Wednesday, December 9, 2009

FORBES: Buffett"s Deadman"s Hand

Martin T. Sosnoff, 02.13.09, 12:00 PM EST

It"s not exactly aces and eights, but Warren Buffett is holding some nice cards.

The headline of this column is a touch melodramatic; after all, Warren Buffett is two-handed.

His left hand is shaky, holding on to his five largest positions valued at over $41 billion. Several dropped more than 50% these past 12 months. So-called defensive holdings like Procter &Gamble (nyse: PG - news - people ) and Coca-Cola (nyse: KO - news - people ) were market performers, declining over 30%. Wells Fargo (nyse: WFC - news - people ), American Express (nyse: AXP - news - people ) and ConocoPhillips (nyse: COP - news - people ) turned into mini-disasters, down more than 50% from year-ago highs.

I like Buffett"s right hand much better. It holds multibillion-dollar positions in convertible preferred stocks and debentures in capital-starved financials like Goldman Sachs (nyse: GS - news - people ) and Swiss Re. Although Buffett is on record that the stock market is in a fundamental buying range, over the past several months tens of billions got earmarked for defensive, fixed-income investments with equity kickers. In short, Berkshire Hathaway"s (nyse: BRK - news - people ) portfolio seems headed closer to a balanced construct rather than pure equities.

Investors can learn a lot from this gambit. Obviously, we odd lotters can"t negotiate privately issued convertible preferreds with 12% yields. But we can buy A-rated preferreds like those from JPMorgan Chase (nyse: JPM - news - people ) and Viacom (nyse: VIA - news - people ) yielding 9%.

Not that these issues stand free of risk: All bank preferred stocks carry the risk of nationalization by the federal government if the bank"s tangible net-worth ratio to risk assets melts away. Viacom"s cable programming franchise could erode, and advertising revenues may drop 20% or more this year.

Serious investors crave yield, starved with 10-year Treasuries at 3% and Treasury paper maturing within five years, adjusted for inflation, in negative yield territory. Even single-A corporates yielding more than 6% months ago now rest below 5% after a major rally. The yield disparity between 10-year, low-investment-grade corporates and Treasuries has closed from 350 basis points to approximately 200--still sizable, but no longer a bargain.

Like all successful investors, Buffett faces the dilemma of inventorying low-basis cost equities. He"s lived by the rule of never selling any viable security even if it"s temporarily overpriced. Growth bails you out if you"re patient, but forever?

I got caught up in this spider web, and it turned sinister a year ago when my inventory in Google (nasdaq: GOOG - news - people ), Apple (nasdaq: AAPL - news - people ) and Celgene (nasdaq: CELG - news - people ) headed south. Google and Apple, even after the past month"s rally, stand schmeissed in half from high water marks.

The disparity between growth and value indexes widened dramatically since year-end, now approximately 1,000 basis points. Investment performance for value players was destroyed by the financial sector"s toxicity.

Wells Fargo"s acquisition of Wachovia (nyse: WB - news - people ) may not be as disastrous as Bank of America"s (nyse: BAC - news - people ) deal for Merrill Lynch (nyse: MER - news - people ) but its commercial real estate loans made at top of the cyclical valuations in 2006 to 2007 remain shaky along with Wells" home mortgage portfolio. Credit card losses for American Express are piercing through conventional loss-reserve allocations, unlikely to top out before mid-2010 as unemployment levitates.

Berkshire Hathaway holds another $25 billion market value in P&G, Coca-Cola and ConocoPhillips. Earnings continue to disappoint for these three properties. Oil stocks currently discount $60 oil with futures now ticking at $40 a barrel. The best diversification play P&G has unveiled is a car-wash franchise--not exactly mind-blowing. In a long recession, Coke drinkers cut back and keep jugs of ice water in the refrigerator. Bottled water demand is shrinking, no longer a growth driver. The most complimentary thing you can say is that these properties no longer are overpriced.

In the present volatile market setting, the tried and true investment concept of defensive investing is on the table for re-evaluation. Even prescription drug demand is under attack. Users break tablets in half, cutting back on their daily intake. Kraft and other consumer food purveyors of high-end products experience contraction in their product lines.

Only Campbell Soup (nyse: CPB - news - people ), McDonald"s (nyse: MCD - news - people ) and Wal-Mart (nyse: WMT - news - people ) escape declining sales as consumers trade down. Mr. Sam"s kosher frankfurters are a hit item currently. Delicious! The big box in my locale, Kingston, was mobbed last Saturday morning while the main floor at Saks (nyse: SKS - news - people ) stood deserted. At Lowe"s (nyse: LOW - news - people ) I couldn"t spot a sales person on the floor.

Like Buffett, I put capital into beaten-down financials, but I"m taking much more risk in the face of rising premiums for insurance underwriters and banks to hedge out risk on real estate and commercial mortgage-backed securities and variable annuities.

I own Goldman Sachs equity and debentures, JPMorgan"s preferred stock, MetLife (nyse: MET - news - people ) and, lately, Allstate (nyse: ALL - news - people ). Allstate is so risky I dare not buy it for clients. The possibility of a dividend cut, equity dilution, more credit downgrades and even insolvency stare you in the face.

I got away with buying the HMO Aetna (nyse: AET - news - people ) when the fear of major losses in its bond portfolio and commercial real estate led to major short-selling. Aetna touched down at $14 and now trades at $32, still selling at eight times this year"s earnings power. Sometimes it pays to be counterintuitive and do what seems at the time to be sheer stupidity.

Last week, Cisco (nasdaq: CSCO - news - people ), an iconic property, reported disappointing numbers--earnings down 30%--and the stock rallied! Numbers weren"t any worse than the Street expected. Parsing the quarterly report, I noted management cut back on overhead. R&D, selling and administrative expense lines were flat compared to a year ago. Cisco may be selling at 15 times earnings, but in a normalized setting it"s at 11 times, an attractive valuation.

Anyone who believes the economy turns at mid-year needs intensive counseling. Buffett turning to fixed-income securities with equity kickers suggests the equity market again faces upstaging this year by other asset classes--even gold, oil and the dollar perhaps, but above all by corporate debentures and preferreds.

Beware of high-yielding common stocks. Analysis shows defensive stocks yielding 7% or more underperform because their dividend-paying capacity is suspect. General Electric (nyse: GE - news - people ) is a good example because it is paying 100% of its earnings at a time when it should be conserving capital. Are outside directors still sleeping on this issue?

The irony in all this is that well-heeled investors didn"t need Madoff in their lives. Low double-digit rates of return existed outside of Ponzi operators. I just wish there was more non-financial paper available in the universe.

Unlike Buffett, I won"t put more than 5% of my assets in any financial house that may crumple for the count of nine if not 10. The list is too long and still expanding. If nothing else, Citigroup (nyse: C - news - people ), Bank of America and AIG (nyse: AIG - news - people ) have made obsolete the euphemism "faded blue chip." These are colorless, shattered chips.

These days, not even the expression "Nobody Buries Disneyland" seems airtight.

Martin T. Sosnoff is chairman and founder of Atalanta/Sosnoff Capital, a private investment management company with more than $9 billion in assets under management. Sosnoff has published two books about his experiences on Wall Street, Humble on Wall Street and Silent Investor, Silent Loser. He was a columnist for many years at Forbes magazine and for three years at the New York Post. Sosnoff owns personally and Atalanta Sosnoff Capital owns for clients the following stocks cited in this commentary: Goldman Sachs, JPMorgan, Viacom, Google, Apple, Celgene, McDonald"s, Wal-Mart, MetLife, Allstate, McDonald"s, Aetna, Cisco, and Disney.

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