Monday, November 24, 2008

Lazy Man's Diversification, Part I: Berkshire Hathaway

Visitors to The Jaded Consumer will doubtless have noticed me pointing out the views of Warren Buffett in connection with timing purchases, choosing an investment horizon, and deciding where the economy is going. One thing not much discussed is how to make money off Buffett's own investment decisions. So, how can you do it?

There is a very simple way to bet on the judgment of Warren Buffett, and to obtain a low-overhead, nicely-diversified portfolio of investments in the bargain. Buy Berkshire Hathaway.

For the bargain investor, the route is surely to buy the B shares, a class of shares with reduced voting power designed to enable retail investors to participate without forcing them to cough up something on the order of six figures per share (that's excluding any decimals). The B shares have traded from over $5000 apiece to just $2000, and are currently trading at $3300 (though when I started writing this piece, the number was actually $2500, sorry I was so slow on the draw). There is no dividend, because that would result in company profits being taxed twice before potential reinvestment: once when earned by the company, and once when paid to shareholders as a taxable dividend. Berkshire Hathaway shares are to be held not for income (which is zero) but for capital gain; The Jaded Consumer does not advocate trading, has no advice on trading, and has no idea how to time investments, and thus suggests BRK.B for long term capital appreciation. A year ago I would have said BRK.B would allow one to invest money in a way that enables owners to sleep well at night and to avoid worry that some fluke in the credit or capital markets or in some particular industry would require sudden action on the part of investors, but let's face it: in the current economic panic environment, virtually anything is possible (especially if you are using leverage). If you avoid leverage like the plague, though, I give you this : BRK.B is a fully-approved Jaded Consumer fire-and-forget scheme for investing for the long term, so you can dedicate your time to having fun and earning your living and not wasting precious time following the markets.

Berkshire Hathaway's Class B shareholders are equity participants in the exact same way as the company's Class A shareholders, but the B shareholders have less fractional interest per share (and even less voting rights). There are two arguments why to buy Berkshire: it's easy diversity, and the thing is well-run.

At the time present management took control of Berkshire Hathaway, the company was principally occupied with U.S.-based textile operations. Its risk was concentrated in a dead-end segment, but management was able to obtain control at a relative bargain. Management began directing cash to investments with a brighter future, and ultimately exited the textile business altogether during the 1980s. Presently, Berkshire Hathaway is a holding company with significant insurance interests, which invests cash not needed for current and near-term obligations in a variety of businesses purchased on the basis of value. Unlike banks, which pay depositors and other creditors for the use of cash, Berkshire Hathaway's insurance business holds money for policy holders rent-free while awaiting the day a claim needs being paid. In short, Berkshire Hathaway has an enviably low cost of capital, and because much of its capital comes from insurance premiums, the company faces the possibility that an underwriting profit will enable it to keep some of the "borrowed" money permanently. This is like BRK.B getting to borrow capital with a negative interest rate. Cool, no?

Of course, underwriting losses are possible, too; however, Berkshire Hathaway makes a point of engaging only in risks that are farly comprehensible, and staying clear of unknown risks that have surprised some competitors over the years. An example is the asbestos liability that threatened the London syndicates who reinsured commercial liability policies; surely, they didn't anticipate assuming something like long-term personal injry risk arising out of workplace breathing conditions, so the syndicates got hammered, but when it came time to reinsure this risk someplace that would remove it from the London syndicates' books, Berkshire Hathaway was there with a modern understanding of the asbestosis risk and enough capital to reinsure the whole thing forever. And Berkshire Hathaway gets to invest that mutibillion-dollar premium while the risk overhangs the company.

Berkshire Hathaway also accepts some other risks. Berkshire Hathaway isn't afraid of risk, you see: it's afraid of uncertainty. A good bet is still a bet, and the year Katrina hit the Gulf Coast was rough. On the other hand, the next year was a bonanza. Over the long term, accepting good risks pays off.

So Berkshire Hathaway has a multibillion-dollar derivatives exposure. Although Berkshire Hathaway isn't subject to FAS-157 and need not write down (or up) its holdings' value on a quarterly basis, derivatives are treated specially and give rise to unrealized losses (or gains) that don't impact the company's taxable income or its cash flow or its liquidity, but do impact its SEC-reportable income. Berkshire Hathaway manages this risk in several important ways. First, there is no counterparty risk. The derivatives that impact BRK.B don't depend in any way on the solvency of any third parties. The derivative positions were created when third parties handed Berkshire Hathaway billions of dollars in options premiums, and Berkshire Hathaway has that money in-hand. Berkshire Hathaway thus enjoys the ability to invest the premium, and obtain a return on these funds, while awaiting the expiration date; it's just like much of the insurance Berkshire writes, offering a potential underwriting profit while enabling investment free of interest. A more accurate way to view the options is that Berkshire Hathaway has written a naked put on the S&P 500, and gets to invest the premium until the expiration date. The second major risk management strategy is that the option cannot be exercised except on the expiration date. Thus, the current market gyrations may send the theoretical value of the options all over the place, but they can't give rise to a realized gain or loss because they will not possibly expire or be exercised for years.

The short answer here is you get Warren Buffett. However, you do get more. This isn't just a portfolio of publicly-traded stocks, although Berkshire Hathaway does own large stakes in a bunch of publicly-traded companies. Coco-cola, Goldman Sachs, American Express, Carmax, Wal-Mart, Anheuser Busch, Burlington Northern Santa Fe, Proctor and Gamble, Johnson & Johnson, NRG Energy, Conoco Phillips ... lots of stuff. You can read up on it in the numerous articles by folks suggesting you follow Buffett into the companies in which Berkshire invests. The problem? Berkshire is a big buyer, and can get terms others can't. Berkshire's deal with Goldman involves a Berkshire-only 10% dividend preferred and a pile of warrants. Berkshire gets 10% indefinitely, with a "free" option to buy in case Goldman goes through the roof. They don't offer this kind of thing to you and me. They offer it to Berkshire.

Some Examples of Berkshire's non-public portfolio:
GEICO (a massive cash cow, and possibly already your auto or property insurer, having about 7.4% share of the auto insurance market);
Dairy Queen, of which Orange Julius has been a wholly-owned subsidiary since 1987 (since 1998);
Sees Candies (since 1972); and
Berkshire USA (this is a reinsurer -- the kind of company that ultimately holds risks insured by insurance companies; with revenues of $18 billion, Berkshire USA had about 10% of the US reinsurance business in 2007).

Berkshire Hathaway's insurance business had $118 billion in revenues in 2007. While Berkshire stands back, waiting to see whether it will face claims, it gets to invest the premiums in a diverse portfolio of profitable companies that create cash. Pretty good, eh?

Berkshire Hathaway's investment in Burlington Northern railroad is part of Buffett's long-term bet on the American economy. Buying Berkshire B shares is a way to get a diverse portfolio with low overhead, and a bite of some great companies you can't buy on your own. Since there's no dividend, the tax consequences of long-term holding are nil until you sell; if you plan to own it until you die, there's no need even to put them in a tax-deferred account.

Berkshire Hathaway is a big buy.

No comments: