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Buffett's Conservatism Show

04 May 2009 @ 10:59 pm AEST

From all reports it was a gloomy day in Omaha where the faithful (35,000 at some estimates) gathered to hear the latest from Warren Buffett after his toughest year of riding the vagaries of the markets.

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The first quarter operating profit for his Berkshire Hathaway company fell slightly from the first quarter of 2008, as many of the company's businesses suffered from the recession and low interest rates hurt returns from insurance and the company's cash pool.

Berkshire generated first-quarter operating earnings of $US1.7 billion, down from $US1.9 billion a year earlier.

Operating earnings exclude investment and derivative gains and losses. He didn't mention net income; that will come when the full results are released this Friday night, Australian time.

Berkshire and Buffett have lost some of their lustre because of the sharp fall in the market and decisions to invest in struggling groups, Goldman Sachs and General Electric. The investments helped stabilise both companies and prevent further weakness from bringing them down.

But those investments are paying higher dividends: three times or more the current return from cash in the US.

Both companies have seen their share prices recover in the market rebound since early March.

His performance in 2008, for example, was hit by his large exposure to the ailing US financial sector, which includes stakes in American Express and Wells Fargo (which he told the meeting he'd love to own outright).

The recent rally in banking stocks has helped Berkshire, whose shares have risen more than 30% since their lows in March, a sign that much of the handwringing by journalists and analysts about Berkshire has been overdone and rubbish.

What many, many people do not understand about Berkshire and quite a few other companies, is that there is no way for them to fully insulate themselves from what happens in financial markets and the broader economy, especially when the credit crisis was so devastating and the recession the deepest since The Great Depression.

These modern American companies are simply too big (General Electric for example and the big oil companies) and the events since August, 2007, have been simply too volatile for size to be any protection (unless you are a giant like Wal Mart Stores).

Buffett told the meeting that the company will probably lose money on derivatives tied to the credit quality of junk bonds, though he still expects to make money on a much larger and longer-term derivatives bet that stock prices will rise. He revealed that one of these latter contracts had been re-worked to reduce any potential damage to the company (he's being conservative).

Buffett said Berkshire's cash stake fell to about $US22.7 billion on March 31 from $US25.5 billion at the end of 2008.

News media reports from the US said the meeting had a decidedly more serious and sombre tone from years past as many investors expressed worries about the economy, Berkshire's investments, and how long the 78-year-old Buffett plans to stay on the job.

In keeping with his new policy to toughen up questions, Buffett had half the questions pre-screened by journalists.

People attending the meeting said that made for a tougher, more substantive and less idealised dialogue with Buffett and his 85-year-old vice chairman, Charlie Munger.

Buffett said no stock buybacks are planned because Berkshire's share price is not "demonstrably below" the company's intrinsic value.

Buffett offered a gloomy forecast for parts of the economy and Berkshire itself, saying some units are laying off workers as managers "look at the reality of the current situation".

He also said massive federal efforts to stimulate activity could pay off, at a possible cost of higher inflation.

"It has been a very extraordinary year," Buffett said. "When the American public pulls back the way they have, the government does need to step in.... It is the right thing to do, but it won't be a free ride."

Buffett said housing prices have yet to stabilize broadly, that retailers may be under pressure for a "considerable period of time" and that he would not buy most US newspaper companies "at any price".

He also said that in insurance, which comprises about half of Berkshire's operations, the earnings power "was not as good last year as normal" and "won't be as good this year".

That means another year where earnings for the investment guru's master company will be challenged.

And the most interesting comment was nicely reported online by Fortune magazine.

"Reflecting on the near implosion of the financial system last fall, Buffett said officials should be judged more leniently when facing "as close to a total meltdown as you can imagine."

"But he warned that efforts such as the Treasury's $700 billion Troubled Asset Relief Program and the $787 billion fiscal stimulus plan passed this year by Congress will have to be paid for, one way or another.

"And with political leaders showing little inclination to raise taxes, one sure way to pay for excess spending is to inflate the value of the currency, Buffett said. The biggest losers in a surge of inflation, he added, would include holders of bonds and other fixed-income assets.

"I haven't had my taxes raised," said Buffett, who has run Berkshire for more than four decades. "My guess is the ultimate price will be paid by a shrinkage of the value of the dollar."

Remember that, and watch the way bond yields are going. Friday the US 10 year government bond hit 3.15%, a new high for the year when demand for money is at a near all time low.

The cost of money is going to rise over the medium term simply because the days of easy credit are gone.

Equity is back in fashion as a way of raising cash and funding companies (for survival right now).

The US, Europe, the UK, Australia, Japan and a host of other economies have seen companies large and small issuing shares to raise cash (or convertible prefs and other quasi equity securities).

It's no longer a trend, but the norm.

Buffett was into this earlier through those deals last year involving Wrigley, Goldman Sachs and GE.

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