Monday, September 5, 2011

Warren Buffett's Investment in BofA - And what is doesn't tell us

A hot topic of discussion lately has been Warren Buffet’s (dba Berkshire Hathaway) investment in Bank of America and the either – good, or great terms, he was able to get on his $5 billion investment.  In investment that BofA said it didn’t need and/or didn’t want.   A lot of the attention has been paid to the implied profitability of the structure of the transaction, and I have read some good analysis of the implicit discount he received (this is from Slate).  There has even been some talk about the implicit wager on the willingness/ability of the federal government to provide a “backstop” by refusing to let another major financial institution fail (a real, and probably accurate market perception).

But for me it boils down to something a lot simpler – size.  By investing $5 billion in BofA, Berkshire became one of the largest shareholders, and if you include the options would be able to control something in the order of 50,000 preferred shares and 700,000 common shares (at an exercise price of about $5 billion).  But even at that level of investment it represents just 14% of BofA’s total market cap as of today, which is down 80% from 2007.  So he got a good return (6%) and liquidity on $5 billion, which is something that is hard to do.  Consider that Berkshire had $47 billion in cash as of 6/30/11, mainly in Treasuries, so the ability to put $5 billion to work at a yield 3x what Treasuries are paying with an equity upside in the form of “at-the-money” warrants is a huge win.  There are only so many places one can put $5 billion without fully taking over a company.  As a matter of fact, there are only 36 companies (including BofA) in the US with a market cap above $70 billion (BofA’s is $77 billion as of 9/1/11).  Investing $5 billion in a company smaller than that would run the risk of having to consolidate their operations in Berkshire’s financial reporting and effectively exercising control over the company, or being stuck with a position they could not hope to get out of efficiently.

Buffett said he was hunting with an elephant gun these days and there are only so many elephants roaming the financial landscape, and you really can’t shoot too many other animals with elephant guns and not completely blow them up.

So at the end of the day I think size – sheer, unadulterated size, explains a lot of the investment in BofA.  And I think going forward Berkshire will probably do a more of what is effectively PIPE (Private Investment in Public Entity) type investing.  Elephant guns aren’t very effective on rabbits, so when he sees elephants out there I’m not going to be surprised when he pulls the trigger.

Thursday, July 28, 2011

What Could the World Do? (The US Debt Issue)

The current financial impasse in Washington has raised some very interesting political questions and some thought provoking financial questions as well.  One of the big questions is if the us does default, What are we gonna do?  The answer that makes the most sense to me is nothing.

Let me explain a little bit.  First the US has about $14.3 trillion in debt, (that is $14,300 billion just to lend some perspective to the number).  Well that is more sovereign debt than any other country in the world (The entire European Union has $13.7 trillion, per the world bank  - Wikipedia .  So the US is the 800 pound gorilla sitting not in the corner, but in the middle of the room.  Assuming the debt impasse and a technical default and downgrade, many institutional investors would be forced to sell based upon their investment policies, but where can you go?  The real answer is that there isn’t anywhere you can really go because there are not enough AAA rated securities to soak up all of the money that would be forced to move out of Treasuries and into something else. 

But for me the question is more basic, why would you need to move your money anyway.  Living in California there are building codes that must be adhered to when building anything in California given the high occurrence of earthquakes (makes sense).  So the biggest, recorded earthquake was in the 8 on the Richter Scale, a level that would cause massive destruction.  But earthquakes codes are not designed for buildings to survive a 10 or 11 earthquake (which also makes sense).  At some point you have to accept that at a certain level the cost, and likelihood of occurrence make certain steps “unreasonable”.  If we have a level 11 earthquake everything is falling down and at that point we are going to have to start over (Noah style).

The same issue exists for US debt.  There is no market that is capable of absorb the money currently in Treasuries, and despite the political wrangling current engulfing us, what is really safer than US debt?  All of our debt is in US dollars, which we alone print, so there is not a currency issue.  We have the largest economy in the world by far (take a look GDP by Country),  and although we all hate the IRS we have a very good means of collecting taxes from our citizenry.  So would you rather have a piece of the income of LeBron James the basketball player or LeBron the bus driver?...the answer is LeBron James the basketball player.  And the reality today is that the US is still LeBron James the basketball player, but we are just having an argument with our fiancĂ©/wife on how we are going pay for the new Bentley.

