Berkshire Still Holds Loads of Cash

Reading homework... Small banks holding Fannie and Freddie... Wachovia's $122 billion shoe... Sign of a market bottom?... Stahl on exchanges... Dyson on Paraguay... "Achtung, baby"... Cash is king...

I strongly encourage you to read Chapter 8 of Benjamin Graham's The Intelligent Investor. It'll help you navigate times like these, when many stocks are down... some are recovering... some continue to fall... and all seem to go up and down like shot glasses at a frat party.

For some time I've been telling you we're going to see hundreds of bank failures over the next couple of years. If Fannie Mae and Freddie Mac preferred stock evaporates in a bankruptcy, some smaller banks could evaporate with it.

The bank with the largest exposure to GSE preferred stock is Gateway Financial Holdings. (GSEs are "government sponsored enterprises"... outfits like Fannie and Freddie that have implied federal backing.) It has 34% of its tangible capital in GSE preferred stock. The bank's market cap is below $100 million. The second biggest exposure is Midwest Banc Holdings, with 32% of its tangible capital in GSE preferred stock. Its market cap is $154 million.

It's highly unlikely GSE preferred stockholders will get anything should the government take over Fannie and Freddie. If these little banks have to write down a third of their tangible capital, their stocks will crash hard. It could become impossible for them to raise more capital.

The current rally in financials is something like a mass fantasy. Maybe the baby boomers are having a huge LSD flashback. This time, those who didn't literally jump off a roof when they were younger are now figuratively jumping off a roof by buying financial stocks like Fannie Mae and Lehman Brothers.

Paraphrasing publishing magnate Felix Dennis' assessment, it looks to me like publicly traded financial companies are not sane places, and their share prices are not decided by sane people. I continue to caution investors against banks in particular and leveraged financials in general.

Another shoe still dropping in the banking sector is option ARM loans. Option ARM loans allow borrowers their choice of payments each month: a regular payment, an interest-only payment, or a minimum payment. The minimum payment doesn't pay all the interest due, so the principal actually grows. When the loan recasts, the new minimum payment becomes the old maximum payment. The loan recasts every 60 months. It can also recast if the principal hits 125% or 115% of the original amount, depending on the individual loan.

Wachovia has about $122 billion of option ARMs, most of which it picked up when it bought Golden West Financial in 2006, at the top of the mortgage bubble. Wachovia says it expects to lose about 12% of its portfolio, just under $15 billion. If Wachovia even survives, a loss rate of 25% wouldn't be out of the question, given the poor, bubble-era underwriting quality.

Word of yet another possible deal between Lehman Brothers and Korea Development Bank hit the headlines. If a KDB/Lehman deal takes place, the price will tell us if KDB has been paying attention to the bath other foreign investors have taken on stocks like Citigroup and Wachovia. I expect Lehman shareholders to be only slightly more thrilled with a deal than Bear Stearns shareholders were with JPMorgan's offer.

Signs of a market bottom? Individual U.S. stock ownership has fallen to a record low. Retail investors owned 34% of all shares at the end of 2006 – the most recent numbers. To compare, individuals owned 94% of all stocks in 1950 and 63% in 1980.

Of course, there were fewer institutional investors in 1950 and 1980. The enormous proliferation of investment funds has put us in the odd position we're in today: more funds than stocks. You have to figure most of these professional financial intermediaries are merely destroying value by charging unjustified fees.

Statistically, the mutual-fund industry must be a net value destroyer. It's simply impossible for a majority of investors to beat the market. It would be like saying everyone at the table can have the largest slice of pizza. The only way that can happen is if everyone's slice is the exact same size. Nobody loses. Nobody wins.

Given that there are no longer any losers in gym class, or math class, or any other portion of the hobbled American secondary-school curriculum, it makes sense that an entire industry based on the idea that everybody can win thrives in the U.S.

The flight of retail investors hasn't hurt the global stock exchanges. They're seeing record volume. Murray Stahl of value investing firm Horizon Asset Management thinks they're the best deal in the markets today. Stahl has been a fan of the stock exchanges for years. To him, they're the "croupiers," the dealers at the tables of the global casino of finance. As long as buyers and sellers show up, they make money.

In his second-quarter letter to investors, Stahl noted rising oil prices and a shaky economy have crushed all stocks – some unjustly...

When one looks at the businesses of exchanges, one observes a bounty of robust operating statistics: significantly increasing volumes, increases in year-over year revenues, expanding margins, and continuous expansion into new markets. They are among the most robust earnings expectations one can find... these possibly most profitable companies in the world are also trading at merely 12x next year's earnings.

There is a world of difference between a P/E multiple of 12x for a securities exchange with a 40% net after-tax profit margin and 12x for an automobile or battery manufacturer or mining company. For those who wax wistful over their missed opportunity to purchase blue chip stocks like Merck in 1982, when it traded at a single-digit P/E ratio and a 7½% dividend yield, they should consider carefully what lays before them today.

