The Warren Buffett Backlash

First, thanks to Abnormal Returns for a good round up of reactions to Berkshire Hathaway’s bad year. Most of these are pretty much the same, a condemnation for a terrible year and all sorts of scrutinizing in hindsight. Being the optimist that I am, I’d like to address a few things or at least make more of a glass half-full argument.

Lets start with Jeff Matthews and his own thoughts on Berkshire’s performance:

Based on the year-end portfolio presented in the letter (and it has changed only modestly over time, but now excludes two stocks, Burlington Northern and Moody’s, in which Berkshire owns 20% and must report its holdings under the equity method,) Berkshire’s entire equity portfolio, which had a $37 billion cost basis and a $49 billion market value at year-end 2008, was, as of yesterday’s market close, worth only about $37 billion.

Now, we know what you’re thinking: you’re thinking, “Warren doesn’t mind, so why should we?”

…Yet Buffett also disclosed what might go down as the second most surprising disclosure in today’s letter: he had to sell some of Berkshire’s stocks to make those headline-grabbing investments in GE, Goldman Sachs and Wrigley:

…Yet the fact is, the value of Berkshire’s equity portfolio is not only of enormous economic importance to Berkshire Hathaway and its shareholders, but to investors around the world who watch what Warren does and frequently imitate his moves.

And the fact that it appears to be right back to its cost basis—after decades of not—is startling.

This sounds really bad, but Matthews mistakenly leaves out dividends. Warren Buffett is not a fan of trading stocks often. Once he builds a core holding, he likes to keep it. Think of companies like American Express, the Washington Post, or Wells Fargo. All of which are over a decade old. Sometimes he makes a mistake of keeping them past their prime, like Coca-Cola but all of these companies feature a pretty good dividend arrangement. Check out page 68 of the annual report, the earnings from dividends and interest payments on fixed income securities are broken out for you.

While Berkshire may have had an equity portfolio that did not move for a year, it received positive dividend payments, that are going to one of the greatest capital allocators in the business. Dividend income actually increased $534 million for the year, but was offset by other declines. In total though, after taxes and minority interests Berkshire received about $3.5 billion in investment income.

The reason I bring up dividend payments is that they’re significant. Buffett is not someone who trades around his biggest holdings, he keeps them. It’s an affirmation of his belief in having a 20 hole punch card for your investments. Find 20 of the best businesses, invest in them, and watch them grow.

Matthews goes on to call Buffett’s selling of stocks shocking and his equity potfolio’s lack of movement startling. But, what if the two are intertwined? One of the biggest and worst performers in Berkshire’s portfolio is Wells Fargo. But if you go back and look, the bulk of the Wells Fargo position was accumulated in the years running up to 2008. Sure, he initially invested in the company back in 1989/1990 but that wasn’t majority of the position. For example, in 2006 to 2007 alone, Berkshire acquired a bit over 80 million Wells Fargo shares. Its arguable that commentators like Matthews are deriding the portfolio’s performance without giving it adequate time. Value investors are, after all, in it for the long term. One year’s performance may not be reflective of the underlying businesses. Wells Fargo is not Citigroup or AIG, it so far has not needed quarter after quarter of government aid. Buffett has already purchased Wells Fargo shares for his personal account, so I’d say he believes that Mr. Market is getting it wrong this time.

Secondly though, I wanted to address Matthews’ shock. If Buffett believes that Mr. Market is having a bout with depression, why wouldn’t he sell stock to find more attractive opportunities? He could be selling cheap to buy cheaper ( “Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share.” - 1981 Letter to Shareholders) The preferred share investments offer Berkshire a steady stream of large dividend payments that can be deployed in the market now. In addition, the fact that he used preferred shares rather than common investments likely indicates that he thinks the market for common stocks will be in flux for a while. This strategy accommodates Berkshire’s size too because Berkshire’s elephant of a cash-horde lacks the nimbleness to acquire positions without alerting the world and raising prices.

