Portfolio manager’s Letter February 2005
2004 was not a great investment year. With the market down or flat for most of the year, our 2004 investment year results in pretty well-followed suit. The composite return for Losch Management Company’s managed accounts was 7.1% on a size-weighted basis and 9.1% when all accounts are weighted equally. This compares to 10.9% for the S&P 500. However, our five-year record still looks much better, with Losch Management Company at plus 13% per year versus the minus 2.8% per year for the Wilshire 5000. This advantage (15.8% per year) quickly put us way ahead of most mutual funds, and I suspect ahead of about 90% of all hedge funds. So the 2004 investment year results were good but not great.
As you can see, small accounts generally did better than large accounts. This is partially because large capital gains make the bigger accounts somewhat less mobile, and penalized their 2004 investment year results. But more important is the fact that these small accounts are mostly IRAs and are nontaxable. With short-term gains not taxable, these accounts have been traded more aggressively.
It says something about the nature of the current market, when it is easier to make money by taking short-term gains than it is with buy and hold. Losch Management Company much prefer the long-term buy/hold approach — it provides us with more leisure time — but with the capital markets flooded with surplus investment funds from all over the world, Losch Management Company see little chance that the returns will be any better this year than they were last year.
Losch Management Company view of the market remains the same as it has been for some time: that this is a cyclical (short-term) bull market within a secular (long-term) bear market. With stock valuations at today’s high level, it is hard to envision much more than single-digit returns from a traditional long-term buy/hold approach.
In bear markets, the most important rule is preservation of capital. In the long run, bear markets always present buying opportunities, and the bigger the bear, the better the eventual opportunity. If you can get to that opportunity with your capital largely intact, the rest is easy. At the 1975 bottom (after a 45% correction in the Dow), it was easy to find stocks that would increase by 500 to a 1,000% in the next 10 years.
Bubbles and long bear markets are the product of human psychology and have very little to do with rational evaluation. As long as human nature stays as it is, there will be mean, nasty bear markets. But the prospect does not bother us, because this is the time when decisions are easy and when you make all your money; you just do not know it until later.
During the lean periods, patience is the most important virtue. Preservation of capital should be the primary investment goal. Losch Management Company’s response to these conditions is a three-pronged approach that incorporates bigger than average (sometimes much bigger) positions in cash which did not help 2004 investment year results.
Company’s basic market strategy involves a large position in Berkshire Hathaway because Berkshire Hathaway is reasonably priced at present levels and with excellent long-term prospects. But more than this, it offers a hedge against a substantial market decline. With its huge cash positions and with Warren Buffett to make the investment decisions, Berkshire Hathaway is one stock that will get more valuable if the market declines. At the same time that it contributes to 2004 investment year results.
At the end of the third quarter, Berkshire Hathaway had $43 billion in cash, plus, as Charlie pointed out at last year’s WESCO meeting, they really do not like to own bonds and would prefer to have that money in something with a better return. So, you can add their $23 billion bond position to the company’s buying power. With $66 billion in purchasing power, a nice market crash would allow Warren Buffett to increase his company’s cash flow substantially above its 2004 investment year results.
A 7% after-tax return (criteria he has often used) would increase Berkshire Hathaway’s cash flow by between $4 and $5 billion. An awful market might present Warren Buffett with his last great buying opportunity, so it is not inconceivable that he might try to leverage his purchases with joint ventures or short-term debt. With his cash committed, $20 billion in debt would represent something less than two years of cash flow.
Buying power of $66 billion represents about $43,000 per A Share, $1,433 per B share, or about 47% of the current market value. Does this mean that if you are 100% invested and all your money is in Berkshire Hathaway, you still have 47% in cash? Of course not, but is it not the functional equivalent?
Recently, Berkshire Hathaway has displayed some tendency to move counter to the market. There have been many days when the overall market is down, and Berkshire Hathaway goes up. But in a prolonged bear market, sooner or later, everything gets hit. But even if the stock market price goes down, Warren Buffett still has his $66 billion. He would have more; Berkshire Hathaway is a cash cow of prodigious capacities, and it is now generating cash at a rate close to a billion dollars every couple of months as indicated by its 2004 investment year results.
So, your functional buying power is increasing as the market goes down, and to compensate for the bother of the changes in Mr. Market’s daily offers, you have the comfort that comes from knowing that Warren will handle the decisions about timing and selection. In this respect, Berkshire Hathaway offers the investor the ability to remain invested and still keep a cash reserve. In the investment world, this is the closest you will come to being able to have your cookie and to eat it at the same time.
The recent purchase of Gillette will have a positive effect on Berkshire Hathaway, which owns 96 million shares of Gillette. Gillette pays a $0.65/share dividend. P&G pays $1.00. So, the purchase benefits Berkshire Hathaway with a $35-million increase in dividend income.
Gillette’s 2004 investment year results show that earnings were $1.62 per share versus $2.42 per share for P&G, so in addition to the $35 million in dividend income, the transaction will increase Berkshire Hathaway’s look-through earnings by another $45 million. This $80-million net increase equals about $52 per “A” share.
If you figure 18 is a decent PE for Berkshire Hathaway, then P&G’s purchase of Gillette adds about $930 per A share — to Berkshire Hathaway’s intrinsic value, without Berkshire Hathaway having to raise a finger. And Warren has been able to lower the risk profile of his stock portfolio (by trading a stock with a 32 PE for one with 22 PE) without incurring tax liability. Sweet!
Somewhere I read that Kilts approached P&G. You don’t suppose there was a nudge from Omaha, do you? Na, Warren would never do that.
Still, he played cheerleader and “pump up P&G” 2004 investment year results big-time — actions that are generally not part of his job description. If you have a suspicious mind, it does create a faint aroma of Omaha cooking.