A piggy getting smoked.
Enormous interest causes bad reporting
Every quarter, when Berkshire Hathaway (NYSE:BRK.B) (NYSE:BRK.A) must file its portfolio activity with the SEC in a so-called form 13F, hundreds of thousands of investors try to draw conclusions from it. Given the widespread interest, many news sites try to satisfy their readers’ need for analysis – however in two decades I have rarely come across a report that was fully correct or complete.
This is probably right because of the enormous interest, as even non-experts in the complex activities of the conglomerate try their hand at analyzing what would require meticulous knowledge of just too many details.
So here is what Berkshire investors should know in order to understand what is going on inside the portfolio and what you absolutely should bear in mind before copying Buffett’s stock ideas.
What the cash hoard tells us (not)
When Berkshire releases its quarterly reports, most news outlets obviously report about the cash hoard accumulated on Berkshire’s balance sheet and not much more, but draw wide-ranging conclusions from this detail. The sole fact that in the most recent quarter Buffett kept north of $150B in cash or short-term Treasuries is certainly mindboggling.
– Does the Sage therefore believe the market is overvalued, since he doesn’t do what we all know him for, i.e. buy stocks? Does Buffett therefore foresee a market crash? And should Berkshire investors request a dividend, since this cash is just uselessly lying around? Or maybe we should apply some sort of discount to Berkshire’s valuation because of this money “that is never put to use”?
First of all, the figure should be put into the right context, i.e. it must be seen in relation to total assets under management. Back in 2013, the cash hoard was about half as large, while total assets were a bit less than 50% of Berkshire’s current $1.02T. The ratio of cash to AUM has varied a bit over the past decade, but never too much. Hence, there is not a lot to see about the general market: Buffett is just as bullish or bearish as he has been for the past decade.
In fact, the idea that the cash hoard can tell us something about a Buffett-predicted market crash is simply false. To invest $150B in stocks, if we exclude the largest corporations out there, Berkshire would need a lot of good investment ideas. For example, to purchase 10% of a huge $270B company like Chevron (CVX), Berkshire would employ only $27B, but since the daily trading volume is just around $1B and Berkshire would certainly not want to move the price too much, it could purchase at best $100-$200m worth of Chevron stock per day. With roughly 20 trading days per month, after three months Berkshire would have employed just $9B, so it would need nine full months to purchase a $27B stake. Finally, it might not really want to get close to 10% ownership, which would trigger almost immediate reporting obligations in case of additions to or reductions of the position. In addition, if Berkshire owned close to 10%, share buybacks at Chevron would force it to sell into the buyback to keep its ownership level below the threshold.
Since, once it decided to get out of the position, Berkshire would also need nine months to sell it, the range of potential investments further shrinks: You need a ton of conviction to purchase a stock which can be sold only with an 18-month delay (9 to purchase + 9 to sell) ‑ especially when everybody will know what you are doing and try to front-run your actions, increasing your purchase price during the acquisition phase and reducing it when you sell.
This explains why Buffett is basically forced to go “elephant hunting”: If he wants to invest amounts that really move the needle, he needs very large targets and full company acquisitions. But such targets are rarely available for attractive prices.
As far as the “useless cash hoard” is concerned, instead of paying a dividend, Berkshire is repurchasing its own stock, thus returning about 2% of its market cap to shareholders each year (on average). This is more tax efficient than dividends and allows the company to flexibly increase capital deployment when prices are low and vice versa.
Investors also have to consider the option value of cash. Cash is not only worth the small interest it earns, but also a portion of the potential very high return it can provide when it is available in periods of distress.
“Buffett buys”
To attract the widest possible readership, news writers prefer talking about Buffett, but there are in fact several investment managers inside Berkshire. Alongside the Sage himself, there are Ted Weschler and Todd Combs who manage around $20B each. In addition, included in the SEC filing there may be some investments made by small insurance operations inside the conglomerate that have nothing to do with the investment decisions by the closely watched trio at the top. For example, Buffett confirmed that this is the case of the index fund investments in Berkshire’s portfolio.
Moreover, some investments are related to the conglomerate’s pension funds. For example, this is the case of DaVita (DVA). This likely means it is a high-conviction, long-term investment, but not necessarily the best short-term trade to piggyback on. It also helps to know that Weschler personally owns a large stake in the company. He has publicly confirmed to be the author of Berkshire’s investment in DaVita.
Some stocks suddenly appearing in Berkshire’s portfolio might also be related to company acquisitions. For example, when Berkshire bought Alleghany, it also acquired its investment portfolio.
