Warren Buffett and Dow Chemical (DOW)

Today’s Wall Street Journal contains a front page article that will be widely viewed on Wall Street, I think, as a bit of comic relief.

In times of financial stress, cash-short companies have tended to go to Berkshire Hathaway for financial assistance.  If successful, they receive both money and the implicit endorsement of Warren Buffet.

In 2009, it was DOW’s turn.  It wanted to acquire Rohm and Haas, another chemical company.   The best deal it could find for a needed $3 billion was in Omaha, where Berkshire took a private placement of $3 billion in DOW preferred stock, with an annual dividend yield of 8.5%.  The preferred has been convertible for some time now into DOW common (yielding 3.4%), at DOW’s option, provided DOW has traded above $53.72 for a period of at least 20 trading days out of 30.

DOW shares were trading below $20 each when the deal was struck seven years ago.

On July 26th, the shares breached the $53.72 barrier and traded above it for five consecutive days–the final two on extremely heavy volume–before falling back.  At the same time, according to the WSJ, short interest in the stock has risen sharply.  In other words, someone has been a heavy seller, using stock borrowed from others.

Who could that be?

Although nothing is stated outright, the strong implication of the article is that the shortseller is Berkshire, which stands to lose $150 million+ a year in dividend income on conversion.

Part of the Wall Street humor in the situation is that the playing field isn’t level.  It’s perfectly legal for Berkshire to sell DOW short, although it does seem to cut against the homespun image Mr. Buffett has been at pains to cultivate for years.  On the other hand, however, DOW would run the risk of being accused of trying to pump up its stock price (and the value of management stock options) if it went out of its way to absorb any unusual selling.

 

Warren Buffett on the US economy

On pages seven and eight of his thirty page-long annual letter to shareholders of Berkshire Hathaway, Warren Buffett takes issue with politicians who are emphasizing the supposed weakness of the US economy.

After arguing, reasonably, that even 2% real GDP growth (more than double the growth of the population) is something Americans should be happy about, he says:

“Though the pie to be shared by the next generation will be far larger than today’s, how it will be divided will remain fiercely contentious. Just as is now the case, there will be struggles for the increased output of goods and services between those people in their productive years and retirees, between the healthy and the infirm, between the inheritors and the Horatio Algers, between investors and workers and, in particular, between those with talents that are valued highly by the marketplace and the equally decent hard-working Americans who lack the skills the market prizes…

The good news, however, is that even members of the “losing” sides will almost certainly enjoy – as they should – far more goods and services in the future than they have in the past. The quality of their increased bounty will also dramatically improve…My parents, when young, could not envision a television set, nor did I, in my 50s, think I needed a personal computer. Both products, once people saw what they could do, quickly revolutionized their lives. I now spend ten hours a week playing bridge online. And, as I write this letter, “search” is invaluable to me. (I’m not ready for Tinder, however.) For 240 years it’s been a terrible mistake to bet against America…”

I’m sure this is at least directionally true.  But it’s also a view from the sunny “winning” side of the struggles for a bigger slice of an expanding pie.  From the “losing” side, however, the picture is increasingly nineteenth century Dickens-ugly.  It’s also debatable whether a very poor family with a flat panel TV is that much better off than a generation-ago family with a radio.

The plight of people left behind by rapid structural change may present much more of a political and social problem than Mr. Buffett is able to see.  Whether such issues become stock and bond market problems as well remains to be seen.

More tomorrow.

Berkshire Hathaway and Kraft

A little less than a month ago, Warren Buffett’s Berkshire Hathaway and Heinz (controlled by Brazilian investment firm 3G) jointly announced a takeover offer for Kraft.  The Associated Press quoted Mr. Buffett as asserting “This is my kind of transaction.”  I looked for the press release containing the quote on the Berkshire website before starting to write this, but found nothing.   The News Releases link on the home page was last updated two weeks before the Kraft announcement.  Given the kindergarten look of the website, I’m not so surprised   …and I’m willing to believe the quote is genuine.  If not, there goes the intro to my post.

