The Natural Limits of Profit Growth: Berkshire Hathaway Edition

A year back, I explained that profit growth are constrained by natural economic forces: in particular, the law of compounding, competition, changes in  the risk environment, changes in the production process (lengthening or shortening), boom bust cycles, and government interventions (e.g.taxation and deficit spending).

Warren Buffett's flagship Berkshire Hathaway should serve as a great example.

In terms of prices, while Berkshire Hathaway had, in the past, outclassed the S&P by a wide margin especially during its maiden years, that magic appears to be ebbing.

Since 1999, Berkshire returns appears to be growing at a rate similar to that of the S&P. In conventional perspective, this makes Mr. Buffett's company a seeming proxy for the S&P.

The crux is that natural economic barriers to profit growth has been eroding on the foundations of Berkshire’s profit growth rates as reflected by stock prices as shown by the chart above from Businessinsider

Now the growth aspect. Agora publishing’s Bill Bonner at the Daily Reckoning says that in realization of this phenomenon, Mr. Buffett seems to be moving his goal post to in order to embellish his social position : (bold mine, italics original)

This focus on quality over price is what turned Berkshire Hathaway into such a money machine for Buffett and his partner, Charlie Munger. For 36 years, the duo tossed their coins and got heads every year.

But in 2000, the tails began to appear. You may say that Buffett and Munger “changed their strategy.” Or they “made a mistake.” But if their success were based on skill, why would they suddenly forget how to make money?

“Berkshire’s investment portfolio performance has been extremely poor for at least the last 14 years,” writes colleague Porter Stansberry.

Between 1970 and 2000, the lowest 10-year annualized return on Berkshire’s investment portfolio was 20.5%.

Starting in 2000, however, the wheels come off. Between 2000 and 2010, the annualized return was 6.6%. And, after never recording an annual decrease in book value, Buffett lost money twice in the 10-year period (2001 and 2008).

note here of the effect of boom bust cycles on Berkshire's balance sheets…

Relative to the S&P 500, these numbers haven’t gotten better since 2010.

In 2011, Berkshire’s portfolio return was 4%. (The S&P 500 was up 2.1%.) In 2012, Berkshire’s portfolio return was 15.7%. (The S&P 500 was up 16%.) In 2013, Berkshire’s portfolio was up 13.6%. (The S&P 500 was up 32.4%.) In 2014, Berkshire’s portfolio was up 8.4%. (The S&P 500 was up 13.7%.)

Last week, Buffett moved the goalposts. Instead of reporting Berkshire’s results in terms of book value only, he showed how well the company did in terms of share price.

Why he did this is a matter of some controversy.

Did he do it, as he claimed, because book value no longer gives an accurate picture of the value of his “sprawling conglomerate”?

Or did he do it because the gods have turned against him; his book value increases have underperformed the S&P 500 for the last 14 years and it is becoming embarrassing?

Barron’s offers an opinion:

Buffett probably can be faulted for not being forthright in the letter about the disappointing performance of the Berkshire equity portfolio that he oversees.

Of the company’s big four holdings, American Express, IBM, Coca-Cola and Wells Fargo, only Wells Fargo has been a notable winner in recent years. […]

Buffett tends to manage the portfolio’s largest and longest-standing investments. Two managers who help run the rest, Todd Combs and Ted Weschler, have outperformed Buffett in the past few years.

If the law of economics has affected the world's greatest investor, why do you think others will be immune?  

In the Philippine context, those stratospheric valuations justified on supposedly perpetual headline G-R-O-W-T-H will be faced with reality soon.

Agency Problem: David Sokol’s Controversial Resignation From Warren Buffett’s Berkshire Hathaway

A good running example of the principal-agent or the agency problem in play has been the unravelling controversy over Warren Buffett’s supposed “would be” successor-David Sokol.

David Sokol recently resigned from Berkshire Hathaway following allegations of unethical practice.

According to Steve Shaefer of Forbes,

Berkshire Hathaway executive David Sokol, who served as chairman of MidAmerican Holding Company and Johns Manville as well as Chairman and CEO of NetJets, resigned from the company in a letter to Warren Buffett Monday.