Some stock positions can also be originated by spin-offs rather than outright purchases, the most recent example being the Liberty Live Nation positions (LLYVK) (LLYVA) (OTC:LLYVB). For each share of Liberty SiriusXM (LSXMK) (LSXMA) (LSXMB) it owned, Berkshire automatically received 0.25 shares of Liberty Live Nation. Hence, when you read in the news about this “purchase” or – if the author was a bit more informed ‑ about the spin-off, the author should rather have looked at the number of shares owned and would have discovered that there actually was an additional purchase of Liberty Live Nation, albeit a very small one (likely due to small trading volume). At quarter end, Berkshire owned 0.3m more than 10.8m shares of LLYVK it had received automatically, while it didn’t add to the LLYVA stake it received.
Somewhat related to this purchase is the new SiriusXM (SIRI) position, which is sometimes erroneously reported as the result of a Liberty Media spin-off. My best guess is that Weschler (who is the likely author of the Liberty Media investments, since he personally owns a large stake in Liberty SiriusXM) purchased a small position in SiriusXM to ensure his voice is heard when it comes to the upcoming decision about the potential merger with Liberty SiriusXM. The two companies are currently discussing a way to merge which would be fair to both sets of shareholders, and Berkshire now owns positions in both of them. While SiriusXM rallied on the day after the disclosure, the position is actually very small ($44m) compared to the Liberty stake ($1.6B). Since with that SIRI investment Berkshire increased the likelihood of a successful merger between Liberty Media and SiriusXM, the stocks that should have rallied on the news should rather have been LSXMA, LSXMB and LSXMK, since they trade at a huge discount to their NAV and a merger announcement would likely close most of this discount. (You can read more about this situation here.)
What is excluded from Berkshire’s 13F
Very rarely do we read about those investments that are totally excluded from the SEC filings, as there is no reporting requirement. These are mainly non-U.S. investments such as BYD (OTCPK:BYDDF) or Lanxess (OTCPK:LNXSF) (OTCPK:LNXSY). We discover these investments only when foreign regulations require disclosures.
In theory, even short positions could be excluded, but we know that Berkshire generally doesn’t short stocks. That said, it might still do it, which means that there could be a position in the portfolio that is actually hedged by a corresponding short position without us knowing about it.
In some cases, Berkshire may ask the SEC for confidential treatment to avoid piggybackers to front run its actions. This was the case in the most recent 13F. The statement “Confidential information has been omitted from the public Form 13F report and filed separately with the U.S. Securities and Exchange Commission” is often lost on websites that provide automatic form 13F analysis.
When we connect the dots between the information provided in the recent 10Q (quarterly earnings report) and the form 13F, we can infer that the omitted position(s) probably relate to a financial stock. More we cannot know.
That said, the interpretation of these situations can be very tricky. For example, when a stock disappears from the list and the confidential treatment statement is included in the filing, the position might actually not have been sold, but simply omitted, as Berkshire is buying even more, but has been granted confidentiality.
“Buffett sells”
We have just seen that an apparent sale could actually mean exactly the opposite. In other cases there have been sales not based on negative assessments related to company fundamentals. For example, when Buffett purchased BNSF, he already owned other U.S. railroad stocks such as Union Pacific (UNP) and Norfolk Southern (NSC). In order to avoid any sort of regulatory issues, he sold out of these stocks although he probably would have preferred to keep them.
When his investment manager Lou Simpson left Geico, Buffett sold off his investment portfolio. Hence, what was reported as a Buffett sale, was actually done simply because Buffett had never bought these stocks personally. He didn’t feel he knew enough about these positions, so he liquidated them.
In some cases, Berkshire might sell into a buyback to keep its ownership below the 10% threshold, which would trigger more rigorous limitations. If this is the case, what looks like a loss of conviction is actually only due to size-related side effects.
“Buffett holds”
Some less sophisticated journalists sometimes refer to Coca-Cola (KO) and other long-term Buffett holdings as “typical Buffett investments” which should inspire value investors. Effectively Berkshire is still holding these investments, and some have been in its portfolio for decades. However, Buffett has not added a single share of Coca-Cola to his holdings for decades.
The fact that holding on to this investment might be smart for Buffett, but might not be equally smart for most of us is rapidly explained: taxes. Of the $22.3B the investment is currently worth, $21B are profits. If Buffett sold out, some $4.4B of taxes would be due. Hence, today Buffett has $22.3B working for Berkshire’s shareholders, whereas after a sale he would only have $17.9B. This means a replacement investment would need to return substantially more than Coca-Cola to yield equal results. Moreover, selling out completely would take him probably about one year, meaning that his selling would be publicly known – and you can guess what this news would do to the share price of Coca-Cola. All in all, the decent, rather safe return Coca-Cola will probably yield on a $22.3B investment is probably worth about the same as the only potentially better returns of a different $17.9B investment.
How to best piggyback and how not to do it
As we have seen, there are many things to know before attempting to interpret Berkshire’s 13F filings. If you don’t follow everything Berkshire-related very closely, it’s probably best to not even try.
