Berkshire Ruminations

Friday, February 20, 2009

At what point does Berkshire get "stupid cheap"?

I own a lot of Berkshire stock. I don’t like seeing it go down because I don’t have a lot of liquidity at the moment, otherwise I would welcome the buying opportunity. But this begs the question, is this indeed a buying opportunity ? Or is it the beginning of the demise of the greatest investment of all time?

With is decline today, Berkshire stock has just experienced its largest drawdown ever. From Jun 19, 1998 to Mar 10, 2000 (the same day the NASDAQ hit its high, by the way), BRK lost 48.9%. From December 7, 2007 to today, BRK has lost 49.33%. It is worth noting that its current low is 81% higher than its 2000 low, which equates to a 5.6% annual compounded rate of return (trough-to-trough). Not exactly Berkshire’s historical annual average.

In my opinion, Berkshire currently suffers from a tremendous lack of transparency. This may sound blasphemous, but it is not. Although Warren Buffett prides himself in holding simple, understandable businesses, Berkshire’s portfolio is anything but. The company has an insurance business that only Buffett fully understands, with mysterious macro bets that seem entirely inconsistent with the style of investing that got the company to where it is today.

Investors are rightfully very suspicious of all these derivatives, particularly since Buffett refuses to talk about them except in broad, vague terms. I’m not faulting him for this necessarily, since for many companies such refusal would be expected. But we expect Buffett to explain everything to his investors much more thoroughly than a typical CEO would. If he believes the annual report should provide investors with enough information to allow them to accurately value the company, as he has said in the past, then it might seem he is now failing in this regard.

In last year’ letter to shareholders he goes in to quite a bit of detail about what derivatives the company owns, but in the current market environment this information is stale and insufficient. For instance, he says,

We have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

This is clearly a much higher level of disclosure than many companies would provide. But it almost raises more questions than it answers. $4.7 billion? Has this happened? The third quarter 10Q provides no more detail, but does indicate that a) the company wasn’t substantially hurt by the derivatives up to that point and b) that it increased the size of its derivative portfolio. (I lump both the options and credit default swaps in to this category.) The real problem is that there is no telling what has happened since September 30.

Of course there are more obvious reasons for the Berkshire’s stock’s slide. Two of Berkshires three largest common stock holdings, Wells Fargo and American Express (Coca-Cola is the third) have each been clobbered by more than 70%, costing the company at least $11billion were we to mark them to market. Ouch. Kinda makes you wonder if he (along with just about everybody else) misjudged the threat of financial contagion on Berkshire’s investments in financials, or for that matter the ability of management at these (supposedly very strong companies) to resist it.

The annual report that is due out in the next few weeks will be very interesting. We have heard the “end of Berkshire” refrain before, not coincidentally at the same time as its last trough that I mention above. So on a superficial level one might be inclined to assume it’s another chicken-little situation. But this recession is different from the tech bubble burst and I’m not counting any chickens just yet anyway. There is just too much uncertainty this time around.

6 Comments:

  • It will be interesting to see over the coming years if Buffett lost his midas touch, or if he proves to be a genius for the 100th time...

    By Blogger Wesley R. Gray, at 20 February, 2009 12:50  

  • Andy,
    Curious what your thoughts are on what price-to-book multiple BRKa should trade at to be considered fair value. Obviously a premium to the insurance industry is appropriate, but it looks like it peaked at 3x tangible book and now trades at 1.5x or slightly above due to the recent mark to market decline on the put options. As you pointed out, figuring out where book value will be is another story entirely.

    By Blogger Chad Brand, at 20 February, 2009 14:26  

  • Chad, interesting question. I think you could look at you question in one of two ways.

    From a theoretical perspective I would say that a mulitple FAR higher than the insurance industry is appropriate. The company is actually only about one-third insurance from a book value standpoint because most of the capital from the insurance businesses (float) is redeployed elsewhere. (Its much bigger on an earnings basis but valuing Berkshire on the basis of earnings is very foolish)
    Anyway, within that third businesses run at much higher levels of profitability than peers due to the return on the float realized through other investments. This would command a much higher multiple naturally. Of the other two thirds of Berkshire, half of this is comprised of operating businesses have a tremendous amount of economic goodwill not recognized on the balance sheet. Buffett usually speaks to this in his letters. The other half, the stocks, well who knows what kind of multiples those demand these days.
    Now, from a more pragmatic point of view I think most people consider 1.5X book to be about right simply because this is the level at which Berkshire has proven to be cheap in the past. I recall seeing a website one time that tracked the spread between bv and mv of Berkshire and then subsequent stock returns. For the life of me I cant find it, but if I do I’ll post it up.

    By Blogger Andy Kern, at 23 February, 2009 07:07  

  • Another question. At what point is the opportunity cost of owning this behemoth right now greater than the other deals out there? After all, Buffett himself sold his jewel (GEICO) the first time in order to invest in a better investment.

    By Blogger David Meehan, at 25 February, 2009 19:11  

  • Why does BRK continue to decline?

    I would have thought that after his wknd letter it woudl begin to establish a support level.

    Getting more and more concerned about this. thanks.

    By Blogger james, at 03 March, 2009 11:17  

  • I found it interesting that Buffett failed to address any of his financial holdings in his letter. American Express, Wells Fargo, U.S. Bancorp, General Electric, etc are resulting in billions of losses and yet he ignored them. I think that may have spooked some people. Personally, I would have been curious to know if he thinks a company like Wells Fargo or American Express still has a "moat" around its business.

    I enjoyed the letter, as usual, but don't think it really hit on any points that he had not addressed on earlier occasions, and thus it did not really boost confidence in Berkshire's holdings.

    By Blogger Chad Brand, at 03 March, 2009 12:06  

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