Buffett announced his departure in a press release Wednesday, which also noted that Sokol owned shares in Lubrizol, a company Berkshire recently agreed to acquire for some $9 billion. The departure of Sokol comes as a shock to Berkshire watchers who figured the executive was one of the potential successors for Buffett.

In the announcement, Buffett stressed that he and Sokol do not feel there was anything illegal in his trades of Lubrizol shares.

Although both David Sokol and Warren Buffett via Berkshire Hathaway denied that this has been the cause of his resignation, media has been all over what has been perceived as ethical impropriety.

The Sokol affair simply highlights what we have been talking about as the conflict of interests by participating agents—based not only from asymmetric information but from asymmetric interests or incentives that drives people’s actions.

Principal Agent Problem Diagram from Wikipedia.org

Mr. Sokol, who acquired shares of Lubrizol before pitching it to his boss, Mr. Buffett, saw nothing wrong with this. In fact, in a CNBC interview Mr. Sokol cites Mr. Charles Munger, Mr. Buffett’s close friend and vice chairman of Berkshire Hathaway of doing the same.

“I don’t believe I did anything wrong. Charlie Munger owned 3% of BYD before he asked me to go look at it.” [dawnwires.com]

In the stock market, when agents or brokers pre-empt their clients by taking positions for his/her account, in the expectations that the clients orders could affect the price movements of specific stocks, is known as “frontrunning” (investopedia.com) an illegal practise that is punishable by law.

Although Mr. Sokol’s case hardly resembles frontrunning, because he bought the shares before he offered it to Mr. Buffett, this goes to show how such practices has punctured on the current laws.

Notes Mr. Jason Zweig at the Wall Street Journal, (bold emphasis mine)

Mr. Sokol's trading falls under what Stephen Bainbridge, an expert on securities at the UCLA School of Law, calls "an enormously gray area of the law." It also is a reminder that a basic principle of securities law—disclosure cures conflicts—is nonsense.

"Even assuming that [Mr. Sokol] did nothing illegal, [his action] is typical of the kinds of conflicts of interest permitted by our financial system that undermine the integrity of markets," says Max Bazerman, an ethicist at Harvard Business School and co-author of the new book "Blind Spots."

Most people have what Mr. Bazerman calls an ethical blind spot. Faced with a potential conflict of interest, you automatically conclude that it couldn't possibly offer any temptation to someone of superior character—like you or those closest to you.

While I agree that this seems like an issue of ‘ethical blind spots’, I don’t share the impression that “conflicts of interest permitted by our financial system that undermine the integrity of markets” or of the insinuation that ‘ethical’ laws are needed to keep the “integrity of markets”. That would be misstating the case.

And that’s because it is the nature of people to be guided by self-interest based on the individual’s distinctive value preferences or priorities. And people’s diversified self interests always conflict with each other, but still could represent benefits for all the concerned, though not equally.(This is the essence of trade)

What has actually undermined the financial system is the conflict of interest (agency problem) between the political agents along with their regulatory patrons and their economic clients. Regulatory arbitrages, regulatory capture, revolving door politics, bailouts to name a few, has been significant contributors to the political-economic inequality.

And as one can see from the above account, current disclosure laws can’t stop people from circumventing them.

Besides, if Mr. Sokol’s allegation of Mr. Munger is accurate, then Mr. Buffett has been obviously tolerant of such practice.

To see why, Mr. Buffett probably sees this as a way to reward his underlings, who by diligent scrutiny over the target companies, takes on risks directly to emphasize their vote of confidence. It’s not even sure that what the underlings buy will be bought by Mr. Buffett.

As Mr. Buffett stressed on Berkshire’s recent press release,

Dave’s purchases were made before he had discussed Lubrizol with me and with no knowledge of how I might react to his idea. In addition, of course, he did not know what Lubrizol’s reaction would be if I developed an interest. (bold emphasis mine)

Thus such actions represent risks borne solely by both Mr. Munger and Mr. Sokol.

Perhaps, for Mr. Buffett this could have signified as parallel to a finder’s fee, that’s if he ever agrees with their investment concept.

