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Profit with Berkshire and Buffett

Posted on: November 3, 2008 - Email Article - Printable Version

Taylor DeStefano

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Berkshire Hathaway Inc. [[BRK.A]] has been receiving a lot of press lately, as CEO and billionaire investor Warren Buffet has been negotiating favorable terms for deals with companies including Constellation Energy Holding Inc [CEG: 26.40, +0.48 (+1.85%)], Goldman Sachs Group Inc [GS: 88.78, +2.02 (+2.33%)], and General Electric Co [GE: 16.63, -0.44 (-2.58%)]. Many investors are wondering if they should follow Buffett’s lead and return to investing in equities, but the answer is not so simple. Even though he is one of the world’s greatest investors, it is not always necessarily prudent for individual investors to mimic his investing decisions. However, his investing expertise has undoubtedly led to the success of Berkshire Hathaway and his acquisition strategy has resulted in consistent growth of the company’s operating businesses.

A Legendary Investor

Buffett is a master of acquisitions that create shareholder value rather than destroy it. He seeks to acquire businesses that are simple and easy to understand, with strong management and a good price, while typically avoiding industries prone to rapid and continuous change. Buffett’s investing savvy has undoubtedly led the firm to increase book value from $19 to over $78,000 in the last 43 years, a rate of 21.1% compounded annually. Berkshire has large investments in American Express Company [AXP: 19.95, +0.62 (+3.21%)], The Coca-Cola Company [KO: 45.44, -0.46 (-1.00%)], Moody’s Corporation [MCO: 22.17, +0.01 (+0.05%)], The Washington Post Company [WPO: 414.00, +0.80 (+0.19%)], and Wells Fargo & Company [WFC: 28.06, -1.94 (-6.47%)], among others.

His conservative investing approach and emphasis on avoiding complicated businesses and financial derivatives has benefited the company tremendously, especially in recent years. In 2003, Buffett dubbed credit default swaps, “the financial weapons of mass destruction.” The CDS problems that have plagued financial firms including Berkshire’s competitor, American International Group [AIG: 1.66, -0.03 (-1.78%)], have proved him right.

Perhaps the most surprising of Mr. Buffett’s success stories is Berkshire Hathaway’s subsidiary, Clayton Homes, which makes and finances prefab and mobile homes. The business was acquired in 2003 and a daunting 45% of their loans are made to subprime borrowers. However, while the mortgage markets have spurred billions of dollars in writedowns, Clayton’s loan delinquency rates have held stable and foreclosures have actually dropped by over 1,000 over the past two years. The company has managed to keep the strength of their loan portfolio because they keep all of their loans on their own books rather than securitizing them. They also shed away from the recent common practice of reeling in buyers with low initial payments and significantly higher payments later on. It helped them to stay away from customers who bought on speculation or those who would sell based on the home losing value.

A Safe Play

Especially with the current turmoil in the market, BRK.A is a safe long term play. As a large conglomerate, Berkshire Hathaway benefits from diverse revenue streams, with businesses ranging from its cornerstone insurance operations to manufacturing and utility companies. The firm is well capitalized and relatively unleveraged. The holding company has $43 billion in cash on its balance sheet, which helps position them to take advantage of good deals.

Luckily, the company has shifted its focus in the past decade from simply insurance operations and investments, to its other three operating sectors: regulated utility business, manufacturing, service and retailing operations, and finance and finance products. This is positive because of the volatility in earnings in the insurance business, and insurance profit margins will surely fall in 2008. The last two years have been rather lucky for insurance companies in terms of catastrophes, with losses on the lighter side; it is unlikely that this will continue in 2008.

Sealing the Deal

Critics might say Buffett reacted too quickly regarding the recent deals made with GE and Goldman Sachs, but he doesn’t believe in perfectly timing his investments. Regardless of good timing or not, Buffett received terms on the deals with both companies that would have been unimaginable several months ago.

In regards to the deal with Goldman Sachs, he received preferred stock with a 10 % dividend and warrants for $5 billion of common stock at $115 per share with 5 years to exercise them. He also purchased $3 billion of preferred shares in General Electric with a 10% dividend and the option to buy $3 billion in common stock over the next five years as well. Surprisingly enough, these companies were not just after capital, as they could have easily found it more cheaply elsewhere. What the companies really sought was the boost of confidence that a Warren Buffett approval would give to investors, and with deals so favorable on Buffett’s end the agreements are highly unlikely to tarnish his stellar reputation.

Conclusion

Some investors have concerns over Berkshire’s succession plan and what will happen if Buffett can no longer act as CEO for the company. However, even though a successor has not been publicly announced, a clear succession plan has been developed and the Board knows exactly who would be appointed to replace Buffett if a situation were to arise. Additionally, the process that Buffett and his partner, Charles T. Munger, have developed for investing is concrete and will remain with the company. The weak economic environment presents a good buying opportunity as the stock has recently taken a hit and is trading closer to its 52 week low of $105,300. Buffett’s donation of the stock to the Gates Foundation should give the stock an extra boost when the Gates Foundation sells the shares to investors. This is certainly not a short term play but a core long term holding in a company with a fortress balance sheet, strong cash flows, and top management that will always be a great investment.