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.

1^st 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 1^st 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 2^nd 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.

http://seekingalpha.com/article/137996-7-reasons-not-to-buy-berkshire-hathaway

US Bail-Out Plan

UK Bail-Out Plan

When P/E fluctuates...is it Price or Earnings?

By Saj Karsan, Wednesday, June 25, 2008

We saw here that although the P/E average for the S&P 500 over the last 100+ years is around 15, the P/E actually fluctuates quite a bit, ranging from 5 all the way to 35. But what's actually happening? Is investor sentiment so fickle that it creates buying opportunities for those who wait for the market to drop? Or do earnings fluctuate based on economic conditions, with prices staying rather stable?

Here's the P/E of the S&P 500 since 1990 split into its two components:

We see that both price and earnings fluctuate, providing for the volatile P/E chart we saw here. Obviously, timing the market is not as simple as buying when P/E's are low, since for all one knows, earnings could drop and actually make P/E's high, leaving the investor holding the bag.

Therefore, other models have been developed that try to determine whether the market is over/undervalued. The Fed model, described here, uses interest rates along with earnings to determine what the market value of the S&P 500 should be. A model developped by Steve Foerster tries to determine when the business cycle hits its peaks and troughs, so that investors can determine when they should buy and when they should sell.


Rather than trying to time the market, value investors try to value individual companies within the stock market, to determine if they sell at discounts to their intrinsic values.

http://en.wikipedia.org/wiki/Fed_model
Fed Model

http://www.corporateinformation.com/Company-Advanced-Search.aspx?CountryCode=458
The P/E of the stocks are split into its two components of Price and Earnings in this site, as illustrated by the chart below.

Ireland - Economic Growth

Financial Ratios and Their Uses

KEY TAKEAWAYS

Earnings per share (EPS) and dividends per share (DPS) indicate stock returns on investment.

Dividend yield measures a shareholder’s cash return relative to investment.

Growth ratios such as the internal and sustainable growth rates indicate the company’s ability to grow given earnings and dividend expectations.

Market value ratios, most commonly price to earnings and price to book, indicate a stock’s market popularity and its effects on its price.


http://www.web-books.com/eLibrary/NC/B0/B65/73MB65.html

Health insurance premiums dwarf worker’s earnings and far exceed overall inflation.

http://rmwyatt.wordpress.com/

Earnings, Dividends and Payout Ratio: Earnings don’t grow at a constant rate. Dividends are more stable than earnings. Payout ratio varies over time.

Dividends are more stable than earnings, so the payout ratio certainly varies over time. Additionally, corporations have shown less willingness to pay dividends, and investors have shown less inclination to demand dividends, to the payout ratio today is roughly half of what it was in the early 60s.

Earnings don’t grow at a constant rate, either. Over the last 53 years, earnings have grown at a 6.7% rate, but that has included times of shrinkage, and boom times as well.




http://alephblog.com/2007/07/09/the-fed-model/

Banking Basics

http://wfhummel.cnchost.com/bankingbasics.html

The Risk Pyramid

Profile of University Graduates' Earnings

http://www.hrsdc.gc.ca/eng/cs/sp/sdc/pkrf/publications/bulletins/2000-000007/page09.shtml

When patience and prudence are ignored, portfolios are at risk.

We urge you to practice discipline and patience. Attempting to forecast the market or nit-pick quarterly returns are efforts that need to be discouraged. You will find it easier to be patient if you first evaluate your personal risk tolerance, time horizon, age, and income needs. This process of evaluation will guide you and us toward achieving the diversification appropriate for your long-term goals.



The stock market, as measured by the S&P 500, has shown an affinity toward investors who are willing to remain patient by holding stocks over long periods of time. The three pie charts above show the percent of periods the stock market was down over various holding periods. In the 61 one-year periods from 1945-2005 the stock market was down in 14 years. In the 56 five-year periods the stock market declined in five of those periods, but in the 46 15-year periods the stock market was not down once. Patience has certainly proven itself as a virtue when it comes to investing.

The Power of Diversification (Modern Portfolio Theory)

LIFO and FIFO

Price-Earnings Ratios as a Predictor of Twenty-Year Returns (Shiller Data)

Price-Earnings ratios as a predictor of twenty-year returns based upon the plot by Robert Shiller (Figure 10.1,^[1] source). The horizontal axis shows the real price-earnings ratio of the S&P Composite Stock Price Indexas computed in Irrational Exuberance (inflation adjusted price divided by the prior ten-year mean of inflation-adjusted earnings). The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later. Data from different twenty year periods is color-coded as shown in the key. See also ten-year returns. Shiller states that this plot"confirms that long-term investors—investors who commit their money to an investment for ten full years—did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well advised, individually, to lower their exposure to the stock market when it is high, as it has been recently, and get into the market when it is low."^[1]

Robert Shiller's plot of the S&P Composite Real Price-Earnings Ratio and Interest Rates (1871–2008), from Irrational Exuberance, 2d ed.^[1] In the preface to this edition, Shiller warns that "[t]he stock market has not come down to historical levels: the price-earnings ratio as I define it in this book is still, at this writing [2005], in the mid-20s, far higher than the historical average. ... People still place too much confidence in the markets and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes."

http://en.wikipedia.org/wiki/P/E_ratio

http://www.invalueable.net/fs_overview.html

Financial Statements 101

Table of Contents

1. Understanding Financial Statements
2. Balance Sheet
3. Income Statement
4. Statement of Cash Flows
5. Statement of Retained Earnings
6. Intrinsic Valuation Modeler™ and Putting it all Together

Market P/E Ratio Volatility Channel for The US Stock Market

The key point of the chart is that earnings and P/Es are cyclical. Spare us the your slacker analysis, merely stating that “you can make any chart look however you want.” (At least this sarcasm is amusing).