This also highlights on the differences of what is seen as an ethical issue. What may seem wrong to the others may seem right to Mr. Buffett (although I would assume that he would distance himself from this controversy)

I think the editorial of Financial Times captures this well, (bold highlights mine)

That Mr Sokol has left to build his own investment portfolio is more than unintentionally ironic. The whole affair highlights Berkshire’s informal style of operation. This is possible because of the high degree of confidence reposed in the company by investors. Mr Buffett and his team can scour the world for opportunities untrammelled by investment mandates and other bureaucratic restraints.

The licence exists, of course, because of Mr Buffett’s superior investment record. He has beaten the stock market indices by a broad margin since the mid-1960s. But it will be harder for Berkshire to continue outperforming given its now-vast size, as even Mr Buffett has admitted. This should give investors pause. The risk of executives abusing informal processes is greatest at times when operational performance is under pressure.

In short, this hasn’t been an issue to Berkshire’s investors because of the rewards these investors have been showered with over these years. It would all be a different story if Berkshire lost money or has underperformed.

The other point is that people should be self-vigilant over their investments in the knowledge that there will always be conflict of interest issues at hand.

To rely on government to resolve ethical issues will only bring about dependency, complacency, and equally, conflict of interest issues but not between private agents but among public and private agents, which should even complicate and worsen the case, as manifested during the last crisis. In other words, more problems will arise from regulations meant to address ethical issues.

The market mechanism for discipline enforced by such perceived misconduct is social stigma or ostracism or reputational risk.

Finally, the public trial faced by Berkshire Hathaway and Mr. Sokol simply highlights of the uniqueness of Mr. Buffett’s management style.

Once Mr. Buffett goes, perhaps Berkshire would most likely lose its magic. All these seem ominous with Moody’s projecting the “Sokol affair” as negative for Berkshire’s credit rating standings (Reuters).

Berkshire’s Corporate Structure and Investment Holdings From theofficialboard.com

Still yet, the complexity of Warren Buffett’s flagship Berkshire Hathaway’s organizational structure operating on her vast investment holdings also underscores the FT’s editorial observations of Berkshire at “now-vast size” or perhaps reaching its growth limit.

And that’s why I have argued here that Mr. Buffett has resorted to political entrepreneurship perhaps out of the desperation to maintain public’s high expectations from a Warren Buffett managed Berkshire.

Bottom line: the principal-agent problem is an inherent feature of the marketplace, which has been immensely underappreciated but must be understood by all.

Graph: Warren Buffett's Berkshire Hathaway Portfolio Holdings

Here is a bubble chart of the portfolio holdings of Warren Buffett's flagship, Berkshire Hathaway from gurufocus.com

Berkshire's portfolio has been mostly into 'blue chips'.

This would be understandable considering the heft and expanse of the estimated $197 billion portfolio.

Everyone Is A Genius In An Inflation Driven Bull Market!

``Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”-Warren Buffett

Recently I’ve been drawn into some discussions about how being “right” might lead to more audience following and how being “right” may come in the face of being unpopular.

As a student of the markets, we understand that incentives drive everybody’s actions.

Conventionalism As Camouflage

Here are some examples of the divergent underlying incentives that impel for some of the actions by market participants:

-For traditional sellside analysts-generate literatures that would prompt clients to trade short term or ‘churn’ accounts.

-For conventional bankers- sell ‘one size fits all’ financial products to a diversified consumer base.

-For many subscription newsletter editors-write wild and audacious forecasts that would elicit attention and/or peddle short term snake oil ‘technical’ outlooks.

-For mainstream economists or financial experts-the need to be seen communicating on the conventional vernacular, as conventionalism secures their career reputations in terms of advancement or job shifts. As the illustrious and chief adversary of the Austrian school John Maynard Keynes once said, ``It is better for reputation to fail conventionally than to succeed unconventionally."

By seeking the comfort of the crowds, there is always the pretext behind what John Maynard Keynes says as being ``better to be vaguely right than exactly wrong.”

In other words, conventionalism is frequently used as camouflage against efficacy.

And for most of the above, divergent risks have apparently been sidelined for profit motives.

Yet, one must realize that for different market actors there are different perspectives from dissimilar incentives and these are the dynamics behind analyzes (reports or studies), communiqués or even quotes from news accounts.

