Kass' Short Bet on Berkshire Falls Short of Reason

In early 2008, Doug Kass of Seabreeze Partners and TheStreet.com issued a sell short thesis on Berkshire Hathaway (BRK.A) which outlined some of his views as to why BRK was an attractive short candidate. Recently, Kass has come out with some updates on his BRK short with some rather sensationalized titles such as, "Is This the End of Warren Buffett?" Titles like that can certainly generate web traffic but don't change the fact that this sell short call - in the context of the current market - is based on a very weak thesis.

I don't own BRK stock because I've never been able to invest in it when it's been at a price that I felt was truly on sale. WEB [Buffett] may also feel the same way because of his general historical aversion to repurchasing BRK stock. From a strictly philosophical reason, I also feel, as a fund manager, I should be able to find better investments than a $140B mega cap company that has holdings in widely held companies like Johnson & Johnson (JNJ) and Coca Cola (KO).

Second, I believe if a value-oriented fund manager really follows the spirit of WEB's investment style, investing in a company where someone else is basically doing your job for you is not fair to your clients (more importantly, can you see WEB placing any of his capital during his partnership years in a fund-like vehicle managed by someone else?), since they can easily purchase BRK and get a fund-like vehicle without the fees.

Last, while WEB is one of the best capital allocators in the world, the amount of capital he manages reduces the availability of viable investment ideas. Now let's move on to Kass's sell short recommendation.

One issue that investors following Kass on BRK should understand is that when selling short, it's really best to choose companies that have very defined problems which can cause a serious and continued drop in its share price. "Good" companies can certainly have problems as well but it's best to find some key "triggers" that can drive the price down. For example, I had written about Costco Wholesale Corp (COST) as a potential short sale candidate in 2008 and while COST is a good company, there were some specific aspects (inflation pass-through of gasoline prices, food price increases, foreign exchange benefits all overstating earnings) that were leading to juiced operating results. Since the cost for selling short can be high given the risk on upward movements, it's important to identify very tangible triggers for selling short.

It appears that Kass never identified real triggers for selling BRK short. As a result, selling BRK short in 2008 resulted in a stock that generally moved in tandem with the broader market. Moving on to Kass's short thesis, it's important to note that while BRK is down, it still outperformed the S&P and other market indices in 2008, which is impressive not only because so many investors struggled in 2008 but more so because the heart of BRK's business is tied to financial markets and financial stocks across the board generally underperformed broader market indices by a very wide margin. Comparing BRK's performance to financial indices like the XLF ETF further demonstrates how well BRK held up on a relative basis.

CHART I: BRK VS. S&P 500 & XLF

However, the real issue I have with Kass is that some of the key points of his short thesis are drummed up to appear much more foreboding than what they really are and some claims appear to be flat out wrong. Selling short can be a a valuable technique but when discussing the rationale for certain short positions, it's generally important to not misrepresent things in order to make a case. The lack of substance behind many of Kass's claims and the flat out inaccuracies in some areas prompted me to post a quick rebuttal.

For example, Kass's main theme regarding his BRK short is that WEB has engaged in style drift by selling customized put options against a variety of market indices. Style drift basically means stepping out of one's main investment strategy. A fundamental, bottom up investor that starts exclusively using technical analysis to manage a portfolio would be an example. Kass seems to believe that WEB is engaged in style drift because he is utilizing derivatives. In his article "Warren Buffett Has Lost His Groove", Kass points out: "In the process of establishing a large derivative position on the S&P 500 by shorting puts, Buffett has deviated from his long-established investment discipline of avoiding 'market plays' and of avoiding 'financial weapons of mass destruction' (derivatives). This 'play' has led to continued, multi-billion dollar losses over the past few quarters. According to the recently released 10Q, Berkshire has lost a total of $9 billion on Buffett's short put position."

The problem is that Kass's statement regarding WEB's use and view on derivatives is flat out wrong. In his 2002 letter (emphasis mine), WEB stated: “Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies."

