Warren Buffett and the Japanese sogo shosha

Yesterday, Warren Buffett announced that one of his insurance companies, National Indemnity, has acquired 5%+ positions in each of the five largest general trading companies (sogo shosha) in Japan. The yen currency asset exposure this creates is reportedly hedged through National Indemnity’s ownership of yen-denominated liabilities.

Buffett has given no rationale that I’ve seen for his purchase, although press reports point to stock prices at 75% of book value.

As it turns out, I spent a lot of time studying the Japanese trading companies at one point in my working career. I was a significant shareholder in Mitusbishi Corp. for a couple of years, and got to know that company quite well.

The general trading companies grew in importance to the Japanese economy after WWII as the country became a growing exporter of all sorts of goods. Each of the large industrial conglomerates (zaibatsu/keiretsu)–Mitsubishi, Mitsui, Sumitomo…–consolidated all its dealings with foreign countries, especially trade finance, in a single entity, its in-house trading company. Given that Japan is a natural resource-poor country, lacking energy resources in particular, the keiretsu were tasked by Tokyo with arranging for steady energy supplies. This task fell to the sogo shosha, as well.

The obvious investment attraction of the sogo shosha is that they’re cheap. On the other hand, they tend to remain cheap, for several reasons:

–the trading companies are embedded in the old samurai-era conglomerate structure. This is the most rigidly hierarchical, stuck in the mud part of the Japanese economy. They are tightly bound to the conglomerate whose name they bear and a re not free to make the economically best decisions for themselves

–they tend to have hundreds of subsidiaries, without any apparent desire to rationalize their structure

–they’re basically finance companies, which tend to trade at low multiples

–in the energy area, they act as national champions, not necessarily as profit-maximizing entities for themselves.

It will be interesting to see whether in this case Buffett is much more deeply knowledgeable about these Japanese firms than I am or whether this is another case of beefing up tech exposure by buying IBM because it looks cheap.

my take on Kraft Heinz Co (KHC)

Late last week, KHC reported 2Q18 earnings.  The figures were disappointing.  More importantly, the company announced it is:

–cutting the $.625/quarter dividend to $.40,

–writing down the value of its intangible assets by $15.4 billion (about 28% of the total) and

–involved in an SEC inquiry into the company’s accounting practices for determining cost of goods sold.  Apparently prompted by this, KHC boosted CoG for full-year 2018 by $25 million in 4Q18.

The stock declined by 27% on this news.

 

What’s going on?

broadly speaking…

KHC is controlled by famed investor Warren Buffett’s Berkshire Hathaway and by 3G, a group of investment bankers behind the consolidation success of beer maker Anheuser-Busch Inbev.

As I see it, Buffett’s principal investing idea continues to be that markets systematically undervalue “intangible assets,” accounted for as expenses, not assets–namely, successful firms’ brand-building through advertising/marketing and superior products/services.  This explains his preference for packaged goods companies and his odd tech choices like IBM and, only after all these many years of success, Apple.  All have well-known brand names cemented into public consciousness by decades of marketing expenditure.

3G believes, I think, that in most WWII-era companies a quarter to a third of employees do no useful work.  Therefore, acquiring them and trimming the outrageous levels of fat will pay large dividends.  Remaining workers, arguably, will figure out that performing well trumps office politics as a way of climbing the corporate ladder, so operations will continue to chug along after the initial cull.

These beliefs account for the partners’ interest in KHC.

 

My take here is that the investing world has long since incorporated Mr. Buffett’s once groundbreaking thinking into its operating procedures, so that appreciating the power of intangibles no longer gives much of an investing edge.  (Actually, KHC suggests reliance on the fact of intangibles may make one too complacent.)  As to G3, it’s hard for me to figure how companies fare after the dead wood is eliminated.

the quarter

The most startling, and worrying, thing to me about the quarter is the writedown of intangibles.  My (admittedly quick) look at the KHC balance sheet shows that total liabilities and tangible assets–working capital and plant/equipment–pretty much net each other out.  This means that shareholders equity (book value) pretty much consists solely in the intangibles that drive customers to buy KHC’s ketchup and processed cheese foods.  That number is now 28% lower than the last time the company looked at these factors.  Did all that decline happen in 2018?  Is this the last writedown, or are more in the offing?