As our favorite iconoclast Nassim Nicolas Taleb warned in Fooled By Randomnes of relying on mainstream media as main source for information, ``Most journalists do not take things too seriously: After all, this business of journalism is about pure entertainment, not a search for truth, particularly when it comes to radio and television”

In A Bull Market, Everyone Is A Genius

There is an old Wall Street cliché that goes “Everyone Is A Genius In A Bull Market.”

That’s exactly what we’ve been saying for the longest time.

NO matter what mainstream experts write about under present conditions; be it pertinent to the technical charting picture, micro fundamentals stories- industry, corporate (prospective merger & acquisitions or earnings) based or even from the macro dimensions, the coincident rise of the market security prices simultaneously with their Panglossian sentiments makes it appear they can’t do anything wrong. Genius has been at work.

Fundamentally these mind frames can be identified as cognitive biases; particularly,

-the fundamental self attribution bias- or the tendency to attribute positive outcomes on skills while negative outcomes on misfortune or as Nicolas Nassim Taleb describes in The Black Swan ``We attribute our success to our skills, and our failures to external events outside our control, namely to randomness. We feel responsible for the good stuff, but not for the bad. This causes us to think that we are better than others at whatever we do for a living.” We previously discussed this in Situational Attribution Is All About Policy Induced Inflation.

-and the survivorship bias or the winner’s bias-to quote Stephen Dubner of Freakonomics, ``The behaviors of winners are remembered and dissected far more thoroughly than those of losers, and given greater weight, even if the outcome was decided by a tiny margin.”

Put differently, people tend to selectively tunnel into so called “winners” at the expense of the overall picture.

Again from Nassim Nicolas Taleb, ``The mistake of ignoring the survivorship bias is chronic, even (or perhaps especially) among professionals. How? Because we are trained to take advantage of the information that is lying in front of our eyes, ignoring the information that we do not see.” (emphasis added)

In short, everyone, including experts, punters, scalpers or investors, can be right for the wrong reasons!!

Machlup-Livermore Model Applied To The Phisix and Berkshire Hathaway

This can be exemplified by looking at the Philippine Phisix from the big picture figure 1.

Figure 1: Phisix: Rising Tide Lifts All Boats

While the Commercial Industrial index (blue gray) have outperformed alongside with the mining index (green), generally ALL major sectoral indices have been on an uptrend (Phi-all violent, Property-Blue, Holding-red, Banking-black candle, Service-orange, and Phisix-gray) since bottoming out in late 2008.

As caveat we seem to be seeing some of the major indices as rolling over (possibly heralding for a temporary corrective pause)-specifically the holding, the property and service indices.

Nevertheless, any security specific underperformance relative to the general trend represents as the exception more than the rule. And it would be apt to quote a reminder from Edwin Lefèvre or a.k.a the legendary Jessie Livermore…

``I NEVER hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they all go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull market or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing.”

In essence, Mr. Lefèvre’s empirical observation goes hand in hand with Austrian economist Fritz Machlup’s conclusion that stock markets have increasingly been driven by inflation [as previously discussed in Are Stock Market Prices Driven By Earnings or Inflation?], where inflationary policies propel investors sentiment and ultimately gets reflected on the market as seen in the rising and ebbing tide phenomenon or our Machlup-Livermore model.

Yet, even Mr. Warren Buffett’s flagship the Berkshire Hathaway which has consistently outperformed the S & P 500 for over two decades could be used as paramount yardstick (see figure 2)

Figure 2: Bigcharts.com: Berkshire Hathaway Also Reflects On Rising Tide

As you would notice, Mr. Buffett’s Berkshire has basically outperformed the S & P when the monetary landscape has been accommodative, from which has likewise been reflected on sprightly markets.

Yet, when liquidity had been drained from the system as a result of the recessionary forces (from overinvestments in technology and communications in 2000) or during the banking crisis of 2008, Berkshire has fallen almost more than the losses of the S & P 500 (both during the dot.com bust of 2000 and the Lehman meltdown in 2008).

So even the world’s most venerated investing guru has been subject to ebbs and flows of INFLATION!!!

