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.

Diversity
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.



Management
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.

Pystar Gets Poured Out

The court hearing the Pystar case (in which Apple sued a white-box maker for selling Apple's operating system without an OEM license as a pre-installed product on a non-Apple computer) just summarily dismissed Pystar's antitrust counterclaims. The fact that there's a universe of competition, and that Apple has been forced to offer more and more product for the same money, and has to advertise to attract buyers and has little power to entrap users unawares all seem to suggest this other anti-Apple antitrust case stands in similar jeopardy.

New Star Trek Movie Approaching At Warp Speed, Sir!

I noticed a new Star Trek movie when I stumbled upon its virtually content-free trailers. They are big on emotive grip, though: images of sweating welders with a sound track of classic clips from the first years of the space program, with the camera slowly giving the image of an Enterprise under construction. Looking over the official web site (warning: Flash), I note that there's no information about the timeline, characters, etc. However, it seems suggested that the story will pick up with the launch of the first Enterprise crew we knew from the TV series, complete with Kirk, Spock, Checkov, etc. -- but ... younger.

As seen here, the director of MI:III and Lost seems to envision Sylar from the first season of Heroes as the proper model for Spock. A bit much emotion in that one-handed choke hold, though. He's supposed to be half-Vulcan, and passionless. Or maybe they are playing on the half that isn't Vulcan, and writing him as an on-the-edge head case who hasn't yet mastered the irrational impulses with which he is cursed by his unnatural heritage. According to the web site, we're supposed to find out near Christmas, or else 5-8-09 -- a suggestion that maybe they blew an initial release target and ended up in summer of '09, and didn't take the time to re-edit all that Flash.

Being long addicted, I'll definitely want to see more ....

Election? We Don't Need No Steenking Election!

Apparently members of the Senate haven't been reading the literature produced by their near neighbor, the United States Supreme Court. This Reuters article discusses the fact that both Democrat and Republican members of the United States Senate are in agreement that a convicted felon should not be permitted to take a seat in the Senate. According to Powell v. McCormack, a chamber of Congress lacks the power to refuse to seat a duly elected member who satisfies the age, citizenship, and residence requirements articulated in the Constitution.

Presumably they will seat him -- then promptly conduct proceedings to expel him. Of course, if they do this too quickly, the Senate could embarrass itself if his still-pending appeal succeeds in overturning his conviction.

Bah! What am I saying? A member of Congress, capable of being embarrassed?

Shameless, the lot of them. The fact a mere felony should cause members of Congress to be up in arms over one of their member is silly: Mark Twain explained Congress was America's only distinctly native American criminal class. Felony is part of the initiation ritual, I'm sure.

Maybe his sin was getting caught. But, no: members of Congress have been repeatedly spotted doing terrible things -- sometimes, with the vote of their offices -- with no ill effects.

Why not let this felon join their exalted ranks? A convicted felon in Congress would be something new for that august body: truth in advertising.

Fannie Mae Ga-Ga For Golf

After being bailed out by federal regulators and recapitalized with taxpayer dollars, Fannie Mae launched a $6,000 golf outing. Maybe not as offensive in cost as AIG's luxury getaway (which included over $20,000 in spa charges alone), Fannie Mae's may be more offensive in principle because -- with only 20 attendees of which several were Fannie Mae execs -- it's much less plausibly a training or marketing opportunity.

It's just a bit of fun on your nickel.

Okay, so it was a lousy six grand. But it adds up. And there's the principle of the thing.

It's not a new problem, it's just a problem previously never of much concern: jobs holding others' money tend to attract folks inclined to treat it as their own. You see it in the public sphere (such as in Congress, where Clinton's aides referred to earmark legislation as a privilege which she used effectively for her constituents, which leads one to wonder who she thinks her "constituents" are) as easily as in the private sphere. It's a classic agency problem. The kind of immunity to oversight with which we've inoculated our top agents seems to prevent them from having their interests aligned with those of the public (for organizations like Congress when they decide how to use money taxed from strangers) or the shareholders (for corporations whose managers aren't the owners).

Fueling Conservation

The recent drop in oil and fuel prices has raised a new question: will Americans' recent decreases in driving (which seemed to be a consistent phenomenon as prices rose) evaporate like gasoline vapors on a hot day?

The answer -- at least in the teeth of severe economic turmoil -- seems to be "not yet."

Of course, this isn't all good news. As Jenna Wade of Roseville, California explains:

Q: How have plunging gas prices changed your driving habits?
A: Not at all. I’ve no job to go to any longer so I no longer drive.

Of course, others simply see their reduced driving as a good habit worth maintaining, and a way to keep money in the bank.

Speaking of keeping money in the bank, some utility companies want to be paid -- just as they would be paid for delivering a kilowatt-hour of electricity -- for investments that help reduce consumer consumption of energy. Their argument is that conservation is capital intensive, and that utilities have a lower cost of capital, so they should be paid to deliver what consumers aren't necessarily in a position to afford -- but to be compensated for it. Depending on the lifespan of some of those improvements, and the accuracy with which savings can be modeled, that might make sense. On the other hand, efficiency that leads to excess -- making the house colder in the summer than previously, because the home holds more of the chill -- might not lead to net gains. There may be some expenses users don't care to avoid, if the total cost isn't big enough to them. The idea is interesting, but I'd like to see the math. And maybe a local demonstration project to see that it works on a city-wide basis, among people unaffiliated with the power company.

If we really can induce good energy practices, all the better.

One Laptop Per Child

If Microsoft had its way, that'd be one software vendor per child.

The One Laptop Per Child (OLPC) program, led by Nicholas Negroponte, is hoping to deliver budget laptops around the world to keep even low-income people abreast of modern technology and to allow them to leverage high tech to improve their lives. OLPC is, in essence, about trying to maintain the possibility of modern education in a world of scarce resources; it is an idealistic effort to provide the tools needed to make sure children can learn to use the tools that make the future possible.

Microsoft's efforts to get pre-installed status on the XO haven't been exactly smooth. OLPC, after all, reportedly rebuffed a no-fee offer by Apple to license MacOS X (whose open-source kernel is derived from the FreeBSD project to which Apple is a contributor, and the Mach project which Apple's retired Avadis Tevanian had nursed at MIT), purportedly because of non-open-source code also involved in MacOS X made the system politically unsatisfactory to OLPC. But apparently you can buy satisfaction. Microsoft, apparently concerned about a future in which discount laptops around the world would obsolete its proprietary file formats and render its high-margin products irrelevant, poured significant resources into a version of Microsoft-Windows designed to run on XO. Microsoft has insinuated its products into the OLPC program, even to the point of causing hardware modifications in OLPC in order to allow its enormous code to be stored and run on the machines. The fact that retail buyers in the US are not yet assured the ability to buy XO with pre-installed Microsoft products is of little concern to either Microsoft (which assumes you as an American can afford a costlier copy, and will do so on your next computer purchase) or OLPC (which is trying to look like an Open-Source advocate).

The fact that towns in Columbia have begun deploying Microsoft-Windows-equipped XO machines in schools (at least in part on Microsoft's nickel, hence the product placement opportunity) suggests that OLPC hasn't really stuck to its principled stance that recipients need to enjoy the Four Freedoms when they use and study software. OLPC is more interested in keeping its own project from becoming irrelevant through lack of funding. And there, OLPC and Microsoft can find common ground.