Client Letter July 2005

You will notice a new fund with a strange name on your statements for the first time this month—it is the Rydex Ursa fund. This is a fund that tracks the S&P 500 index in reverse. In other words if the S&P goes Down 1% in a given day the Rydex Usra will go up by 1%. The reverse is of course true and on those days that the market is up the Ursa fund will be down by an equivalent amount.

This could be considered a hedge against a fall in the stock market, but since most of our long positions have been eliminated, it is more just a pure bearish bet. It is my version of Buffett's purchase of put options in the fall of 2000. I use this particular option because it is the simplest. It may not be the cheapest way to bet against the market, but it is a vehicle that I can use in all but the smallest accounts. It can be used in taxable and nontaxable accounts, and in margin and cash accounts. (There is, however, a minimum purchase requirement of $5,000.) This reduces my administrative burden to some extent as I only have one security to keep track of in my attempt to keep your results uniform across many different types of accounts.

It may additionally have one big advantage over shorting individual stocks. While a short can never be a long term gain, this security, if we are able to hold for 12 months, would be subject to long-term-gain taxation.

Last month I wrote about the possibility that Berkshire might buy its own stock back. I have since checked my figures and find that Berkshire's book value has been growing at an annual rate of 8.1% for the last five years, not the 6.8% per year figure that I used in last month's letter. This gives us a low-end buy-back point that is somewhere north of $69,117 (since we know that intrinsic value is growing faster than book value) as of the second half of 2005.

The Intrinsivaluator estimates that Berkshire's growth for the last 5 years at an annual rate of 12.7%. This does not seem an unreasonable rate to me given the leverage that Berkshire gets from its insurance float. Yet this growth rate would place the point where its relative value as Buffett's 2000 repurchase offer of $45,000 at $87,010.

Yet Berkshire is not buying its own stock. This would seem to indicate that Berkshire has been growing at less than 12.7% for the last 5 years. Or that things are different today. One thing is different now compared to 2000: the elephants are cheaper, though not quite table ready. They are still a lot cheaper now than they were in 2000, and another bear market like the 2000 to 2003 experience might well relieve Berkshire of a large portion of their cash problem. In 2000, Coke was selling at 43 times earnings. Now it is at 22. Wells Fargo was selling at 20 times earnings whereas today it is selling at a PE of 14.8. Costco was 50 times earnings and now it is 21.7. Anheuser Busch was at 27 but is now 16.7.

One good bear market might well bring some of these stocks into Mr. Buffett's sweet spot. They are all large capitalization stocks and would allow Berkshire to deploy a lot of capital. In 2000 all large American companies were grossly overvalued. Yes, they are still overvalued today, but not nearly so much as they were in 2000.No matter what the value of Berkshire's stock, there is no guarantee that Berkshire will buy its own stock if Buffett feels he may have a better use for the company's huge cash pile.