Investment Manager’s Letter September 2006
Berkshire Hathaway has maintained a long-term position in USG Corp., formerly US Gypsum Co. the countries largest producer of wallboard used in residential and commercial construction, and ceiling tile used mostly in commercial construction. The company has recently emerged from bankruptcy that was caused by legal problems related to asbestos. Part of the legal settlement, arranged by the bankruptcy court the company recently raised cash with stock offering. The purpose of offering was to provide funds for a trust that will be responsible for any and all asbestos claims, with USG itself relieved from any further legal liability for asbestos injury.
As part of the agreement for the offering Berkshire Hathaway agreed, for a fee, to purchase any stock that was not sold through the offering and received permission from USG Corp. to buy up to 40% of its outstanding stock. Prior to the offering Berkshire Hathaway owned 6.5 million shares. On the day of the offering, July 28, Berkshire Hathaway was able to purchase an additional 6,969,274 shares. Since then Berkshire Hathaway has continued to buy stock in the open market.
Number of Shares
|August 2, 2006||592,500||$45.46|
|August 3, 2006||26,900||$45.71|
|August 7, 2006||82,900||$45.80|
|August 8, 2006||1,200||$45.81|
|August 9, 2006||587,100||$45.98|
|August 10, 2006||118,500||$46.01|
|August 11, 2006||23,500||$46.03|
|August 21, 2006||567,200||$45.92|
|August 22, 2006||390,200||$45.97|
|August 23, 2006||734,700||$45.90|
|August 24, 2006||7,000||$46.03|
Since the 24th and during the period from August 11th to the 21st USG was trading well above $46, and there was no additional buying. With 89.9 million shares outstanding Berkshire Hathaway now owns 18.6% of the company. My guess is that if the stock does trade back down to below $46 Berkshire Hathaway will buy more stock. I, as investment manager, think Warren will buy as much as he can get at his price. In fact, I strongly suspect that he would love to buy the whole thing. USG fits very nicely into Berkshire Hathaway’s building material, companies.
This I suspect is part of what we will call Buffett’s hurricane synergy, the idea that if Berkshire Hathaway can buy enough companies in the building materials, construction, and a manufactured housing industries. Then, when its the insurance companies are paying insurance claims for catastrophic damage due to hurricanes and earthquakes, Berkshire Hathaway as a company will just be transferring money from one pocket to another.
We have no way of knowing if this is what Buffett has in mind, but it is hard for me to think of a company that fits this pattern better than one that makes wallboard and ceiling tile.
This is the list (so far) of Berkshire Hathaway subsidiaries that may receive some revenue from construction, disaster recovery, reconstruction, redecoration and repair.
Acme Building Brands
Carefree of Colorado
Clayton Homes, Inc.
Cleveland Wood Products
Court Business Services
Forest River, Inc.
Nebraska Furniture Mart
Wayne Water Systems
R.C. Willey Home Furnishings
I, as investment manager, do not know if it is theoretically possible for Berkshire Hathaway to buy enough construction related businesses so that a hurricane, as far as Berkshire Hathaway is concerned, would become a wash (they take in as much from reconstruction as much as they payout in insurance claims). It may not be possible, and certainly we have a long way to go, but it is an interesting idea. For a company whose culture is founded on moat building this would be an architectural masterpiece. Can you imagine the position of other reinsures trying to compete with a company that had nothing to loose from paying losses.
It is true that the law of large numbers is working against Berkshire Hathaway in many areas, but in the catastrophic insurance business, it may well be that, the bigger you are, the deeper your moat. This is just a part of the pattern we see where Buffett is moving away from areas where size is an anchor, and into businesses were size makes you stronger.
Reuters on August 23 carried an interesting story about hedge funds by Dane Hamilton.
“Renaissance Technologies Corp., a top-performing hedge fund group headed by billionaire James Simons, has amassed $8.5 billion for a new computer-driven hedge fund it says could handle $100 billion, a person familiar with the situation said on Wednesday.”
“The new “quantitative” fund, which started last year, has doubled in asset size since she February, the source said, largely on the promise that Renaissance can generate sustainable high returns through complex math-driven strategies developed by Simons over several decades.”
