2000. Buffett certainly missed an incredible move upin the Nasdaq during this period.2. Was Buffett going a little too far in not investing in technology? Was he
ignoring the American dream of constant exploration and conquest,now expanding not only in land and industry, but also through thecyber-depths of the Internet?To Buffett’s credit, he remained consistent and stuck to his investmentphilosophy of waiting for a margin of safety. For Buffett, buying LevelThree on the open market at $100 a share did not give him his margin ofsafety. But on July 8, 2002, when it was announced that Buffett, along withseveral other investors, had bought $500 million of Level Three convertiblepreferred in a private placement, things were different.
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For one thing, Level Three was now trading at $2.89, a greater than 95percent fall from its peak. Second, the preferred was going to pay a nine percent dividend and was going to be redeemed within 10 years. Buffett felt thatthe company had sufficient assets to at least pay him his coupon over thenext several years. It had $1.5 billion in cash and a 20,000-mile network thatcould always be sold off in a worst-case scenario. Finally, the shares wereconvertible at a very reasonable $3.41/share.The news of Buffett’s investment was surprising enough to send theshares up to $4.26 per share the day the deal was announced, putting Buffett’s shares already 50 percent in the money. By the time Buffett had liquidated 95 percent of his investment in November 2003 he had made 95percent on his money. As of this writing in October 2004 the shares of LevelThree are back down to $3.71.Note that these were not distressed bonds that Buffett was snapping upat a discount, an activity in which other investors and traders often engage.This investment in Level Three was specifically a deal engineered in part byBuffett’s friend and partner, Walter Scott, who was running the show atLevel Three. Again, this is not a criticism of the approach. Buffett has builthis career on the fact that opportunities come knocking on his door ratherthan the other way around. However, it makes the challenge of trading orinvesting like Buffet that much more difficult.Buffett would not have bought common stock shares of Level Threewithout having that dividend kicker to give him his free ride—not even atthe low price of $2.89. And once he did convert to common stock, he wasmostly a seller rather than a holder. Nor was there any way to buy the distressed debt of LVLT at that time; the company did not have any debt withthose specific terms, nor was its debt as distressed as that of many of itspeers due to its strong balance sheet (an aspect that I’m sure gave Buffetthis margin of safety in the investment).
WILLIAMS COMPANIESWilliams Companies was another recipient of PIPE financing by Buffett. InMarch 2002, the entire energy industry was in a death spiral due to the collapse of Enron. Energy companies were all being quarantined by the banksin a vicious epidemic of “Enronitis.” In other words, all of the energy com-
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panies were having difficulty getting financing and were quickly selling offassets to stave off bankruptcy. It was at this time that Buffett entered thepicture through his Mid-American Pipeline subsidiary.In March 2002, he purchased $275 million of convertible preferredstock directly from Williams. The preferred paid a 9.875 percent dividendper year and was convertible into stock at $18 per share. The stockinstantly jumped from between $16 and $17 to over $20. However, this risewas short-lived as the company continued to report losses and the stockeventually slid below one dollar. At this time (August 2002), Buffett participated in a group loan to Williams for another $1.17 billion, this timesecured by substantially all of Williams’ oil and gas assets.Less than one year later, Williams was back on its feet enough (and thebanks were starting to do energy financing again) so that it was able toredeem both of these loans at a nice profit for Buffett (see Exhibit 7.3).While it is difficult, if not impossible, for the average investor to findhimself or herself a group of good PIPE deals to enter into, there are severalkey lessons to take away from this chapter:• When examining Buffett’s past equity holdings, it is always worthwhileto understand how he came to hold those equities and what wasinvolved in the investment decision. It is one thing if he bought common stock on the open market. It is another if he was able to convertto those shares after enjoying several years of nine percent dividendsat low risk.• Buffett looks at the notion of margin of safety not only in the fundamentals of the underlying equity, but in the structure of the transactionitself. Not every investor can do this, of course, but it is important torealize that having more than one “back door” in a strategy is animportant exercise. Always ask yourself what your recourse will be ifyour initial plan for a stock purchase or a trade of any sort does notwork out.• While it might not be possible to get the specific PIPE deals that Buffetthas gotten, it is interesting to note that Buffett took the two absoluteworst industries, broadband telecom and independent power producers, and plowed money into them. He did this not with common stocks,but into more senior levels of the capital structure. If an investor did
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Williams COS
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not have access to PIPEs but did buy senior-level bonds in a basket oftelecom and energy companies during these periods, he or she wouldhave done very well.