The fall in the stock price seems to me to correspond closely to the writedown.  I’d expect the same to hold the in the future.  And it’s why I think the risk of further writedowns is a shareholder’s biggest worry.

 

–A dividend reduction is always a red flag, especially so in a case like this where the payout has been rising.  It suggests strongly that something has come out of the blue for the board of directors.  However, KHC appears to be indicating that cash cows are being divested and that loss of associated cash flow is behind the dividend cut.  I don’t know the company well enough to decide how cogent this explanation is, but it’s enough to put the dividend cut into second place on my list.

–an SEC inquiry is never a good sign.  In this case, though, it seems that only small amounts of money are at issue.  But, if nothing else, it points to weaknesses in management controls, supposedly 3G’s forte.

 

Final thoughts:

–Experience tells me the whole story isn’t out yet.  I’d want to know whether KHC is taking these actions on its own, or are the company’s lenders, its auditors or the SEC playing an important role?

–This case argues that the intangible economic “moats” that value investors often talk about have less protective value in the Internet/Millennial era than in earlier, slower-changing times.

 

 

 

 

gains for Berkshire Hathaway (BRK) on GE and BofA

Every investment company has to make public filings with the SEC that disclose its quarter-end investment positions.  Comparing the changes between filings allows anyone to see the investment moves of high-level professionals, even though this comes with a lag.

Recently, the press has picked up on the results of two investments made by Warren Buffett/BRK during the financial crisis.  He provided finance to Bank of America (BAC) and to General Electric (GE), two companies whose operations were under great stress because of recession.  As he has done in other instances, Buffett demanded, and received, a long-running option to convert what were essentially commercial loans into the companies’ common stock at 2008 prices, in the case of GE, and 2011 prices, in the case of BAC.

BRK and GE, BAC

BRK has recently cashed out of its position in GE completely and has converted the BAC preferred stock it bought into common.  Back of the envelope, here’s how Mr. Buffett made out:

–BRK lent GE $3 billion and received a total of $4 billion back, including the sale of all the stock bought through warrant exercise;  a gain of 33.3% over nine years, during which time the S&P 500 gained 250%+.

–BRK lent BAC $5 billion.  It has received about $2 billion in dividend payments and has a gain of about $11 billion on the BAC stock it now owns.  That’s a gain of 260% over six years, during which time the S&P 500 gained about 110%.

Together:  BRK lost $6.5 billion by its investment in GE vs. holding an S&P 500 index fund;  it has gained $8 billion vs the index so far on holding BAC.

evaluating results

A more interesting question:  did BRK do well or badly?

On GE, the answer is clear.  The investment did very poorly.

On BAC, the answer is also clear.  The investment gave BRK more downside protection, and higher income, than the common during a time when BAC was in hot water.  And it came just before BAC began its long run of outperformance against the S&P 500.   So this was a home run.

Regular readers will know that my overall view on Mr. Buffett is that he persists in using a manual typewriter in a Word (or Google docs) world.  You have to hand it to him on BAC.  But GE’s salad days were long gone when he put BRK’s money into it.

Warren Buffett and Amazon (AMZN)

I read a recent comment Warren Buffett made expressing his regret at never having bought AMZN.

As far as I can see–and I’ve never met Mr. Buffett–he’s an urbane, sophisticated, complex individual who chooses a down-home persona to market himself to the world.  I don’t regard anything he says that involves the stock market as being a stray, off-the-cuff remark.  I wonder what he meant.

the top ten

As of March 31st, Berkshire Hathaway’s top ten holdings are, in order:

Kraft Heinz

Wells Fargo

Apple

Coca Cola

American Express

IBM (adjusted down for Buffett’s announced intention to pare his holding by 30%)

Phillips 66

US Bancorp

Charter Communications

Moody’s.

