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Berkshire Hathaway
The case against BKRA

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By duxburyrj
June 9, 2005

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Warren Buffett once said: "Charlie and I believe that when you find information that contradicts your existing beliefs, you've got a special obligation to look at it-and quickly." Let's examine the case for not buying BRKA.

THE CASE AGAINST BRKA:

I think that most would agree with the notion that Warren Buffett is the greatest capital allocator of all-time. My fear, with regard to Berkshire however, is not Buffett's relative investment acumen, but it pertains to the idea that it just may be that despite his talents the current 'macro' environment and Berkshire's legacy assets (the size of its paper holdings) are too much for anyone to handle.

Let's flashback to the 1970's: Berkshire Hathaway is a small holding company that generates some cash. Buffett buys some low cost insurance float businesses and deploys that float in paper assets that generate extraordinary real rates of return. Berkshire, with its cost of capital near zero and its ability to find investments that generated very high rates of return led to a growth in equity capital that few would have thought possible.

So much for our very brief history lesson; Now, I know that most people recognize that the investment environment is very different today than the one that existed at the end of the 1970's when Buffett felt, "like an oversexed guy in a whorehouse," but I feel that the gravity of the situation is vastly underestimated by most....and maybe even by Buffett himself. While most would not dare to question Buffett's investment judgment and, let's face it, the guy is short the US dollar to the tune of $21 billion so most would say that he understands that the situation ain't all that rosy. Nevertheless, let's take a look at the following.

For most Berkshire shareholders I know that an evaluation of the global 'macroeconomic' picture borders on heresy, but even Buffett acknowledges that what we are witnessing is a pretty rare environment given the global imbalances, so we should all pay attention.

To me, the primary global imbalance remains the divorce between the rate of creation of paper assets from societal output. In short, debt (which represents claims on future output...which we can think of, in rough terms, as nominal GDP) is growing far faster than GDP. It is impossible for this situation to persist in perpetuity and some resolution is in the cards. The trick is to correctly gage the impact of this rebalancing on Berkshire.

Before moving on to that task, let's spend a few moments thinking about this imbalance in slightly greater detail. For nearly fifty years until 1982, the ratio of non-financial debt to GDP stood at an almost constant 1.3 times. From that date on the ratio degraded and has now stands at 2.04 times. More worrisome is the fact that for the past five years that ratio has been increasing at a rate of 2.8 times. That means that it now takes nearly 2.8 units of non-financial debt to generate one incremental unit of GDP. The inverse of this ratio is the productivity of money and credit and it is crashing. Non-financial debt growth is now increasing at almost $2 trillion per year versus nominal GDP growth of around $700 billion. Claims on output are clearly growing far faster than output itself. In fact, non-financial debt growth currently equals nearly 17% of GDP. Compounding at that rate will clearly lead to poverty among paper asset holders as it will never be possible for paper holders to garner the claims on future output that they believe that they posses at the moment.

There are only a few ways that this situation may resolve itself: First, the value of paper assets can contract very rapidly during an economic recession/depression faster than nominal GDP falls. Second, nominal GDP growth can be much higher than the growth rate in the nominal value of paper claims on output. If this is to occur, it is almost certain that prices of goods and services will have to increase dramatically given the amount of paper outstanding today and its growth rate. Third, we could have some combination of the two.

Impact on Berkshire

In my opinion, Berkshire could be trapped here. Historically, value was created by the enormous divergence between cost of capital and the ability to deploy that capital. As we can see from the above paragraph, the current environment may make that impossible for quite some time. While just about anyone can see that the above scenarios are very negative with regard to the ability of deploying capital at a high rate of return, I am most concerned about Berkshires cost of capital. Insurance companies generate float that has a variable cost base to it. That is, they make assumptions about what they will have to pay out in the future on the policies that they write today. Given the very large imbalances in the system, the fact that they will be corrected and the likelihood that the Fed will engender to take inflation in goods and services (I believe that they will attempt to take this rout as opposed to deflation and crushing the credit system) makes this a very dangerous period of time for those who generate long duration float (liabilities). Given that the duration of a new dollar of liabilities at Gen Re is about six years, inflation estimates are very important. I believe that it is highly likely that goods and services inflation, and therefore Berkshire's cost of float, may be far higher in the future than Berkshire investors are assuming.

Many will say that Gen Re and GEICO made it through the 1970's etc. (though GEICO made it just barely), but the economic imbalances today are many times greater than the imbalances of that period and the risks are, therefore, much higher in my opinion. To give you an idea just how disturbing even minor pricing errors for a great insurance company can be, I refer you to Progressive Corp. in 2000. Though PGR and GEICO are both relatively short-tailed businesses, but GRN isn't, and even short-tailed businesses can get behind and stay behind the curve if the cost of claims settlement rises at an ever-escalating rate for a number of years. In short, BRK could see much higher float costs and much, lower return generating options for a very long time given the size of the imbalances.

This begs the question; just how bad are things in the economic world? Well, there are no historical analogs to today's environment so there are no past comparisons to be made. The world has never existed entirely with a fiat currency (the very thing that allows the excessive leverage situation that is debasing paper holders claims on output) and the world surely has never seen a period where the issuer of the reserve currency is the most indebted country on the planet, dependent on capital flows from some of the poorest countries of the world. The math associated with debt growth is unsustainable and the view that I hold is that this is the biggest problem that the global financial system has faced since the Great Depression. While some may think that this is alarmist, I do not. Today, I think that Berkshire shareholders face a much higher potential for escalating float costs (maybe even dramatically so) and lower return (perhaps even negative) deployment possibilities. As such, it is possible that Berkshire has entered into a period of wealth destruction. Buffett is attempting to hedge some of this out by shorting the dollar, it is an open question, however, if this is enough. Certainly, I expect Berkshire to be the last financial company left standing and the option value of that may be great (high market share and pricing flexibility as the last viable insurer), but this is probably a long way off given the magnitude of the imbalances that exist today.

Today is almost the mirror image of the 1970's for Berkshire shareholders. Then, low cost float and plentiful investing opportunities made for investment nirvana for the next 25 years. Now, the potential exists for dramatically higher float costs if the economic imbalances of today are inflated away and the return potential for paper assets under almost any scenario is grim. Buffett has been warning for years that it is tough to find places to deploy capital. The cash build-up has been extraordinary. Now, I worry that the cost of float could go far higher than we have imagined in an inflationary scenario. If it does...well, even Charlie Munger warned us in 2004...."If Argentina happens here...we can't save you."


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