CHAPTER 8
Junk
hen businesses need to raise money, they can do so in two ways(assuming that raising money through profits is not possible).They can sell off equity (for instance, in an IPO or a secondaryoffering, or a PIPE transaction), or they can borrow money by sellingbonds. The interest rate on the bond is determined by a variety of factors,the most important two being what the federally imposed discount rate isand what rating the ratings agencies such as Moody’s and Standard &Poor’s have assigned the company.The discount rate is important for the following reason: If I can get ayield of, say, five percent from treasuries and I know this is risk-free unlessthe government defaults, then a corporation with presumably more riskthan the U.S. government better be paying me substantially more than fivepercent for me to take on that risk.The rating from the ratings agencies is also fairly important. Moody’sand Standard & Poor’s, in general, do enough due diligence on every company in order to determine the relative safety between the bonds of different corporations. If a company is rated AAA (for example, BerkshireHathaway), then I have a high degree of comfort that I will be paid back ifI loan them money. (Hence, when Berkshire Hathaway issued its SQUARZbonds in May 2002, it actually had a negative yield. The yield was a function of the historic lows on federal interest rates, the extreme safety of
W
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Berkshire as determined by the ratings agencies, and the fact that the bondwas actually a convertible, so it had extra features other than the yield. Thisbond is the first, and at the time of this writing, the only, example of a bondwith a negative yield). If a company is rated in junk territory, B− or below,then the interest rate needs to be high enough to compensate the bondholder for that additional risk.Although bonds are rated by the agencies, once they are issued, the market sets the price and yield. As with any other securities, the twin forces ofgreed and fear in the bond market will often send prices to one extreme orother. In 2002, for instance, after the bankruptcy of Enron, many of its bondswent straight to zero. As a result, many investors had no idea what shoewould drop next and ended up selling the corporate bonds of many energycompanies en masse, even somewhat stable ones. Similarly, when the pricesof Internet stocks were falling up to 99 percent, the bonds also were in afreefall and some corporate debt was yielding up to 20 percent or more.When Buffett analyzes junk bonds, he doesn’t care as much if the company has a stable and consistent ROE or earnings. All he wants to know is,Can the company generate enough cash to pay him back?In the 2002 annual Berkshire Hathaway letter, Buffett comments:[Junk bonds] are not, we should emphasize, suitable investments forthe general public, because too often these securities live up to theirname. We have never purchased a newly issued junk bond, which isthe only kind most investors are urged to buy. When losses occur inthis field, furthermore, they are often disastrous: Many issues end upa small fraction of their original offering price and some becomeentirely worthless.There are a couple of interesting points in these four sentences. First,“often these securities live up to their name.” In other words, the market isusually efficient. If the market is telling us that these bonds are junk, thenchances are they are junk. This is not to say that they will not pay theirexorbitant yields, but the risk is commensurate with the payoff and there isno additional margin of safety.Furthermore, the fact that Buffett has never purchased a newly issuedjunk bond is telling. Many people do purchase such issues. In fact, WallStreet would almost cease to exist if people stopped purchasing suchissues. But Buffett has determined there is essentially zero edge to buying
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into an issue that Wall Street right from the start is labeling as “distressed”enough to be paying a junk rate yet in demand enough that many investorsare clamoring to pay those rates. Chances are, he figures, the rates are nothigh enough at the moment of issuance and he would prefer to wait.However, Buffett goes on to say in the same annual letter: “Despitethese dangers, we periodically find a few—a very few—junk securities thatare interesting to us. And, so far, our 50-year experience in distressed debthas proven rewarding.” There is an important reason why it is only the“very few” that appeal to Buffett. A bond, unlike a growing company, has amaximum value it can return to the investor: the face value