So either Kass did not evaluate BRK as closely as he should or he is focused more on betting that the reader won't follow up on their own due diligence and fact check. So the entire notion of style drift could be debunked by quickly reviewing WEB's complete take on derivatives. Irrespective of why Kass would lead his readers astray, selling puts is something BRK has been doing with individual stocks such as Burlington Northern (BNI) recently. More importantly, WEB is likely to engage in any financial transaction where the risk/reward is mispriced.

After this initial flawed, central part of Kass's thesis, the rest of his points are somewhat obvious, low-value statements. Kass highlights "bombs" in WEB's portfolio like The Coca-Cola Company among some weaker financials like American Express (AXP). In "Warren Buffett Has Lost His Groove", Kass states that WEB's "performance over the past five years, and especially over the past year, is beginning to trail off badly." Unfortunately, this, like Kass's claim of WEB's style drift, is wrong as shown by BRK's performance against major indices over the past five years.

CHART II: BRK VS. MARKET INDICES - FIVE YEARS

Kass also asserts that WEB's "salad days" are over, referring to easier money made in the insurance industry in earlier years. About 12-18 months ago this may have been true, but apparently Kass has ignored the massive capital shortfalls facing many of BRK's peers in the insurance industry and how this will ultimately impact BRK's future profits and opportunities. Kass also seems to place no consideration on recently acquired businesses like Iscar and how these will benefit BRK.

Last, and perhaps most significantly, Kass spends far too much time pointing out that many of BRK's stock holdings have dropped in value. Very few stocks rose in value in 2008 so the notion that "bombs" like KO dropped in value is hardly something to base a sell short thesis on. Given that these stocks dropped in value, it's natural to expect that BRK would drop in tandem. This focus also illustrates a major problem with Kass's BRK short that anyone that sells short should consider. While some holdings like Gannett Inc. (GCI) may never rebound significantly, a good portion of WEB's portfolio includes leading global companies such as ConocoPhillips (COP), COST, KO, JNJ, Kraft Foods (KFT), and Wal-Mart Stores (WMT). The point is that when the market rebounds, BRK will follow in tandem with it and could outperform given the number of high quality public holdings held in BRK that complement many of BRK's closely held businesses.

A good short, like Crocs (CROX) or Downey Financial (DSL), would generally keep crumbling once the bad news starts hitting these companies irrespective of what the broader market does, but BRK will most likely move up and rebound with the market. In the case of shorting BRK, Kass would be better off shorting the S&P500 and getting more bang for his buck given the S&P500 fell more than BRK in 2008. However, writing about shorting a common index wouldn't draw nearly as many readers to his web pages.

DISCLOSURE: NONE

Comments

[PROXIMO:]

The Doug Kass thesis on Berkshire may be flawed. I did not read it and have no plans to. I will mention that in February of 2000 in a prominent GROCERY STORE in the town I resided in, I noticed the store had put up a free-standing display with do-it yourself day trading stock kits(manuals, how-to etc.).Right smack in the middle of all the food. About two weeks before the beginning of the dot-com meltdown. Sometimes anecdotal evidence is not all bad. The past year or so, I mean I can't flip on a business tv program without words of wisdom referencing Warren. How many invest-like-Buffett books have been published in the past couple of years? To say nothing of the hundreds, or thousands, of Buffett wannabe money managers proudly, openly claiming WEB style of investment. WEB has forgotten more than I will probably ever know about the financial markets. But I do know he has much financial exposure to the markets, and that there may be more big trouble ahead for the economy, especially the financials. And the stock market with it's derivative investments doesn't give a damn about Buffett's stellar reputation.

Feb 10 12:05 PM

[this articl...:]

Amit I think you missed the point. Identifying the company as an attractive short was a profitable trade. It was somewhat contrarian. That is his style, and commonly leads to attractive relative returns. He did have some bad calls last year, but from what I have read, had positive results overall.

Based on my review of your piece you are suggesting that using options is not style drift. Even though the index puts crushed him, let's concede the issue.

