Gustavo Ballvé on December 8th, 2009
Home, Insurance, Investment Themes, Logistics, Portfolio Management

The Financial Times yesterday had a Lex piece on Berkshire Hathaway’s valuation, going out of its way to point out that it didn’t have a clear opinion on whether the stock is cheap. However, that’s beside the point. There is an increasing amount of BRK shares sold short and people seem quick enough to point to the Burlington deal as the culprit, for many reasons (listed inside). They may be missing the number one reason, and it’s one that merits attention.

Here’s a story that points out that the percentage of shares sold short has quintupled after the BNI deal. There are many “mainstream”, “make-sense” reasons as to why this might be:

1) Berkshire could lose its AAA credit rating due to reduced cash levels (S&P, Fitch and insurance specialist A.M. Best have placed Berkshire on “watch”);

2) It was an oversized, expensive deal that dilutes shareholders;

3) Buffett and Munger aren’t getting any younger…

Well, here’s another: it’s a simple merger “arbitrage” opportunity created by the deal’s structure.

As described in the official press release and better explained in the conference call (on page 6, question number 4), the deal is a share exchange where each BNI share is worth approximately US$ 100 in Berkshire shares IF Berkshire’s share price at the time of the exchange is set between US$ 80,000 and US$ 125,000. This means that within this range of Berkshire Hathaway prices, a shareholder of BNI would get MORE Berkshire shares as the price approaches US$ 80,000 (below this number it doesn’t matter, since the exchange ratio is fixed). So BNI holders have an incentive to short BRK/B and pocket the difference when the deal closes – at which time they’ll hold an excess of Berkshire at attractive prices…

Of course, there are two things that could go very wrong for shorts:

1) As speculated here and in some research we’ve read, BRK/B shares post-split could be included in the S&P 500 index – with the huge sums of money invested in S&P 500-pegged funds, the buying volume could (and usually does) mean a 3-4% increase when the index change is made public.

2) Buffett could announce a share buyback program if Berskhire approaches the lower limit – while he has never done that, and his available cash is relatively depleted after the deal, Berkshire generates some US$ 10bi per year and his credit is still good…

That’s all beside the point. Much more interestingly: what does this deal say about Berkshire’s sharpness in deal-making? Are they losing their edge? We won’t even judge the deal’s merit (cheap, decent or overpriced). We’re just wondering whether the fact that Buffett appears to have created a less-than-ideal deal structure is reason for concern.

Finally, we’d point out that in the unfortunate case that either Mr. Buffett or Mr. Munger dies any time soon, or if the price formation is really altered by this “arbitrage”, there could be an interesting opportunity to buy Berkshire shares. We’re talking about a company with quality assets whose culture will outlive the two, and a company whose current “bets” on inflation, energy, transportation and USA recovery (and related financial market bets, e.g. the famous S&P 500 put) represent a very interesting long-term play. We wouldn’t bet against this – and certainly not against Buffett.

LINKS:

Has Buffett lost his mind? – Dec. 8th article on the Lonely Value Investor blog pointing to the original article (link below) and to a Bruce Greenwald interview blasting the deal as “insanity” (read his answer to the 2nd question). Bruce Greenwald is the Columbia University value investing dean.

Berkshire + Burlington, a Nov. 4th rant in the Lonely Value Investor blog. Not judging merit in this piece, it does link to 3 bearish pieces in “serious” publications such as Barron’s (subscription required), Bloomberg (by none other than Alice “Snowball” Schroeder) and TheStreet.com.

Buffett says Burlington ‘not a bargain’ – Nov. 14th article on Bloomberg quoting a Charlie Rose interview. The full interview transcript can be found here, and as usual it’s quite interesting. The part on Burlington starts after a bit of an introduction, but it’s near the top.

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