plus all of thecoupons of the bond. A business, on the other hand, can keep growingforever—there is no cap on the maximum return of a business. Nevertheless, in extreme cases, the returns of a bond can exceed the hoped-forreturns, in the short-term, of even the best businesses.For instance, in 1983, the Washington Public Power Supply System(WPPSS) was involved in five building projects. Two of these, Projects 4and 5, were building nuclear reactors. It was these projects that turned intoa $2.25 billion default for WPPSS when it had to abandon the projectsafter a state ruling that threw into question who would pay for the energythat is produced if it is no longer needed. However, although Projects 1, 2,and 3 had “material differences in the obligors, promises, and propertiesunderlying the two categories of bonds, the problems of Projects 4 and 5have cast a major cloud over Projects 1, 2, and 3” (from the Berkshire Hathaway 1984 annual letter). This cloud sent the bonds issued to pay for theseprojects down to 40 cents on the dollar and yielding an average of 16 percent. Buffett bought $139 million of the bonds.The question was: Is the potential reward worth the risk inherent inbuying $139 million of the bonds? Buffett knew that there is a ceiling to theamount he could get back: the coupons plus the initial face value of thebonds. Buffett also realized that these bonds might be worth zero if he didnot analyze the risks of the defaults on Projects 4 and 5 carefully enough.Would it be better, for instance, for him to buy a business for $139 million?However, he states:In the case of WPPSS, the “business” contractually earns $22.7 million after tax (via the interest paid on the bonds), and those earningsare available to us currently in cash. We are unable to buy operating
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businesses with economics close to these. Only a relatively few businesses earn the 16.3 percent after tax on unleveraged capital that ourWPPSS investment does and those businesses, when available forpurchase, sell at large premiums to that capital.Viewing the investment in the context of “Should I buy a bond or anoperating business?” allows the investor to avoid many mistakes that bondinvestors have made in the past. Buffett points out the example of AAA taxexempt bonds in 1946:In effect, the buyer of those bonds at that time bought a ‘business’ thatearned about one percent on “book value” (and that, moreover, couldnever earn a dime more than one percent on book), and paid 100cents on the dollar for that abominable business. This was during aperiod of substantial post-war growth when businesses were earningup to 15 percent on their book value.Additionally, in that 1984 letter to Berkshire shareholders, Buffettstated another interesting factor in his decision on the WPPSS bonds. Henoted that these bonds were not long-term, and the risk of runaway inflation in the future makes him hesitant to ever purchase a long-term bond.This theme remained with Buffett until the present day, when the fear ofinflation has even compelled him to make, for the first time ever, substantial investments in foreign currencies.There is a similarity between the WPPSS bonds and the next junkbonds that Buffett mentions in his annual letters: The RJR Nabisco bonds.In both cases, the sell-off on the bonds was not directly related to falteringeconomics in the business.RJR Nabisco was the target in the famous takeover engineered byleveraged-buyout shop KKR and made famous in the book and subsequentmovie, “Barbarians at the Gates.” In order to pay for the takeover, KKR hadto issue junk bonds backed up by RJR’s cash flow. If KKR had made a mistake in how they valued the cash flows prior to the takeover, or the business faltered for whatever reason, then the potential for full payment onthose junk bonds could become suspect.However, RJR was performing fine as a business. The real issue wasthe blowup in general of the high-yield market. With the demise of Michael