First we need to find out whether a specific investment is effectively originated by Buffett (likely if it is larger than $2-$3B), his investment officers (likely for investments between $100m and $2-$3B) or some other insurance operation. But then there is a lot more work to do.
In fact, in order to understand the level of conviction, we need to consider the position size in relation to assets under management: A $1B position is likely not Buffett’s and represents about 5% of either Todd Combs’ or Ted Weschler’s portfolio. So it is a decently sized position, but not really a big bet. Although we obviously also have to consider the available trading volume (there might simply not have been enough time to buy more) and possible restrictions (at 10% ownership unpleasant reporting obligations are triggered).
Since all three capital allocators at Berkshire have shown that they are flexible enough to purchase stocks in one quarter only to sell them off in the next one, assessing conviction is key alongside an assessment of how durable this conviction is likely to be.
For example, when Berkshire purchased a $200m position in Intel (INTC) several years ago, the position probably represented a very small bet by one of the two younger managers and could be bought and sold very quickly. Which means such a position could easily be just a short-term trade and at the very moment when a retail investor copies the investment, Berkshire might already have sold out. (It effectively kept the Intel position only for very little time.)
More unusual was the recent purchase of Celanese (CE), a position approaching 10% ownership of the company, patiently built during a long price slump over several quarters and then immediately sold, presumably with little, if any gain. An observer might have believed this investment to be a high-conviction pick by Weschler (who has worked in the chemical industry in the past), only to see that it effectively wasn’t. Presumably, in Weschler’s view the thesis changed – or he simply found some more attractive investment.
Similar conclusions apply to Buffett’s (confirmed) Taiwan Semiconductor purchase (TSM): It took Buffett more than one quarter to buy and more than one to sell. In the meantime, investors correctly believed it was a Buffett pick and therefore likely large and long-term. Buffett himself thought so as well ‑ until he changed his mind.
All this tells us how hard it is to copy Berkshire’s investment ideas: First of all, you might not even understand from the 13F what is really going on. And if you act quickly, Berkshire might act even before you. If you wait a few quarters to feel safer about Berkshire’s conviction and its durability, prices might not be attractive anymore.
That said, it is probably not smart at all to blindly copy investments without having done a solid due diligence. When looking at the average stock pick at Berkshire, at least in the past 20 years it probably has not even performed better than an index fund. Those investments that have really moved the needle in the past decades have been the largest ones: BNSF and Apple (AAPL). Which, by the way, justifies Buffett’s large cash hoard. To outperform, he needs the possibility to do very large acquisitions. The stock portfolio won’t do the job, given the many problems created by its enormous size described earlier. It necessarily is similar to every broadly diversified insurance company portfolio – unless there is the chance to invest really huge sums in one of the very few gigantic companies like Apple. Only in such cases can Buffett add substantial value, because he can confidently allocate many dozens of billions.
That said, Berkshire’s stock ideas are obviously still worth considering: They are likely well researched and low risk. Given Berkshire’s necessarily slow pace of position building, retail investors can easily get better prices than Buffett and his investment managers. However, if they don’t understand the businesses they own, they won’t be able to hold on to them when difficulties arise, they won’t be able to profit from lower prices by adding to their stakes, they won’t be able to sell once the thesis changes and they likely won’t size their positions appropriately.
Again, the importance of position sizing: 50% of Berkshire’s portfolio is in one single stock (Apple) and it has always been above 20% right from the second quarter of Berkshire’s ownership. Many have piggybacked on this Buffett investment, but few have shown the same level of conviction, which means their returns have been smaller. But conviction can come only from your own research and experience.
This means there is only one part of an investor’s work that we can partially outsource to Berkshire: the search for new ideas. Instead of going through dozens of annual reports and putting most of them on the “too-hard pile”, in the 13F we can quickly find ideas that are worth our time. The caveat is that these ideas belong to a fundamentally unattractive part of the stock market, i.e. the larger companies, which are very likely well covered by professional analysts and therefore unlikely to offer truly outsized returns. And if they do, we would need to allocate a huge part of our portfolio to them, which makes things again rather risky – especially considering how quickly Berkshire itself has traded out of some recently established positions.
In a nutshell, if you do only little or no research yourself, instead of trying to figure out Berkshire’s investments to piggyback on them, buy an index fund. Your results will likely be the same or better.
On the other hand, if you are willing to do robust research and are able to size positions according to your personal conviction, you will likely be better off focusing on smaller companies which Berkshire doesn’t buy anymore, since they won’t move the needle for Berkshire’s size.
Somewhere in the middle between these two extremes is the usual piggybacker’s position: Unwilling to independently look for potential investments, he outsources the first part of his work to Berkshire, letting its investment managers find those ideas worthwhile of doing further work. After some decent research, he decides to copy some of these investments, allocating small parts of his portfolio to them, thus forgoing the benefits of portfolio concentration (alongside the related risks). Thus, his investments will likely return just as much as an index fund.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
Read the full article here