Despite Recent Weakness, Buffett’s Berkshire Hits Buyout Trifecta

UPDATE: 7/14 11:45AM

It has been brought to my attention that Berkshire does not own shares of Rohm & Haas. For some reason I incorrectly thought it did. Maybe Buffett used to own some of it, or maybe I just got confused some other way. At any rate, my apologies. Obviously, 2/3 of this post still applies, but just ignore the ROH part. Sorry for the confusion!

Things have not been great lately for Warren Buffett and Berkshire Hathaway (BRKA) shareholders. BRK stock has dropped more than 20% since December and large Buffett holdings in the financial services area such as American Express, Wells Fargo, Moody’s, and U.S. Bancorp are hurting his equity portfolio. Buffett has also taken some heat for publicly bashing the use of derivatives, but privately writing billions in credit default swaps.

Despite the recent headwinds, you may have noticed that Buffett is still hitting some home runs. Just this year three Buffett investments have received takeover offers, all at significant premiums of 50% to 80%. What is amazing to me has been the prices offered for some of these companies. For instance, Mars is paying 32 times 2008 earnings for Wrigley (WWY). Dow Chemical (DOW) just offered a staggering 11.5 times EBITDA for chemical company Rohm and Haas (ROH).


Those are hefty prices by any measure, so I will be interested to see how smart those deals turn out to be several years from now. Buffett, for one, seems to think $80 per share is a bit steep for Wrigley. He is selling his stake to Mars for $80 per share, providing financing for the deal, and after the deal closes he inked a deal to buy a stake in the Wrigley subsidiary at a discount to the $80 purchase price. Not a bad deal if you can get it.

Full Disclosure: The author and/or his clients were long shares of Anheuser-Busch and U.S. Bancorp for investment purposes, and Wrigley as a merger arbitrage play, at the time of writing

Sifting Through Buffett’s Annual Shareholder Letter

Warren Buffett’s annual letter is always a good read and the recently released 2007 version is no different. There are a couple points that Buffett mentions this year that I think are worth pointing out and commenting on regarding the current market environment; corporate creditworthiness and sovereign wealth funds.

Buffett is often criticized for speaking out against the widespread use of derivatives and at the same time, initiating derivatives positions for Berkshire. However, just because certain derivatives are extremely risky and may pose a serious threat to our financial system, that does not mean that every single derivative contract is bad. There are many derivatives that do not use tons of leverage and pose little threat, and those are the ones Buffett is using.

In the letter, Buffett points out that Berkshire has entered into 94 derivative contracts which fall into two categories; credit default swaps and long term short put positions on several equity indices. The former is interesting because corporate credit spreads have widened dramatically recently, and investors are worried that default rates are set to spike in coming years.

Buffett has decided to insure bondholders against default over the next five years, and in return has received more than $3 billion in premiums for these contracts. He is betting that actual corporate defaults are less than the rates currently implied by the market prices of credit default swap contracts. Given that current prices are artificially high for credit protection, due to the unstable credit markets, the implied default rates right now are well above typical historical loss rates at the end of an economic cycle.

What does this mean to individual investors? It means that high yield bonds are extremely depressed right now and many smart investors are betting that the market for corporate debt has swung too far into the pessimistic camp. If you agree and believe that although earnings might fall in coming years for certain companies, they will still be able to repay their debt, then high yield bonds and credit protection are interesting areas for investment. Investors can play this two ways.

First, you can simply buy high yield corporate bonds or bond funds. High quality managers are salivating at some of the yields currently available in the corporate bond market and are more than willing to wait out this economic downturn, collect interest payments, and get repaid several years down the road if their financial analysis proves accurate.

You can also invest in a company like Primus Guaranty (PRS), a small publicly traded writer of credit default swap contracts. Essentially, Primus is doing exactly what Buffet has done, but they do it for a living. As credit spreads widen and premiums rise for selling credit protection, Primus will do more business at more lucrative prices.

Another point Buffett raises in his letter that I think is interesting is the rise of sovereign wealth funds. For those of you who are unfamiliar with the term, these are simply government owned investment funds of foreign countries. As the global economy has expanded and the developing world sees increased economic prosperity, foreign governments are flush with cash, and like anyone else in that situation, are looking for places to invest it.

As the world’s biggest market, it is not surprising that the U.S. has seen China buy a 10% stake in the Blackstone (BX) IPO and Abu Dhabi invest in Citigroup (C). Of course, some on Capitol Hill are worried about foreign money being invested in U.S. companies. Although these are passive investments, and bring with them no control of operations, national security concerns are being voiced by many.

Buffett makes the point that this trend is largely the product of our own doing. The U.S. is racking up huge deficits, issuing debt to any foreign country who will buy it, and the resulting weak dollar is prompting foreign investors to invest in U.S. equities. They are simply diversifying their investment portfolio. After a while, you can only buy so much U.S. debt without getting a little worried about our country’s financial health. Many U.S companies, although navigating through tough times, look more attractive than the government does for investment dollar allocations.

