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Wednesday, February 27, 2013

ASIA TIMES: Buffett as a leading indicator


By Martin Hutchinson 


Feb 26, '13

Warren Buffett's political pronouncements are intellectually vacuous hot air, yet I suspect he retains excellent investor's instincts about the future trajectory of the US economy. So when he manifestly overpays in a US$28 billion acquisition of the food producer H J Heinz, we should listen and ponder what the deal tells us about where we are going. On cool reflection, the answer to that question is manifestly a survivalist one. For Warren Buffett it's clear: when Cash is Trash, Beans are Queens! 

As in many of his transactions, Buffett has negotiated a favorable structure in the Heinz purchase: $8 billion of his $12.5 billion commitment takes the form of 9% preferred stock, which will pay

him a fixed dividend of more than four times the current 10-year Treasury bond rate. Nevertheless, his preferred stock will be junior to $12 billion of Heinz debt; if Heinz, including its debt, becomes worth only $15 billion, as it was in 2009, then the value of Buffett's preferred stock, his common stock and his partner 3G Capital's common stock will be only $3 billion between them. 

In addition, Buffett will have little control over the investment; he is to leave the operating management to 3G Capital. One can understand the rationale for this. His saintly reputation in left-of-center circles would be severely dented if he were personally responsible for firing tens of thousands of unsuspecting US Heinz workers while relocating the entire operation to some low-wage hellhole. 

Still, the theory is that any asset is worth more if Buffett buys it, even though the justification for Berkshire Hathaway's (NYSE:BRK-A and BRK-B) astronomical share price (which, however, has underperformed the S&P 500 Index over the past five years) looks a little bedraggled as a result of this transaction. 

At first sight, it might seem that Buffett merely expects a burst of inflation, unaccompanied by a rise in interest rates. That is a reasonable supposition - one can imagine that even if inflation appeared, Ben Bernanke at the Fed or his probable successor, Janet Yellen, would be extremely reluctant to raise interest rates. 

At most they would cut back somewhat on the additional "stimulus" provided by their foolish bond purchases. Instead they would allow inflation to rise to an alarming level, meanwhile allowing investors in short-term or long-term bonds to be subjected to hugely negative real returns (and in the latter case, severely negative nominal returns as long-term rates rose in spite of Fed opposition). 

With over $40 billion of cash at the last balance sheet date (some of it tied up by insurance commitments) Berkshire Hathaway would be especially vulnerable to such an outcome. It would lose money in real terms on its short-term bonds and would be forced to recognize capital losses on its holdings of long-term bonds as interest rates rose. If it diversified its holdings into "inflation-proof" US equities, it would find their value eroded also, as corporate profits fell with rising debt costs and price-earnings ratios declined from their current high levels - as they did in the late 1970s. 

The most obvious hedge against this eventuality would be to buy gold and silver. However, Berkshire Hathaway suffers from the problem that its purchases would be large enough to distort the relatively thin gold and silver markets. With the world's annual gold mine production being only around $150 billion, any attempt to shift a substantial portion of Berkshire Hathaway's holdings into gold would push the metal's price into an upward spiral. 

There is however a simple alternative: the shares of gold and silver mining companies. These have wildly underperformed gold and silver prices in the past two years and are now heavily undervalued, unless you think precious metals prices are about to collapse. 

The largest gold miner, Barrick Gold (NYSE:ABX), for example is on a forward P/E ratio of 6.3 times, little more than a third the 17 P/E ratio of the S&P 500 Index - and unlike ordinary companies, Barrick's earnings are not vulnerable to an upsurge in inflation - they would benefit hugely from it. Barrick's market capitalization is around $30 billion, large enough to be worth a Buffett takeover, and indeed there are several other possible mining stocks, all very reasonably valued, on which Buffett could practice his takeover skills if he wished. 

A mining takeover is an equally good inflation hedge to a Heinz takeover, and much more reasonably priced. Thus Buffett, famously a value investor inspired by Graham and Dodd's 1940 masterpiece Security Analysis, must have some serious reason for not concentrating on the precious metals sector. I can think of two possibilities. 

The first is that the political effects of Buffett launching into a major campaign of buying precious metals, or making takeover bids for mining companies, would be from his point of view highly counterproductive. Such a campaign would confirm that the fiscal and monetary policies of the past five years had been highly damaging, so much so that a rational investor had been forced to protect himself from a bond and stock market collapse and the inflationary erosion of his capital. 

Needless to say, the sight of Buffett engaging in rational self-protection in this way would cause a stampede by other investors into hard assets, further damaging the confidence-trickster flim-flam on which current worldwide fiscal and monetary policies depend for their sustenance. 

To put no finer point on it: a precious metals or mining company purchase program by Buffett would be highly politically incorrect, something that appears to matter far more to Buffett than it did to his admirable Republican Congressman father Howard Buffett (R-Nebraska). 

You may argue that Buffett is above such considerations, that his calm investor rationality simply determines the optimal asset allocation strategy without regard to vulgar political considerations. Very well, in that case there is only one conclusion to be drawn about Buffett's investment outlook: he must fear not simply an inflationary upsurge, but a collapse, at least temporary, of the fabric of Western civilization. 

While either gold or silver has been the monetary instrument of choice for almost all major world civilizations, their value depends on the existence of an ordered civilization, with the rule of law and a substantial volume of monetary transactions. The exquisitely organized Song dynasty China was able to move to paper money for a century or so before the Mongol invasions, but China for most of history relied on silver as a means of exchange. Even when the country was suffering from hyperinflation in the 1940s, gold and silver were accepted as payment for the goods and services that were available. 

However, as you can read in Jung Chang's Wild Swans, during the Maoist famine years of the "Great Leap Forward" of 1958-61, when market mechanisms ceased to operate, gold and silver were no longer useful, because possession of them endangered your position in a society that was full of informants and imprisoned the bourgeois. 

Similarly during the Ukrainian famine of 1928-32, possession of gold and silver got you labeled as a "kulak" and subject to liquidation by Stalin's secret police. 

In both cases however, food itself remained a highly acceptable means of exchange and could obtain you any kind of services available, or indeed antique furniture and jewelry if your taste ran to that sort of thing and you were confident your political connections made you safe from liquidation. 

There is thus a more sinister potential implication of Buffett's Heinz purchase. He may believe that inflation will become extreme, that the monetary system will break down completely, that even gold and silver will become unacceptable stores of value in a period in which their value is after all itself a matter of fiat since gold at least has no practical use. 

In that event, a breakdown of the monetary system would presumably be accompanied by a breakdown of the distribution system, causing the entire 310 million population of the United States to revert to barter and subsistence farming. 

At that point, the most valuable commodities would become food staples and armaments. With baked beans piled in warehouses around Omaha, and a ketchup lake at an undisclosed location, Buffett could dominate the post-Apocalypse economy to an even greater extent than he dominates the present one. He would of course need a collection of bodyguards and a sophisticated means of self-defense, so maybe we should look for future Buffett purchases in the armaments sector. 

Alternatively, Buffett may believe that the chance of a truly Apocalyptic economic outcome is small, but that a temporary period of post-Apocalypse-like conditions is still possible, during which his Heinz investment (and that in any armaments manufacturers) could prove immensely valuable. 

The prospect of a breakdown of civilization may seem a remote one, but for five years we have suffered under monetary and fiscal policies more extreme than any previously attempted. Their eventual collapse is certain. Maybe Buffett's deep investment genius is telling us, in the face of his public political persona, his view on what form that collapse will take. 

Martin Hutchinson is the author of Great Conservatives(Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition,Alchemists of Loss in both Kindle and print editions. 


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