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Milken and Drexel, the credibility of all high-yield bonds came into question. And for good reason. As Buffett noted in the 1990 letter to BerkshireHathaway shareholders:In some cases, so much debt was issued that even highly favorablebusiness results could not produce the funds to service it. One particularly egregious “kill-’em-at-birth” case a few years back involvedthe purchase of a mature television station in Tampa, bought withso much debt that the interest on it exceeded the station’s gross revenues. Even if you assume that all labor, programs, and serviceswere donated rather than purchased, this capital structure requiredrevenues to explode—or else the station was doomed to go broke.With issuances like that, which were being quickly bought up anddevoured by savings and loans institutions that would soon be bankrupt, itis no wonder that investors decided to throw out the baby with the bathwater and sell off all high-yield instruments they could find in their portfolios.This explains the sell-off in RJR bonds. Buffett, having dealt with KKRbefore (see the Arcata example in Chapter 5 on merger arbitrage), determined that the cash flows on RJR were sufficient to pay off the bonds andbought up to $440 million of the bonds during late 1989. In 1991 RJRannounced that it was retiring the bonds and paid off the full face value ofthe bonds, rendering Berkshire a healthy profit of $150 million.As seen in Chapter 7, Buffett’s interest in high yield extended to notonly purchasing discounted bonds on the open market, but buying them inthe form of convertible preferreds directly from the company. This gavehim the added one-two punch of getting not only the benefits of the highyield, but removing the problem of having the ceiling on his potential returnby allowing him to convert into equity at a later date.In the tech and energy company sell-off of 2001 and 2002, Buffett againdipped into the high-yield market on several occasions.For instance, in late 2002, Buffett began buying up debt in telecomcompany Nextel. Nextel’s stock had fallen 95 percent from its peak in 2000to its low in 2002; in 2002, it was even flirting with possible bankruptcy. Inresponse, it used cash flow to retire up to $3.2 billion in debt and slashed5,300 jobs in an attempt to cut costs. For 2002, Nextel posted a $1.4 billionprofit, its first profit in 15 years. However, the combination of the recession
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and Nextel’s prior problems still had the rating agencies ranking the company’s debt as junk. In this environment, when interest rates were alsobeing cut down to 50-year lows, Buffett was able to buy up $500 million ofNextel’s bonds.In early 2003, the markets were reeling in anticipation of the war in Iraqand the uncertainty that would come with it. At the same time, Buffett wascoolly buying $100 million worth of Amazon.com bonds yielding 10 percentin anticipation that they would be called back by the company within amonth—with the $1.3 billion in cash and marketable securities that thecompany had on hand. The company did redeem the bonds, giving Buffetta 22 percent annualized return for his efforts at relatively low risk.
CHAPTER 9
Warren Buffett’sPersonal Holdings
ost people think of Warren Buffett and Berkshire Hathaway asthe same entity. And this is not unreasonable. The fortunes ofboth have been inextricably linked since Buffett took financialcontrol of the company in 1965 and became the full-time chairman andCEO in 1968. However, Buffett does occasionally make stock trades outside of the context of his role as chief asset allocator of Berkshire. Theseare particularly interesting to look at for three reasons:
M
1. At Berkshire he has to be able to allocate over $30 billion. Many good
investments or trades are not appropriate for a cash portfolio of thissize simply because they are too small. Buffett probably takes the bestof these small investments and does them for his own portfolio whenthey are not appropriate for the Berkshire portfolio.2. At Berkshire, Buffett has more often than not gone the Fisher/Munger
route of “paying up” for good, growing companies that might be tradinghigher than book value, or in some cases, higher than their intrinsicvalue. Many of these investments have worked out quite well (CocaCola and Gillette come to mind, and more recently Petrochina), butthey are not the classic Graham-Dodd investments that Buffett was
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schooled on. In his personal portfolio, Buffett has more often goneback to his roots and picked companies that were trading below bookor even liquidating their assets. These are cigar butts that Buffett feltobligated to pick up off the ground and smoke one more time.3. The picks in his personal portfolio are more reminiscent of the types of
trades he would do in his hedge fund. He did work-out situations thatin many years resulted in up to 50 percent of the profits or more forthat year.For all of these trades, it is impossible to know the full details of thetrade; Buffett never talks about them and is only obligated to file his ownership when it exceeds five percent of the company. However, we can stillpick through the filings and the news reports on the companies and try toexamine what happened, when, and why.
