David Sokol and Berkshire Internal Controls

The David Sokol situation has raised any number of issues -- not the least of which is the nature and efficacy of Berkshire internal controls. Interestingly, Sokol discussed them in some detail during his March 31 CNBC interview.

JOE Kernan: There's a lot of, there's other employees as well. This brings up, or begs the question to a lot of people about what Berkshire's internal controls are on employee purchases —

.....

SOKOL: I mean, Warren and (Berkshire CFO) Marc Hamburg furnish us a list of stocks that we are restricted on. Any companies that, you know, that apparently Warren or historically Lou Simpson, or now Todd Combs, or whoever, is invested in, ah, that, you know, we can't ever buy or sell without first contacting Mark. This certainly wasn't one of those companies.....

.......

SOKOL: That's right. In fact, I have no authority whatsoever. I couldn't spend a dollar of Berkshire's money buying, buying a security tomorrow.

It is not publicly known if Berkshire audits the trading activity of its named insiders with respect to companies on the 'list'. But if not, it could be accomplished in a relatively short time. It is reasonable to believe it could be done in a matter of hours -- with the cooperation of insiders, if it hasn't already been done.

Piecing together Berkshire's investment process, it is based on extreme concentration of decision making regarding capital allocation. Buffett (and Munger) make the decisions, with Simpson and Combs running a small portfolio.

Buffett is also famous for what is an unusual decision making style. These are well known and include:

1. Doesn't do auctions or hostile takeovers.

2. Doesn't talk (extensively) without a selling price.

3. Isn't interested in pitches involving publicly traded companies.

4. Extensively uses publicly available financials.

5. Uninterested in the types of work done by most stock analysts.

Of special note is this comment which has been included in his published acquisition criteria for years:

We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.

Considering this as well as the new information that Berkshire uses a control system for public companies based on a list -- the effectiveness of Berkshire's systems in the past are explainable.

If Berkshire insiders refrain from trading in stocks on the list, and given that Buffett/Simpson/Combs are the only decision makers regarding publicly held companies, then the only real possible candidates for "front running" are Berkshire acquisitions of public companies in which Berkshire currently has no position.

Over the last decade, that has included Clayton Homes and Burlington Northern (which would have presumably been on the 'Hamburg' list) which makes for a very short list.

This approach is an interesting variant on the well known separation of duties principle. It is reasonable to assume that Berkshire has established industry standard accounting controls. Their overall thrust is to eliminate the opportunities for insider trading.

Contrast this with a typical asset manager. They have their own analysts, use proprietary data, methods, and processes, and delegate significant parts of the process over a number of employees.

Berkshire's home office has only 20 employees, none of them (except Marc Hamburg) senior executives. I would assume that they are aware of numerous proposals -- so many that it is likely that they would be of little value to typical traders. Among other things, Berkshire is frequently mentioned in the press as a potential savior of a doomed company -- the last hope of imploding companies.

So -- how does this relate to Sokol?

One thought is that Sokol, who has no experience in financial or investment firms outside the totally unique environment of Berkshire, inferred that anything not proscribed by the Hamburg list was fair game. Of course this is speculative, but Sokol's behavior is very difficult for me to explain any other way.

More specifically, he lacks the usual motivation and associated behavior associated with insider trading. He doesn't need the money, and the amounts involved, while significant, are not material to Sokol's personal wealth -- and certainly not sufficient for him to take huge personal risks. More importantly, he made no effort to hide his trading.

His actions are consistent with that of a person that was simply unaware of the significance of his trading. This is not an excuse, but a hypothesis.

The 'Hamburg' process -- a proscribed list of publicly traded securities -- may be a clue to how an intelligent man could behave so recklessly.

Berkshire has a system that explicitly proscribes insiders from trading in specific securities. The also have a principle based standard that no one should do anything that they would be uncomfortable reading about on the front page of the New York Times. Sokol has now had the opportunity to to do exactly that. Whatever else is said, it couldn't have been comfortable.

Normalized Earnings - Berkshire Hathaway 2010 Annual Report

Warren Buffett is fantastic at making arcane accounting accessible to an average investor. But it can be hard to go from his big picture analogies to the detailed figures that make up the published financials.

