In the early stages of the cycle

The market retreated 9% in May. These losses, although painful, largely reflect excessive concerns surrounding the debt crisis in Europe, but also the uncertainty created by the resignation of Indonesia’s Finance Minister.  So with these concerns easing, greater opportunities shall come. Most crucially of all, the economy is doing well and is even expanding at its fastest pace since the 2008 crisis – although still below the very fast growth pace at its peak in 1995 – supported by benign inflation and record low interest rates. Manufacturing is strong and the Manufacturing Index rose an impressive 5% in 1Q10 YoY – its largest increase since 1Q08. Exports are at a decade high. Fiscally, things are in good shape and the Debt-to-GDP ratio has fallen to only 28%. Bank lending has been prudent with loans growth of 21% p.a. over the last 5 years. All in all, we believe the economy is in an early stage of a 7-year cycle, meaning strong earnings growth to come. On the political front, there are inevitably some frictions from time to time, but huge gains in achieving political stability have been made. Using a bottom-up approach, we arrive at a new index target of 3,193, implying 15.5x 2010 PER. As we will argue later, there is upside to this target, stemming from the anticipated economic expansion which will surely lead to earnings upgrades.

May 2010, source: Danareksa

Buffett’s worst year

Berkshire Hathaway reports a rough, down 2008, cheered up by preferred-stock investments Buffett likes.
By Carol Loomis, senior editor at large

NEW YORK (Fortune) — Berkshire Hathaway reported today that its net worth fell in 2008 by $11.5 billion, a decline reducing its per-share book value by 9.6%. That was Berkshire’s worst result in the 44 years that Chairman Warren Buffett has run the company and, in fact, only the second decline in that period. The other drop was 6.2% in 2001, a year hurt by 9/11 and other problems in Berkshire’s insurance operations.

Per-share book value changes are the customary way that Buffett reports the company’s results because this method incorporates all of Berkshire’s capital gains and losses whether they are realized or not. A large decline in the value of Berkshire’s stock holdings was indeed the central reason that Berkshire reported a down year.

Under the more commonly used yardstick, earnings (which do not reflect unrealized gains or losses), Berkshire reported profits of $3,224 per share for 2008 against $8,548 in 2007.

Berkshire’s profits stemmed mainly from interest and dividends on its investments and the earnings of its 70 operating subsidiaries. Berkshire has extensive holdings in two industries, insurance and utilities, whose earnings are not closely correlated with those of the general economy.

Even so, the total pretax earnings of all Berkshire’s operating businesses (not including insurance for this calculation) fell by a bit, from just over $4,000 per share to just under that figure. The decline reflected the sagging results of the many Berkshire operations that are being hurt by a sour economy, among them those in housing-related businesses (Johns Manville, Shaw Industries) and retail (including furniture, jewelry, and candy companies).

Berkshire’s (BRKA, Fortune 500) shares have taken a beating. The A stock dropped from $142,000 at yearend 2007 to $96,600 a year later, and in 2009 it has fallen further, closing at $78,600 yesterday. From its top of $151,000, hit in late 2007, the stock is down 48%.

In his chairman’s letter, Buffett states that 2008 had good points mixed in with the bad. But in an unusual admission for the opening pages of the letter (a point easily recognizable by this writer because she has edited Buffett’s letter for 32 years) he says bluntly, “During 2008 I did some dumb things in investments.”

The dumbest, he said, was buying a large amount of ConocoPhillips stock when oil prices were near their peak and in no way anticipating the dramatic drop in prices that subsequently occurred. Buffett said he still thinks the odds are good that oil will sell in the future at much higher prices than the $40 to $50 per barrel now prevailing. But even if prices should rise, he said, “the terrible timing” of the Conoco purchase has cost Berkshire several billion dollars.

Berkshire data show that the company entered 2008 with 17.5 million Conoco (COP, Fortune 500) shares and ended with nearly five times that many, 84.9 million shares. At yearend, when Conoco stock was about $52, Berkshire’s unrealized loss on all its shares (both those bought in 2008 and earlier) was $2.6 billion. But the stock closed yesterday at $37.40. If Berkshire still owns all its Conoco shares, the unrealized loss has grown to $3.8 billion.