LASER MORTGAGELaser Mortgage was a mortgage-backed real estate investment trust (REIT)that quickly got into trouble in 1999 and 2000 when interest rates spikedup. They used heavy leverage and made very concentrated bets that backfired horribly when mortgage lenders defaulted on them, causing them tomark down book value significantly. Because of these defaults and markdowns, investors lost faith in management’s ability to correctly value itsportfolio and the stock soon plunged below book. In October 2000 themanagement threw up its hands and announced it was looking into apossible liquidation of its portfolio and ultimate distribution of proceeds tothe shareholders.Buffett began acquiring stock most likely in early 2000 when the stockwas trading around $4 and book value was around $4.51. On April 13, 2001,Buffett filed a Schedule 13G filing with the SEC stating that he owned979,000 shares, or about 6.98 percent of the company.On April 25, 2001, the Laser Mortgage board of directors approved theliquidation and dissolution of the company, immediately approving an initial distribution of $3.00 per share. In 2003, they made another distribution
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of $0.50 and on July 5, 2004, they made a final distribution of 0.86 andclosed the doors.
JDN REALTYJDN Realty was a REIT (real estate investment trust) that owned 15 millionsquare feet of shopping centers. For each shopping center the companyattempted to anchor the shopping center with a “value” tenant such as Walmart or Lowe’s, who were its two biggest tenants. The company reportedsteady results until 1999 when they announced they had to restate theirprior five years’ worth of earnings. The management team was hiding executive compensation by not properly reporting related party transactionsdetailing up to $5 million. The stock crashed from high to low over 50 percent and the lawsuits started flying.However, the value of JDN’s real estate did not change at all. Both Walmart and Lowe’s reaffirmed that they were going to remain tenants of JDNproperties. When the company began trading below its book value, instepped Buffett. His first filing was in April 2000, when he reported that heowned 1.7 million shares. This was followed by a later filing in February of2001 where he announced he was up to 2.5 million shares. In Q1 of 2003,JDN merged with DDR Realty for $13 per share.
TANGER FACTORY OUTLET CENTERSWithout getting into the discussion of whether the Internet created a bubble, the technology certainly consumed the public imagination in a way notseen since the advent of the printing press. REITs involved in the development of shopping malls were particularly hurt because of the belief thatshopping would soon be dead except through e-commerce.Tanger develops factory outlet centers, and shares were decreasing indirect proportion to the Internet index increases. People assumed that factory outlets were no longer necessary since they could now buy everythingthey needed from the comfort of their living room. The millennia-old technique of trying on clothes before buying them was deemed no longer nec-
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Tanger, 1993–2004
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essary. By March of 1999, the company was trading at a 27 percent discountto its net asset value, much lower than that of its peers. Additionally, thecompany was yielding a 12 percent dividend and steadily increasing the dividend. And it wasn’t in danger of overdeveloping like many REITs do during boom times, since Tanger pre-leases every space before it begins thedevelopment of a new strip mall.In April of 1999 Buffett bought five percent of the company, eventuallyincreasing his stake to more than 13 percent by 2000 and then reducing hisstake to below five percent by mid-2001. When Buffett first bought thestock, it was trading at almost 40 percent from its high just a few monthsearlier, even though business was better than ever (see Exhibit 9.1).Around the same time that Buffett bought Tanger he also bought a fivepercent stake in Town and Country Trust, a developer of office buildings.
HRPT PROPERTIES TRUST
On December, 2001, Buffett filed with the SEC that he had bought 5.1 percent of HRPT for his personal portfolio. I think the graphic in Exhibit 9.2describes it best.
Warren Buffett’s Personal Holdings
EXHIBIT 9.2
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HRPT Property Trust
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It looks like Buffett filed right when the stock hit its five-year low point.Right before the announcement, HRP, which was a developer of office building space, announced that it was going to be receiving shares of Five StarQuality Care through its ownership in Senior Housing Properties Trustwhich was distributing the shares of Five Star. HRP, in turn, was going todistribute the shares to its shareholders. In addition to HRPTs’ having asteady income and dividend—plus a divesting of unstable healthcare properties—Buffett probably calculated an arbitrage involving the Five Starshares. Within two months he had collected his Five Star shares, and thenpromptly reduced his stake to 1.77 percent.
