Thursday, November 12, 2009

Warren Buffett and the Business of Life: Part 2 of 7

With the stock market so expensive, for the past several years Buffett had continued to buy mostly whole businesses. Berkshire bought Iscar, a highly automated Israeli maker of metal cutting tools, in its first acquisition of a non-U.S. company. For Fruit of the Loom, Buffett bought Russell Athletics. Berkshire took control of Equitas, assuming the old claims of Lloyd's of London in exchange for $7 billion worth of insurance float, and also bought electronics distributor TTI. Buffett invested steadily in the stock of BNSF (Burlington Northern Santa Fe) railroad in 2007, setting off a minor flurry of interest in railroad stocks. His interest in railroads was built on the thesis that U.S. imports from Asia, especially China, would continue to stay high--and the goods would have to be transported to markets all over the United States. Railroads have an advantage over trucking because of their greater fuel efficiency. The level of imports at the time he began buying this stock reflected a relatively weak dollar (compared to what came later) and a boom economy. As these conditions reversed, he stayed true to his long-term strategy; he would eventually increase Berkshire's stake in BNSF to more than twenty percent of the railroad.

One investment that Buffett did not make was in the Wall Street Journal. Although it was his favorite newspaper, he had never owned its stock. When press lord Rupert Murdoch offered to buy the paper in 2007, some Journal editors and staffers hoped that Buffett would save it in the cause of quality journalism. But he would not pay a premium price for what he considered a rich man's trophy, even to play a potentially historic role in media. Long ago, during the days of the Washington Monthly, the unsentimental side of Buffett had divorced his fondness for journalism from his wallet. Nothing had changed that.

In Buffett's lifetime, the rapid "disintermediation" of the entirety of traditional media--that is, the replacement, at varying speeds, of recorded music, movies, newspapers, radio, television, and magazines by a single medium, consisting of the Internet and various hard storage devices such as the personal computer and the iPod--was the greatest change in business that he had ever witnessed in any of the industries he had studied. Even his favorite of Walter Annenberg's "essentialities," the Daily Racing Form, had become, for all practical purposes, toast.

Buffett would always love reading newspapers, but his investing was tightly focused on simple businesses that were as close to immortal as possible. Newspapers--in fact, any sort of media--no longer qualified. Candy, on the other hand, was an immortal business, and the economics of the candy business remained predictable.

In 2008, candy maker Mars, Inc. announced that it was buying Wm. Wrigley Jr. Company for $23 billion. Buffett agreed, through Berkshire, to lend $6.5 billion as part of the deal, in an arrangement facilitated by Byron Trott, his investment banker at Goldman Sachs. Trott had been responsible for several of Berkshire's acquisitions. He understood how Buffett thought, and Buffett said that Trott had Berkshire's interests at heart. Like many of Buffett's investments, the Wrigley deal harkened back to his childhood, when he had refused to sell a single stick of gum to Virginia Macoubrie. "I've been conducting a seventy-year taste test," Buffett said about Wrigley's.

Buffett's first thought after agreeing to make the loan--of course--had been to call Kelly Muchemore Broz and ask her to set aside a little space at the next shareholder meeting, in case Mars and Wrigley wanted to sell products to his shareholders. The 2008 meeting turned into a mini-festival of candy and chewing gum. Attendance set a new record: 31,000 people.

In another deal that year typical of Buffett, Berkshire acquired Marmon Holdings, a small industrial conglomerate with sales of $7 billion. The seller was Chicago's Pritzker family, which had decided to break up its business to settle family squabbling that had broken out after the death of Buffett's old coattailing hero Jay Pritzker in 1999.

Around this time, Buffett had also become more interested in the energy business, even though he had sold the PetroChina stock--for which he had recently taken a lot of heat, because when the price of crude oil peaked in July 2008 at $147 per barrel, six months after the sale, PetroChina's stock kept rising. Buffett's critics didn't hesitate to speak up; he was accused of selling PetroChina too soon. Buffett said that he felt Berkshire had made enough money on the stock. What no one knew at the time was that Buffett was buying a huge slug--66.4 million shares--of ConocoPhillips stock. He was also increasing Berkshire's stake in NRG Energy, Inc.

