Thursday, August 6, 2009

In Defense of the Oracle

With Berkshire Hathaway’s (BRK.A) Q2 results due out later today, there is a whole lot of Buffett bashing going on in the blogosphere. In an article in Seeking Alpha today, Rolfe Winkler says that he feels betrayed by Warren Buffett. Also, Karl Denninger of The Market Ticker, a site that I follow daily, claims in this piece that Buffett is a hypocrite for blasting the bailout while investing in companies that benefited mightily from government assistance. The reason for this criticism? It seems that someone has leaked that BRK is about to announce blowout numbers, a fact that apparently rubs some people the wrong way, given the state of the economy.

Assuming BRK did actually experience a large recovery in book value and a significant positive reversal of the value of its derivative exposure, the question is should we be upset? With 9.5% (as of today, probably more tomorrow) of Americans unemployed and over 16% under-employed, should we begrudge companies and individuals that have seen their fortunes improve since the free fall the US economy experienced in Q4 2008 and Q1 2009? I actually don’t think either of those questions can be answered in generalities. Some people seem to relish criticizing the capitalist machine as a whole, but from my perspective that lumps too many companies in together without considering their roles in facilitating the near collapse of our financial system or the means in which they have been able to regain their thunder.

Specifically, BRK is not Goldman Sachs (GS) and I think it is unfair and foolish to put them in the same basket. As this article in NY Times today reminds us, there are a lot of people who are very unhappy about Goldman’s bonus accrual, high VAR, and proud refusal to change its risky business model that brought the company near collapse (apparently in a classic example of revisionist history, Goldman now disputes this fact even though it had to turn itself into a bank holding company just about overnight so it could have access to Fed funds). Furthermore, GS’s blowout Q2 profits and amazing trading record (on 46 days during Q2 GS made $100M or more in trading!) have made many, including myself, concerned that GS is playing fast and loose with implicit taxpayer support.

While the differences are obvious to people familiar with these companies, I think it is valuable to contrast the factors that helped GS record a great Q2 with those that have buffeted BRK. First, GS received 100 cents on the dollar from AIG to the tune of $13B while Merrill Lynch apparently only got $.17 for its claims against the troubled insurer. GS has also issued $3.4B in debt backed by the FDIC at rates well below those that companies that did not have backing (think CIT and the 13% rate the company is paying on new debt) had to pay. Also, being allowed to convert to a bank holding company gave GS access to the Fed’s discount window without having to comply with regulations that govern such companies for 2 years. In effect, for 2 years GS gets all the benefits of being under the Fed’s too big to fail umbrella without any real detrimental impact on the business model.

On other hand, BRK has benefited mainly from rising markets and slowly improving economic conditions. The absolute free fall the economy was in late 2008 and early 2009 seems to have subsided. So, while BRK’s operating companies that cater to consumers will likely continue to face headwinds, it is logical to conclude that the bounce off the bottom helped many of these companies in Q2. Also, the huge rally in the US equity markets has allowed BRK to recoup a decent chunk of the losses it experienced when the companies it owns big stakes in plummeted in price. According to today’s article from Bloomberg:

The value of shares Berkshire reported holding as of March 31 increased 23 percent in the second quarter. Berkshire is the largest shareholder in American Express Co., whose stock rose 71 percent in the three months ending June 30. Buffett’s firm is also the biggest investor in Wells Fargo & Co., which jumped 70 percent, Goldman Sachs Group Inc., which rose 39 percent, and Burlington Northern Santa Fe Corp., up by 22 percent.

Of course you can argue that the government and Fed have taken extreme measures to prop up the economy with little regard for future fiscal obligations. There is no question that the Fed’s actions and the government stimulus have been very beneficial for the stock market as investor confidence has risen dramatically. But BRK is certainly not alone in seeing its holdings increase in value due to the rising tide. I didn’t see a lot of criticism of Bill Miller because his fund was up close to 20% for the year. In other words, while I am cautious on the sustainability of the rally in stocks, it is hard to make the case that BRK is a direct and unique beneficiary of government largesse like GS has obviously been.

Next, I want to respond to some of the criticisms put forth by Winkler and Denninger in their pieces. I understand some of their points for sure, but I also think that some of their concerns are overstated and exaggerated. First, let’s start with Winkler who decided to entitle his article “Buffett’s Betrayal.” This is the crux of his argument:

Today, Buffett remains famous for investing The Right Way. He even has a television cartoon in the works, which will groom the next generation of acolytes.

But it turns out much of the story is fiction. A good chunk of his fortune is dependent on taxpayer largess. Were it not for government bailouts, for which Buffett lobbied hard, many of his company’s stock holdings would have been wiped out.