 

As to the “my kind” idea, it is and it isn’t.

On the one hand, Buffett has routinely been willing to be a lender to what he considers high-quality franchises, notably financial companies, in need of large amounts of money quickly–often during times of financial and economic turmoil.  The price of a Berkshire Hathaway loan typically includes at least a contingent equity component.  The Kraft case, a large-size private equity deal, is a simple extension of this past activity.

On the other, this is not the kind of equity transaction that made Mr. Buffett’s reputation–that is, buying a large position in a temporarily underperforming firm with a strong brand name and distribution network, perhaps making a few tweaks to corporate management, but basically leaving the company alone and waiting for the ship to right itself.  In the case of 3G’s latest packaged goods success, Heinz, profitability did skyrocket–but only after a liberal dose of financial leverage and the slash-and-burn laying off of a quarter of the workforce!  This is certainly not vintage Buffett.

Why should the tiger be changing its stripes?

Two reasons:

the opportunity.

I think many mature companies are wildly overstaffed, even today.

Their architects patterned their creation on the hierarchical structure they learned in the armed forces during the World War II era.  A basic principle was that a manager could effectively control at most seven subordinates, necessitating cascading levels of middle managers between the CEO and ordinary workers.  A corollary was that you could gauge a person’s importance by the number of people who, directly or indirectly, reported to him.

Sounds crazy, but at the time this design was being implemented, there was no internet, no cellphones, no personal computers, no fax machines, no copiers.  The ballpoint pen had still not been perfected.  Yes, there were electric lights and paper clips.  So personal contact was the key transmission mechanism for corporate communication.

Old habits die hard.  It’s difficult to conceive of making radical changes if you’ve been brought up in a certain system–especially if the company in question is steadily profitable.  And, of course, the manager who decided to cut headcount risked a loss of status.

Hence, 3G’s success.

plan A isn’t working  

One of the first, and most important, marketing lessons I have learned is that you don’t introduce strawberry as a flavor until sales of vanilla have stopped growing.  Why complicate your life?

Buffett’s direct equity participation in Kraft is a substantial departure from the type of investing that made him famous.  I’ve been arguing for some time that traditional value investing no longer works in the internet era.  That’s because the internet has quickly broken down traditional barriers to entry in very many industries.  It seems to me that Buffet’s move shows he thinks so too.

 

 

 

 

Warren Buffett’s latest portfolio moves: the 4Q14 13-f

Investment managers subject to SEC regulation (meaning basically everyone other than hedge funds) must file a quarterly report with the agency detailing significant changes in their portfolios.  It’s called a 13-f.  Today Berkshire Hathaway filed its 13-f for 4Q14.  I can’t find it yet on the Edgar website, but there has been plenty of media coverage.

Mr. Buffett has built up his media and industrial holdings, as well as adding to his IBM.  The more interesting aspect of the report is that it shows him selling off major energy holdings–ExxonMobil, which he had acquired about two years ago, and ConocoPhillips, which he had been selling for some time.  Neither has worked out well.

There’s also a smaller sale of shares in oilfield services firm National Oilwell Varco and a buy of tar sands miner Suncor–both presumably moves made by one of the two prospective heirs working as portfolio managers at the firm (whose portfolios are much smaller than Buffett’s.  Buffett has told investors to figure smaller buys and sells are theirs.)

Three observations:

–the Buffett moves would have been exciting–maybe even daring–in 1980.  Today, they seem more like changing exhibits in a museum.

–if I were interested in Energy and thought it more likely that oil prices would rise than fall, I’d be selling XOM, too.  After all, it’s one of the lowest beta (that is, least sensitive to oil price changes) members of the sector.

