Friday, March 19, 2010

Issue X - Buffett

Dear Readers,

Over the past thirty years, Warren Buffett has emerged as the most admired all-around investor in the world. His simple, yet deep-rooted investment philosophies and an uncanny ability to simplify what many find extremely complicated helps to explain his all-around appeal to everyone from novice investors to seasoned market veterans. As a result, the self-written annual reports of Berkshire Hathaway, the conglomerate which he heads, have become required annual reading for many on Wall Street and Main Street alike. This issue of Greener Pastures contains some of my reactions to Berkshire’s 2009 acquisitions and Annual Report, released on February 27.

For those who may be unfamiliar with the setup of Berkshire Hathaway, it originally was a textile manufacturing company based in Massachusetts. Buffett bought it in 1965, and it has become a holding company for his investments. For the companies he buys, Buffett is perhaps the most hands-off owner in the world. The head office in Omaha has less than 15 employees (Buffett likes to point out this number is 14.8, because there is a woman who only works four days a week, and that it really ticks him off when people ask if he is the .8). Therefore, when Buffett buys a company, he leaves it intact and lets the CEO, often the same person who established and built the company, continue their work unimpeded. Indeed, the personality and brand-building talents of the CEO are something that Buffett seeks in a purchase. Al Ueltschi, the founder of Berkshire subsidiary FlightSafety International once said, “I feel like the company is still mine and that I still run it, I just swapped my publicly-traded stock for his publicly-traded stock.” For these reasons, the “Buffett CEO’s” are a vaunted group of individuals that are equally grateful for the assurance that Buffett will never sell their business.

One interesting thing from this year’s Annual Report is that Buffett explicitly mentioned that he believes Berkshire Hathaway is worth far more than its book value. He does this several times throughout the letter. I was a little surprised to read this at first, since Berkshire “A” Shares were trading around $118,000 when the Annual Report was released, 40% more than the year-end book value of $84,487. However, the shares have been on a tear since the beginning of the year, so this may not have been the case when he began the process of writing the letter. One passage states, that “in aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie [Munger, his long-time partner] and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value.” Buffett further references the insurance distortion when he states, “Our property-casualty (P/C) insurance business has been the engine behind Berkshire’s growth and will continue to be. It has worked wonders for us. We carry our P/C companies on our books at $15.5 billion more than their net tangible assets, an amount lodged in our “Goodwill” account. These companies, however, are worth far more than their carrying value.”

In the past year, Buffett’s most notable purchase was his biggest ever: the acquisition of Fort Worth, Texas-based Burlington Northern Santa Fe Railway (BNSF). Buffett already owned 22 percent of the railway, so he was familiar with their operations. It is a long-term bullish bet on the health of not only the US economy but that of China as well, since because BNSF provides access to major ports on the west coast. Therefore the company benefits whether it is shipping China-bound goods west or China-made, Wal-Mart bound goods on the return. In particular, Buffett, in the Annual Report, extols the benefits of having not only the railroad but access to its data as well. He quotes BNSF CEO Matthew Rose in characterizing the railroad as a “kaleidoscope” that offers insight on global trade flows. In fact, for years Buffett has said that rail data is among the economic data to which he pays the most attention. Berkshire’s portfolio already includes manufacturing, home builders, home furnishers, jewelers, real estate, credit, insurance, and air transportation; with the addition of ground transportation, it can be argued that Buffett now has constant access to a bank of US economic data that is second to only the Federal Reserve, although I’m sure many would argue his is actually better.

Since the acquisition, a lot of speculation has floated around with regard to the use of Berkshire Hathaway stock to pay for a portion of the railroad. Furthermore, criticism has arisen from his decision to classify BNSF within Berkshire as a Utility. Many long-time Buffett followers had expected him to establish a “Railroad” segment. He defended the decision in the Annual Report, arguing that both Utilities and Railroads are highly regulated and have high capital expenditures, among other things. Buffett biographer Alice Schroeder (a CPA, and author of Snowball, the best-selling 2008 Buffett biography) recently said that she was disappointed by this classification. She argued that it makes Berkshire “less transparent,” adding that he is including a transportation company to a segment that includes Mid-America Holdings, a holding company of public utilities. She recently posted on her blog that “If being a regulated and capital intensive business is what creates an operating segment for financial reporting, the insurance businesses would also be combined with Mid-America.”

Additionally, many have criticized the BNSF acquisition on the grounds that Buffett simply paid too much for the company. This is particularly important because railroads, as mentioned earlier, are highly capital-intensive in addition to being highly cyclical. Cash flow is good when the times are good, but capital expenditures are always present. That said, some commentators have brought up the fact that Buffett paid almost 9 times trailing cash operating income (EBITDA), 20 times trailing earnings, and 2.7 times book value. He addressed this issue in the Annual Report: “Charlie and I decided that the disadvantage of paying 30% of the price through stock was offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and liked for the long term. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We also like the prospect of investing additional billions over the years at reasonable rates of return. But the final decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made no sense. We would have then been giving up more than we were getting.”

