Saturday, February 28, 2009

Berkshire Hathaway 2008 Annual Report

Berkshire Hathaway released its Q4 and annual report today. We have covered Berkshire in other sections in this blog. For the previous sections please take a look at this report:

The last report in this blog.

Now fast forward to the current year, will Berkshire be a sound investment for 2009 and 2010?

The company continues to be very sound and is increasing its moat in many segments of its operating businesses. Let us do a quick intrinsic value check as of 12/31/2008. If we use Warren Buffett's two column method, we have 122 billion in cash and investments + earnings per share of 3224. At the end of 2008, the intrinsic value of the company was around 110K/A share.

Berkshire as a company earns between 10-12 billion dollars a year from its various operations. This is accretive to the book value of the company. Typically, this money is invested to return 10-15% returns. It is very important to note that Berkshire is a compounding asset even when the markets are down as opposed to some of the other companies which rely on the consumer spending to rebound.

To see how the operating businesses will do, let us look at how the operating businesses did in Q4 of 2008 and equate it to 2009. In 2009, we have:

1. Insurance, Re-insurance:
This should do better than 2008. Primarily this is because of the financial position of hedge funds and other businesses having problems with capital.

2. Utility sector:
This sector should continue to do well in 2009 inspite of the economy. We can peg its earnings at par with 2008 if not more.

3. Investment and derivative gains/losses:
This should abate from its 2008 levels. My expectation is that it should start posting a gain from 2010 onwards.

4. Dividend and interest income:
I believe this should increase significantly in 2009 compared to 2008. This declined slightly in 2008 compared to 2008 but should pick up in 2009, 2010.

5. Income from manufacturing and other businesses:
This may decline by upto 20% but such a decline will reduce operating earnings by about 500 million dollars. I believe this should be made up by the gains in insurance which is gaining market share.

6. Investment portfolio:
This should recover from current position by end of 2009 or atleast in 2010.

From a three-five year horizon, Berkshire looks attractive. It looks more attractive than many other stand alone businesses which are trading at low prices in today's market.

Sunday, February 15, 2009

Preferred stocks

Let us take a look at what constitutes a preferred stock. From investopedia, we have the following definition:

A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock. Preferred stock generally has a dividend that must be paid out before dividends to common stockholders and the shares usually do not have voting rights.

Many of the preferred stocks are callable. Let us see what does this mean, again from investopedia:

A type of preferred stock that carries the provision that the issuer has the right to call in the stock at a certain price and retire it. Also known as "redeemable preferred stock".

The preferred stock is different than a convertible. A convertible is typically a bond that pays a certain interest that later can be converted to common stock.

When we analyze some of the preferred stocks, it is common to see the term "debenture" in the literature. Let us see what this stands for. Investopedia helps us again.

"A type of debt instrument that is not secured by physical asset or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both corporations and governments frequently issue this type of bond in order to secure capital."

Now, let us take a look to see who issues preferred stocks. It is typically the financial institutions and utilities that issue preferred stocks. The banks typically issue preferred stocks as they are able to raise capital without diluting the equity holders.

Typically, a preferred is not a great investment as they may not be called on the callable date as they typically pay a dividend to perpetuity. The second problem with preferred stocks is that the dividend doesnt increase with the companies earnings but the price of the preferred may see wide fluctuations.

So, why is the preferred stock interesting? From Wall Street Journal page, many preferred stocks are generating attractive yields. Some of the banks are particularly interesting. The strongest banks in the US include Wells Fargo and USB. How do we analyze the preferred stocks? There are two tests that come to play.

1. Is the bank stable enough to pay the dividends and outlast this downturn?
2. How is the interest rate calculated? E.g: If the interest is a fixed percentage, one may lose out if the market rebounds and inflation creeps in. However, if the interest is pegged to the LIBOR, the odds of failing against inflation is low.

Investopedia helps us define LIBOR again:

The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year.

Now, let us see which banks have yield against the LIBOR and which ones dont. The WSJ article shows us the current yields on preferred stocks. The yields are wider on banks with troubled assets - e.g: Bank of America and MBNA. The yields are lower on Wells Fargo and USB which have stronger franchises. The regional banks such as Suntrust also enjoy a higher yield as they are perceived to be weaker franchises compared to the larger operations.

The website Quantum Online lists some exotic securities one can follow through. Let us look at a couple of securities.

The first one is USB-L and USB-H. USB-L is currently trading at a higher price but offers about the same dividend as USB-L. While there is certainly more downside risk for both, there is a key difference between these two offerings. While offering identical yields, USB-H is trading at a significantly lower price than USB-L. This is because USB-L offers a higher yield that is fixed at a specific rate. If the inflation is to increase, USB-H will become more attractive than USB-L. From a longer term point of view, USB-H is more attractive than USB-L as USB-H offers more upside. Specifically, USB-H offers more opportunities for capital gains than USB-L.

There are other preferred stocks that one can browse in the above links. Each of them offers its own risks and rewards. One should do one's own due diligence before jumping and buying these stocks.