Year to date Berkshire equity portfolios are demonstrating reasonable success versus their benchmark, as we’ve generated a slight positive return versus a market thats down slightly and choppy.

 On a security basis, about 2/3 of our selections are ahead of the market, with notable strength in selected financials, consumer staples, and domestic airlines. Stocks that are lagging the market include a major car rental concern and a domestic wireless carrier. In both cases we think the valuation/risk trade off still warrant ownership in our portfolio.

The relatively soft (but not disastrous) economic data released of late validates the average positioning of the portfolio. We are allocating client capital to big liquid companies with global footprints that we believe can generate high returns on capital, healthy free cash flow and dividend growth even in the face of economic headwinds. We believe the energy and commodity space do not possess this ability and earnings estimates are too high against the back drop of deleveraging, excess global capacity and tight credit.

Two companies in our portfolio made announcements this week.  

JPMorgan Chase (JPM) held an investor presentation whereby they articulated their outlook. The bank estimates its normalized earnings power is over $5.50 per share. We estimate, over time its true worth is over 10 times that number. The bank reiterated that provisioning remains adequate and credit conditions are stable to improving.  

Coca Cola (KO) announced their intentions to buy the North American operations of their largest bottler in a transaction valued at nearly $13 billion. The stock fell on the news. We think the transaction makes the company more capital intensive, reduces returns, and could weigh down earnings until 2012.  KO believes the model of simply collecting royalties by selling concentrate to its bottlers in an increasingly niche oriented and fragmented beverage market no longer makes sense. These products require more control over the bottling, marketing and distributions according to the company.   

 We welcome your comments and questions.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

Our thesis on the airline industry is working out and the stock prices have demonstrated strong momentum of late.

There were two important themes to our purchase some time ago – falling oil prices and capacity cuts. We wanted to own companies whose earnings were sensitive to falling oil prices (as opposed to those who hedge). This has worked out and every 5$ drop in crude adds significantly to the earnings for many carriers. It is ironic but it was actually high fuel prices that put the airlines in the more favorable position they are in now. They forced the carriers to cut capacity, right-size their fleets which lowered their overall cost structures and firm up pricing.

These tough measures were all being implemented before the economy turned down. Additionally, as the economy really started to decline, oil prices fell even faster than anticipated which helped out even more.

As an added bonus, many companies have successfully embarked on various cost cutting initiatives. These are making meaningful improvements to the bottom line. The rough environment experienced over the last few years have forced the carriers to be disciplined in capacity and cost cutting, and they’ve made meaningful strides.

Now, volumes have either stabilized or increased. That’s a combination which creates a tremendous amount of earnings leverage – particularly as the companies swing to profitability. We still recognize these are extremely risky companies with weak balance sheets, but believe if their fundamentals continue to stabilize they may still have some additional appreciation potential.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in airline stocks.

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

For stocks it sure seems like it. On the front page of today’s (12/20) Money & Investing Section of the Wall Street Journal, there is a great visual bar chart of stock market returns by decade. Guess which one ranks dead last? The 2000′s ending December 15, 2009. Its annualized decline of -.5% per year so far eclipses even the declines of the 1930′s! Similarly, the November 24th issue of Time Magazine ran a cover story called “The Decade from Hell.”

We’d like to think with improving (but not great) fundamentals and lower (but still not screamingly cheap) valuations, stocks are set up to do better in the next ten years than the last ten (not a high bar!). So if ever there was a time to say  “out with the old and in with the new”, this would be it!

Remember the guy in 2000 who predicted the Dow would go to 35,000? It was Harry Dent, author of The Roaring 2000’s. In that book, he argued that in the long run, stocks are no more risky than bonds, and therefore should have the same discount rate applied to their earnings. Conceptually his math was correct. If you apply a very low discount rate to a stream of earnings (or cash flow), you can produce enormous theoretical stock market values. It is now obvious his inputs into his discounted cash flow model were way off. His book was published right around the peak of the market in 2000.

So what is the good news? According to Forbes Magazine, Mr. Dent now has a book called, “The Great Depression Ahead.” He predicts the Dow is going to 3600. Let’s hope this prediction turns out to be as a good a contrarian indicator as his last one was.

Michael Lewis, author of Liars Poker, Money Ball: the Art of Winning an Unfair Game, and The Blind Side: Evolution of a Game, has once again put forth an important work that yields keen insight into the inner workings of Wall Street.

Lewis has compiled an excellent anthology of articles from modern day financial crises. Lewis reprints (along with some of his own commentary) some of the seminal news articles, white papers, interviews and government reports from past financial panics such as: the 1987 Stock Market Crash, The Asian Currency Crisis of 1997-1998, The Russian Debt Crisis of 1998, the Collapse of Long Term Capital, The “Dot-com” Crash of 2000, culminating in the current Sub-Prime Mortgage Crisis which unfortunately is not quite over.  Lewis lays out the articles in a way that captures the mood and sentiment before, during and after each crisis.

A few things are striking about the book. The first is the format. The anthology format allows the reader to skip around and focus on areas which are the most interesting to him. For example, I enjoyed the finer points of the policy dilemmas facing monetary officials during the Asian Debt Crisis. Do you raise interest rates to defend your currency (at the expense of already weakening exports), or lower them (and risk massive capital flight and deleveraging?) Lewis’s experience as a bond trader at Salomon Brothers yielded some very interesting insights into the debacle at Long Term Capital (“How the Egg Heads Cracked” which Lewis personally wrote for the New York Times in 1999.)

