Because if its size and reputation, Berkshire Hathaway [(BRK.A) (BRK.B)] has unique investment opportunities that other companies do not enjoy. Everyone knows Berkshire is a good source of capital when liquidity dries up. Warren Buffett uses these opportunities to do what is best for Berkshire shareholders with respect to preferred stock, warrants, subordinated notes and other investments. The March 31st 10-Q assigns a cost of 16.8b and a carrying value of just over 21.9b to "Other investments" or hybrid investments and we want to look at the positions that make up these totals. Warren and Charlie are not big fans of Black-Scholes but we're going to use it to look at the warrant positions anyhow.
Bank of America (BAC)
Berkshire has 5b in preferred Bank of America stock. The 6% dividends mean Berkshire gets 300m paid per year until BAC redeems the preferred. Once BAC redeems the preferred, Berkshire will be paid 5.25b. We'll round up to 5.3b for this valuation and we're not even counting the dividends. The BAC Aug 25, 2011 8-K talks about this in more detail.
Berkshire also has BAC warrants:
- Risk-free rate: .02
- Spot price: 12.18 as of Mar 28 (Mar 28 was the last trading day of the Mar 31 quarter)
- Strike price: 7.14
- Time to maturity (days): 3,076 (Mar 31, 2013 to Sept. 1, 2021)
- Volatility: .59 per the BofA warrants article by Dr. David Kass
There are 700m of these warrants so that brings the Black-Scholes total to an approximate value of 6.3b as of Mar 31.
We think the BAC total value is at least 11.6b as of Mar 31. This is an incredible home run given the fact that Buffett only paid 5b for this position.
The Wrigley October 6, 2008 8-K doesn't give us a lot of specifics but we can get some details from Berkshire's filings.
The Berkshire 2009 10-K says the 4.4b and 1b of notes are carried at cost:
We own $4.4 billion par amount of 11.45% subordinated notes due 2018 of Wrigley ("Wrigley Notes") and $2.1 billion of 5% preferred stock of Wrigley ("Wrigley Preferred"). The Wrigley Notes and Wrigley Preferred were acquired in 2008 in connection with Mars, Incorporated's acquisition of Wrigley. During 2009, we also acquired $1.0 billion par amount of Wrigley senior notes due in 2013 and 2014. The Wrigley subordinated and senior notes are classified as held-to-maturity and accordingly we are carrying such investments at cost.
We'll conservatively value the 2.1b of preferred stock at cost as well.
For the purposes of this article, we'll look at the value if this preferred is not converted to common. The Dow October 27, 2008 8-K talks about this investment saying the aggregate price was 3b and dividends are paid quarterly in arrears, at a rate of 8.5% per annum. Again, we're not including the present value of dividends in this analysis so we'll say this has a cost and value of about 3b.
Goldman Sachs (GS)
The Goldman Sachs preferred has been redeemed but the warrants are still outstanding:
- Risk-free rate: .02
- Spot price: 147.15 as of Mar 28 (Mar 28 was the last trading day of the Mar 31 quarter)
- Strike price: 115
- Time to maturity (days): 184 (Mar 31, 2013 to Oct 1, 2013)
Volatility: .23 - This 6-month volatility number from Morningstar is subjective. One problem is that it is from the time of this writing instead of from March 31st.
The volatility number is somewhat random but we can be a little bit off with it and still get comparable valuations. For example, if we use .20 for volatility, then we get a value of 33.56 and if we use .30, then we get a value of 34.83.
There are 43,478,260 warrants, so the Mar 31 Black-Scholes total is around 1.47b. We'll round to 1.5b.
General Electric (GE)
The General Electric preferred has been redeemed but the warrants are still outstanding:
- Risk-free rate: .02
- Spot price: 23.12 as of Mar 28 (Mar 28 was the last trading day of the Mar 31 quarter)
- Strike price: 22.25
- Time to maturity (days): 199 (Mar 31, 2013 to Oct 16, 2013)
Volatility: .19 - This 6-month volatility number from Morningstar is subjective. One problem is that it is from the time of this writing instead of from March 31st.
Again, the volatility number might be off. If we use .15 then we get 1.65 and if we use .25 then we get 2.27. Either way, the GE position is very small compared to the others.
There are 134,831,460 warrants, so this brings the total Black-Scholes valuation to around 254.8m.
We'll be conservative and just call it 200m.
16.8b is the total cost according to Berkshire's March 31 10-Q.
The total cost up to this point is over 15b. In order to get to the grand total of 16.8b, we have to add in the cost of the GS and GE warrants. The GS preferred and warrants were purchased for a combined cost of 5b. The GE preferred and warrants were purchased for a combined cost of 3b. Much of this 8b is now out of the picture since the GS preferred and the GE preferred have been redeemed. We're only left with the cost of the warrants.
Approximate Carrying Value Excluding Dividends
1.5b GS warrants
.2b GE warrants
Berkshire is using conservative accounting. Our total is just under 24b, which is higher than Berkshire's carrying value of just over 21.9b. This is significant considering the fact that we're not even assigning a present value to the substantial dividends.
It is beyond the scope of this article to measure these positions precisely. Still, this should help investors see that the BAC and Wrigley positions are huge while the GE position is tiny.
Berkshire's 2009 10-K says these positions exceed short-term opportunities for investment income:
In 2009, we acquired a 12% convertible perpetual security issued by Swiss Re for $2.7 billion, an 8.5% Cumulative Convertible Perpetual Preferred Stock of Dow for $3 billion and senior notes of Wrigley due in 2013 and 2014 for $1.0 billion. Investment income generated by these investments will greatly exceed income currently earned on short-term investments.
Buffett is making no secret of the fact that these hybrid investments are excellent. Swiss Re was out of the picture by March 31 but the Wrigley and Dow investments are a big part of this article.
I am grateful to Greg Feirman for his help analyzing these hybrid investments.