But I’d be buying shale oil and tar sands companies that have solid operations and that have been trampled on Wall Street in the rush to the door of the past half-year or so.  That doesn’t appear to be Mr. Buffett’s strategy, however.  His idea seems to be to cut his losses and shift to areas like Consumer discretionary. (A more aggressive stance would be to increase energy holdings by buying the high beta stocks now, with the intention of paring back later by selling things like XOM as prices begin to rise.)  NOTE:  I’m not recommending that anyone actually do this stuff.  I’m just commenting on what the holdings changes imply about what Mr. Buffett’s strategy must be.

–early in my career, I interviewed for a job (which I didn’t get) with a CIO who was building a research department for a new venture.  I was a candidate because I was, at the time, an expert on natural resources.   The CIO said the thought there were three key positions any research department must fill:  technology, finance and natural resources.  All require specialized knowledge.    I’d toss healthcare into the ring, as well.  I’d also observe that stock performance in these more technical areas is influenced much less by the companies’ financial statements than is the case with standard industrial or consumer names.

Mr. Buffett is an expert on financials–he runs a gigantic insurance company, after all.  On tech and resources, not so much, in my opinion.  Financials are the second-largest sector in the S&P 500, making up 16% of the total.  Tech makes up 19.5%; Energy is 8.3%; Healthcare 14.9%.  The latter three total 42.7% of the index.  As a portfolio manager, it’s hard enough to beat the index in the first place.  Being weak in two-fifths of it makes the task even harder.

Buffett, Duracell and Proctor and Gamble (PG)

Warren Buffett’s company, Berkshire Hathaway (BRK), is buying Duracell from PG for $2.9 billion.

The deal is a little more complex than that, though:

structure:  PG will inject $1.8 billion in cash into Duracell prior to the sale.  It will then swap the enlarged company for BRK’s 52.8 million share holding in PG.  This makes the headline number for the deal $4.7 billion.

a win-win

PG has been interested for years in offloading Duracell, which it acquired through its purchase of Gillette in 2005.  Duracell has gone ex growth, as today’s mobile devices like smartphones use rechargeable batteries, not disposables.  Complicating the issue is the fact that Duracell is on the books at the price Gillette paid for it in the 1980s.  So a sale for cash would presumably trigger a big capital gains tax.

With this deal, PG gets rid of a no-growth brand that no trade buyers were beating down the door to get.  It avoids taxes.  It accomplishes a share buyback at the same time and takes out a large seller whose activity would depress the stock price, to boot.  So, for PG the deal is a big winner.

BRK offloads its entire holding in PG at once.  I estimate the task would take three months in the open market, during which time PG shares would doubtless be depressed as the news hit Wall Street’s trading floors.  BRK also avoids taxes on a position that’s on its books at the cost of Gillette convertible bonds it bought in 1989.

On the surface, it appears that BRK doesn’t make out so well.  It has aguably swapped a slow-growth dog for money plus a no-growth cat.  But let’s look at the numbers.

Let’s say sale of the PG shares in the open market would bring in $4.7 billion but trigger taxes due of $1.2 billion (a number I just made up).  So the net to it is $3.5 billion.  By doing this deal instead, BRK gets $1.8 million in cash plus 100% ownership of a company that generated $400 million+ in cash over the past year.  This means BRK only needs Duracell to stay afloat for four more years to recover the price it’s paying.  In addition, PG disappears from the portfolio everyone watches (as a 100% holding, Duracell never makes it in). Looks like a good deal.

what catches my eye

I hadn’t realized before, but I’ve read in the Financial Times and the Wall Street Journal that this is the third such deal BRK has done in the past year.  This looks a lot to me like portfolio housecleaning.

Warren Buffett’s trademark has long been to buy consumer-oriented stocks with strong brand names, superior products and excellent distribution networks.  All are “moats” that defend against competition.  However, all these competitive advantages are being steadily eroded by generational and technological change.

It looks to me like a big (and overdue) strategy shift may be underway at BRK–one that the company, understandably, wants to keep under wraps for as long as possible.