Despite these great earnings projections, the five major exchanges are down between 35% and 53% this year.

I'm not sure when Stahl's letter came out, but it looks like the deal has gotten better. As of this morning, NYSE Euronext (NYX) trades at 10.7 times earnings.

If you want a great way to buy NYSE Euronext, try LaBranche (LAB). It owns 1% of NYSE Euronext. With NYSE 57% below its 52-week high, LaBranche has taken huge noncash charges as it writes down the fair value of its NYSE shares. But LaBranche's core business (NYSE floor trading) continues to produce free cash flow.

LaBranche's market cap is around $409 million today. Its NYSE stake alone is worth $128 million. If NYSE Euronext is easily worth twice where it's trading today, then when you buy LaBranche, you're getting NYSE at a big discount, PLUS you're paying maybe seven times free cash flow for LaBranche's core business.

Another beaten-down stock, iron ore producer Vale do Rio Doce, may be headed for its best performance in a decade. The Brazilian company's stock fell 26% this year, but analysts expect the stock to double in the next year – three times the expected gains for the world's biggest mining companies, BHP Billiton and Rio Tinto.

Most analysts expect iron-ore prices to rally 20% in 2009, but Vale will see most of its growth as demand from Chinese steelmakers rises and freight rates fall. Vale ships most of its ore from Brazil, not Australia, where BHP and Rio are based.

According to the International Monetary Fund, Paraguay is the world's big winner with soaring food costs. Despite raging poverty and corruption, a subtropical climate and tons of great farmland increased Paraguay's trade balance by 12.2% of its 2005 GDP – the only country to have a double-digit increase. Soybeans are the South American country's cash crop. Paraguay is the world's fourth-largest soybean exporter.

Tom Dyson visited Paraguay earlier this year. He thinks it could be one of the best places to invest for the next 10 years. Read about it in DailyWealth.

New highs: none.

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"'If you renounce your citizenship under the new tax law, you'll first pay a huge exit tax equivalent to about half of your net worth for the privilege.' Is that really true? I have gotten so fed up with the politicians and the stupid, arrogant and naive public that elects them that I want to leave. If figure that if it is a simple case of me not wanting the same things that the Amerikan public wants, then I should be the one to leave. If they are going to take from me half of what I have struggled to earn with my two jobs, then I will start the goddamn revolution." – Paid-up subscriber Matt

Ferris comment: I think it was the rock group U2 that said, "Achtung, baby."

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Medford, Oregon

September 2, 2008

Berkshire Still Holds Loads of Cash

By Ian Davis

It's a bear market in Berkshire Hathaway stock...

Warren Buffett's holding company is currently 21.8% off the peak it reached on December 10, 2007. Investors have been fleeing the stock in droves.

This is because at the beginning of this year, Buffett himself said profits would decline. He said 2007 profits were unusually large do to some exceptional results in the company's insurance division.

In the first half of 2007, Berkshire Hathaway's net income was a fantastic $5.7 billion. The first half of this year, its net income fell to $3.8 billion.

Thing is, any way you slice it, Berkshire Hathaway is still making – and holding – loads of cash.

Cash Is King in a Bear Market

Having loads of cash right now is important for two reasons...

The obvious reason is the current liquidity crisis going on in the U.S. Many companies are finding it expensive, if not impossible, to find funding.

Just look at the current "junk-bond spread." The junk-bond spread is the difference between the interest rates on risk-free U.S. Treasury bonds and risky high-yield bonds.

Usually the spread is around 4.5%. Meaning smaller, less-established companies need to pay about 4.5% more than Treasuries to get financing. Today, the spread is just shy of 8%... almost as high as it was at the height of the dot-com crash.

Berkshire Hathaway has a lot of cash when cash is hard (or expensive) to find. So it's in a good position right now because companies that used to be able to borrow easily at low rates are now clamoring to pay high rates to the few companies that have cash to throw around. Berkshire is one of those companies.

Secondly, during a bear market, many companies that are financially secure still get swept away by the falling tide. This is a perfect opportunity for cash-rich companies like Berkshire to step in and make acquisitions on the cheap.

For example, Berkshire Hathaway is the parent company to HomeServices of America, the second-largest U.S. real estate brokerage firm. HomeServices is using the bear market as a chance to expand its market share.

It plans to buy up distressed brokerages. The head of HomeServices, Ron Peltier, said he expects to spend $200 million in the next two years buying up distressed brokerages at pennies on the dollar.

Warren Buffett excels at finding value... And there's lots of it lurking in today's beaten-up market. Berkshire Hathaway will come away from this bear market in an even better position than it's currently in.

The long-term trend is still down, but the stock has found some support recently. It's 5% off the low it reached one month ago. I believe Berkshire Hathaway is a great long-term hold in this market. But I would wait for a successful retest of its previous low before jumping on board.

Good investing,

Ian Davis

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