The Berkshire Soap Opera

Earlier this week, Warren Buffett’s Berkshire Hathaway issued a surprising press release: one of their longstanding top executives, David Sokol, had resigned.

Here’s the gist of the story… Warren Buffett and his partner Charlie Munger make all the major acquisition decisions for Berkshire Hathaway. Executive David Sokol recommended to Buffett a company called “Lubrizol,” mentioning at the time that he owned some shares of it himself. Buffett was not particularly impressed with the idea of acquiring Lubrizol. About a week later, David Sokol spoke with the CEO of Lubrizol, and based on that conversation spoke with Buffett again, further recommending it as a good purchase. As a result, Buffett changed his mind and purchased Lubrizol, sending its stock price soaring.


What David Sokol had neglected to point out was that when he said he owned, “some shares” of Lubrizol, he actually meant 10 million dollars’ worth (more than 96 thousand shares). In just one day after the Berkshire purchase announcement, Lubrizol stock jumped from $104.50 to $133.80, earning David Sokol a cool 2.8 million dollars.


Was what David Sokol did illegal? Probably not. Was it unethical? Somewhat. Was it honest and open? Not at all.


On July 26th, 2010, Buffett wrote a letter to all Berkshire Hathaway managers (including Sokol), saying that reputation and honesty are of paramount importance to Berkshire’s business. For example, Buffett wrote: “We must continue to measure every act against not only what is legal but also what we would be happy to have written about on the front page of a national newspaper in an article written by an unfriendly but intelligent reporter.” At the end of the letter, Buffett reminds everyone that “there’s plenty of money to be made in the center of the court. If it’s questionable whether some action is close to the line, just assume it is outside and forget it.” Clearly, Sokol didn’t think that any of this applied to him.


Does this mean that Berkshire’s internal controls are weak? Does it mean that you should sell Berkshire stock? Of course not. Berkshire’s internal controls remain amongst the best in the world.


David Sokol didn’t do anything explicitly illegal. But, he did play too close to the line – and he knows it.

____


“Somebody is doing something today at Berkshire that you and I would be unhappy about if we knew of it. That’s inevitable: We now employ more than 250,000 people and the chances of that number getting through the day without any bad behavior occurring is nil.”

Warren Buffett, July 2010

____


Berkshire’s press release regarding David Sokol’s resignation is available at:
David Sokol Press Release

The FDIC - Combating Stupidity Since 2011

Those who understand behavioral finance know that sometimes you have to protect people from orchestrating their own financial doom: in The Intelligent Investor’s Mind, I devote a section of every chapter to it. Financial quants and investment professionals (who should know better) are no exception. In fact, great genius is required to create a truly phenomenal financial disaster.

On March 29th, the Federal Deposit Insurance Corporation approved new rules for mortgages – essentially “anti-greed, anti-laziness” rules - that align the interests of homeowners, bankers and investors.

Under the new rules, banks will not be able to repackage and sell a mortgage (ex. Mortgage bonds, CDOs), unless the borrower puts down a 20% or greater down payment. If the borrower puts down less than 20%, the bank will be forced to keep some of the risk on its own books - known in the industry as “keeping skin in the game.”

Effectively, these new rules force banks to care about the quality of the loans they receive from mortgage brokers, and care how those loans perform. Prior to this, a mortgage broker could underwrite a loan from someone they knew couldn’t pay, sell it to a banker who didn’t care if the owner couldn’t pay, and in turn sell it to an investor who didn’t bother (or didn’t have the skill) to check to see if the owner couldn’t pay.

The National Association of Mortgage Brokers will undoubtedly hate the new rules. They are already fuming about the Federal Reserve’s new “Truth in Lending” regulations in general. Despite pushback, however, the matter will be put to vote this week and is expected to pass.

The days of dreamers with bad credit and no cash, walking into a mortgage broker's office, getting approved, then sitting on their new sofas & waiting for riches through equity appreciation are truly over - even if the market comes back.

People will always find new and ingenious ways to ruin themselves financially. Even so, it’s nice to see the old gaps being closed.

____

"If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring."

George Soros
____

US Banks to Rumble

I’ve been recommending US bank stocks for over a year now – after all, they are powerhouses of future potential. Though bank stocks have risen slightly in the past year (about 15%) there is still far more room to move. And, things are about to get hotter.

Last week, the US Federal Reserve approved buybacks and dividend increases for many of the major banks. JP Morgan, for example, is repurchasing approx. $15 billion worth of shares, having already repurchased $7 billion last year. Wells Fargo jumped its intended share buyback program from $1 billion to $6 billion. What is the significance?

Share buybacks reduce the number of shares outstanding, increasing the amount of earnings per share. For example, if you buy 100 shares today, and the company buys back 30% of its shares, you effectively own 130 shares’ worth of former value. Put another way, if there are $0.50 of earning per share now, a 30% share repurchase would give you $0.65 of earnings per share. Buybacks compound the value of your purchase.

Most banks will be buying back their shares as a mix of common and Trust Preferred Securites (TruPs), the latter of which is really a kind of debt. The common share repurchases will affect earnings per share directly, while the TruP repurchases will effectively decrease debt load and interest payments – all good things.

Stunningly (and wonderfully), despite announcing these huge stock buybacks, bank stocks have traded flat for a week! Why, you may ask?

First off, people still have an intense mistrust of US banks. Stated more bluntly, most people either fear or despise banks, and wouldn't go near them as an investment. For the rational, thoughtful investor, this is a good thing. Bank stocks are likely to remain underpriced for some time.

People also worry that the world economy is unstable, and that the banks will be spending too much money on their stock repurchases instead of holding the money for emergencies. Make no mistake… no bank wants a repeat of 2008 any time soon. Banks are repurchasing their stocks because said stocks are grossly underpriced, and because they can. The banks are sitting on hordes of cash.

Stock symbol XLF (US bank index fund), provides a great way to buy US Bank stocks with a small amount of cash. For the risk tolerant, UYG (the 2X movement stock index fund) is also available.

____


"Superior risk management positioned JPMorgan to capitalize on the crisis."

Barbara Rehm, editor, American Banker

_____


Disclosure

Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

_____