Berkshire Ruminations

Friday, June 22, 2007

The Chipotle Mispricing Persists

The stocks of Chipotle Mexican Grill are both down today on an analyst downgrade, which is fine. The company’s price has certainly been bid up. What continues to amaze me, though, is the lack of attention to the very obvious mispricing that exists between the company’s class A and class B shares. For one thing, oftentimes the B shares aren’t even mentioned, or reports will just make reference to “shares of Chipotle,” as if they are all the same. Something very interesting has been going on here but no one seems to care.

When Chipotle was spun off of McDonalds last year in an IPO, it had only one class of publicly traded stock. McDonalds retained a majority interest in Chipotle, though, calling the shares it owned B shares and assigning ten times the voting power to them. Then, when McDonald’s sold its remaining interest in October (perhaps because it saw CMG as overvalued?) the B shares came to market.

The shares have the same economic value. That is, the B shares are identical to the A shares except for the fact that they have more voting rights. So, if anything, the B shares should trade at a small premium to the A shares. But they don’t. They have persistently traded at a 7% discount to the A shares. This is an example of investor irrationality. I read about it in various places after the phenomenon began, but it took a call to the company itself before I believed it.

Anomalies like this drive academicians nuts. How can this happen? Why aren’t arbitrageurs eliminating this discrepancy? The literature on behavioral finance contends that such anomalies can persist when there are “limits to arbitrage.” This explains why shares of 3Com traded at a discount to shares of Palm, which it owned, my favorite Wall Street anomaly of all time. Know-something investors couldn’t get their hands on shares of the overvalued stock to short, so it kept getting pushed up.

But I don’t think this can explain the persistent mispricing in this case. Both classes of stock trade several hundred thousand shares per day, and I personally have been able to buy both classes – the A’s before the B’s were around, then was able to easily sell the A’s and buy the B’s. So there is no liquidity concern here, and even if there were, I would expect the A shares to be discounted as there are slightly fewer of them outstanding (and thus they are less liquid).

So can this discrepancy be arbitraged? The short answer is yes, but it has not been profitable yet. Since the phenomenon continues to persist, those who shorted the A shares and bought the Bs have not yet realized any gain. And if it takes long enough to correct the mispricing, they may never realize a gain. I found it difficult to get historical price data for CMG.B because, again, everyone is focused on the A shares. It isn’t available on Yahoo, Google or even Ameritrade’s resources. I finally found a source for both classes on the Chipotle IR website, although I had to search for each day’s price independently. I then, painstakingly, charted the profit from an arbitrage of them by manually entering them into excel. And here it is, in all its glory:

I assume that I initiated the arbitrage trade on January 10, since this was around the time that I personally learned of the mispricing, by buying Class B shares at $52.40 and shorting Class A shares at $56.21 . The cost basis is the cost of the shares I bought, $52.40, so to date the arbitrage would have produced a gain of $2.00/$52.40, or 3.8%. If we assume the cost of shorting is 9% APR, or 4.5% over the six months we were short, then the interest on the short would completely wipe out the gain on the long. And this ignores the time value of money, the return on the market and, perhaps more importantly, the fact that a long position in either class of stock would have produced a great gain.

The analyst report that came out today also makes reference to the large short interest in CMG in the explanation of its downgrade. Couldn’t this simply be because of investors trying to arbitrage the difference?

PS - What do you suppose SocialPicks will say about this one?

FD: I have no position in any stock mentioned in this post.

Thursday, June 21, 2007

Andy Kern does not make "picks"

As the name of this blog should indicate, my goal is not to make stock picks but rather to muse about current events in the stock market and the field of finance generally. Nonetheless, a website called SocialPicks has taken it upon themselves to label my thoughts as either a "buy" or "sell" recommendation. This is not what I do, so I take exception to what this site is suggesting. I never asked to be covered by this group, nor have they responded to my requests that they stop. Further, they tally my "picks" and track and rate my performance! Ugh.