Next, you are using hindsight to say it would of been smarter to short something else. To say it wasnt a short because the entire market crashed...That is not useful analysis. Hindsight is 2020

CROX was a big fat short. But shorting momentum stocks generally gets you crushed Amit. Ask all the guys that were short when that stock doubled. Additionally securing a borrow on CROX when it was ripping was extremely expensive, if not impossible some days.

Don't quit your day job.

Feb 10 12:34 PM

[Alex Filonov:]

Kass made money on this bet, so he is right. He might be wrong long term, but it's completely different matter. My take on it: Kass had a gut feeling that he can make money shorting Berkshire (correct), and he explained that gut feeling to himself and others the way he did (maybe incorrect).
Never forget that there are lots of ways of making money on the market. If you win on the wrong thesis, you still win, and if you lose on the right one, you still lose.
From my point of view, there is a big danger for Berkshire: coming retirement of Charlie Munger and Warren Buffett. That's much bigger danger than anything Kass mentioned. Good manager(s) can always make up losses, bad manager will always underperform the market in the long term. There aren't many managers out there equal to the Munger and Buffett genius.

Feb 10 12:38 PM

[Not Very Br...:]

This article is way off base and should probably be taken down due to how off the author is. To say, "It appears that Kass never identified real triggers for selling BRK short." is wrong from the start. Look at the transcripts and what has been written about BRK's 2007 annual meeting. Buffett openly stated that BRK had the most revenue in its history and did not expect to repeat it in 2008. He said that the insurance revenue would go down. Buffett told you to sell BRK around the all time high (if you need a source read Jeff Matthews book).

Secondly, comparing BRK to the XLF is asinine. The XLF only holds financials, whereas BRK at the time when Kass went short (pre GS position) is only composed of about 35-45% financials. The XLF is a bundle of financials based on market cap, not selected based on due diligence. I'm glad BRK could out perform a passively managed ETF.

With regard to the derivatives exposure, I'm sure Kass has done his research and knows that, "we own about 65 derivative contracts that we believe will be very profitable in the future. (Warren Buffett)" but as of now they are not. They are way out of the money. On puts sold on the 4 major indexes, BRK received about 4-5 billion in premiums and are priced at 8-9 billion loss and could potential be 36 billion loss...not very likely, but possible.

Amit, you also show pretty charts comparing BRK to the major indexes over a 5 year time horizon. Why? Kass openly says how brilliant and amazing Buffett is. I believe he called him an icon. Kass was short for about 8 months. He covered in August. So the 5 year charts mean nothing.

Finally, the whole last paragraph is just plain dumb. Starting with sentence 1. Yes, CROX and DSL would have been great shorts if you were early like Kass, but if you were late and got caught in the massive squeeze when they doubled you are screwed. Also, have you tried to borrow a share of CROX? Second sentence, how do you know he wasn't short the S&P? He is known as the bear of Boca. Third sentence, "writing about shorting a common index wouldn't draw nearly as many readers to his web pages." Isn't this what you are doing? Kass made bank on the trade and you are writing about it having flawed logic 8 months after he covered his last share?

Feb 10 12:59 PM

[bnme:]

Wow. Already a couple of you are falling for the BS on the derivatives. The index puts don't expire until a decent part of a decade later, and more. Not only that, they are Euro puts in that the buyer can't exercise them until expiration, years later. The losses are due to mark-to-market accounting. Also, it was mentioned in various places that BRK doesn't have to post collateral. Berkshire gets $5B to play with for a decade and a half, and the maximum risk is losing somewhere in the $30B range if all the indexes are 0. Buffett liked his odds, and I wouldn't doubt him on that. Also, is writing naked index puts any different than what Berkshire does when it takes big bets in their insurance businesses?

Secondly, the author made a good point (responding to Alex F here) in that Kass would've made more money by shorting the S&P. If we criticize expert advice on the long side that doesn't beat the market, then it is no different to criticize it on the short side. By your logic (Alex), Kass would be right even if he tossed a dart at a stock table. His pick is no better than random, if not worse, since he couldn't beat shorting the S&P.

