Tuesday, 27 July 2010

7 Reasons Not to Buy Berkshire Hathaway

I am a big fan of Warren Buffett. However, I believe it is more advantageous to follow Buffett’s stock picks than own Berkshire Hathaway (BRK.A) for the following reasons:
1. Portfolio Concentrated in US Dollars
Berkshire has a portfolio of 41 stocks. The total portfolio value is $48,025,404,085 as of May 15, 2009, according to CNBC. The top 6 holdings: The Coca-Cola Company (KO), Wells Fargo & Company (WFC), Burlington Northern Santa Fe Corp. (BNI), Procter & Gamble Co. (PG), American Express Company (AXP) and Kraft Foods Inc. (KFT) account for almost 70% of it.
Paul Krugman, the recipient of the 2008 Nobel Price in Economics, in his new, greatly updated edition of The Return of Depression Economics,defines that failures on the demand side of the economy – insufficient private spending to make use of the available productive capacity – have become the clear and present limitation on prosperity for a large part of the world. The quintessential economic sentence is supported to be “There is no free lunch”; it says that there are limited resources, that to have more of one thing you must accept less of another, that there is no gain without pain.
With US government’s huge stimulate package, the deflated US dollar is unavoidable. With few exceptions, such as POSCO, Sanofi-Aventis (SNY), Swiss Re and Tesco plc, majority of Berkshire’s portfolio and operations are based in US and tired to US Dollar. That’s why I rather own iShares MSCI Emerging Markets Index (EEM) or Vanguard Emerging Markets Stock ETF (VWO).
2. Troubled Derivative Bets
Berkshire is big into the derivatives market, which made more complexity to the already black-box-like conglomerate’s balance sheet. The company as of March 31 had $13.85 billion of paper losses on derivatives, according to Reuters. Contracts tied to junk bond defaults mature between 2009 and 2013, and Buffett admitted they may lose money. S&P said the U.S. junk bond default rate rose to 5.42 percent from 3.96 percent at year-end.
1st quarter 2009 operating earnings, which exclude investment and derivatives gains and losses, came in at $1.705 billion. In other words, Berkshire’s paper loss in derivatives would wipe out 2 years operating earnings.
3. Buy What You Know
Berkshire is an insurance-focused conglomerate and owns more than 60 subsidiaries including insurance, clothing, furniture, candy, restaurants, natural gas and corporate jet firms. As you can see from the chart I compiled, from its 1st quarter 2009 report, 34% of revenue was from insurance.
I never understand insurance companies’ financial statements. The only thing I know about insurance is about projections, assumptions, probabilities and promises for future delivery, typically at a far-off date. Most of the products are highly intangible. Every year when I read Warren Buffett's annual letters, I always skipped the insurance portion, otherwise I would have had to reach for some aspirin.
4. Low Margins
Buffett said many of Berkshire's nearly 80 businesses were hurt by the recession and lower consumer spending, including housing-related units that make bricks, insulation and paint. Even if the rescue of the financial system starts to bring credit markets back to life, we might still face a global slump that’s gathering momentum. The only bright spots coming in are its utilities and insurance companies, which include Geico and General Reinsurance.
The 2nd biggest operation, McLane, is marked by high sales volume and very low profit margins and has been subject to increased price competition in recent years. The gross margin rate was 6.95% in 2009. Approximately one-third of McLane’s annual revenues are from Wal-Mart. A curtailment of purchasing by Wal-Mart (WMT) could have a material adverse impact on the earnings of McLane.
Out of Berkshire's total $260 billion assets, only $48 billion is in equity. In other words, majority continue earnings are still need to come from operational business.
5. Downgrade By Moody's
Two credit rating agencies took away Berkshire's "triple-A" ratings in 2009, including Moody's Investors Service. The global credit crisis might be temporary, but the company could face significant pressure if it persists.
According to CFA ( source: cfapubs.org), between 1980 and 2000, banking sector accounted for 4% of the Japan Nikkei in 1980, peaked at 22%, and then came back to about 4% again. If the same happens to US, then we could still have a long way to go.
6. No Dividend
Berkshire didn’t pay any dividend.
7. “Warren Buffett Premium”
The average Price/Book for Property & Casualty Insurance company is 1.05, while Berkshire’s is 1.35. If anything happens Buffett, the stock might drop 30% instantly. Even something happens to Charlie Munger…
On Jan 2, 2008, Berkshire (BRK.A)’s price was 139,300. By the year-end on Dec 31, 2008, it was 96,600: it dropped over 30%. Though it still performed better than S&P, it was certainly not the loss of 9.6% reported by the Main Street media, which looked at book value only. We need to compare apples to apples.
Last Friday, May 15, 2009, the Wall Street Journal reported that the Treasury department will make $22 billion federal bailout funds available to a number of life insurers. This will certainly help insurance industry as a whole. In addition, as Donald Guloien, new President and Chief Executive Officer of Manulife Financial Corporation (MFC) stated in his memo to Manulife employees on May 4, 2009, “We would expect that global financial regulators may require higher levels of capital, and this will favor the stronger and more conservative companies.” People are looking for reliable, strong and trustworthy companies, and there will be a “flight to quality” that will favor Berkshire as well. However, you can always buy ETFs such as Financial Select Sector SPDR (XLF), if you like the financial sector.
By not owning Berkshire, you are not benefiting from deals and terms that are only available to it, such as Harley Davidson's (HOG) 15% and Tiffany's (TIF) 10% debt offerings, GE and Goldman Sachs Group Inc.'s 10% preferred stock, etc. To make that up, you might check into iShares S&P U.S. Preferred Stock Index (PFF) that might give you something in comfort.

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