ConocoPhillips was the cheapest of the major energy stocks, and Buffett was concerned about inflation. Still, it was a surprising move at a time when complaints were proliferating that speculators were manipulating the energy market. Buffett's next move was equally counterintuitive. He wrote various derivative contracts for Berkshire that amounted to optimistic calls on the stock market in various economies. Some of these were direct bets on the market, and others were indirect bets that tied up some of Berkshire's capital, rendering it unavailable in the event of a market crash.

The direct bets were "put options" on four stock indices--the Euro zone, the United States, the United Kingdom, and Japan--that would expire between 2019 and 2028. Berkshire would pay the buyers if any of the indices were lower at expiration than they had been when the puts were written. The total maximum exposure to these contracts (before taxes, and before $4.9 billion of premiums and the investment income they will earn) was $37.1 billion. Most likely, Berkshire would lose nothing, or a smaller amount. To lose the entire $37.1 billion, all four stock indices would have to fall to zero, in which case the world and whoever is running Berkshire at that time will have far bigger problems to worry about.

In deciding to insure investors against the risk that most of the world (except China) becomes insolvent, Buffett had handicapped the situation the way he would a catastrophe reinsurance contract--by assessing probabilities--and concluded that he liked the price compared to the risk Berkshire was taking. One curious aspect of these deals was their duration. Buffett had entered into contracts worth tens of billions of dollars, which would take up a chunk of Berkshire's capital and whose value would not be known until he was between eighty-nine and ninety-eight years old. It was as if he had staked out a plot of capital within Berkshire, and leased it for this term. For the first time, he seemed to be acting on his determination to match Rose Blumkin's lifespan.

This analysis of Buffett's actions in recent years is constrained by close perspective and lack of hindsight; it is more akin to reporting and should be considered as such--in other words, more subject to revision than other portions of the book. However, it appears that Buffett, the ultimate capital allocator, did not fully understand how much capital he was committing to these deals. Buffett's analysis excluded one other variable. Investors on the other side of Berkshire's equity-index puts needed to hedge their credit risk on Berkshire. Buffett would later acknowledge (at the 2009 shareholders meeting) that he did not realize this. He thought of Berkshire, with its "Fort Knox" balance sheet and triple-A credit rating, as having essentially no credit risk, even though investors looked at it differently--quantitatively. If Berkshire could not pay for any reason, they would lose money. The investors bought credit default swaps (CDSs), a type of derivative that insures against credit risk, to make bets that would pay off if Berkshire stock fell.

The CDS price, or "swap spread," is an indicator of a company's bankruptcy risk. Stocks tend to trade in the reverse direction of their swap spreads. The CDS market has certain flaws, an important one being that a company's bankruptcy risk grows as its stock price falls, and its stock price falls if its perceived bankruptcy risk rises. This self-reinforcing loop means that even companies with strong finances can find their balance sheets encumbered by perceived credit risk if their stock prices fall when their swap spreads rise.

Initially, this feedback loop did not seem important to Berkshire. Its stock price was approaching an all-time high; few people were paying attention to the puts; Berkshire's balance sheet seemed impregnable.

Buffett's sanguine attitude about the market, as displayed in the Conoco--Phillips stock, the derivative deals, and his investing in a pair of Irish banks that were profiting from the booming--some said speculative--Irish economy, was all of a piece with another decision: to maintain large positions in certain stocks, specially financial stocks, but also in the rating agency Moody's and in Coca-Cola, despite record stock valuations and signs of a bursting real estate bubble. In his mind, Buffett could clearly foresee the outlines of a potential financial meltdown. He explained how he wanted Berkshire to be positioned if that happened: "We want to be the lender of last resort." Berkshire's balance sheet made it, as Buffett always said, the "Fort Knox of capital."

But it was as if he had never sat down and asked himself: What would Berkshire's balance sheet look like if global stock markets fell by fifty percent?

This would later prove an important omission.

Link.