There once was a time when the investment success of individuals like Warren Buffett was written off as a statistical aberration. If a million people participate in a coin toss, there are going to be 500,000 winners. If those 500,000 winners then proceed to another coin toss, there are going to be 250,000 winners, and so on. That argument has been weakened somewhat over the years as the strong form of the efficient market hypothesis has been less appealing to academics and practitioners alike. Markets are empirically not always efficient, even if they often are.
More recently, critics intimate or outright allege that Buffett’s recent success is primarily due to having access to deals other investors do not have. A Google search for “Warren Buffett Sweetheart Deals” returns more than 20,000 results. There are reasons why people are persuaded by this analysis. Take for example Berkshire’s agreement to invest in Bank of America in 2011. For $5 billion, Berkshire received preferred stock that yielded 6% and warrants to purchase Bank of America stock at $7.14 per share for ten years. With Bank of America’s stock now exceeding $24 per share, Berkshire’s profit now amounts to more than $12 billion plus the cumulative dividends received on the preferred shares – about another $1.8 billion pre-tax. Similar deals, but with richer terms, were struck with Goldman Sachs and General Electric during the financial crisis.
More recently Berkshire agreed to invest in one of Canada’s largest mortgage lenders: Home Capital. For C$9.55 per share, Berkshire purchased about 20% of the company and also agreed to provide a C$2 billion line of credit. With the stock now trading around C$17 per share, Buffett has nearly doubled his money in less than a month.
Certainly, the executives at companies like Bank of America and Home Capital are not looking to give one of the richest people in the world a handout. There are a couple of key factors at play when these transactions are made. Berkshire Hathaway has two qualities that companies have to have in certain situations: the first is the signaling that comes from Berkshire’s investment and the second is the enormous capital strength the company possesses.
The first quality of Berkshire being purchased took years to acquire. It stems from a reputation of consistently making wise investments and avoiding outsized risks. Around the time Berkshire made its Goldman Sachs investment, Lehman Brothers also came calling. Berkshire declined to invest regardless of the terms because, it accurately, understood the cultural and financial deterioration that took place there.
The second quality is more important. In a world enthralled by strategy consultants and private equity firms that maximize short-term return on equity and financial leverage, Berkshire remains comfortable consistently being overcapitalized. Countless observers routinely suggest that Berkshire should pay a large dividend or buy back shares to engineer a more shareholder friendly balance sheet. The fact of the matter is that the balance sheet allows Berkshire to make contrarian acquisitions and supply capital when it is most desperately needed.
The recent announcement of the intended acquisition of Oncor, a Texas utility, at a price somewhat lower than two previous deals that were announced and failed. It may be that Berkshire is also not able to close this acquisition, but it certainly seems that the regulators in Texas would prefer that it does? Why? Because unlike other companies trying to acquire Oncor, Berkshire can give its potential Texas customers a balance sheet that is supportive of stability and long-term investments.
In reality, every entity has the same options to consider that Berkshire has. It just takes an incredibly long time to build a quality reputation and an enormous capital base. But, those thinking that the success of Warren Buffett and Berkshire Hathaway is due merely to “sweetheart deals” would be wise to take a look at the playbook. They might learn something.
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