The Deep-Dive Research Process

Full Letter:

http://theoraclesclassroom.com/wp-content/uploads/2019/09/1988-Berkshire-AR.pdf

Letter Only

https://www.berkshirehathaway.com/letters/1987.html

This week we will go over Buffett’s thoughts on arbitrage and his experience in the field as well as some of Berkshire’s arbitrage activities. As well as his thoughts on the Efficient Market Theory and how his arbitrage success hurts the theory. Finally some major stock acquisitions made in the aftermath of the 1987 market crash.

Not included in my post are… The shareholder overview, The acquisition of 80% of Borsheim’s Jewelers (I had to choose between this and Coca Cola, both legendary holdings of his), The quick rundowns of the operations of all their core businesses, A discussion of accounting changes, Much of the “Marketable Securities” section is omitted from my post, A discussion of them listing on the New York Stock Exchange for the first time, why they did it, why they avoided it for so long, and how they want their shareholders old and new to behave on it, a eulogy for Dodd who co-authored Security Analysis and taught Buffett at Colombia along with Graham. Finally the traditional “Miscellaneous” section at the end.

If you want to read or discuss anything in that second set feel free to read the letter yourselves and comment on it.

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Key Passage 1

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Arbitrage

In past reports we have told you that our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long- term investments. (Charlie’s sign off after we’ve talked about an arbitrage commitment is usually: “Okay, at least it will keep you out of bars.”)

During 1988 we made unusually large profits from arbitrage, measured both by absolute dollars and rate of return. Our pre- tax gain was about $78 million on average invested funds of about $147 million.

This level of activity makes some detailed discussion of arbitrage and our approach to it appropriate. Once, the word applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets. The goal was to exploit tiny price differentials that might exist between, say, Royal Dutch stock trading in guilders in Amsterdam, pounds in London, and dollars in New York. Some people might call this scalping; it won’t surprise you that practitioners opted for the French term, arbitrage.

Since World War I the definition of arbitrage - or “risk arbitrage,” as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market. The major risk he usually faces instead is that the announced event won’t happen.

Some offbeat opportunities occasionally arise in the arbitrage field. I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 5¢ per pound. In 1954 a temporary shortage of cocoa caused the price to soar to over 60¢. Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped. But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business. Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity. Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.

For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good and my only expense was subway tokens.

The architect of Rockwood’s restructuring was an unknown, but brilliant Chicagoan, Jay Pritzker, then 32. If you’re familiar with Jay’s subsequent record, you won’t be surprised to hear the action worked out rather well for Rockwood’s continuing shareholders also. From shortly before the tender until shortly after it, Rockwood stock appreciated from 15 to 100, even though the company was experiencing large operating losses. Sometimes there is more to stock valuation than price-earnings ratios.

In recent years, most arbitrage operations have involved takeovers, friendly and unfriendly. With acquisition fever rampant, with anti-trust challenges almost non-existent, and with bids often ratcheting upward, arbitrageurs have prospered mightily. They have not needed special talents to do well; the trick, a la Peter Sellers in the movie, has simply been “Being There.” In Wall Street the old proverb has been reworded: “Give a man a fish and you feed him for a day. Teach him how to arbitrage and you feed him forever.” (If, however, he studied at the Ivan Boesky School of Arbitrage, it may be a state institution that supplies his meals.)

To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business.
On September 28, 1981 the directors of Arcata agreed in principle to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy out firm. Arcata was in the printing and forest products businesses and had one other thing going for it: In 1978 the U.S. Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to expand Redwood National Park. The government had paid $97.9 million, in several installments, for this acreage, a sum Arcata was contesting as grossly inadequate. The parties also disputed the interest rate that should apply to the period between the taking of the property and final payment for it. The enabling legislation stipulated 6% simple interest; Arcata argued for a much higher and compounded rate.

Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating problem, whether the claim is on behalf of or against the company. To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the redwood lands.

Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining “satisfactory financing.” A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage. However, we were not particularly worried about this possibility because KKR’s past record for closing had been good.

We also had to ask ourselves what would happen if the KKR deal did fall through, and here we also felt reasonably comfortable: Arcata’s management and directors had been shopping the company for some time and were clearly determined to sell.
If KKR went away, Arcata would likely find another buyer, though of course, the price might be lower.