My own reaction is that Buffett partially used his company’s stock because he believes it is still at a premium. After all, if it wasn't, then why use it? Additionally, the tone he takes in this passage can roughly be translated into “trust me on this one.” Not a problem for most Berkshire Hathaway shareholders, especially when you consider that Warren Buffett holds the distinction of having minted more millionaires, and indeed more billionaires, than anyone else in the world. Such a statement may initially seem odd for outsiders, but this is more or less typical of Buffett. It also reinforces another Buffett trait -- the trust and regard that Buffett holds for his CEO’s, the newest of whom is Matthew Rose.

In a similar manner to his treatment of BNSF, Buffett has Clayton Homes (a manufacturer of prefabricated homes) under the category of “Finance and Financial Products.” I found this odd, but it began to make sense as I read through that section of the Annual Report. His main problem is the newfound competition with the government’s housing programs. He states that “currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 5 1⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels. In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan.” If I’ve understood that correctly, Buffett is complaining is because the government’s actions are hindering his ability not to sell the homes themselves as much as they are hindering his ability to finance them. No wonder he categorized Clayton as he did. He goes on to say that Berkshire can’t borrow at a rate approaching that available to Fannie Mae and Freddie Mac. This will hurt sales, and “a multitude of worthy families who long for a low-cost home.” Even though I am a diehard Buffett fan, I disagree with him here.

Even though S&P stripped Berkshire of its AAA rating last month in the wake of the BNSF purchase, Buffett always has the advantage of his reputation. I would think that even without that rating, Buffett can command favorable terms on just about anything, a great example being the terms he got when purchasing preferred stock in Goldman Sachs during the financial crisis. In the Annual Report, Buffett estimates that Clayton’s buyers are paying to Berkshire are about 375 basis points more than those offered by Fannie and Freddie. Apparently, it’s not an issue of credit. Buffett insists that Clayton’s buyers are no different than everyone else, stating “Clayton’s delinquencies and defaults remain reasonable and will not cause us significant problems.” As I mentioned, if he really wanted to, he could negotiate a smaller spread than 375 basis points. I truly believe that he does want to sell more homes, it’s his company. But his categorization offers a window to what might be the real issue. Of course he could sell more mobile homes if buyers could get rates closer to conventional mortgages. However, he would lose the massive profits he makes on financing them. Furthermore, I get the impression that if this continues much longer, he may make a political statement or two on the subject.

Before I conclude, I will say that I could have made this 10-15 pages long, as I am a big fan of Warren Buffett and have a lot to say about the subject. Topics that I’ve left out include his relative lack of commentary on two subjects; his investment in Goldman Sachs, and also concerns he might have about the near future with regard to his municipal bond insurance business. With the recent bankruptcies of AMBAC and MBIA, Berkshire Hathaway is now the second-largest municipal bond insurer in the country, second only to Assured Guaranty. With the increasing media coverage about the financial woes of California and many other municipalities across the nation, I am surprised he did not share his views on this business in the Annual Report.

Finally, the Berkshire Hathaway Annual Report is the quintessential, witty Warren Buffett in action. Every year the report features passages that are quoted for years thereafter, whether they summarize an aspect or problem about Berkshire Hathaway or the economy in general. Highlights this year included his view on how to cure the housing glut in the US. “There are three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers; or (3) reduce new housing starts to a number far below the rate of household formations.” Another highlight was a general statement about small value destroying acquisitions as opposed to a large one, attributed to Charlie Munger: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?”

Respectfully Yours,
Matthew R. Green
March 19, 2010

Friday, March 5, 2010

Issue IX - Treasuries

Dear Readers,

United States Treasury Bonds have been considered the safest investments in the world for the greater part of the past century. They are universally liked by foreign governments, sovereign wealth funds, pension funds, all the way down to the average investor. Backed by the implicit full faith and credit of the US Government, the status of Treasuries as a safe investment was highlighted most comprehensively by the swelling demand for them during the nadir of the financial crisis. In September-November 2008, public and private investors wanted nothing but the safest paper, and the flight-to-quality that began late that summer resulted in the greatest short-term rally that Treasuries have ever seen. Consequently, those prices came back down to earth in 2009. However, as the deficits continue to pile up, and hundreds of billions in unfunded liabilities continue to smolder, there has rightfully been speculation with regard to the full faith and credit of the US Government.

Two hypothetical scenarios have emerged in recent months. The first is the possibility that China, the largest purchaser of Treasuries, will scale back on such purchases, causing yields to rise. The other theme of recent speculation, as mentioned by PIMCO’s Bill Gross in a recent fixed-income outlook, is whether corporate bonds are potentially a better investment than US Government bonds.

In late 2009, US Treasury department data revealed that China was no longer the largest holder of US Treasury Bonds. However, two weeks ago revised numbers were released showing that China was still the largest buyer, holding $894.8 Billion of Treasuries. Nevertheless, this number is down from its mid-2009 peak of over $900 billion, as China reduced its holdings of US Treasuries by about $45 billion. While it is too early to determine whether this is a permanent trend, it represents a definite stall in the rise of US debt owned by the Chinese, which had been rising for the last decade (refer to Chart 1).