BURNHAM PACIFIC PROPERTIESThroughout 1999 and 2000 Burnham Pacific, an owner of shopping malls,was consistently selling off its stores at a premium to the value of thosestores recorded in the books. With the company trading at a discount to net
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asset value, otherwise known as NAV, and a poison pill adopted to ward offa hostile takeover, shareholders were getting restless (and suing). Finally, atthe end of 2000, shareholders approved a complete liquidation plan.Buffett bought over five percent of the liquidating company in December, 2001, and enjoyed the benefits of its final six months of liquidatingproperties for more than they were initially valued at.
MGI PROPERTIESBuffett first bought shares of MGI Properties in October 1998 when he filedwith the SEC disclosing a five percent stake. Later this stake was raised to8.3 percent and then 13.5 percent.In June 1998, the company disclosed that it was liquidating all of itsassets and distributing the proceeds to shareholders. The liquidationvalue was estimated at $33 and the stock at the time was trading around$20. We don’t know what Buffett’s acquisition price was, but it is fair tosay he believed in the liquidation value and assumed he was getting adecent arbitrage between the price he was acquiring and the eventual liquidation value. Around 1998–1999 when Buffett was making many of hisREIT purchases, reports were appearing in the media that seemed to suggest that these REIT purchases were part of a bigger macro statement onREITs in general. However, this was definitely not the case. In most ofthe situations, Buffett was buying purely for the liquidation value and theensuing arbitrage.
BELL INDUSTRIESBell has been around for 50 years in a variety of businesses. It is a miniconglomerate that began a transition to the IT services business in the late1990s and began selling off its other businesses. In 1999 it sold the precisionmetalcraft division, an electronics distribution division, and its graphicsimaging business. On December 13, 1999, Buffett filed with the SEC that heowned 5.93 percent of the shares. We don’t know the exact reasons for hisfiling; perhaps he assumed that there would be more liquidations and moredistributions of the results of those sales.
Warren Buffett’s Personal Holdings
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Bell Industries
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Buffett sold his shares within two months when the stock spikedupwards, probably because he had bought them—not a bad investment technique, if you can manage it. In Exhibit 9.3 you can see the spike in volume thatoccurred on the left-hand side precisely when he announced his holdings.Another type of arbitrage that Buffett has engaged in with his personalportfolio is closed-end fund arbitrage. A closed-end fund (something thatBuffett’s detractors often accuse Berkshire Hathaway of being) is a fundwhose shares trade on the stock exchange like any other company. Unlikean open-end fund, a closed-end fund has a fixed number of shares and nolonger accepts inflows or outflows of money.In the next chapter on closed-end fund arbitrage, we examine anotherexample from Buffett’s personal portfolio with Baker Fentress.Although 99 percent of Buffett’s net worth is in Berkshire Hathawaystock, it is interesting to see him dart in and out of stocks through the years,using Graham-Dodd principles and snatching profits where he can.It is worthwhile to note here the holdings of the Buffett Foundation,although its portfolio is not quite the same as his personal portfolio, whichBuffett seems to actively manage. Exhibit 9.4 shows the holdings as of June30, 2003, as filed in the Foundation’s 990-PF filing.
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Buffett Foundation Holdings as of June 30, 2003 Filing
InvestmentsDoverDow JonesDun & BradstreetEdison InternationalEnergizerEntertaiment PropertiesExelon CorpFederal ExpressFed National Mortagage AssnFirst EnergyFirst Industrial Realty TrustFive Star Quality CareFleetwood Enterpnses IncFlorsheimFortune BrandsFPL Group IncFranklin CoveyFriedmansFurniture Brands IntlGabelli Equity TrustGabelli Global Multimedia TrustGabelli Utility TrustGallaher GroupGannettGATXGC CompaniesGeneral DynamicsGeneral ElectricGilden Activewear IncGillette CoGlimcher Realty TrustGolden West Financial CorpGraham-FieldHaverty FurnitureHCA IncHershey FoodsHighwoods PropertiesHollingerHollinger InternationalHomeFed CorpHorace Mann EducatorsHospitality Properties TrustH&R BlockHRPT Properties TrustInsignia/ESG HoldingsInsweb CorpInternational Business MachinesInternational Flavors&FragrancesInternational PaperIStar FinancialLaser Mortgage MgmtLeucadia National
# Shares
Cost
Market Value
8001005010031001002001,20066100110016400100100100