Being Crazy Isn’t Enough . . .

The Brothers Festrunk:  Wild and Crazy Guys.

The Brothers Festrunk: Wild and Crazy Guys

For nearly a decade ‘The Essays of Warren Buffett’ have been required reading for employees and interns alike at our firm. This indexed compendium of Mr. Buffett’s Berkshire Hathaway annual reports contains valuable insight into the mind of one of the world’s few consistently correct investors. The rules he established kept him from forays into the difficult to value, capital intensive and volatile sectors of communications and computing – and rightfully so. His rules have also historically kept him from spending too much on potential acquisitions across other areas of the economy. Here is a laser-like focused segment from his 1990 annual report discussing another area of deep conviction:

“The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.”

How true indeed. In conversations and presentations we often cite the even higher octane leverage – of various types – that the USA and Europe have fallen in love with gulping down during the two decades since the aforementioned prose was penned. Only this time the lemming like zeal referenced by Mr. Buffet is leading the entire west, not to mention him, to a lemming like fate.

So what could explain his investment in Goldman Sachs (of which if you followed his actions during the fall of 2008, you have lost value* today) or more recently Bank of America? Is it that these are ‘well managed banks at fair prices?’ Can’t be. The management at the Bank of America and numerous other mega-institutions has driven the western financial system perilously close to insolvency. Just this past week the USA Government, via the Federal Housing Finance Agency, announced that it is suing many of the largest banks (Bank of America alone for nearly $31,000,000,000) due to their involvement in ‘alleged’ improper dealings and outright abuses within the mortgage market. This sort of liability could run very deep – even considering that claims may be settled for pennies on the dollar. These are just not the sort of usual risks or attributes that Berkshire Hathaway actively pursued in the past.

It just might be that this action is what remains for the majority of solvent entities, including vaunted companies such as Berkshire Hathaway, in response to the teetering financial system. They are trying to prevent a systemic financial collapse through propping up integral institutions. I am reminded of Franklin Delano Roosevelt who advised ‘when you come to the end of your rope, tie a knot and hang on.’

And hang on they are! In my view Berkshire Hathaway has followed the Peter Principal**. In the current period the highest and most profitable level that can be attained in an economy is that of a ‘financial services’ company. As it stands now, believe it or not, that is what 40% of our economy is – financial services. Berkshire Hathaway appears to own so called bricks and mortar businesses mostly because they are a good way to obtain stable cash flows which in turn allow confidence in writing insurance policies.

Unfortunately, their deep involvement in financial services leaves them helplessly intertwined in an economy that is completely dependent upon the success of liquidity providers – the banks. I suspect that the reason for Mr. Buffett’s recent investment in Bank of America is to act as a bridge loan while the rest of the system tries to rescue itself once again. That is where the brothers Festrunk pictured above come in – it’s been great partying with them and the banks since the 1970s, but now these two wild and crazy guys are about to pass out. Hopefully there is someone there to take them – and figuratively the west – to the hospital so that they can recover.

I believe Mr. Buffett’s investment in Bank of America should be taken as a warning sign, not a sign of relief. Until the west deals with its debt binge it will be best to underweight the region and let it sleep it off.

While this article is yet another fairly dark interpretation on what is occurring, it should be recalled that nearly half of the planet is in quite a different position – especially if certain trends such as regionalization steadily progress. This much more positive topic is a point my next article will further explore.

* The deal was announced on September 23rd, 2008. Mere mortals could not invest in the ‘deal’ that Mr. Buffett obtained, but if they bought the stock the following day’s open at $128.44, they would have seen their shares decline to $107.06 as of the publishing date of this article. Of course, Mr. Buffett’s Berkshire Hathaway earns a 10% dividend yield on his preferred shares as well as the investment has another sweetener attached in the form of ‘warrants’. These warrants are valuable if the stock raises above $115 a share. This might be looked at as a type of inflation protector to the core preferred share investment. If inflation rises, then the shares should rise to some degree with inflation. Above $115 the investment becomes positively adjusted against inflation via the warrants.

** In a hierarchy, this case an entire economy, a company tends to rise to its level of incompetence – meaning that with 40% of the USA economy based in Financial Services it is only a matter of time before the good deals are all absorbed and incremental gains begin to come from increasingly poor deals. Eventually a company caught in this cycle will deteriorate or even implode due to the stresses caused by decreasing marginal returns accumulating until the business model is compromised.