The second is how eerily similar each crisis seems to unfold. It’s almost as if there is a custom made template for financial panics. All you need to do is fill in new dates, the new financial instrument and change the names. The story is almost always the same: 

• A new financial innovation or asset class gains prominence.
• There is a view the innovation has tamed risk.
• The innovation produces fantastic gains for institutions.
• There is a central figure who rises to “rock star” like status and fame (think: Henry Blodget, Jack Grubman, and Michael Milken).
• Stories of ordinary citizens getting obscenely rich proliferate through the main stream media (“dot-com” day traders, Beardstown Ladies, condo flipping bar tenders etc.).
• A prominent member of the financial community stands up and warns of impending risk.
• They are ridiculed and dismissed.
• The bubble bursts.
• Panic ensues.
• The fall out is viewed as destabilizing to the overall financial system and the real economy.
• Congressional hearings begin.
• Society spends considerable resources trying to figure out how this could happen. It turns out no one knows how the first domino falls. The only common denominator seems to be a massive under pricing of risk. Lewis’s opening commentary on quantitative risk management (Value at Risk, Black Scholes etc) is particularly on point.
• Most importantly, once the panic ensues, in almost all cases, there is a prevailing view that the crisis is absolutely insurmountable.
• The storm passes.
• A new bubble forms.

My only complaint about the book is that it did not address the Real Estate Crisis of the early 1990’s, or the bursting of Japan’s Real Estate Bubble, both of which are much more akin to what is happening in America now.  Much of the book revolves around panic surrounding financial and quantitative innovation, however.

What are some of the broader perspectives investors can take away from reading the book? Risk cannot be tamed through mathematical models. They simply cannot predict how humans will react and adapt while under stress.

Panics crashes as well as opportunities have been around for centuries. The list of panics is long and they happen with alarming frequency.  The names, faces, dates and values change from crisis to crisis, but the story line stays the same. While this current crisis is a nasty and deep one, investors would be wise to remember the predictable story line of “Panic” also includes the word “Recovery.”

-Gerard Mihalick, CFA

Stocks were again volatile last week. The S&P 500 closed at 879 versus its close of 876 last Friday. The Dow closed at 8629, essentially unchanged from the prior week. There were plenty of gyrations throughout the week though.

For 2008, the S&P 500 and Dow are now down 40% and 35%, respectively. The S&P is up nearly 20% from its low of 741 which was reached in November. This intraday low actually eclipses levels dating all the way back to 2002.

The week started off with a large rally when President-elect Obama unveiled his plan for a large stimulus which focuses on infrastructure and energy build outs.

Later in the week, selling pressure began to mount. All eyes turned to the fate of the US automakers and potential economic fallout if they were to collapse.

Tension and selling pressure accelerated Thursday. Bank of America announced its plans to cut 35,000 jobs over three years (largely merger related). Also, JP Morgan CEO Jamie Dimon discussed that the U.S. bank is having a “terrible” November and December, blaming the “normal culprits:” mortgages, credit, high yield bonds and loans.

Friday morning, news that the Senate killed the auto bailout plan sent stocks sharply lower. Stocks regained their footing after the White House said it would be willing to extend the auto industry funds from the TARP (Troubled Asset Relief Program). The S&P climbed 6.7 points erasing a 3% loss. The Dow climbed 65, while the NASDAQ climbed over 2%.

More broadly, while equity market volatility and bad economic news remains the norm, we are  encouraged by the performance of equities over the last few weeks. There is now resilience, which is noticeably different than the swift and relentless declines witnessed in early to mid fall.

That period was punctuated by panic selling as investors started to come to grips with the depth and magnitude of the problems facing the world economy. Of perhaps greater magnitude, large financial institutions were in the midst of a painful process known as ‘deleveraging.’ Deleveraging is process whereby institutions (particularly hedge funds and large financial institutions) are forced to sell assets to pay down the lines of credit that are being called by their lending facility. Forced liquidations like this (unlike fundamental ones) create a viscous cycle. The more the market declines, the more participants have to sell, and the more participants have to sell the more the market declines. While painful, it is a curative process that takes excesses out of the system, which eventually can allow asset prices to rise going forward.

In contrast, market action from the November lows has been much more constructive. Yes, the market is higher, but even on “down” days the selling appears more “orderly” and not full of panic. Earlier in the fall, sellers met no resistance what so ever and totally overwhelmed any buying activity. The market wound up in what seemed like constant free fall. Not so of late.

Perhaps more importantly, we also are seeing several cases where worse than expected economic or earnings news comes out, yet stocks actually go up.

For example, on December 5 it was reported the economy lost over 530,000 jobs for the month which was far worse than expected. Yet, stocks rose sharply. This may indicate that the forced sellers are out of the market. Hedge funds are reporting high cash balances, which may signal at least a temporary respite from the deleveraging phenomenon.

Or, it may indicate stock prices were already so depressed they reflected horrible economic news – and then some. There is no rule that says stocks have to immediately settle to fair value – dislocations above and below true value can be large and persistent. Perhaps investors now can quantify the depth and magnitude of the recession (which officially began last year) and its impact on earnings (which most expect to be quite severe). This way, instead of worrying about which financial institution will fail next,  we can all look out to the other side of the canyon, and start assessing long term value, which is quite possibly higher than where we are today.

No one knows if we’ve hit bottom, and plenty of challenges remain. News flow will likely be negative for a while. But recent action has been more encouraging, however. If in twelve to eighteen months we are rewarded with substantially higher equity market values, we may look to this period, when stocks stopped going down on increasingly bad economic news that marked the turn.

Important Disclosure: The views expressed in this commentary and www.berkshireobserver.net reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness. Past Performance is no guarantee of future results. Berkshire is an SEC registered investment advisor that manages accounts for individuals, institutions. A copy of our current ADV II is available upon request. References to particular securities are intended only to explain the rationale for the portfolio manager’s views and decisions with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.