Chart 1 – China’s Holdings of US Treasury Bonds 2000-2009

A recent guest on Bloomberg Radio speculated that an impending disaster would occur if China were to scale back its purchases of Treasuries to the level of a decade ago. Yes, of course that would be a disaster, but it is not likely unless China’s economy completely and utterly collapses. According to the World Bank, China's GDP more than tripled from $1.2 trillion in 2000 to $4.33 trillion in 2008. With continuing diversification, it is reasonable to say that if China scaled back on its purchases of Treasuries, it could return to 2006-07 levels, but even that would represent a 40-50% retracement, which is unlikely. The Chinese need safe investments to protect their ever-increasing wealth, especially with the current economic uncertainty within their own borders.

In China, there is currently a real estate bubble for which its government is attempting to engineer a soft landing. One of the measures undertaken is the raising of reserve requirements to prepare Chinese banks for the hit they may take. When the bubble inevitably pops and the Chinese demand safe investments, it is likely that their appetite for US Treasuries will at least be sustained. With yields on longer-dated US Treasuries already rising, this appears even more likely. Therefore, while I do not see the Chinese selling off Treasuries on any sizable scale, a steep Chinese recession could sap demand and cause yields to rise, contributing to inflation.

Furthermore, as government deficits around the world increase, we are potentially entering an era where the paper of selected corporations appears safer than selected nations’ sovereign debt. This was not the case previously and is still generally not. However, there is an emerging debate among fixed-income commentators about whether the highest-rated corporations could consistently trade at yields below that of their home country’s debt. Bond guru Bill Gross (CEO of PIMCO) recently commented on the current fixed-income landscape in his March 2010 investment outlook. He stated that “the narrowing in spreads since late November solicits an interesting proposition: government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous ‘unicredit’ type of bond market. If core sovereigns such as the US, Germany, UK, and Japan ‘absorb’ more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee.”

This poses the question of whether the numerous sovereign debt crises that have been sprouting up can be truly resolved by issuing more debt. The answer depends on the initial debt levels of the economies in question. The more indebted the nation, the more spreads will narrow for that country’s paper if their policymakers are successful in their efforts. Gross further stated, “When sovereign issues become more credit-like, as evidenced in Greece, Spain, Portugal, and a host of others, they move closer in yield to the corporate and agency debt that supposedly rank lower in the hierarchy.” Therefore, the answer depends on the combination of future inflation, the result of quantitative easing programs, and the recoveries of individual economies. More importantly, going forward sovereign debt investors will be on the lookout. Those economies that continue to bail out their institutions and fail to incorporate fiscal discipline will be more closely scrutinized. Finally, if the world economy relapses into recession from its current fragile state, it will be interesting to see what the appetite will be for Treasuries, PIIGS Bonds, UK Gilts, etc. No disrespect to Sinatra, but love may not always be lovelier the second time around.

With regard to China, in my opinion there is no such thing as an economic “soft landing.” Alan Greenspan was initially commended for having supposedly engineered such a scenario for the US economy in 2001-02. That praise waned with the onset of the financial crisis. He said in a 2009 interview that “September 11 was the type of event that historically could result in the undoing of a nation.” With the nation in shock, plus an economy already reeling from the bursting of the technology bubble, Greenspan began a series of sharp interest rate cuts to spur activity. While this fueled the housing boom and assisted the subsequent five –year bull market, the increased private debt that it encouraged (personal and corporate) ultimately made the 2008 fallout much worse than it otherwise would have been. I am not saying that it would not have happened, but in hindsight I think most would agree that a sharp 1-2 year recession, perhaps ending in 2003, rather than a mild nine-month recession would have been okay if it had prevented the housing bubble from growing out of hand which, as we know, is the root of the economic malaise of the past three years.

If the debt situation becomes unmanageable, my sense is that our leaders will first resort to raising taxes. When the ability to raise taxes fails, inflation will be the solution. It will need to be controlled, however. It could easily get out of hand, and when the political outcry becomes too great, then maybe, just maybe, our leaders will finally cut entitlement spending. This, however, is always an option of last resort because of the negative consequences for those in office. Furthermore, external default would not be enough to solve the problems the US faces, besides the fact that it would strain economic relations with the rest of the world. In a worst case scenario, US assets could potentially be seized by foreign governments, along with many financial institutions failing in the US and abroad. China can’t stop buying our debt because that would force the US to cut spending immediately, perhaps causing a recession in which the US consumer will stop buying Chinese products, and the economic interdependency would manifest itself in the worst way. There are no easy answers. The pain has to go somewhere, and because times were so good for so long we were able to delay the problem. It has only had the effect of building up the eventual pain that will need to be felt.

Respectfully Yours,
Matthew R. Green
March 5, 2010