Street Capitalist: Event Driven Value Investments

Felix Salmon over at Reuters has a good piece discussing Michael Lewis’ review of The Snowball, Alice Shroeder’s biography on Warren Buffett. I highly enjoyed that book and thought Lewis wrote a pretty fair review. Salmon though had a few points in his post that I wanted to discuss.

First, Salmon says:

Would Buffett really have gained from going private? I doubt it, somehow: having sought-after equity with which to pay for acquisitions was extremely valuable to Berkshire Hathaway.

I’m not really sure if this is really a benefit for Berkshire not being private. Berkshire’s strength as an acquirer has more to do with the cash that’s generated from its operations, turnover in investments, and the company’s insurance float. These would still exist if the company was private. As for selling stock to fund acquisitions, I think that this has really only been done once, with Dexter Shoes and it was a decision that Buffett has gravely regretted ever since. See the 2001 Letter to Shareholders where the Dexter investment is discussed:

Finally, I made an even worse mistake when I said “yes” to Dexter, a shoe business I bought in 1993 for $433 million in Berkshire stock (25,203 shares of A). What I had assessed as durable competitive advantage vanished within a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion– to buy a worthless business.

To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future – you can bet on that. A line from Bobby Bare’s country song explains what too often happens with acquisitions: “I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.”

Salmon goes on to say:

Finally, as Lewis says, “as rich as Buffett became, he never stopped measuring himself by how much money he had”. When Berkshire Hathaway was trading at a significant multiple of book value — as it nearly always was — Buffett could judge how much money he had just by taking the number of shares he owned in Berkshire Hathaway and multiplying them by the share price.

If Berkshire went private, however, Buffett could do that no longer: he would have to measure his own wealth on book value alone. Which, while surely a large number, wouldn’t be quite as large as the market value of his stake in Berkshire Hathaway.

But Lewis writes in his review:

He tells Schroeder that he pretty much measures his whole life by Berkshire Hathaway’s book value, and the reader can’t help wondering if that is ultimately how he measures other people, too.

I’ve bolded “book value” for added emphasis but I think you get the idea. For someone like Warren Buffett, who over the course of decades has made billions by mastering the art of valuation and navigating through market bubbles, the idea that he would care about Berkshire’s overinflated value seems a bit far fetched. He knows when Berkshire is a bargain and what it is not. See the 1999 Letter to Shareholders:

Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange (“NYSE”). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the “third market” or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.

Please be clear about one point: We will never make purchases with the intention of stemming a decline in Berkshire’s price. Rather we will make them if and when we believe that they represent an attractive use of the Company’s money. At best, repurchases are likely to have only a very minor effect on the future rate of gain in our stock’s intrinsic value.

My guess is that Buffett may get a kick out of seeing his net worth appreciate to an overinflated value, but that’s about it. Seeing as he has a good grasp on what Berkshire is worth at any given time, he probably knows that those overinflated valuations are often only temporary. After the Dexter investment, I would argue that Buffett is highly unlikely to use stock for any future acquisitions; limiting the usefulness of Berkshire stock when it is overvalued.

I personally think that staying public had some major intangible benefits for Buffett.

By creating such a level of transparency between Buffett and the outside world, Berkshire Hathaway was really able to be the masterpiece that he had hoped to create. Berkshire is really like that work of art that goes on tour to the major museums of the world for everyone to see. We’re all given access to the company’s financial statements and letters. That kind of transparency facilitates a greater degree of understanding about Berkshire Hathaway helps create the “cult” of followers that Buffett and Charlie Munger often joke about. With that kind of buzz, entrepreneurs are able to hear about how Berkshire is run and reach out to Buffett in hopes of selling their businesses.

Buffett is able to find great businesses that are often led by great people. He rarely has to enter into a turnaround situation, so Berkshire Hathaway has become this conglomerate of companies that all tend to have strong competitive advantages in their own respective industries. I think it is extremely rare to find a situation like this in the world of private equity. Those guys don’t seem to get as great of deals as Buffett, so they have to resort to taking out massive amounts of leverage to amplify their returns to make them more worthwhile. In addition, they’re often forced to perform open heart surgery on their portfolio companies by slashing departments and parachuting in new executives. It’s extremely difficult and I think that’s why we’re seeing a number of these recent PE acquisitions file for bankruptcy.

Being public really helps in communicating the values that Buffett prizes to the rest of the world and makes it easier for ordinary people to check out. Business owners often don’t have to work through intermediaries like investment bankers and instead can go straight to Buffett. It cuts through the gross inefficiencies of the acquisition process and forges a stronger relationship between the entrepreneur and the owner.

I know it’s not the only reason for Berkshire’s success, but it is definitely part of the equation.