If Buffett was a high frequency trader, with tons of turnover, I could maybe accept Matthews’ argument regarding the equity portfolio’s lack of movement. But he’s not. When he acquires some of these big stakes, he keeps them for years, through the bad times and the good. That makes the dividend payments of these securities rather important. Quite a strange omission from someone who sells a book about the annual meeting.

Moving on to Felix Salmon of Portfolio magazine’s Market Movers:

He had to liquidiate some of his stock-market portfolio in 2008 in order to make investments in GE, Goldman Sachs and Wrigley. Which stocks did he sell? “Primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips”.

With hindsight, of course, the main stock he should have sold, before it entered a truly torrid 2009, was Wells Fargo. And selling Wells — or American Express, for that matter, which has also sunk like a stone of late — would have made a lot of sense, given that he was loading up on financials in the form of Goldman and GE securities. But instead he chose to go massively overweight financials, and sold instead safe-and-reliable defensive stocks. Weird.

Salmon seems quite certain about what should and should not have been sold and disagrees with Buffett’s increased exposure to financials. We know that Buffett believes Wells Fargo is undervalued and added shares of it to his personal account around the summer of 2008. I don’t think that he particularly cared whether he had X more in financials or Y more in healthcare. It is likely that when Buffett sold these positions, he was not thinking about diversification but rather the bargains available. He has never been a huge proponent of diversification:

The strategy (of portfolio concentration ) we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.

(Berkshire Hathaway - 1993 Chairman’s Letter to Shareholders)

Salmon is really making an apples to oranges comparison when he disagrees with selling JNJ for GE. You should not compare the performance of GE to JNJ. One is an investment in a preferred share deal and the other is simply a common stock investment. The preferred investments are not an investment on the basis of share performance, if they were, Buffett would have bought the common shares. Rather, they’re actually more of a bet on survivability. For Buffett to make money on his GE or GS investment, the companies simply have to survive and be able to pay their dividends to him. In the longer run, he does have warrants that give the ability to acquire shares of the common, but they’re not as important. If GE survives a year and Warren Buffett earns 10% on his $3 billion dollar investment, that return may likely outperform common stocks, especially if the market’s performance stays in this panicked state.

I find the particular passage enlightening:

Our convertible preferred stocks are relatively simple securities, yet I should warn you that, if the past is any guide, you may from time to time read inaccurate or misleading statements about them. Last year, for example, several members of the press calculated the value of all our preferreds as equal to that of the common stock into which they are convertible. By their logic, that is, our Salomon preferred, convertible into common at $38, would be worth 60% of face value if Salomon common were selling at $22.80. But there is a small problem with this line of reasoning: Using it, one must conclude that all of the value of a convertible preferred resides in the conversion privilege and that the value of a non-convertible preferred of Salomon would be zero, no matter what its coupon or terms for redemption.

The point you should keep in mind is that most of the value of our convertible preferreds is derived from their fixed-income characteristics. That means the securities cannot be worth less than the value they would possess as non-convertible preferreds and may be worth more because of their conversion options

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(Berkshire Hathaway Chairman’s Letter to Shareholders 1990)

Now the new investments aren’t exactly the same as these convertible preferreds, but they both share the fixed income characteristics that Buffett describes. In 1989, Buffett said, “Under almost any conditions, we expect these preferreds to return us our money plus dividends.” He goes on to say that it will be disappointing if they don’t also get to take advantage of the convertibility aspect of these securities. Still, it affirms the idea that one of the prime drivers in these preferred investments is the ability to receive dividend payments, convertibility is less important. The certainty is derived from betting that these companies will survive and be able to pay dividends to Berkshire.

It’s rather foolish to proclaim what mistakes Buffett has made when we’re only 3 months into the new year. Buffett has never been much of a market timer. When I saw his editorial in the NYTimes I thought it was nice but not indicative of any market bottom. In the past he’s exhibited little in market timing ability, yet when looked at over longer periods of time he always manages to come out on top. Maybe he deserves the benefit of the doubt, but at the very least, Berkshire’s performance should be gauged from a period longer than 3 months into the new years.