The point is: anyone can mesmerize themselves with the delusions of market prices exhibiting conventional metrics while ignoring the fact that the impact of inflation to the prices of diverse financial markets including the currency market has been intensifying. In short, misdiagnosis leads to wrong therapy or errant investing actions.

To excerpt Agora Publishing’s Bill Bonner, “people seem to come to believe just what they need to believe – just when they need to believe it”, even if they are unsubstantiated by evidences or by facts.

And this is what distinguishes us from the mainstream.

The Curse of Deleveraging Haunts Warren Buffet’s Berkshire Hathaway

Warren Buffet’s flagship Berkshire Hathaway has been virtually whacked.

Hence some people have been asking, what’s wrong with Warren Buffett? Has the world’s best stock market investor lost his Midas touch?

Berkshire was down about 8% last night, and has been in a losing streak for 9 consecutive days. And is down by about 50% from the peak.

Courtesy of Bespoke Investments

According to Bespoke Investments, ``While nine straight days of negative returns are not too rare for Berkshire (red dots in chart below), the magnitude of the drop is notable. Since November 7th, which was the last day Berkshire finished up on the day, the stock has declined by 29%. This is by far its largest percentage decline over a nine day period.”

So what’s been troubling Berkshire?

The most likely answer: the widening spreads of the company’s Credit Default Swaps.

According to Fool.com’s Alex Dumortier, ``The five-year credit-default-swap spread hit 440 basis points yesterday. That means the annual cost of insuring $10 million in Berkshire debt against default over five years is $440,000.”

Courtesy of Fool.com

In short, the cost of insuring Berkshire Hathaway’s debt has soared. The investing public has priced Berkshire’s credit risk as more than that of Republic of Columbia!

Courtesy of Bespoke: CDS Spread: Safest Financial Company No more

Why? According to many reports, the imputed reason for the surge in the spreads had been due to concerns about Berkshire’s exposure to derivatives. The credit swap market seems to imply that Berkshire is on the hook for some $37 billion, which could risk a credit rating downgrade from its “Triple A” status.

And such downgrade may translate to a call to raise collateral supply to counterparties and subsequently impose onerous demand to raise cash.

Nevertheless, Mr. Warren Buffett acknowledges this in his 2002 annual (emphasis mine),

``Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.”

He even discloses Berkshire’s derivatives risk in its 2007 annual report (emphasis mine),

``First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

``The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion.

``The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written.”

Following observations:

-Worst case scenario for the high yield index exposure will be a loss of $4.7 billion. Yet such losses if it were to materialize will arrive at different expiry dates somewhere between 2009 until 2013.

-Losses from put options sold on four stock indices can only be realized upon the expiration of contracts between 2019 and 2027.

To quote Stacy-Marie Ishmael in FT Alphaville, ``People are freaking out about BRK possibly having exposure of $37 billion, but this is the maximum payout if ALL FOUR major world indices were at ZERO 14-19 years from now!”

-Proceeds from sales of put options are at $4.5 billion. If Mr. Buffett manages to make 7% over the same period this would amount to $17.4 billion or nearly half of the assumed worst case scenario.

-Berkshire still has more than $33 billion in cash which if gradually invested in the present environment should, in the words of Dr. John Hussman, “be associated with extremely high subsequent returns.”

-In addition, when does having a substantial cash position become a liability under the present "debt deflation" environment?

-Of course, all these assume that we are looking at the same risk factors as those who are pricing in a credit downgrade.

Moreover, there is the danger of a self fulfilling prophecy which given the extent of the debt unwind, could lead to a reflexive self feeding action: market outcome influencing fundamentals.

All these add up to only one thing, extreme fear associated with the tidal wave of deleveraging.

As I wrote to a client, ``The seemingly insuperable force of deleveraging is simply looking for any standing issues to bring to its knees. And for securities included in markets that have been globally intertwined, there is no escaping its fury. Whether it is stocks, bonds, emerging markets, commodities, currencies, in the face of debt deflation [Harry] Markowitz's Nobel prize from his portfolio diversification or the Modern Portfolio theory seems non-existent, if not a flawed theory.”

So Mr. Buffett looks more likely a victim of contagion, than from a loss of his magical aura.