"I am very skeptical of earnings forecasts, because they have been so terrible for most of my adult life.  The conspiracy of optimists always seems to overestimate future earnings.

Trailing earnings are real data, not opinion of guesswork. They provide a factual basis for valuation, and not a wishful or theoretical version. Those who were claiming that there is no recession have now taken to saying we are at the worst levels of the recession. Often, we see forward earnings estimates at the heart of this faulty analysis."

http://www.ritholtz.com/blog/2009/02/a-cyclical-look-at-pe-ratios/

Retained Earnings or Reserves

What is the correct company value? Value versus Price

What is the correct company value?

Nobel Prize winner in Economics, Milton Friedman, has said; “the only concept/theory which has gained universal acceptance by economists is that the value of an asset is determined by the expected benefits it will generate”.

Value is not the same as price. Price is what the market is willing to pay. Even if the value is high, most want to pay as little as possible. One basic relationship will be the investor’s demand for return on capital – investor’s expected return rate. There will always be alternative investments, and in a free market, investor will compare the investment alternatives attractiveness against his demand for return on invested capital. If the expected return on invested capital exceeds the investments future capital proceeds, the investment is considered less attractive.



http://www.strategy-at-risk.com/2009/02/15/what-is-the-correct-company-value/

Stocks with High Dividend Yields have outperformed in the U.S.

Why are Dividends so Important?
"Dividends have historically accounted for more than half a stock's total return."  Jeremy Siegel, PhD.

Stocks with High Dividend Yields have Substantially Outperformed the S&P 500 for 10 and 20 Year Periods.

Dividends are evidence that a Company is profitable.  Corporations find it difficult to pay out false earnings.

An S&P study shows that stocks that paid dividends outperformed non-payers by 1.9% per year from 1980-2003.

When Dividend is Cut or Omitted?

The Board of Directors proposes that no dividend be paid for the financial year 2009 (0).

http://www.swedbank.com/idc/financialreports/AnnualReports2009/en/Om_Swedbank/Ekonomiskt_sammandrag_2009/ekonomiskt_sammandrag_2009.html

Indonesian shares rise fast...

http://82.118.73.16/assets/print?aid=INJAK25793320100205

A key to beating the market is to invest in companies with strong returns on capital when they trade at low P/E's.

You wouldn't know it from looking at Acme's stock price, however. The company trades with a P/E of just 11, despite excellent returns on equity. To see the company's valuation in perspective, consider the P/E ratios of the following companies with similar returns on equity over the last five years (see chart).

Acme is not as recognizable as the rest of the names, but this is precisely why investors are offered this company at a discount. Many would argue that because the company is small, its riskiness is higher than the companies above. While that may be true to some extent (for example, three customers each exceed 10% of Acme's sales), the upside is also higher as the company has room to grow. Acme has an on-going goal of generating 30% of its sales from products developed in the last 3 years. This is something that the large companies listed above would have great difficulty achieving.

In his book, The Little Book That Beats The Market, Joel Greenblatt discusses how the key to beating the market is to invest in companies with strong returns on capital when they trade at low P/E's. Acme fits this description well.

Of course, investors cannot buy simply on the basis of a company's P/E. Further investigation of a company's risks and opportunities is necessary, as well as a careful reading of the company's notes to its financial statements.

http://www.gurufocus.com/news.php?id=86069

Economic performance of a Bank (National Australia Bank 2005)

Year 2005

Table 17: Gross value add in the community17
Year to 30 September 2005	$m
Net interest income	7,082
Fee income	4,157
Trading income	656
Net life insurance income	1,672
Other income	289
Net operating income	13,856
Significant revenue	2,493
Total net income	16,349
Other costs18	(3,811)
Movement in excess of net market value over net assets of life insurance controlled entities	335
Significant expense	(2,209)
Total	10,664
17 Gross value add in the community for the Group includes Australia, Europe, New Zealand, the United States and Asia. 18 Excludes salary-related costs, income tax relating to ordinary activities, payroll tax, fringe benefits tax, depreciation and goodwill and includes outside equity interests.

Table 18: 2005 distribution of community value
Distribution of community value	Australia $m	Europe $m	New Zealand $m
Shareholder19	2,125	1,525	424
Government20	1,665	251	131
Employees21	2,348	1,205	325
Depreciation & goodwill	268	175	73
19 Net profit attributable to ordinary shareholders. 20 Includes income tax relating to ordinary activities, payroll tax and fringe benefits tax. Excludes net GST and VAT payments. 21 Salary-related costs, excluding payroll tax and fringe benefits tax.

Interest expense
Year to 30 September 2005	$m
Deposits and other borrowings	10,401
Other financial institutions	1,780
Bonds, notes and subordinated debt	1,494
Other debt issues	115
Total interest expense	13,790

Full year dividend     166 cents

On 9 November 2005, a final dividend of 83 cents per full-paid ordinary share, 80% franked, was declared in respect of the year ended 30 September 2005. This brings the full year dividend to 166 cents (80% franked). Refer to Figure 22.

Diluted earnings per share     248 cents (after significant items)

Diluted earnings per share (after significant items) increased 26.5% from 196 cents to 248 cents. Refer to Figure 22.







http://www.nabgroup.com/0,,76586,00.html

Dupont Return on Equity Model (Graphic)

Return on Equity and Invested Capital (Graphic)

http://yahoo.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHTML1?SessionID=s0MYW0RaIQfzvKB&ID=5187822