This year he introduced an important new metric to the report -- Normalized Earnings. He offers no details on how he came up with the figure, ($12 billion), but it is simply another approach to separate the noise of short term fluctuations from the underlying, core value of the firm.

This figure is another approach to complement the two principle metrics he has always used. That is -- for the short term, operating earnings and for the long term, change in book value (shareholder equity).

Buffett defines normalized earnings as, "... a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006." And he has selected a figure of $12 million as his estimate.

He once again discusses the long term (46 years) metric he has consistently shown at the beginning of each annual report -- change in Book Value.

"To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance....Yearly figures, it should be noted, are neither to be ignored nor viewed as all-important. The pace of the earth’s movement around the sun is not synchronized with the time required for either investment ideas or operating decisions to bear fruit."

To demonstrate the value of this metric over intermediate time periods, the report (page 5) includes the exact same data aggregated into rolling 5 year periods. This exhibit is striking in regard to the extent to which the figures stabilize and present a much clearer picture of past performance.

This works particularly well for Berkshire, since it doesn't pay dividends. Book value is the aggregate of the entire financial history of the firms -- and includes all capital gains -- both realized and unrealized. And all the exceptions that are typically excluded from operating earnings.

Later in the report, a discussion of operating earning vs net earnings repeats numerous prior discussions:

"Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours."

Net earnings are a GAAP figure that is meaningful for most businesses, but is severely flawed for a firm with a large investment portfolio and atypical derivative contracts. Operating earnings exclude the change in derivative liabilities as well as realized capital gains and losses.

Since 2006, Berkshire has issued a press release with the non GAAP operating figures reconciled with the GAAP net income figures. They have included this statement (from 2007):

"In our earnings summary, we distinguish between what we call “operating earnings” and investment and derivative gains/losses. Berkshire possesses a huge reservoir (about $35.5 billion on June 30, 2007) of pre-tax unrealized investment gains. The cashing of these in any given quarter (or the realization of losses, for that matter) can materially distort net income figures as well as comparisons between periods. We do not wish investors to mistakenly focus on a bottom-line number affected by large investment gains that do not stem from economic accomplishments during the reporting period and that have no concurrent impact on the intrinsic value of the company. Both trends in our operating businesses and their health are best judged by income before all investment gains or losses."

The only thing missing from this explanation is the implicit assumption that the only additional information is the latest quarter's data. Everything else has already been published and presumably included in valuation of the company. Another way of stating this is that over a single quarter, operating earnings are much more appropriate for a firm like Berkshire than GAAP net income. The quarterly press releases stress this both in quarters where the headline net income figure is higher as well as lower than operating earnings.

Page 33 of this years annual report:

This is a GAAP exhibit and reconciles the balance sheet to the income statement -- and illustrates the various items that impact the change in book value other than net income. The largest is 'Other Comprehensive Income" and includes unrealized capital gains -- which is shown in detail on page 33:

Note that over the 3 year period, the largest items - unrealized capital gains/losses and their tax impact - net to a modest figure. This reflects the market crash in 2008 as well as the stock market recovery in 2009 and 2010.

Net income is clearly a better proxy for earning power (for lack of a better term) than comprehensive income. However, it includes realized capital gains/losses and derivative gains and losses. And also remember that GAAP is designed for all businesses in all industries -- and most businesses don't have any derivatives and have modest capital gains/losses.

" After-tax investment and derivative gains/losses were $1.87 billion in 2010, $486 million in 2009, $(4.65) billion in 2008, $3.58 billion in 2007 and $1.71 billion in 2006."(page 27)

The net income for 2010, 2009, and 2008 of $13.0, $8.1, and $5.0 billion, less derivative and investment gains/losses, are the operating earnings of $11.1, $7.6, and $9.6 billion. The three year average net income was $8.7 billion vs average operating earnings of $9.4 billion.

The 2010 operating earnings of $11.1 billion as well as the three year average of $9.4 billion provide a lot of support for the new metric, normalized earnings, estimated at $12 billion.

[end of part 1]

BP -- Relief is Two Weeks Away

It is likely that two developments during the first half of July could effectively end much of the uncertainty regarding the oil spill. The first is the relief well, which is, according to BP technical executive Kent Wells, proceeding better that anyone could have hoped for.

