdings (an odd choice if you ask me) and recently offered to acquire a property and casualty insurance company (the Warren Buffett comparison is worth noting here) but was rebuffed by Fremont Michigan InsuraCorp.

In the short term, Biglari and his fellow shareholders have reaped the benefits of his shift from a capital intensive negative free cash flow restaurant business to a more lean and efficient holding company. The stock has more than doubled from the $144 price ($7.20 pre-split) it fetched on the day Biglari took over.

The larger question remains how well this young former hedge fund manager can further deploy Steak n Shake’s operating profits in the future. At more than $300 per share, the stock trades for 1.6 times tangible book value of around $196, versus about 1.9 times for Berkshire Hathaway.

In my view, any price over 1.5 times tangible book value for an unproven concept and management team is too much to pay. However, given the results thus far it should come as no surprise that investors are willing to shell out more for the stock than they were previously, despite a lot of uncertainty over Steak n Shake’s future. Count me as one who will be interested in monitoring the situation going forward but would only take a flier on Biglari if the price to do so got cheaper.

Full Disclosure: No position in Steak n Shake at the time of writing, but positions may change at any time

Down 45%, Warren Buffett & Berkshire Hathaway Are On Sale

About a year ago, I commented on an article that appeared in Barron’s which argued that Warren Buffett’s Berkshire Hathaway (BRKA) was overvalued. In my post, entitled Barron’s Pans Buffett’s Berkshire, I agreed with the article that Berkshire Hathaway stock looked overvalued. A lot has changed since then. Berkshire shares have fallen 45% from their high and hit a fresh yearly low on Wednesday at $84,000 per share. At that price, the stock looks cheap.

As I discussed in my 2007 post, the best way to value Berkshire Hathaway looks to be on a price-to-book basis. Berkshire’s core business is insurance (which is valued with price-to-book) and the company’s assets are largely in publicly traded securities, whether it be common stocks or various types of debt instruments. Going a bit further, I would use tangible book value, rather than total shareholder’s equity, because Berkshire has more than $30 billion of goodwill on its books.

The essential question is, at what price would Berkshire Hathaway be cheap? I would love to purchase the stock at tangible book value of $56,000 per share, but that appears to be a long shot, as one might expect given Buffett’s track record and the strong management team he has assembled there.

Accordingly, wouldn’t you agree that even 1.5 times tangible book would be a solid entry point for a long term investment in Berkshire Hathaway? I certainly think so. Well, guess what? Today the stock closed at $84,000 per share, which just happens to be both a new 52-week low and exactly 1.5 times tangible book value of $86.6 billion. Not only does that look cheap, but all of us non-billionaires can buy the class “B” shares for only $2,783 each.

Full Disclosure: No position in Berkshire Hathaway at the time of writing, but positions may change at any time

Warren Buffett Op-Ed Explains Why He Is Buying, Not Selling

Warren Buffett’s Op-Ed in the New York Times today is a must read. He echoes many of the same thoughts I offered in my quarterly letter to clients last week, but don’t take it from me, the Oracle of Omaha feels the same way.

You can read the full piece here:

Some highlights:

In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary. So… I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

I haven’t the faintest idea as to whether stocks will be higher or lower a month or a year from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “skate to where the puck is going to be, not to where it has been.”

Buffett Adds $3B of GE Preferreds, Still Takes No Equity Market Risk

Warren Buffett is stepping up to the plate again, buying $3 billion in 10% preferred stock from General Electric (GE), after adding $5 billion of Goldman Sachs (GS) preferred just days ago. Many are focusing on the confidence factor the Buffett moves suggest, which I agree with to a large extent. However, keep in mind that this second deal is just like the first in that he is not taking on any equity market risk by purchasing preferred stock. As long as these firms stay afloat, Buffett can’t lose a dime, regardless of where the common shares trade in the future.

Full Disclosure: Peridot was long shares of GE at the time of writing, but holdings can change at any time

Buffett Treads Lightly With Goldman Sachs Investment

If one of your first reactions upon hearing of Warren Buffett’s $5 billion investment in Goldman Sachs (GS) was, “Wow, I didn’t think Goldman was a Buffett-type company,” you are probably not alone. Warren has typically preferred consumer-related businesses with wide moats (high competitive advantage and barriers to entry). He often tells people that he would feel perfectly fine owning Coca Cola (KO) or Wrigley (WWY) if the stock market closed down for five or ten years. It would be hard to have the same level of confidence with Goldman Sachs.

So before you go out and load up on GS common stock on this news, let’s review exactly what Buffett is getting, and more importantly, the price he is paying. The $5 billion deal involves two parts:

1) $5 billion in preferred stock

These preferred shares are senior to common stock and pay a 10% annual dividend. Think of them as unsecured bonds paying 10% interest. He is not buying common shares with the initial $5 billion. In addition, if Goldman ever wants to retire these preferred shares (companies typically “call” preferred shares when they have excess cash), they have to pay Buffett a 10% premium to their face value. The vast majority of normal preferreds are callable at par, not at a premium.

2) Warrants to buy $5 billion of common stock at $115 per share

Buffett has the option to buy $5 billion of common stock at $115 per share at any time over the next five years. Keep in mind that while this part is common stock, there is absolutely no risk for Buffett on these warrants. Five years from now, Buffett earns a profit of $43 million for every dollar GS stock trades above $115 per share. If the stock is below $115, he does not lose a dime, as there is no risk on his part. These warrants are essentially call options he is getting free of charge.

From the terms of this investment, we can see why Buffett has decided to invest in an investment bank even though he typically goes for much safer and predictable operating businesses. Goldman does have a superior management team and great talent, but investment banking is not a business I would expect Berkshire to expand into anytime soon.

While he is taking a bit more risk by banking on Goldman’s survival, consider how the landscape has changed for Goldman in recent days. Not only has the government indicated they are willing to take dramatic action to help these firms survive, but it also has allowed Goldman to become a bank holding company. Goldman may very well use this new capital to build out their commercial banking operation.

With this deal, Buffett is banking on government intervention succeeding in greatly lowering the risk that Goldman Sachs gets into deep trouble. For such a bet, I’d say Buffett got a great deal by waiting things out and not investing until he figured the odds were stacked strongly in his favor.

Full Disclosure: No positions in the companies mentioned at the time of writing