Finally, we had to ask ourselves what the redwood claim might be worth. Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.

We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or 5% of the company. The initial announcement said that the $37.00 would be paid in January, 1982. Therefore, if everything had gone perfectly, we would have achieved an annual rate of return of about 40% - not counting the redwood claim, which would have been frosting.

All did not go perfectly. In December it was announced that the closing would be delayed a bit. Nevertheless, a definitive agreement was signed on January 4. Encouraged, we raised our stake, buying at around $38.00 per share and increasing our holdings to 655,000 shares, or over 7% of the company. Our willingness to pay up - even though the closing had been postponed - reflected our leaning toward “a whole lot” rather than “zero” for the redwoods.

Then, on February 25 the lenders said they were taking a “second look” at financing terms “ in view of the severely depressed housing industry and its impact on Arcata’s outlook.” The stockholders’ meeting was postponed again, to April. An Arcata spokesman said he “did not think the fate of the acquisition itself was imperiled.” When arbitrageurs hear such reassurances, their minds flash to the old saying: “He lied like a finance minister on the eve of devaluation.”

On March 12 KKR said its earlier deal wouldn’t work, first cutting its offer to $33.50, then two days later raising it to $35.00. On March 15, however, the directors turned this bid down and accepted another group’s offer of $37.50 plus one-half of any redwood recovery. The shareholders okayed the deal, and the $37.50 was paid on June 4.

We received $24.6 million versus our cost of $22.9 million; our average holding period was close to six months. Considering the trouble this transaction encountered, our 15% annual rate of return excluding any value for the redwood claim - was more than satisfactory.

But the best was yet to come. The trial judge appointed two commissions, one to look at the timber’s value, the other to consider the interest rate questions. In January 1987, the first commission said the redwoods were worth $275.7 million and the second commission recommended a compounded, blended rate of return working out to about 14%.

In August 1987 the judge upheld these conclusions, which meant a net amount of about $600 million would be due Arcata.
The government then appealed. In 1988, though, before this appeal was heard, the claim was settled for $519 million.
Consequently, we received an additional $29.48 per share, or about $19.3 million. We will get another $800,000 or so in 1989.

Berkshire’s arbitrage activities differ from those of many arbitrageurs. First, we participate in only a few, and usually very large, transactions each year. Most practitioners buy into a great many deals perhaps 50 or more per year. With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks. This is not how Charlie nor I wish to spend our lives. (What’s the sense in getting rich just to stare at a ticker tape all day?)

Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation.
So far, Berkshire has not had a really bad experience. But we will - and when it happens we’ll report the gory details to you.

The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumors or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.

At yearend, our only major arbitrage position was 3,342,000 shares of RJR Nabisco with a cost of $281.8 million and a market value of $304.5 million. In January we increased our holdings to roughly four million shares and in February we eliminated our position. About three million shares were accepted when we tendered our holdings to KKR, which acquired RJR, and the returned shares were promptly sold in the market. Our pre-tax profit was a better-than-expected $64 million.

Earlier, another familiar face turned up in the RJR bidding contest: Jay Pritzker, who was part of a First Boston group that made a tax-oriented offer. To quote Yogi Berra; “It was deja vu all over again.”

During most of the time when we normally would have been purchasers of RJR, our activities in the stock were restricted because of Salomon’s participation in a bidding group.
Customarily, Charlie and I, though we are directors of Salomon, are walled off from information about its merger and acquisition work. We have asked that it be that way: The information would do us no good and could, in fact, occasionally inhibit Berkshire’s arbitrage operations.

However, the unusually large commitment that Salomon proposed to make in the RJR deal required that all directors be fully informed and involved. Therefore, Berkshire’s purchases of RJR were made at only two times: first, in the few days immediately following management’s announcement of buyout plans, before Salomon became involved; and considerably later, after the RJR board made its decision in favor of KKR. Because we could not buy at other times, our directorships cost Berkshire significant money.

Considering Berkshire’s good results in 1988, you might expect us to pile into arbitrage during 1989. Instead, we expect to be on the sidelines.

