Warren Buffett can teach the world a thing or two about derivatives

He’s sold billions of dollars of them through his Berkshire Hathaway investment group. And with markets in a mess, he’s taking paper losses. But Berkshire has a huge financial cushion. That and Buffett’s management of investor expectations offer lessons for other mark-to-market sufferers.

First, he keeps that cushion plumped up. Berkshire has written derivatives on stocks and bonds with an underlying value of nearly $50bn. That’s much higher than the derivatives’ market value, which fell an estimated $1bn in the third quarter, contributing to a 77pc decline in Berkshire’s profits compared with a year earlier.

But Buffett’s company still made a profit, even with the markets in disarray. So although the final profit or loss on the derivatives won’t be known for years, he appears to have scaled his exposure so that paper losses along the way are highly unlikely to put a big hole in Berkshire’s balance sheet, undermining its other businesses.

Second, it helps that Berkshire doesn’t borrow much. The company doesn’t have to post collateral on its derivative positions – provided, among other things, it doesn’t lose its strong credit rating. With little leverage, there’s enough of a buffer that even much bigger paper losses won’t trigger that. American International Group, for one, found out the hard way that a vulnerable credit rating plus huge mark-to-market losses can quickly lead to downgrades and a life-threatening outflow of hard cash.

Third, Buffett has always told shareholders to look beyond quarterly earnings and to keep in mind the somewhat artificial accounting effects at work on both the upside and downside. He has even, once in a while, hinted that he thought Berkshire’s stock was over-valued.

By contrast, Wall Street bosses who paid themselves handsomely based on paper gains on the way up have zero credibility when they try to excuse mark-to-market losses. It’s just possible Buffett will still end up losing a lot of real money on his derivatives. But others could learn from his skills in setting the stage so that investors aren’t scared off by paper losses along the way.

Berkshire reports losses

Berkshire Hathaway, the investment firm run by Warren Buffett, the world’s richest man reported a 77 per cent drop in third-quarter profits, as a $1.01 billion loss on derivatives and other investments combined with sharply reduced results from its operations across the board.

The group announced net earnings of $1.06 billion, it’s fourth straight quarterly decline, down from $4.55 billion the year earlier as so-called operating earnings on its insurance underwriting business plummeted by 83 per cent

Profits on investments made by Berkshire’s insurance unit fell by 12 per cent to $809 million in the third quarter, while the non-insurance businesses it owns contributed a collective profit of $1.08 billion, 7.8 per cent down.

Read article here

Major pointers in a Leveraged Buyout/ Recapitalization

What to look out for in a Recap/LBO situation and how to analyze one?

In recapitalizations and Leveraged Buyouts, the theme is often similar in that these companies often trade below their intrinsic value. These are probably the old economy type of stocks versus the new economy type stocks plagued by generally slower growth rates. These old school companies generally grow at slower growth rates as compared to the "googles" and "apple" of today and hence are ignored by the general public at large and hence trade at a discount to intrinsic value. Other reasons as to why these old school companies trade at discount is that these companies generally have so much cash and are in a net cash position that the public is afraid that the company's management will dissipate the cash through inefficient capital allocation reinforcing the fear that when there's cash, it is easily spent. What the public often wants is a redistribution of that wealth to its shareholders and often a reorganisation of the company to allocate capital more efficiently. Now even if the latter is not what the general investing public wants immediately, a recapitalization can help the investing community "see" that it is pursuing appropriate capital allocation which you will see in following paragraphs.

Typical elements of a Recaitalization should include:
1) Non cyclical Industries - When a leveraged recap occurs, it normally occurs in mature industries without cyclicality. Why? Because companies that encounter cyclical downswings that go through a recap or LBO usually have a lot of debt and hence downswings would magnify the losses or reduce earnings drastically due to altered capital structure where higher interest payments need to be forked out. Conversely as well, any form of topline growth assuming all things constant will magnify the bottomline. Hence, companies that are cyclical in nature are inappropriate candiates for a leverage recap or an LBO. But it can also be argued that during a cyclical upswing, a leveraged recap can occur such that bottom line earnings are magnified. My answer to that would be because the economy behaves in a haphazard fashion, predicting a cyclical upswing in the middle of a cyclical downswing would be disastrous for the private equity firm that does so in my opinion.

2)Steady financial profiles- When companies have stable cashflows, an extension of the previous point above are normally suitable for going private transactions. You do not want any form of cyclcality in this business.

3)Competive advantage and dominant market share- The company most preferrably should have some form of "moat" and dominant market share which adds a stability and predictability element.

4)Low debt plus company in a net cash position- You, as an investor would want the company to have a net cash position = cash and cash equivalents - total debt . If the industry leverage ratios are higher compared to the company that you are looking at it is a good sign that this company is a potential recap candidate because chances are that it has unutilised debt capacity which means that it can take on more debt. One point that Ben Graham adds to the process is that a company's capital structure can be optimised when it can serve very comfortably the debt it can put on its balance sheet. Normally, interest coverage ratios are between 3 to 4 times are very comfortable to be serviced by a corporation with a net cash balance, unutilised debt capacity and generate excess and stable operating cash flows.

5)Low Capex- The company preferably should have a low capex requirements such that its free cashflow is enhanced. The good thing about a recap is that valuation metrics are shifted to a cashflow basis instead of an EPS basis due to the need to pay down debt and interest payments after a recap.

Effects of a recap

1) Short term spike in earnings and ROE- This happens due to the tax shield that the larger interest payments has on the bottom line if the top line is stable. This is a catalyst that investors should look out for.

2)Internal Changes- A recap forces the management to be more disciplined in handling its capital allocation. For one, i believe that capital allocation will be handled in a more efficient manner than before the recap as there is a tremendous need to focus on cashflows to pay down debt and interest. There is in a sense fiscal discipline being practised as opposed to lax capital budgeting processes previously.

3)Discipline forces management to think of ways to focus on EBITDA and there is potential for EBITDA to increase in the prcess of a recap due to capital allocation efficiency. The management stops splashing out on corporate jets and tries to reduce unnecessary expenses can help to increase EBITDA

4)A recap often comes with some equity incentive for management. Mangements become incentivised alongside ordinary minority shareholders. This is one that an investor should look out for. In fact, Joel Greenblatt emphasizes this point again and again in his book.

5) A huge payout can be given out in the form of a dividend and this can be 75% of the market capitalisation of the pre recap share price or larger, financed of course by debt mostly. This is the monetising of future cashflows and giving back to sharehlders which make them happy.

6)After the recap, the focus on deleveraging the company causes book value to rise.

So how does one look at such stocks. I reckon that one should look at such companies when the interest rate environment is falling because when rates fall, LBO activity increases due to the cheaper cost of funds. Owning a stock that has the above elements can be candidates for an LBO, going private transaction where premiums are offered.

In the case that an LBO is not offered, if management is astute, they will conduct a recap on their own producing a stub that will rise in value due to short term ROE and earnings growth expansion even though it is a stable industry! The effect of the distribution and stub's rise in price should prove to be quite lucrative.

Best regards,
Lucas Lim

Buy American. I Am.

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Read article here

Buffet speaks on the US economy