What is more, they are completely ignoring even the general sentiment of my posts. For instance, earlier this year I wrote a post about my thoughts on the Home Depot situation, which was really just a reflection on what is good and what is bad corporate governance. Somehow, for some reason, the website decided to label this an Andy Kern "buy." Or, last month I titled a post "Sell GGG - They recalled their baby toys." This was supposed to be funny because GGG doesn't make baby toys, rather Google Finance had confused the company with a different one of a similar name. Well, SocialPicks didn't get the joke (or more likely, just didn't read the text of the post) and labled this an Andy Kern "sell." All these errors cause the "Andy Kern tracker" to have a very low rating.

I am posting this in the hopes that someone out that can provide me with contact information for the owners of this website. I have sent repeated emails and gotten no response, but I know of no other way of contacting these people. I would like a mailing address or phone number so I can have my attorney write a friendly letter explaining that they ought to stop such defamation. So far as I can tell, this is outright libel.

All that I have been able to find so far is the name of two of the operators, Weiting Liu and Jason Fang. If anyone has any other information I would appreciate the help.

Friday, June 08, 2007

Value Plays Rebuttal - Part 2

Now on to the question at hand. Is Berkshire better off without Warren Buffett? Todd seems to be asserting that holding cash of $40 billion alone is grounds for Mr. Buffett’s removal from office. Is Todd suggesting that Mr. Buffett is not efficiently allocating his capital and thus should leave the company? Perhaps, but if that is the case then I suggest he rethink Mr. Buffett’s track record, you know the most impressive capital allocation track record ever.

It is a theme I hear often repeated: Buffett did well in the past, but won’t do well in the future. This is true in one regard. Berkshire is now a big fish. It will certainly not perform as well as it has in the past because its “universe of potential investments,” as Mr. Buffett puts it, is much smaller now. There aren’t a lot of $40 billion dream companies available for sale at the moment, nor will there ever be. Does this mean Buffett should lower his standards? Certainly not. What many people argue, though, is that it means Berkshire should pay a nice $26,000 per share dividend. (That’s $40 billion divided by 1.54 million Class A equivalent shares.) I am not terribly opposed to that idea, but here are some reasons why it might be worthwhile to let him continue to hold this cash.

The company’s cash horde has been around its current level since yearend 2003. In that time, the per-share book value of Berkshire has increased 68%, compared to a return of 73% for the S&P 500. However, also in that time Berkshire stock has only increased by about 30%. Perhaps the market is deterred because it is uncomfortable, as is Todd, with the company’s huge stash of cash. I would suggest that if the company can essentially match the performance of the market while maintaining such a large cash balance, then the operations in which it is engaging must be doing exceptionally well.

So what good does sitting on $40 billion in cash do? Well sooner or later there will come an opportunity that will quiet everyone down about this. Berkshire spent $10 billion on acquisitions in 2006 and Mr. Buffett hinted at the possibility of a huge acquisition sometime soon. But since the company had operating cash flows of about the same amount as the costs of its acquisitions, the cash balance didn’t change. Mr. Buffett also hinted at a possible but unlikely acquisition at last years meeting. (He said it was in the neighborhood of $15 billion – some people speculated it was Omaha-based ConAgra.) But I think what we can infer from this is that he his actively seeking ways to put the $40 billion to use. Unfortunately, bargains are hard to come by in this market, as I am sure any value investor these days is aware.

But what a mistake it would be if the company paid out all that cash only to miss an opportunity that would be highly profitable. If the cash is paid to shareholders, they will be forced to pay income tax immediately and may or may not be able to invest it at a rate of return greater than what Berkshire would otherwise earn. Remember, Berkshire, despite its cash, is still not underperforming. So at the worst, that $40 billion is earning its shareholders the same return as the S&P 500.

But when that big acquisition opportunity does come, Berkshire will be ready. I have faith that Mr. Buffett is confident enough that it will happen sooner rather than later, and that is why he is willing to wait with so much cash. I also think that over the course of his career he has proven himself to be a responsible custodian of shareholders’ wealth. If he wants to sit on $40 billion in cash, I trust that he sees the likelihood of being able to invest it sometime soon as sufficiently great to justify doing so. And lets not forget that Mr. Buffett himself is the largest shareholder of Berkshire Hathaway, and would get billions from a large dividend like that.