As a result, foreigners want to buy equities as well as bonds. Buffett points out we certainly can’t blame them for buying stocks rather than more bonds. And it is much easier for them to do so now because so many financial institutions are trying to raise capital after sub-prime mortgage blunders. In my view, as long as these remain passive investments, we really can’t complain. When operational decision making becomes as issue, as it was when an Abu Dhabi firm wanted to run our ports here in the U.S. (the deal was squashed), then it makes sense to talk about national security threats, but only when a real threat is apparent.

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

Straight Talk from Buffett

One of the great things about listening to Warren Buffett speak, and I suspect one reason why thousands gather each year in Omaha for his company’s annual meeting, is that despite the fact that he is a brilliant man he speaks in plain, logical language that is easy to follow and usually hard to argue with. If you want the truth, without the media spin, and in as few simple words as possible, just ask Buffett.

Here are excerpts from a Buffett blurb on latimes.com from Thursday discussing current financial market conditions:

“It’s sort of a little poetic justice, in that the people that brewed this toxic Kool-Aid found themselves drinking a lot of it in the end,” he said.

“I wouldn’t quite call it a credit crunch,” he said. “Money is available, and it’s really quite cheap because of the lowering of rates that has taken place.”

He added: “What has happened is a repricing of risk and an unavailability of what I might call ‘dumb money,’ of which there was plenty around a year ago.”

He is so right on this. People in the media keep complaining that “banks aren’t lending money anymore” and the Fed has to help boost liquidity. Banks are still lending money, they are just doing so only to people who have good credit (and thus actually deserve to be given loans).

It’s funny that people complained that the banks were giving loans to anyone and everyone, and now they are upset because many people can’t get loans anymore. You can’t have it both ways.

The fact that “dumb money” is no longer available is a good thing. Perhaps retail sales drop a few percentage points and loan losses increase a few because of it, but overall our financial system will be less leveraged and healthier as a result.

If you can’t put any money down or verify your income, you can’t afford to buy a home. I’m glad the banks are finally realizing this. And for those who are credit worthy, the Fed is lowering borrowing rates so the banks can make money on the loans they are willing to extend.

Barron’s Pans Buffett’s Berkshire

When I heard the media reporting that the Barron’s cover story this weekend was a piece warning investors that shares of Berkshire Hathaway (BRKA) were overvalued, I was both surprised and in agreement. I think many publications would avoid panning Berkshire’s investment merits, even if they believe the stock to be too high, just because we are talking about the greatest investor who has ever lived. On the other hand, the case that BRK is overvalued is pretty strong, so from that standpoint, Barron’s might be doing investors a favor by pointing it out.

I didn’t read the full article, but the news wires are reporting that Barron’s concluded that BRK is about 10% overvalued at current levels. I decided to take a quick look at the stock’s valuation to see if I agreed with that. I was already aware that Berkshire’s P/E was well above 20, which is why I do not own any shares in the company, but at that same time, one could surely argue that most of Berkshire’s value should not be measured using a P/E ratio. As a result, I did some quick number crunching using book value rather than earnings per share.

The reason for using book value is quite simple. A majority of Berkshire’s net worth comes from stock holdings in public companies as well as operating businesses (from which most of the net income is derived from the insurance business). Insurance companies are valued using price-to-book ratios (typically they garner a ratio slightly above one) and common stock investments can be valued easily using current market values.

As of September 30th, Berkshire’s book value was $120 billion. Of this, more than half ($66 billion) lies in the company’s stock holdings. That leaves $54 billion in book value from Berkshire’s operating businesses. If they were solely in the insurance business, I might assign a price-to-book value of somewhere around 1.2x to them, but Berkshire is more than just insurance. As a result, you could conclude that Berkshire’s operations should be valued at two times book, so let’s use that number.

Quick math nets us a value for Berkshire of $174 billion (2 x $54b + $66b). At Berkshire’s current quote of $137,000 per share, that would make BRK about 18% overvalued, even more than the Barron’s estimate. Buffett clearly is worth a premium for most investors, but at the very least, Berkshire stock hardly looks like a bargain after a huge move upward in recent months.

Full Disclosure: No position in Berkshire Hathaway at the time of writing

Buffett Record is One Thing, Outlook Quite Another

Before you go out and buy a stock simply because Warren Buffett either has owned it for a long time or recently purchased it, consider the following quote from his letter to shareholders, released yesterday.

“Expect no miracles from our equity portfolio. Though we own major interests of a number of strong, highly-profitable businesses, they are not selling at anything like bargain prices. As a group, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6-8% per year over the decade and that their stock prices will more or less match that growth.”

What should investors gleam from this statement? Should they take it at face value, or just assume Buffett is being modest and trying to keep expectations low so he can exceed them more easily? If you are one of the many people who have asked me about my views on some of his larger holdings in recent months, you already know where I stand on this issue. Take what Buffett says as the truth. His days of drastic outperformance are long over.

Consider Berkshire Hathaway’s performance in 2005; up 6 percent using the metric Buffett prefers. That compares with 5% for the S&P 500 with dividends reinvested. A solid year, but hardly something that one should bend over backwards to mimic. It also is right around the 7% estimated growth rate he offered in his letter.