Kass's pick is no better than pure random luck, so far.

Feb 10 01:03 PM

[Chacer:]

Just a few thoughts - The Dervivates bet is a business that Berkshire has been in for over a decade - he just calls it Super Cat insurance. For Kass to call this style drift shows a failure to understand the breadbasket of BRKA's insurance business. Puts on the S&P=Lloyd's Asbestos=Florida Hurricaines=CA Earthquake. He is paid handsomely to assume those potential losses.

As to "Kass made money on his bet so he is right" - I suppose its true, because the stock went down, but what hasn't. The proverbial chimp could have done as well at picking a short. Mr. Kass, Wow us by saying you shorted BAC at $35

Feb 10 05:24 PM

[ilovesum:]

Kass bet on the momentum of the market and the unresolved problems that were going to continue the downward momentum. Housing , financials , employment , deficit issues were all present , what was the most likely thing to happen?
Shorting Buffett was a chess move and a headline grabber , as the other posts and author have said , he would have done better shorting anything else.
The Berkshire culture will continue.
Buffett and Munger have an ability to find people that have the same philosophy as they do and I wouldn't bet against them or their chosen sucessors.
Do you really think Buffett or Munger give a rats behind about what Doug Kass thinks? They don't , their out their making a fortune.

Feb 10 07:29 PM

[mpharbold1:]

Amit is being criticized way too much here in these comments. I've been tracking him on seekingalpha for the last couple of years and he is about the best if not the best. I distinctly remember his calls on CROX, DSL, and COST. His arguments are well thought out and researched and he has been dead on most of the time.

Feb 10 08:08 PM

[EMS:]

You guys are brothers or cousins, right ?


On Feb 10 08:08 PM mpharbold1 wrote:

> Amit is being criticized way too much here in these comments. I've
> been tracking him on seekingalpha for the last couple of years and
> he is about the best if not the best. I distinctly remember his calls
> on CROX, DSL, and COST. His arguments are well thought out and researched
> and he has been dead on most of the time.

Feb 10 09:17 PM

[Macro:]

What were the returns of Doug Kass and Seabreeze capital? Why does it smell like this roaring mouse of Kass is bitching up WEB's leg in order to attract attention and replace fund withdrawals. He's lucky that WEB is too cordial and busy to take Doug's pathetic ponziclownery on realmoney seriously.

Feb 11 12:21 AM

[Flav:]

Kass is just a deceptive clown. Earlier in 2008, after the Bear Sterns meltdown, he suggested that the market had limited downside. On July, he recommended initiate a long position in financials. He even disclosed he had Citi as one of its holdings (when it was trading near the low 20's). Not satisfied with that, he even disclosed (and adviced initiating) a position in LEH!!!! Want the proof? Here it is: www.thestreet.com/stor...
His sponsor web site exalts him as an investment magician, advertising him as if he had been "right as rain"... with the market falling an astonishing +30%, and running a short only fund, it was kind of impossible to have a bad performance and not beat the market (i think).
What's really ludicrous and hilarious at once, are his investments surpirses, dubbed "outlier" events. He posts a series of delirious events that never actually take place, and assimilates market deveopments to his stupid advice. How in the hell does this person gets all that media attention?
This post is getting too long, but i want to highlight other lousy advices from Mr Kass. These posts are some proof of his misjudgment: www.thestreet.com/stor..., www.thestreet.com/stor..., www.thestreet.com/stor...
Just check the stocks his fund bought at the time it did it. It would be really interesting to see what really was his funds performance, if it really did had thoso holdings on its portfolio

Feb 11 06:51 AM

[hownow:]

Excellent..

..but why stop at XLF ??

..may as well compare BRK with LEH and ask why Kass did not see the obvious short that LEH was..

..um.. how's *your* fund doing ??

Feb 11 09:52 AM