Source:  CNBC (a format that allows easy sorting of the SEC data)

The list comprises 80% of Berkshire’s equities.

 

Yes, despite Buffett’s well-advertised aversion to tech, there are two IT names in the top ten.  But IBM is cutting edge tech circa 1975 and AAPL is a high-end smartphone company looking for a new world to conquer.

the Buffett approach

All these firms do have the signature Buffett look:  they have all spent tons of money developing important consumer-facing brand names.  While that spending has created an enduring consumer franchise, there is no hint of the existence of this key asset on the balance sheet.  Rather, the all-important brand-building expenditure is accounted for as a subtraction from asset value.

The one possible exception to this is Charter, whose cable networks rather than sterling service and extensive advertising give it near-monopoly access to customers.  Here again, however, the ability to gradually write off the cost of constructing those networks through depreciation argues that the balance sheet severely understates their true worth.

The formula, in brief:  the “hidden” value of extensive well-staffed distribution networks plus iconic brands built through extensive spending on advertising and promotion.

limitations

The obvious limitations of this approach are:  that while novel in the 1950s, the whole world has since adopted Buffett’s once-pioneering approach; this would be great if there were no internet undermining the value of traditional brand names and distribution networks.

In other words, a software-driven, internet-based firm like AMZN seems to me to be the last thing that would ever be on the Buffett radar.  It also seems to me that taking AMZN seriously would mean rethinking the the whole Buffett investment approach–not the valuation discipline, but the idea of the value of traditional intangibles–and recasting it in a much techier way.

why not adapt?

Why not do so anyway, instead of kind of limping to the finish line?

Maybe it’s because that doing so would attack the heart of the intangible brand value of Berkshire Hathaway itself–and that attack would come not just from a nobody but from the brand’s most credible spokesperson, the Sage of Omaha himself.

 

Warren Buffett selling Wal-Mart (WMT)

Investment companies are required to file lists of their holdings with the SEC at the end of each quarter.  The latest such 13-F form for Berkshire Hathaway shows a buildup in Apple and airlines   …and the sale of virtually all of Buffett’s long-term holding in WMT.

WMT as icon

A powerhouse in the 1970s and 1980s, WMT has been a bad stock for a long time.  It had a moment in the sun during the market meltdown from mid-2007 through early 2009, when it rose by about 1% while the S&P 500 was almost cut in half.  Since the bottom, however, WMT has gained 40% while the S&P is up by 219%.

Wal-Mart isn’t an obviously badly run company.  It isn’t, say, Sears, or the Ackman-run J C Penney.  But it does have a number of impediments to achieving significant growth in earnings.  One is its already gigantic size.  A second is its focus on less affluent rural customers who were disproportionately hard-hit by recession and who have in many instances yet to recover.  There’s increased competition from the dollar stores.   And there’s Amazon, whose competitive threat WMT itself admits it played down for far too long.

My reaction:

old habits die hard.  Mr. Buffett built his career from the 1950s onward on the observation, novel at that time, that traditional Graham/Dodd portfolio investing techniques glossed over the considerable value of investment in intangible assets–brand names, distribution networks, superior business practices.  However, by the time I entered the business in the late 1970s, other people–me included–were beginning to adopt his methods.  So thinking about intangibles became part of the toolkit, rather than something special.  Then, of course, the internet began to erode the power of intangibles to stop newcomers from entering a business.  Mr. Buffett, like any successful incumbent (including WMT), has been slow to adapt.

WMT as metaphor for today.  WMT could become more profitable quickly if its heartland lower-income customer base could earn more money.  One way to do that would be to bar imported goods from the country, with an eye to creating manufacturing jobs in the US.  Of course, that would also destroy the WMT value proposition in the process.  So rolling the clock back to 1950 isn’t the answer, either for the health of WMT or for its customers.