The Ridgewood Group Value Investing Blog

Speaking of headline risk (one of the reasons cited for Berkshire’s current valuation discount), we think that “headline risk” along with other investment-speak terms like “profit taking” or “value trap” either don’t exist or aren’t helpful. Saying it differently using Henry Miller’s words, “Confusion is a word we have invented for an order which is not understood.”

In each of the above cases, nobody (especially the experts) wants to admit that they are confused. This is probably a sincere consequence of self denial - as human beings we have an even greater capacity to delude ourselves than we do others. Consequently, plausible-sounding but meaningless terms like “headline risk” have been resourcefully created to avoid admitting that “I am confused and have little time or inclination to uncover the deeper patterns that may be at work.”

As we have said before, the risk that matters is the risk of losing money in the long-term. The real question that should be asked and answered is not whether surprise headlines may occur, but what impact foreseeable or unforeseeable developments and headlines will have on the long-term health and viability of the underlying business. Indeed, if headlines blow matters out of proportion and scare away other investors, the more proper characterization from a long-term investment perspective is not “headline risk”, but rather “headline opportunity”.

In examining Berkshire, it is helpful to understand some of the concerns that are creating the present opportunity. These reasons may include the following:

• The recent and well publicized scandals relating to AIG and the ongoing probes that create something that the pundits call “headline risk”
• Warren Buffett, the Chairman, CEO, and largest shareholder is 75. Though in good health, the market may anticipate that the price will fall sharply after an announcement of his death or disability
• Berkshire’s largest businesses involve insurance, though having some commodity characteristics, Berkshires insurance subsidiaries are differentiated by their credit worthiness and ability to write large risks so they have long-term promise. In the short-term, however, almost all insurance businesses are facing near-term pricing pressures after several great years of firm and increasing pricing in the aftermath of the 9/11 attacks
• Berkshire maintains large cash balances and the low returns currently earned on those balances may be a concern to some
• The lack of a dividend despite strong cash flow
• The “high” price and the limited liquidity associated with the stock as a result of never splitting its shares
• Current management’s focus on fundamentals and building the business for the long-term. The flipside of this emphasis is a notable lack of promotional activity. On the contrary, Berkshire has acted decisively to dampen speculation in its shares whenever possible
• Susan Buffett’s death in 2005 meant that her holdings passed on to the Buffett Foundation which may sell to fund its activities. This overhand of stock might be creating additional pressure on the price.

 

While all of the above are legitimate concerns, we believe that the long-term future of Berkshire is probably more dependable than that of the majority of other companies. Using our framework, we would point out that Berkshire:

 

1. Owns a collection of outstanding businesses whose economics we can understand
2. Enjoys strong competitive advantages
3. Is led by a deep bench of ethical and forthright management superstars including the team of Warren Buffett and Charles T. Munger and an outstanding board that more recently includes Bill Gates
4. Is currently selling for a price under its intrinsic value.

Although the factors cited above have been in place for sometime and are generally well recognized, Berkshire has continued to be “on sale.” Moreover, Berkshire has the wonderful additional characteristic that it is a safe investment with very low risk of losing our money from current levels. Even on a short-term basis it tends to trade opposite to the market and is rightly viewed as a safe haven in times of difficulty. If some of the macro factors we cited at the beginning of our 2005 semi-annual letter to clients start having a real impact, Berkshire’s price should begin to reap the benefits, both from a short-term flight to quality and a longer-term ability to deploy its capital in the compelling market values that would be created by any gloomy consensus that arises sometime in the future.

 

Over the long run, buying companies as strong as Berkshire (a minority of companies to begin with since there are not many of its caliber) at a significant discount to intrinsic value is likely to produce good results.