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Convertible Stocks

Berkshire made five private purchases of convertible preferred stocks from 1987-1991.

                         Dividend  Year of            Market
 Company                   Rate    Purchase   Cost    Value
 -------                 --------  --------  ------  --------
						(dollars in millions)

Champion International Corp	9 1/4%	1989	$300	$388(1)
First Empire State Corp		9%	1991	40 	110
The Gillette Company 		8 3/4%	1989	600	2,502(2)
Salomon Inc 			9%	1987	700	728(3)
USAir Group, Inc. 		9 1/4%	1989	358	215

When the purchases were made, Warren expected

(a) the returns from them to moderately exceed those from medium term fixed income securities.

(b) they would not beat the returns from a business with wonderful economic prospects.

(c) they would give back at least their capital plus dividends under almost any circumstances.

As it turned out, (a) was met (but only because of the performance of Gillette), (b) was correct and (c) could be wrong (because of USAir Group).

Leaving aside Gillette, the returns of the convertibles would be no more than equal to those earned from medium term fixed income issues.

Furthermore, the returns for Gillette would have been even greater had Warren purchased the shares directly at that time instead of the convertible.

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Convertible Preferred Stocks

Warren Buffett values convertible stocks by looking at three things: interest rates, credit quality and prices (or more precisely, valuation) of the related common stocks.

He warns against inaccurate or misleading valuations by others. For example, several members of the press calculated the value of all their preferreds as equal to that of the common stock into which they are convertible.

By their logic, Warren’s Salomon preferred, convertible into common at $38, would be worth 60% of face value if Salomon common were selling at $22.80.

The problem with using this valuation is that all of the value of a convertible preferred would reside in the conversion privilege and that the value of a non-convertible preferred would be zero, no matter what its coupon or terms for redemption.

This does not make any sense at all.

The correct way of valuing convertible stocks is to firstly look at their fixed-income characteristics. Then, you look at the conversion option and see whether it adds additional value to the basic fixed income valuation.

What this means is that the securities cannot be worth less than the value they would possess as non-convertible preferreds.

What happens if Warren Buffett Dies?

Warren candidly mentions three things that would happen if he passes away suddenly:

(1) None of my stock would have to be sold; (2) Both a controlling shareholder and a manager with philosophies similar to mine would follow me; and (3) Berkshire’s earnings would increase by $1 million annually, since Charlie would immediately sell our corporate jet, The Indefensible (ignoring my wish that it be buried with me).

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A change in accounting has it that insurance companies have to quote their equity securities at their market value. Before this, these were quoted at the lower of aggregate cost or market value.

This means that an investment owned by Berkshire directly could be valued very differently if it was now owned by one of it’s insurance subsidiaries (even though the business owned is exactly the same!). Therefore, when reading the accounts, it is important to understand the accounting conventions used and interpret the numbers accordingly.

Warren feels that when measuring the operating performance (earnings), we should compare it with all securities measured at cost and not market value. This is because the market value might vary greatly in different years and this will distort the comparison.

A large decline in securities values might make medicore earnings look good. Conversely, successful equity investments might make operating performance look bad even if it’s not the case.

Warren again mentions that the earnings rate on equity employed should be used to measure performance rather than just the earnings per share as the latter will always rise on an expanding equity base even if the business performance stays the same.

As a example, assume a dormant savings account with $1000 that earns 10% interest every year. In the first year, the earnings (interest) will be $100. In the second year, the earnings will be $110. In the third year, the earnings will be $121. That’s a 10% increase in earnings every year, even for doing nothing. On the other hand, if you look at the earnings rate (compare interest to account balance), you will notice that the earnings (interest) are consistent at 10%. Nothing much has changed.

Also, when looking at any investment performance, we should always compare it to the inflation rate and tax rate. Warren calls this the investor’s misery index. The ultimate aim in any investment is to increase the purchasing power of the capital over time. This is achieved as long as the investment returns (minus tax) is higher than the inflation rate.

One interesting observation is that the book value of Berkshire at the end of 1969 would have bought one half ounce of gold. 15 years later, the book value (that has compounded at 20.5% annually) would have bought about the same amount of gold. A similar comparison can be made with Middle Eastern oil.

The government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.

The continuous (under)performance of the textiles unit leads Warren to conclude that capital would be much better employed in a good business purchased at a fair price, than in a poor business purchased at a bargain price. Always remember this!

There’s a short discussion on bonds as an extraordinary amount of money has been lost by the insurance industry in the bond area within the year.

In periods of high inflation and uncertain interest rates, many insurance companies have decided that a one-year auto policy is inappropriate. Six-month policies have been brought in as replacements.

It is ironic that they have then turned around, taken the proceeds from the sale of that six-month policy to purchase a bond for thirty or forty years.

The buyer of long term money has been able to obtain a firm price now for each year of its use while the buyer of just about any other product or service will never be able to do the same. In most other areas of commerce, parties to long-term contracts now either index prices in some manner, or insist on the right to review the situation every year or so.

Warren would never buy any straight thirty or forty year bonds as he has severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day.

However, convertible bonds provide an attractive alternative as the conversion option gives the bonds an earnings retention factor. They also have a shorter life than that implied by their maturity dates.

A note about quarterly reporting. There’s no narrative with Berkshire’s quarterly reports. The owners and managers both have very long time-horizons in regard to this business, and it is difficult to say anything new or meaningful each quarter about events of long-term significance.

On the other hand, you can (and should) expect to hear directly from the CEO on what’s happening in the annual reports.

A final note about trading activities in shares. It is puzzling why some managements seek high trading volume in their shares. In effect, such managements are saying that they want a good many of the existing shareholders continually to desert them in favor of new ones – because you can’t add new owners without losing former owners.

Warren much prefers owners who like their company and stay on as shareholders. This can be seen in low share turnovers among the owners, reflecting a constituency that understands their operation, approves of their policies, and shares their expectations.