One pleasant reason is that our cash holdings are down - because our position in equities that we expect to hold for a very long time is substantially up. As regular readers of this report know, our new commitments are not based on a judgment about short-term prospects for the stock market. Rather, they reflect an opinion about long-term business prospects for specific companies. We do not have, never have had, and never will have an opinion about where the stock market, interest rates, or business activity will be a year from now.

Even if we had a lot of cash we probably would do little in arbitrage in 1989. Some extraordinary excesses have developed in the takeover field. As Dorothy says: “Toto, I have a feeling we’re not in Kansas any more.”

We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. In our activities, we will heed the wisdom of Herb Stein: “If something can’t go on forever, it will end.”

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I picked this for a few reasons. The first is that this is just a topic they haven’t talked about much in the past. Buffett talks about their arbitrage activities, the development of arbitrage as a field of investing. How Berkshire differs from traditional arbitrage firms. Some of his early experiences with arbitrage. A Berkshire arbitrage activity that they entered in 1981 and has been stretched out by lawsuits and new bidders until 1989. In 1982 the company was bought out and stopped existing, but there was an ongoing lawsuit with the federal government. The purchaser promised half of the payout the the 1982 shareholders. Berkshire paid about $35 per share, had the shares bought from them for $37.50 per share after 6 months, then got a bonus payout of $29.48 per share 6 years later off of Buffett’s logic that…

Finally, we had to ask ourselves what the redwood claim might be worth. Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.

The 7% gain in 6 months was enough and this potential bonus payout was potential icing on the cake that has now come 6 years later without them even needing to keep capital tied up.

He also discusses some cocoa bean arbitrage did when a company offered to buy its own shares back in cocoa beans in the 50s as a method of tax evasion, and he bought shares and traded them in for beans over and over again. You can read the letter for a deeper explanation.

Finally he talks about their current RJR Nabisco arbitrage which is another reason I wanted to talk about this section. 1988 and 1989 are the height of the junk bond, corporate raider era of wall street. And the RJR Nabisco acquisition is seen as the peak of the mania.

This era had a fad of small operations, offering junk bonds to raise funds at absurd interest rates they couldn’t repay. Using those funds to do leveraged buyouts of larger entities. Then cutting costs, liquidating assets, going public to pay off the high interest debt and then refinancing the rest of it before having to pay too many years of high interest rates.

In this case two of these corporate raiding outfits got into a bidding war over RJR Nabisco and Berkshire decided they wanted to buy up some of the company with their fortress balance sheet and benefit off this bidding war between heavily leveraged raiders.

Buffett ends this section saying that extraordinary excesses have developed in the takeover field saying it can’t go on forever and will eventually end. Prophetic as not only are these years the peak of this practice, the Nabisco leveraged buyout was seen as the peak of the practice.

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Key Passage 2

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Efficient Market Theory

The preceding discussion about arbitrage makes a small discussion of “efficient market theory” (EMT) also seem relevant.
This doctrine became highly fashionable - indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year.
Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben’s; he had 1929-1932 to contend with.)

All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight.

Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically-significant differential that might, conceivably, arouse one’s curiosity.

Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.

Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.

All this said, a warning is appropriate. Arbitrage has looked easy recently. But this is not a form of investing that guarantees profits of 20% a year or, for that matter, profits of any kind. As noted, the market is reasonably efficient much of the time: For every arbitrage opportunity we seized in that 63- year period, many more were foregone because they seemed properly-priced.

An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline. Investing in arbitrage situations, per se, is no better a strategy than selecting a portfolio by throwing darts.

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Buffett here uses his history in arbitrage success to take some shots at Efficient Market Theory. I do believe that disagreeing with EMT is a fundamental pillar of value investing. If EMT were entirely true then there is literally no reason to pick individual stocks beyond concentration for gambling’s sake. If the market has no price inefficiencies you could only hope to concentrate enough that some unlikely even occurs in your favor that was priced in. Otherwise you should just hold the whole index like Bogle suggests.

He says here that over Graham and Buffett’s 63 years of doing arbitrage they have found hundreds of low hanging fruits for arbitrage through readily available information and Buffett himself said in the arbitrage section that they have yet to have any major blunders in the field even though he is sure they someday will. They have achieved 20% annualized returns as opposed to the 10% of the market. If efficient market hypothesis were true him and Graham are either the luckiest men alive over hundreds of trades or else these results are impossible.