Since June 17th, when the #1 relief well was drilled to 15,900 feet (measured distance from sea level), the following progress has been made.

1. The 13" casing was set in cement.

2. The remaining distance of less than 2,000 feet has been drilled to within 600 to 800 feet measured distance to the planned intersection point.

3. The distance from the Macondo well has been closed from about 200 feet to about 16 feet.

4. 3 or 4 ranging runs have been completed. A ranging run involves pulling the drill string and attaching a special ranging tool to determine the exact location vis a vis the Macando well.




Remaining tasks include the following:

1. Drill 600 to 700 feet parallel to the Macondo well.

2. Take ranging runs as needed.

3. Stop within 50 feet of the planned intersection and cement the final casing (liner).

4. Intersect the well bore and kill with mud, then cement.

Based on the success of the past two weeks, it is reasonable to expect that the relief well operation will continue to make relative rapid process.

In addition to the relief well, which would end the leakage into the Gulf, the BP subsea containment effort is close to capturing the vast majority of the remaining leakage. The current liminting variable is their ability to process oil brought to the surface.



To that end, BP has all the infrastructure in place to connect the Helix Producer to the kill line from the blowout protector, attached to subsea manifolds and a floating riser, and increase their processing capacity by about 20,000 b/d.

It is likely that this will result in all the oil that can be produced using the current 'top cap' can be processed. If this is done and if the total leakage is less than 45,000 b/d, then the amount of oil leaking into the Gulf will be minimal. In addition, the uncertainty regarding the well float rate will be resolved with a high level of confidence.

According to BP, the only issue regarding implementation of the Helix Producer are high seas from Hurricane Alex. They have said they need 3 days with seas of 3 feet or less (the current waves are in the 6 feet to 8 feet range.

Based on recent history, the BP subsea containment effort has consistently run into delays, so the possibility of problems using experimental technology remains high.

The investment thesis of this is based on the fact that the media is taking an very pessimistic view of the likely outcome of the oil spill. And, there are still risks involved. All the things that have been discussed at length in the popular media could happen. The worst case is not reflected in the current price of the stock.

However, the relatively better outcomes discussed in this post will be discounted sooner rather than later. Take advantage of uncertainty while it is still weighing heavily on this stock with the knowledge that better outcomes are significantly more likely than relatively worse outcomes.
________________________

The primary sources for this are BP and Government press releases. Diagrams modified from BP diagrams. The author has options positions on BP.

Off Topic - A good way to Bicycle in the North Chicago Suburbs

It is so simple, I can't believe it took me so long to figure it out.

1. Drive with your bike to Sheridan Road.,

2. Park.

3. Ride around on the other side of Sheridan. Toward Lake Michigan.

The older suburbs on Lake Michigan are great places to cycle. On the other side of Sheridan, there is no on street parking (at least in places like Lake Forrest). So, park on the other side of the street and you can bike in a fabulous setting.

These suburbs don't do something gauche like have gates. They carefully filter out the traffic and people by subtle barriers. By the time you get to Sheridan, you have made it. They use all tactics -- one way streets, 3 increasingly more efficient ways of going north/south (I94, 41, Green Bay Road) to discourage through traffic. etc.

I just started biking close to my vehicle since the weather has been shaky lately. This encouraged me to just randomly park the vehicle (too embarrassingly large to admit-but a rental) on an attractive street and just go from there. I keep as close as it seems prudent to the vehicle and just explore.

The streets next to the Lake are very well maintained. The landscaping is immaculate. Very little traffic. This is the perfect place to casually cycle.

From the Archives:

On May 8th of last year, Richard Kline had this to say to me:

May 8, 2009 at 6:12 am
So cap vandal, there are so many problems with the putative positives you advance here regarding the stress-less tests that I’m going to pass on the rest of that list. But let’s just review:

No one said that most of the $8T in assets in the banking system are bad. The problem is that the concentration of loss is in the major financials which are holding the rest of the system, the government, and the country hostage to their busted dreams. Your rhetorical attempt to stuff the desperate losses of the Big Few under the skirts of the weary solvent many does you no credit.

