Chris Lau - Seeking Alpha

Monday, March 02, 2009

Buffett says Economy in Shambles

"The economy will be in shambles throughout 2009 -- and for that matter, probably well beyond." - W. Buffett
This entry is lengthy, because Buffett, and his teacher, Benjamin Graham ("The Intelligent Investor" and "Security Analysis") forms the core fundamentals in my overall investment strategy. Although the market is currently working on a new set of unknown and changing rules, not all of the core fundamentals are applicable at least for the short term. Still, Buffett has returned 362,319% since 1965. In 2008 his company lost 9.6%. The S&P 500 lost 37%. On a relative basis, I would say that Buffett did very well (almost four times better).

Summary of Warren Buffet's Berkshire Hathaway results for 2008:
  • Revenue fell 12 percent to $24.59 billion.
  • Lost $4.61 billion in junk bonds, derivative contracts
  • Profits was $3,224 per share for 2008 against $8,548 in 2007
  • Investments fell from $90,343 per share of Berkshire to $77,793
CNN noted that Berkshire's profits stemmed mainly from interest and dividends on its investments and the earnings of its 70 operating subsidiaries. Berkshire has extensive holdings in two industries, insurance and utilities, whose earnings are not closely correlated with those of the general economy."During 2008 I did some dumb things in investments."

Buffett's Investment Strategy
  • The paradox of Buffett's investment year will be evident: To put Berkshire's pile of cash to work at prices he considered attractive -- "I like those preferreds," he said recently -- he had to endure a terrible stock market that savaged many of the stocks the company already held. He has always declared, though, that he is perfectly content to see Berkshire's stocks fall in price, because that allows him to buy more of them cheaply.
Buffett's Investment Goals:

"In good years and bad, Charlie and I simply focus on four goals:

(1) maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash;

(2) widening the “moats” around our operating businesses that give them durable competitive advantages;

(3) acquiring and developing new and varied streams of earnings;

(4) expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results."

The Good News:
For objective #4, Buffett is referring to the solid management in their utilities business. In the insurance business, Berkshire made $2.8 billion just to "float" $58.5 billion of insurance.

Notable comment about insurance:
"GEICO grows because it saves money for motorists. No one likes to buy auto insurance. But virtually everyone likes to drive. So, sensibly, drivers look for the lowest-cost insurance consistent with first-class service."

The Bad News:
"I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action."
Having little to no reaction is like being a rock that won't change. The economy today needs investors who are more fluid and more reactive to the facts that matter. The challenge, of course, is knowing which facts matter and which ones do not.

On Housing:
Foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay.

Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.
I am a part-time real estate in Toronto. The first thing I do is check and counsel buyers about how much they can and should spend on a home.

On Clayton, the home lending unit for Berkshire:
At the moment, it is much better to be a financial cripple with a government guarantee than a Gibraltar without one.
I find this situation troublesome. The government is stepping into the home lending business, and creating a level of competition that hurts healthy lenders.

Buffett Steps It Up a Notch Too:
When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.
I do not agree that buying $14.5 billion worth of fixed income from GE, Goldman Sachs, and Wrigley is worth trading in the well-run J&J and P&G. These companies may fall due to declining consumer spending. However, low energy prices will keep costs down, and "recession-proof" items will ensure sales don't fall that much.

...But the U.S. Treasury bond bubble of late 2008 may be regarded as almost
equally extraordinary.

Comment: I am short TLT, long TBT.

On Cash:
Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted.

They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

I fit in this category. My investment thesis lies squarely on protecting principle, and acting when there is clear evidence that the economic implosion experienced in Q4/2008 and in the foreseeable future abates. I am sure that Castlemoore Inc. would agree with this thesis, since I have re-modeled my strategy to be "aggressive" than in the past (Castlemoore currently recommends a 30% equity holding and 70% cash).

Admittedly, one thing I am cognizant of is being paralyzed from taking action when the time is right, because there can never really be a way to predict when that time is right.

On being part of the herd:
"Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns."
I interpret this as an investors need to be objective, separate, and independent in thought from others.

A Red Flag:
Berkshire has $37.1 billion in put contracts. This means that if the major indices are below a certain level in 2019 - 2028, Berkshire could in theory lose $37.1B if the indices were 0. This is unlikely, so a more reasonable target loss would be a 25% decline in the indices (from inception of each contract). This translates to a $9B loss payable between 2018 and 2028.

To-date, Berkshire has a paper loss of $5.1B (loss is reported due to changes in accounting rules).

The Bad News (Results)

Buffett bought large amount of Conoco Phillips stock when oil prices were near their peak and in no way anticipated the dramatic drop in prices that subsequently occurred.

Buffett said he still thinks the odds are good that oil will sell in the future at much higher prices than the $40 to $50 per barrel. Even if prices should rise, he said, "the terrible timing" of the Conoco purchase has cost Berkshire several billion dollars (paraphrased from CNN Money; link is below).

Other Losses:
  • American Express (AXP, Fortune 500) shares fell by $5 billion
  • Coca-Cola (KO, Fortune 500) stake sank by $3 billion
  • Wells Fargo have lost well over half their market value, falling from $9 billion to $3.65 billion.
  • Holdings in U.S. Bancorp (USB, Fortune 500) is down by around $800 million
Final Comment:
I had thought that Berkshire would reduce or eliminate its holdings in banks, but in doing so the paper losses become real ones.

Full Letter Here
CNN Money's on Berkshire

Other Links
Hedge Fund (Thanks Dan, from KaChing)