Monday, November 7, 2011

Buffett Invests Over $ 20 Billion in 3Q 2011

In what was a very rough quarter for stocks, Buffett went on a bit of a buying spree.

Bloomberg: Buffett Broaden Portfolio By Spending $ 23.9 Billion

The bulk of Berkshire Hathaway's (BRKa) investment dollars in 3Q went into the following:
$ 6.9 billion in miscellaneous equities
$ 5.0 billion in Bank of America (BAC) preferred shares/warrants
$ 9.0 billion acquisition of Lubrizol

This Bloomberg article:

Berkshire bought just under $ 7 billion in equities in the quarter (equity purchases were ~$ 3.6 billion in the prior quarter and a bit more than $ 800 million the quarter before that).

According to their latest filing, just $ 676 million of equities were sold in the latest quarter.

Unless permission is granted by the SEC to withhold data on some holdings, there'll be more details on the specific equities that were purchased by Berkshire when the 13F* is filed later this month.

Core operating earnings at Berkshire were just fine but wild swings in the derivatives portfolio, a non-cash accounting matter that reveals nothing about long run economic performance, reduced net income 24% to $ 2.28 billion.

This Wall Street Journal article points out:

- Derivatives losses are mostly an accounting matter
- Berkshire does not part with any of its cash
- Buffett calls the large quarterly swings "meaningless" and says operating results are a better measure
- Operating earnings were $ 3.81 billion versus $ 2.79 billion a year ago.

Now, while the swings in accounting value of these derivatives may be meaningless in the short run, the "float" these derivatives provide to Berkshire is not meaningless at all. They have profited significantly from the float the derivatives contracts provide:

...our derivatives "float"...is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake. - 2008 Berkshire Hathaway Shareholder Letter

In the 2008 letter, Buffett also said:

We have told you before that our derivative contracts, subject as they are to mark-to-market accounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie and me. Indeed, the "downs" can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealings will lead you to think similarly. - 2008 Berkshire Hathaway Shareholder Letter

Interpreting Berkshire's operating performance quarter-to-quarter isn't always straightforward. Lots of noise in the numbers.

Net income reveals little. A reflection of accounting limitations, not Berkshire's core economics.

In the 3rd quarter of 2011, derivatives happened to lower net income but this cuts both ways. Consider that, just as an example, in 2009 derivatives pre-tax mark-to-market gains (losses) for Berkshire were as follows:

1Q ($ 1,517)
2Q  $ 2,357
3Q  $ 1,732
4Q  $ 1,052
Source: 2009 Berkshire Hathaway Shareholder Letter

So, that year, in 3 of the 4 quarters derivatives provided substantial mark-to-market gains and, in contrast to the most recent quarter, boosted net income. Naturally, mark-to-market accounting results that have no cash impact are just as meaningless when they happen to artificially inflate net income as when they reduce it.

The bottom line is that derivatives do definitely add complexity and certainly some noise to the numbers reported by Berkshire.

Yet, if you step back it's a company with a nearly $ 150 billion equity/bond/cash portfolio, a balance sheet providing very low cost capital**, and the combined earning power of the 68 non-insurance businesses that produced nearly $ 10 billion in pre-tax earnings in 2010 (a more than 6x increase on a per share basis compared to 2000).

Ultimately, where the value comes from is pretty straightforward.

The Berkshire portfolio, its low cost float (actually less than zero cost historically), and the earning power of the non-insurance businesses are key elements of Berkshire's value creation machine. These elements of value won't change but, increasingly, non-insurance operations should continue to become more the driving force.

In Berkshire's early years, we focused on the investment side. During the past two decades, however, we've increasingly emphasized the development of earnings from non-insurance businesses, a practice that will continue. - 2010 Berkshire Hathaway Shareholder Letter

Finally, there is another important, if more subjective, element that drives the growth in Berkshire's intrinsic value. More from the 2010 letter:

We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.

This "what-will-they-do-with-the-money" factor must always be evaluated along with the "what-do-we-have-now" calculation in order for us, or anybody, to arrive at a sensible estimate of a company's intrinsic value. That's because an outside investor stands by helplessly as management reinvests his share of the company's earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company's current value; if the CEO's talents or motives are suspect, today's value must be discounted. - 2010 Berkshire Hathaway Shareholder Letter

As an example, Buffett points out that a dollar in the hands of Sears or Montgomery Ward in the late 1960s "had a far different destiny than did a dollar entrusted to Sam Walton."

For Berkshire, it is the long-term performance of the equity/bond/cash portfolio, effective insurance underwriting (to deliver a low cost of float), non-insurance operating business performance, and how effectively retained earnings is deployed that determines Berkshire's growth in intrinsic value.

The kinds of gains and losses produced by derivatives may affect Berkshire's reported net income in a substantial way. Yet, when there is no affect on cash and investment holdings, they are meaningless economically, do not impact Berkshire's core economic performance, and tell the investor nothing about operating performance and value***.

Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours. - 2010 Berkshire Hathaway Shareholder Letter

The less than perfect but more meaningful operating earnings for Berkshire Hathaway was $ 8.1 billion over the first nine months of 2011 and should easily exceed $ 10 billion for the full year.

I won't be surprised if that level of operating earnings will grow nicely over the coming years along with the value of the portfolio.

Adam

Long BRKb

* Permission is granted when a case can be made that the disclosure would cause buyers to drive up the price before Berkshire makes additional purchases.
** Much of this, of course, being insurance float that often ends up free or better. The underwriting results over Berkshire's entire history have been significantly profitable. Underwriting results determine the long run cost of the float even if inevitably short run volatile. Producing long run underwriting profits is the equivalent of being paid to hold someone's money.
*** The potential value to Berkshire shareholders is a different story. In the latest annual report Buffett said the remaining derivatives "float" on the "equity put" portfolio was $4.2 billion. Buffett said: What is sure is that we will have the use of our remaining "float" of $4.2 billion for an average of about 10 more years. Crucially, almost all Berkshire derivatives contracts are free from obligation to post collateral.
 
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