Your reference to mortgage backed securities and their supposed absence from the system as a cause for relief is misconceived. This is well known, yes: most of that paper was on-sold. —And then the Big Lost Few turned around and wrote CDS swaps against those securities for face or against the bonds of those securities purchasers for face, so guess where the ‘loss’ on those securities will progressively boomerang back to? Now the bulk of those losses haven’t been realized yet because the tranching structures of those MBSs were designed to absorb the first losses internally and on the small players. Which is exactly why the Big Few are putting us through this whole dismal charade of ’solvent today, my friends’ to raise capital _before those swap losses_ are put to them. Think that THOSE exposures were adequately accounted for in these ‘tests,’ my friend? If so, I’m sure that Citi has a slice of preferred they’d love to sell you cheap. Or even dear (I mean why not, the public gets the bill?).

Then there is the matter of securitized LBO debt you haven’t managed to drag into the discussion, quite a lot of which is left on the sometime ’speculation’ banks (which is what they should be called). Think that those are marked to market, especially when the minders of accounting standards were dragooned into ‘mark and let mark’ practices?

In view of these small further matters, without even going into other relevant Concerns, that $6B at Wells, yes that $75 headline ARE COMPLETELY MEANINGLESS NUMBERS. They are numbers for the media and the rubes, but not meaningful estimates of probable losses. If you added a zero on the right end to that Wells raise we might be talking the real money. If it was indeed large private capital standing on the sidelines about to buy in to the six at Wells, I would tell its deployers, Please don’t: start your own clean major bank with it, and make a killing. Although given all the money floating around from the public put to the Big Few which they aren’t investing in the real economy, I suspect that we will have considerable shadow purchases funneld through the hedges to prop up each others equity, here. No smart money is going to buy into Wells, but others in the same boat have every incentive to take public money and quitely support each others’ capital to make the whole show go on.

The problem we have here, my friend, is that the entire core of the financial system has become an aggregated slime mold of formerly distinct Enrons, bloated 100 times larger.

And your assurance that large private capital would ne-eev-eerrrr invest in the banking system again if they were nationalized is . . . music to my ears, that sounds about right. We need a banking system which serves the country, not a greed parade that hollows it out. Most of those folks: they’re working with Other Peoples Money anyway, not their own. That money will flow to real return, and real returns will return to the banking system to attract them when said banking system is sound. Which it is not and will not be so long as sham shows like this ‘fooled yah’ examination are promoted by a government which still, as of today, refuses to regulate the financial industry in any meaningful fashion. And that outcome, my friend, sucks dynamite.

I'm not going to address Richard's points in detail. In fact, as critics go, his post was articulate and representative of the better as opposed to the worse [from my perspective] commenters.

It sounds alarmist today. On May 8th, it wasn't far from the blogosphere mainstream.

That's one reason I quit blogging. I just didn't have the energy to keep up with the shrillness. Plus, some of my premature bullishness started to be confirmed by the markets, and just sitting on my long positions was proving more profitable than trading.

What a difference in 4 months.

I'm Back....

To my loyal readers, I am back from an extended break.

No one wants to hear, "I told you so." and being right is not a good way to be popular. Still, there are times that you just can't resist.

As far as I can tell, I'm the only financial blogger that praised the "stress tests." The KBW index looks good since May 7th.

So, I'll just say it.

I was right. Find someone else with something good to say about the stress tests from that period, if you can. Or else, a little credit from my critics on "naked capitalism"

Especially those that accused me of hopeless naivete. That plus being oblivious to the facts and an apologist for banking swine.

However, owning long positions for one's own account and acting on one's opinions can provide a certain highly pleasurable reward that is MUCH better than extracting some sort of recognition from the blogosphere.

More on Roubini....

With regard to the stress test being consistent with the IMF estimates, consider the following from the blog Alea:

Still, it is useful to know whether our estimates are consistent with what has been found by others. Two studies released within the last few weeks essentially bracketed the supervisory estimate. The International Monetary Fund estimated lifetime losses that would imply a loan loss rate for U.S. banking firms of about 8 percent in a stressed scenario. One of the major rating agencies estimated an annual loan loss rate of about 4-3/4 percent in a stress scenario for the next two years.  More broadly, our informal survey of the results of a considerable number of private-sector studies and analyst reports published over the past several months generally placed our projected loss rates for key portfolios near the midpoints of the ranges of these independent estimates.