Consider Berkshire’s largest holding as of December 31st; more than $8 billion dollars of Coca Cola (KO). Coke stock has been dead money for 10 years, even as the S&P 500 has nearly doubled, as the chart below shows.

I will repeat here what I have told those who have asked. I would not expect shares of Berkshire, or Coca Cola, or Anheuser-Busch, or Wal-Mart, or Proctor & Gamble, or Washington Post, or any of Buffet’s other large holdings to make you rich from here on out. They were all great buys at some point in time, say 15 or 20 years ago, but now they are richly priced, even as growth prospects have diminished greatly as they have grown into industry behemoths.

Why then does Buffett continue to hold these stocks, even if he only expects them to return 7% per year? The answer lies in the fact that he has said his ideal holding period for a stock is “forever.” If I was to argue with Buffett on one aspect of his investment philosophy, that would most likely be the one I would choose. Holding a stock “forever” will ensure you own it during both the good times and the bad times. The latter is something investors should strive to avoid.

Buffett’s Possible Successor

Probably the number one concern among Berkshire Hathaway (BRKA) followers is the successorship of Warren Buffett. Buffett is in his mid seventies and clearly will not be around forever. What will happen when the cockpit is turned over to someone else? Will someone else be as investment savvy as Buffett? Surely not. Will Berkshire stock drop as Buffett himself is most likely valued highly by current shareholders?

Many people think Lou Simpson will take over for Buffett when the time comes. Simpson is the CEO of capital operations for Geico. Basically, he manages the float for Geico’s insurance business, which amounts to several billion dollars. Interestingly, while Buffett gets the credit for portfolio additions to Berkshire’s investment portfolio, often the smaller buys are the work of Simpson, not Buffett.

Taking a look at Berkshire’s holdings as of June 30th, we can get a good idea of which investments are the work of Buffett, and which have Simpson’s fingerprints on them. Buffett’s largest holdings are the ones he has held for years. Gillette, Coca-Cola, Wells Fargo, American Express, Washington Post, to name a few. After subtracting Berkshire’s top 10 holdings (mostly those older buys) as well as its position in Proctor and Gamble (due to the pending merger) and PetroChina (which was one of BRK’s largest holdings until it was trimmed dramatically in the first half of 2005), Berkshire’s $35 billion public company portfolio is narrowed down to less than $3 billion invested in 20 companies.

Since Buffett has stated in the past that Simpson manages about $2.5 billion, it is safe to assume this small portion represents what investors should expect to see on their position sheets should Simpson be named Buffett’s successor. As a result, more often than not relatively small new additions to BRK’s portfolio are the work of Simpson, not Buffett himself.

Concentration Explains Much of Buffett’s Investment Success

Last week I gave a guest lecture at the University of Missouri-Columbia Business School for a course entitled “Managerial Influences on Portfolio Selection.” The course focuses on studying Warren Buffett and his investment strategies. Proponents of “efficient market theory” (a view with which I strongly disagree) attribute success stories like Buffett’s to sheer luck. This is a preposterous contention, but it is important to understand why Buffett has done so well for such a long time.

All of the reasons are too great in number to mention here, but an important aspect of Buffett’s track record is the conviction by which he relies. Since he could only find a certain few great investment ideas at any given time, Buffett’s portfolios never looked anything like an index fund or any type of widely diversified portfolio.

In fact, as of the beginning of this year Berkshire’s top five holdings represented more than 70 percent of its equity investment portfolio (see chart above). This level of concentration has been a staple of Buffett’s investment strategy since he started his hedge fund in the 1950’s and even with Berkshire Hathaway decades later. The lesson to be learned is quite simple; Buffett attained such a brilliant track record by not only being right, but also by making sizable bets when he had extreme faith in his investment ideas.

P&G Purchase of Gillette Continues Merger Mania

The Oracle of Omaha has to be very happy today. His holding company, Berkshire Hathaway, owns a 9 percent stake in Gillette (G), a stock that rose $6 today on word that consumer products giant Procter and Gamble (PG) will buy the company for about $11 billion in stock.

Fortunately for Mr. Buffett, he is on the receiving end of this deal. While he is publicly raving about the prospects for the combined P&G/Gillette, it is fairly obvious that this is not the kind of purchase Buffett himself would ever make. Procter is paying a whopping 28 times forward earnings for Gillette. With P&G shares fetching about 20 times earnings, this merger is extremely dilutive. Analysts estimate earnings per share will drop 15 to 30 cents in the upcoming fiscal year, as much as a 10 percent dilutive effect.

Company executives will clearly try and mask the dilution by praising its plan to buy back billions of dollars in stock, but that doesn’t change the fact that P&G paid 28 times for a mature, slow growth, cash cow business. Sure there will be some synergies, but like with most deals, they will be overstated from the outset. It will be very interesting to see how well P&G stock does for Buffett and Co. over the next 5 or 10 years. I suspect despite all of the rave reviews presented today, actual stock price appreciation long term won’t be all that impressive, given current valuations.