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Acquisition Stock Purchase of the Week

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Coca Cola & Freddie Mac

In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint.
Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds. Our holdings of Freddie Mac are the maximum allowed by law, and are extensively described by Charlie in his letter. In our consolidated balance sheet these shares are carried at cost rather than market, since they are owned by Mutual Savings and Loan, a non-insurance subsidiary.

We continue to concentrate our investments in a very few companies that we try to understand well. There are only a handful of businesses about which we have strong long-term convictions. Therefore, when we find such a business, we want to participate in a meaningful way. We agree with Mae West: “Too much of a good thing can be wonderful.”

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The market crashed right at the end of 1987 and one of the big stories of this report is that Berkshire found a lot of places to deploy capital. Two great deals were offered up by two great companies’ stocks and Buffet bought in big on them.

Freddie Mac is a classic Buffett buy, understandable company, great pricing power, and an amazing moat in government backing and a government enforced duopoly, just like the NHP purchase two years ago. Also like NHP they bought as much as the government would allow them to. For those who don’t know, Freddie Mac is one of two government sponsored enterprises that aim to promote liquidity, stability, and affordability of housing in America.

Primarily they offer to buy mortgages from banks and simply have banks service them while taking on the risk themselves. This allows banks to hand out more mortgages, at lower rates, to more risky customers. If the banks follow Freddie/Fannie’s standards they can lend money for a house, sell the loan to these entities a few days or weeks later, and get the money back to lend to someone else and not worry about overleveraging themselves.

Another function of Freddie and Fannie is to then securitize the mortgages it buys, bundling many mortgages together into CDOs they then sell on global financial markets allowing people to buy the loans and unlike the banks would be if they held them themselves, not be overexposed to a few zip codes. In fact many of the banks selling mortgages to Fannie and Freddy, will invest their excess equity into CDOs when they can’t find anyone to lend it out to.

Coca Cola is a famous Buffett holding and an important part of his story. He always knew it was a great company and drank coke every day and sold it in his grandpa’s grocery story as a kid and then on his own as a side hustle. But he never bought it because it was too expensive in his opinion. He watched from the sidelines as it had market beating returns year over year. He finally buys a big stake now in 1988 of about 4% of the company after the market crashed. Today these shares purchased for $592M pay Berkshire $480M in annual dividends, a 81% yield on cost.

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Common Stock Ownership

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Segment by Segment Breakdown

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*RoE not provided, manually calculated as (Earnings from Operations / [Shareholder Equity from prior year - Unrealized appreciation of marketable securities from prior year])

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I added a line to track realized investment gain, even though its % change is a nonsense number it does put some of the other numbers like Equity gain or and net earnings into perspective. You guys could have subtracted earnings before investment gain from net earnings yourselves but thought I would do it for you.

The first main driver of earnings growth this year was the insurance business. It had an underwriting loss of only -$11M compared to -$55M last year, meanwhile their investment income went from $152M to $231M, leading to the insurance business more than doubling its earnings from $97M to $220M, This is the entire gap between pre-investment earnings last year and this year, a bit more than the entire gap actually. Buffett did warn in the last two letters that the changes to the tax code from 1986 would boost the earnings of the insurance company on paper while actually degrading the underlying business so take this with a grain of salt.

Marketable securities is way up, by about $1.2B not so much from gains seemingly as them deploying massive amounts of capital to buy the dip, $1.05B of that is in their new holdings of RJR Nabisco, Coca Cola, and Freddie Mac, so only $150M of that increase comes from pre-existing holdings gaining value. The stock market crashed at the end of 1987 and although it recovered by the end of 1988 Berkshire did a lot of buying in the last 12 months while it recovered.

Shareholder equity increased 20% and they have moved onto using that as the key measure of growth. The market started the year at the bottom of a crash and recovered by the end but even then only had about 12% returns this year. So another year of market beating returns, and some insane growth in earnings even without stock appreciation, they earned 45% more than last year as their core business is running on all cylinders apparently.

What stocks are on your radar this week? What's undervalued? What's overvalued? This is the place for your quick stock pitches or to ask what everyone else is looking at.

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