Really? So, buying American Express (AXP) after the salad oil scandal and buying Washington Post (WPO) because Buffett thought it had a great moat was not investing the right way? The idea that the events over the past few years and the subsequent investments that were made by Buffett somehow invalidate his previous success is ludicrous. Maybe it is true that he made the General Electric (GE) and GS investments based on some notion that the government would not let them fail. But, if the government had not helped bring the financial system back from the abyss millions of investors around the world would have been wiped out. Very few investors own no stocks of companies that were not materially helped by the emergency actions taken. Anyone who who follows me knows that I am not a fan of a lot of what the government and Fed have done. But to single out Buffett for betraying investors because he decided to invest in GE and GS seems misplaced.

Further, with all due respect Mr. Denninger, I would not call the rates that Buffett received from those deals usurious. The market was in turmoil and these companies needed capital and his support. It was the government that you criticize every day that underpriced the TARP investments. The Oracle only sought a return on his investment that was commensurate with the risk he was taking on. Maybe Buffett used his position and status as an advantage and maybe he understood that the government would not allow the financial system to crumble. But, just like he knew the salad oil scandal was not going to kill AXP, he knew this crisis would not kill best in class companies like GS and GE. Accordingly, I look at this allocation of capital as savvy investing. I wish I had had enough experience to know that at some point the government would literally intervene in the markets. If so, I would not have been on the sidelines for this massive rally. Not that I approve of everything that has been done, but pretending that the government doesn’t care about the direction of the markets is like pretending that there isn’t a pink elephant in the room. Neither is going to do you much good or make you rich.

Additionally, I would like to respond to a criticism that both authors make in their pieces. Here is an example from Denninger’s posting:

Wells Fargo, a firm that Berkshire has a massive holding in, is a bank with dubious reserves and provisions in its mortgage book. One of many, of course. Yet Warren, Mr. Ethics, has refused to demand that Wells (along with other financial firms he holds) come clean on their loan book valuations, despite overwhelming evidence from seized banks thus far that essentially every bank is and has been overvaluing these so-called "assets".

Berkshire owns a big chunk of Moody's, a stake they recently trimmed. But Moody's is in fact at the heart of the credit storm - it was only through the granting of ratings that we now know were absolutely unsupportable that the credit bubble was able to be blown and maintained in the first place. Worse, Berkshire's other businesses, the core of which are insurance and banking-related firms, were and are absolutely reliant on that ratings business in order to raise capital in the markets.

The argument goes as follows: Buffett owns large stakes in companies that were part of what caused the financial crisis and therefore he is complicit. Considering that before all of this trouble began, just about every large cap mutual fund listed Bank of America (BAC) as one the largest positions, then under this logic just about everyone with a 401K is also blame. Of course BRK owns very large stakes in these companies and could have a lot more say than individual retail investors. But, Buffett’s success over the years has come from a hands-off approach. He has no interest in telling the managers of operating companies or companies in which BRK is an investor how to run their business. This is why people want to sell to BRK and have the company as a major stakeholder. Buffett has made a legendary career off of finding competent managers that don’t need to have their hands held.

Should BRK have sold Wells Fargo (WFC) and Moody’s (MCO) because of questionable practices? Maybe, if investing was solely a moral game. This is where I think Winkler has it all wrong. Investing the right way does not necessarily mean only giving capital to companies that are spotless. We live in a capitalist world and just like every human is imperfect, there are no perfect companies. Buffett likes the moats and underlying earnings potential of both of these companies and thus continues to hold shares. I also think it worth mentioning that he holds such large stakes that it is very difficult for him to unload shares without moving the market price. While this is not a reason to hold stock in a company that turns out to be morally reprehensible, these potential costs have to be considered by any manager who has to answer to his or her shareholders.

In conclusion, I think that what we have to remember is that first and foremost Buffett is an investor. Yes, he is an iconic man who has done as much for teaching the merits of value investing as anyone who has ever lived. But, as anyone who reads The Snowball by Alice Schroeder finds, he is still just a man who has all the flaws of other men. Just because many in the popular press have portrayed him as an angel who always makes decisions based on the best outcome for society as a whole, does not mean this deification is justified. There is no question that he talks his book on many occasions. I agree that it was hypocritical to suggest that he made some investments with the assumption that Congress would do the “right thing” and then decided to criticize the bailouts as a whole. But ask yourself, how many times have you felt two ways about the government’s actions? How many of us are cheering the stock market rally but feel sick inside about the growing fiscal deficit and potential for inflation down the road? My guess is that there are a lot of us out there who don’t know exactly how to feel. This by no means exonerates Buffett. But my hope is that what it will do is help kill this ridiculous idea that he is somehow different from any other investor whose primary concern is the welfare of his stakeholders. Maybe then we won’t waste so much time attacking the idea of the man.

(Picture courtesy of