Investment Manager’s Letter October 2010
In the third quarter of 2010, the S&P 500 rose 11%, following a decline in the preceding quarter of 12%. Although Berkshire Hathaway’s derivative position does not exactly track the S&P, it is close enough that we can guess that the third quarter will just about reverse the loss in derivatives shown in the second quarter, so that instead of a two billion dollar loss, the third quarter will show a $2 billion dollar gain. Improved conditions at subsidiary companies could add another $200 million to the bottom line. Assuming that insurance losses remain about where they were in the second quarter, Berkshire Hathaway will show a net gain of $4.3 to $4.6 billion. This is, of course, a WAG (wild ass guess), because as long Buffett is in charge, any estimate of Berkshire Hathaway’s earnings will remain pretty much in that category.
The biggest question mark in this estimate is probably in the area of investment gains. In the second quarter, investment gains were $383 million. In the first quarter, Berkshire Hathaway’s gains amounted to $1.318 billion, so I, as investment manager, guess my estimate should read $4.2 to $4.3 billion plus or minus a billion. In any event, the comparison to the last quarter and last year will look pretty good — plus 120% from this year’s second quarter or plus 27% from last year’s third quarter for Berkshire Hathaway. Year over year comparison will show Berkshire Hathaway with about $10 billion versus to $5.3 billion for the first nine months of 2009.
The most interesting aspect of the report will be to see what Buffett is doing. At the end of the second quarter, Berkshire Hathaway held $12.7 billion in corporate bonds with unrealized gains of $2.2 billion. In view of his recent statement that he can think of no reason to buy fixed income, it will be interesting if he takes some profit in these bonds.
Mr. Market’s reaction to the news, as always, will depend on his mood at the time of the announcement, but it will be harder than normal to find much downside the third quarter report.
At the end of the second quarter, Berkshire Hathaway’s cash was back up to $27 billion. With operating cash flow at $3 billion per Quarter, plus the $2 billion they picked up in float from buying CNA’s asbestos liabilities, Berkshire Hathaway’s cash could be as high as $32 billion as of September 30. It could be higher than this if Buffett does sell some of his corporate bonds, and it could be lower if he spends substantial money on equity purchases. In any event, it may not be too long before Berkshire Hathaway’s cash problem that we thought was solved forever a year ago, will be back to just as nasty as it was pre-crash.
In the first quarter of 2011, Swiss Re’s redemption premium on its 12% preferred drops from 40% to 20%, and Swiss Re has indicated that they will redeem as soon as that happens. Since the preferred was priced in Swiss Francs, Berkshire Hathaway will get not just the principle, and the 20% premium, but also a nice bonus from the appreciation in the Swiss Franc. The Franc was selling at a discount to the dollar when the deal was signed on March 23, 2009, and now trades at a premium to the dollar. It seems likely that they will redeem, in view of the fact that they can probably refinance this 12% obligation for about 3% in today’s market. If they do, Berkshire Hathaway will harvest about $4 billion in cash. Add in a couple more quarters of $3 billion in operating cash flow and Berkshire Hathaway’s cash could be back to $42 billion by the end of the first quarter of 2011.
Buffett has said that we should not expect a dividend or buy-back for ten years, so just what are his plans for this torrent of cash that will be descending on Kiewit plaza in the mean time? I’ve, as investment manager, been around way too long try to predict what Buffett will do next, but his next deal may have to be bigger than his last one. It wasn’t so long ago that $5 billion was a big deal but today that would hardly be worth the boss’s time. Nobody is more aware of this than Buffett, and if he really does not intend to pay a dividend for a decade, it would indicate he has some heavy duty plans for the next ten years. Don’t be surprised if Buffett goes out with bang.