According to the World Bank roughly 2/3 of US debt is held by American institutions.  With Bond rates at their lowest levels in years, there is still a very deep market for US debt, and if the debt ceiling were not an issue we could easily just print up more bonds to handle our current fiscal situation.  And despite the fact that China is our largest foreign holder of US debt, they represent less than 10% of our total outstanding debt (US Debt Holders), and they also don’t have anywhere to dump a $1 trillion in US debt without dramatically effecting the value of their holdings (remember there is nowhere for the money to go).
So what will happen?  Politics matter, and our inability to manager our politics is going to cost us in the short run and the long run.  The US has been the center of the financial world for the past 60 years, not because we are cooler than everyone else in the world, it’s because we built the financial infrastructure, and London needed to focus on rebuilding falling the end of World War II.    So we might be opening the door for someone to supplant the US in terms of our world financial prowess, but think about like this - The UK was at one time the most powerful country in the world with one of the largest economies in the world, despite the fact that it is a relatively tiny island nation, with not that many people.  Today the US has the third largest population in the world (behind on China and India) which means we have a lot of people who will continue to innovate and expand our economy, and we have the largest economy in the world (something that won’t change any time soon) which means we are going to be here for a while….no matter what Washington does.

Thursday, July 14, 2011

One Man's Tweet is Another Man's Treasure (maybe.......)

One Man’s Tweet is Another Man’s Treasure

To value a company at 40 times revenue suggests a growth of the order that usually is note seen among public companies, at least not those that survive.  Not a direct indictment of Twitter and its investors which, according to media reports, placed a value on the company of approximately $8 billion, but it does beg some serious question in my mind, the biggest one being what if anything does Twitter’s value show us.

As finance guy, anytime I hear or read about those grand valuation for companies, thanks to my undergrad finance and econ professors, I immediately try to figure out what type of growth these investors are expecting to justify these “lofty” valuations. And at the end of the day that’s what you’re supposed to be buying as a shareholder – a share of the cash flows generated by a company.  The basis of capitalism is risk and return, where those who risk capital are more handsomely reward than those who do not, but the reality today is that we also reward timing and opportunity (sometimes to a greater degree) and it is hard at times to assess the extent to which timing skews or obliterates fundamentals.  But the reality is fortunately or unfortunately depending on your perspective finance fundamentals and valuations always, and I mean always losses out to supply and demand, which is the definition of a bubble.  But almost by definition few people see bubbles in the midst of the bubble and hindsight is always 20/20.

But let’s talk about Twitter for second.  I just did some back of the envelope calculations, that took me right to where I thought I would be.  Now this is based on the reported numbers which may or may not be accurate, but if the numbers are even close the conclusion is the same.

Twitter has an estimated value of $8 billion based on revenue of approximately $200 million and close to breakeven profitability.  This is a price to sales ratio of 40x (by comparison  I read Zynga has valuation of 33 or 37x sales, which for my money is just the same).  As a shareholder you  buy Twitter with some expectation of return/price appreciation over your holding period.  So if you  assume a 15% annual return over 5 years, the market capitalization would need to roughly double to $16 billion, which may seem possible over 5 years.  But in five years the price/sales ratio will have declined (it usually does for companies) due to the company’s growth (hopefully); as an example Goodle has a pricse/sales equal to roughly 6x.  But if in 5 years Twitter had higher growth prospects that Google today (on a relative basis) and traded at a 10x price/sales ratio, sales would need to reach $1.6 billion  to justify the $16 billion value, which is a growth rate of 8x current revenue (Google’s revenue has grown 10x since its IPO).  Not saying Twitter isn’t the next Google, but does Twitter have the same value proposition for advertisers (who knows), will they be able to find a new revenue stream other than advertising (maybe), will they have future competitors (it’s possible or not).  The reality is that as an investor you are buying into certain assumptions for the future if you buy Twitter.

One reality is that everyone doesn’t have a 5 year holding period and a lot of the investors will do just fine selling their shares after the IPO for what will surely be a return of several multiples on their initial investment, and because of the timing of their sell and the opportunity of their purchase everything will be just fine for them.

So at the end of the day what does Twitter’s valuation tell us about finance, or the state of the economy, or the technology 2.0 bubble – nothing.  All it tells us is that the value of Twitter is $8 billion today and to buy in now you have to hope to seem some pretty impressive things if you plan to hang on to it after the IPO.