If you don’t trust Warren Buffett to make the best decisions for the company, then I suggest not purchasing the stock. But I think you are making a big mistake. I know Warren Buffett. I have had lunch with Warren Buffett. I know and trust close friends of Warren Buffett’s and can assert confidently that all the good things you hear about Warren Buffett’s character are absolutely true. There aren’t many people I know with such upstanding principles. The fact that he is the most successful investor ever shouldn’t be reason for anyone to doubt his integrity, but many people do anyway. I don’t. And I will continue to own Berkshire Hathaway.

FD: I own shares of Berkshire Hathaway.

Value Plays Rebuttal - Part 1

Todd Sullivan over at Value Plays suggested that I rebut the argument he made that Berkshire Hathaway is better off without Warren Buffett. His post, which I suggest you read first, contends that Berkshire sits on too much cash, and has sat on it for too long. Thus, Mr. Buffett should step down and allow someone else to run Berkshire’s investments. The post elicited a plethora of anonymous Todd-you-are-an-idiot comments, some of them fair, some of them not. I don’t think my faith in Mr. Buffett is quite as blind as these anonymous readers, nor am I afraid to attribute my comments to myself. So here I go, an unbiased and - what is the opposite of anonymity? Nymity? Anoanonymity? Whatever it is, that is how I am presenting the following comments.

Berkshire Hathaway is unquestionably better off with Warren Buffett. I would even go so far as to say that most American businesses would be better off with Warren Buffett. He is the greatest businessman and business leader in history.

However, contrary to popular belief, many of the stocks that Berkshire buys are not necessarily Warren Buffett picks. Mr. Buffett is much more focused on the acquisition of entire businesses. The minority interests Berkshire takes in companies such as Wal-Mart, Johnson & Johnson and US Bank (and losers such as Pier 1 Imports and H&R Block), although listed on Berkshire’s consolidated statements, are most likely investments made by Lou Simpson of GEICO. Whereas other Berkshire subsidiaries send earned capital directly to the parent company, GEICO invests its own cash. Mr. Simpson has been so successful at investing GEICO’s float that historically he has been suggested to be a heir to the throne. (If only he weren’t so old.)

In his posting, Mr. Sullivan commits several errors of fact. Let me address two of them:

Tood states that “[Buffett’s] recent purchase of 10% of Burlington Northern and 15% stake in USG marked the first time this century he has taken a meaningful stake in any company.” And also that “Berkshire's investment portfolio today resembles a mutual fund with small positions in over 30 companies that are bought and sold regularly.” Neither of these statements is true and it seems Todd has forgotten that Berkshire also owns 73 businesses either outright or has a stake large enough to allow for complete consolidation on Berkshire’s financials.

To put things in perspective, Berkshire’s stake in Burlington Northern is currently worth about $3.3 billion, according to its April 2007 beneficial ownership filing. And even the now close to 40% stake in USG is worth less than $2 billion. This is relatively small compared to the acquisition of Iscar Metalworking in 2005 for $5 billion, or Berkshire’s 85% stake in Mid-American Energy, which purchased PacificCorp for $5.1 billion in 2006. The company has made several other acquisitions of comparable size, such as Shaw Industries in 2001 for $2.1 billion or Clayton Homes in 2003 for $1.7 billion. To suggest that Berkshire has not made meaningful acquisitions this century is simply not accurate.

Nor is accurate to characterize Berkshire’s investment portfolio as resembling a mutual fund of 30 companies. It is true that Berkshire has “investments” – or minority interests – in about 30 stocks, but the total market value of these stocks is only about $60 billion. For a company with balance sheet totals of $250 billion it should be clear that the company is much more than a portfolio of 30 stocks. People in the press and on blogs like to talk about the public equities Berkshire owns because they are still available for purchase to the public. Wanting to chase Berkshire’s success, these are the investments they focus on. But in reality, the company’s common stock investments represent only a small portion of the company.

Berkshire Hathaway is a conglomerate of 73 subsidiary businesses, which also happens to own a portfolio of 30 stocks.

FD: I own shares of Berkshire Hathaway.