That hammering may psychically bother Buffett the most — he detests making faulty judgments about stock prices — but Berkshire’s biggest financial blows in 2008 came from two of the company’s long-time holdings: The market value of Berkshire’s American Express (AXP, Fortune 500) shares fell by $5 billion, and its Coca-Cola (KO, Fortune 500) stake sank by $3 billion.

Berkshire’s huge position in Wells Fargo (WFC, Fortune 500) suffered very little in 2008, but has been hammered this year. The 304 million Wells shares that Berkshire owned at yearend 2008 have lost well over half their market value, falling from $9 billion to $3.65 billion. Berkshire’s stake in U.S. Bancorp (USB, Fortune 500) is down by around $800 million.

The good points about 2008 for Berkshire? Well, Buffett had been long looking for places to invest the company’s bulging granary of cash, and the tumbling prices in 2008 provided him opportunities (a word obviously not fitting the Conoco purchase). In the fall, inking a deal announced earlier in the year, he put $6.5 billion into Wm. Wrigley Co., by means of 11.45% subordinated notes (that was $4.4 billion of the investment) and preferred stock that pays a 5% dividend ($2.1 billion) and carries upside possibilities that have not been disclosed. The investments helped finance Mars Inc.’s purchase of Wrigley.

The preferred stock opportunities expanded after the financial world fell apart in September. On October 1, Berkshire bought $5 billion of Goldman Sachs preferred paying a 10% dividend and acquired warrants — exercisable for five years — to purchase 43.5 million common shares for $5 billion, a price per share of $115. Goldman has been well under that price most of the time since and closed yesterday at $91.

In a similar deal, carried out on October 16, Berkshire purchased $3 billion of General Electric 10% preferred and acquired warrants — again, good for five years — to buy 134.8 million common shares of GE for $3 billion, a price per share of $22.25. GE’s stock, weighed down by GE Capital (which, in loans, is effectively the fifth-largest bank in the nation), has been a general disaster since and closed yesterday at around $8.50.

To finance all those purchases, store up for a $5 billion acquisition of utility Constellation Energy that fell through, and keep Berkshire’s operations well supplied with cash, Buffett felt obliged, he said in his letter, to sell some portions of holdings that he would have preferred to keep. Principally, he said, the stocks sold were Procter & Gamble, Johnson & Johnson, and Conoco. Berkshire’s positions in all three were established in the last few years, though the P & G holding materialized when that company merged in 2005 with Gillette, whose stock Berkshire had owned since the early 1990s.

The paradox of Buffett’s investment year will be evident: To put Berkshire’s pile of cash to work at prices he considered attractive — “I like those preferreds,” he said recently — he had to endure a terrible stock market that savaged many of the stocks the company already held. He has always declared, though, that he is perfectly content to see Berkshire’s stocks fall in price, because that allows him to buy more of them cheaply.

CHANGES IN THE ANNUAL MEETING: Buffett also announced in his letter that new procedures will be used in the question periods at Berkshire’s annual meeting on May 3, in Omaha. Three journalists will collect questions e-mailed to them by shareholders; choose the most interesting and important; and ask them of Buffett and Berkshire vice chairman Charles Munger, neither of whom will have been told what the questions will be.

The questions the journalists select will be alternated with others asked directly by shareholders chosen by a drawing held the morning of the meeting. Previously, all questions were asked by sleep-deprived shareholders who lined up at the meeting arena until the doors were opened and then raced to microphones to establish a priority position. Buffett said in his letter that he had concluded “sprinting ability” was not a good determinant for who should get to ask questions.

The three journalists are the writer of this article, Carol Loomis of FORTUNE (who, as previously noted, has long edited Buffett’s annual report letter — without pay, by the way); Becky Quick of CNBC; and Andrew Ross Sorkin of The New York Times.