The strategy has made Simons, a former Harvard and MIT math professor, extremely wealthy, with a net worth that Forbes estimated at $2.7 billion. Simons was recently named the top hedge fund earner, with a 2005 salary of $1.5 billion.
The returns allowed Renaissance to charge some of the highest fees in the business: a 5 percent management fee on assets invested and a 44 percent performance fee, substantially higher than the standard “2 and 20″ percent many funds charge.”
For me this story is scary. Not just little scary, like the Haunted Mansion, but big scary like to Tower of Terror. I just finished reading Roger Lowenstein’s “When genius failed”. Reading the above article was like reading the book all over again. The parallels are absolutely eerie.
I mean, if you change a few names and the date at the top of the page. It’s the same story. We can only hope that this time the story it has a different ending. Long Term Capital Management fell because of a combustible mixture of genius, hubris and leverage. It is a great story that demonstrates how easy it is for very smart people, to do dumb things. But in my opinion it would have been more properly titled as “What Happens When Smart People are Not Quite as Smart as They Thought They Were”, Hubris is a great equalizer for smart people, it works hard to bring them down to everybody else’s level, and as the boys at LTCM learned it can work very fast and it can bring you down to well below zero.
I am not saying that James Simmons will end up being the next John Meriwether, he probably won’t, and he may very well turn out to be just as successful in the next 18 years as he has been in since 1988. No matter what happens to the New Renaissance though, the symptoms are there, the same virus that infected Wall Street in 1998 looks to have reappeared and spread rapidly. Hubris is a virus that feeds on money and what better symptom of the disease could there be than 5% and 44%, management fees? The more you make, the smarter you think you are. As Charlie says it’s not about greed. It’s about pride. You want everybody to know that you are the smartest guy on Wall Street.
Long term capital management took 2.7 billion in partner’s money and leveraged it up to 100 billion by borrowing from every major bank on Wall Street and in the process brought people like UBS, Goldman Sachs and Merrill Lynch to the brink of disaster.
Models fail, because markets change. Markets change because behavior changes. In the case of really successful models their success accelerates and dictates change. The model’s success changes the environment that produced model. Success attracts attention and money; Meriweather’s fund became so large that it ran out of intelligent things to do with its money.
From the article, we don’t know if New Renaissance is borrowing big from Wall Street, and we don’t know if their computer models use any assumptions that are as stupid as those used at LTCM. (Lowenstein believes that one of the biggest problems with long-term capital’s models was that they were dependant upon the assumption that markets are totally efficient) This seems to me to be a very tenuous premise to float your models on. To make matters worse, for three years Meriweather’s crew had phenomenal returns. This attracted so much money that it disrupted the old trading patterns.
What we do know is that there will be plenty of suspects, lots of hedge funds with expensive computers and kids from MIT that want to prove how smart they are, and lots of institutions with big money, fishing for high-yield in an environment about as stable as Chernobyl.
The great accelerator of the destruction at LTCM was leverage. All the big players from Wall Street and around the world got in line to pony up. We don’t know that today’s hedgies are leveraging up 30 times, but there is nothing to stop them. Derivatives are a great security blanket. Everyone thinks they are hedged. This does not mean that there is no risk, it just means that nobody knows were it is.
Much of the regulatory structure that was set up in the last century is useless when it comes to monitoring Hedge fund activity. LTCM was able to ignore regulation “T” because they were not buying stock; they were buying derivatives based on stocks. Nothing has changed since 1998 hedge funds do not have to report their positions and derivatives are not counted as leverage. No one but their banks know how leveraged the hedge funds are, and if today’s hedge funds are like Long-Term Capital Management they borrows from many different banks and demand secrecy of everyone, so that no one will know the real size of their position.
We have no way of knowing if LTCM will repeat, because we have no way of knowing what the Hedge Funds are doing, but we can see that the anecdotal data is not encouraging. Human nature being what it is, I can think of absolutely no reason that we should assume that, in the end, it will all work out for the best. As for the consequences, it may well be that someday soon; Mr. Market will enter the elevator on the 10th floor, and suddenly find himself in the basement.