Question

Summarize two topics you found to be most noteworthy in this reading. Must be in own word(200words).

Buffet Essays I. Preferred Stock

When Richard Branson, the wealthy owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: "There's really nothing to it. Start as a billionaire and then buy an airline." Unwilling to accept Branson's proposition on faith, your Chairman decided in 1989 to test it by investing $358 million in a 91/4% preferred stock of USAir. I liked and admired Ed Colodny, the company's then-CEO, and I still do. But my analysis of USAir's business was both superficial and wrong. I was so beguiled by the company's long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point: USAir's revenues would increasingly feel the effects of an unregulated, fiercely competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline's past record might be. ([Again, if] history supplied all of the answers, the Forbes 400 would consist of librarians.) To rationalize its costs, however, USAir needed major improvements in its labor contracts-and that's something most airlines have found it extraordinarily difficult to get, short of credibly threatening, or actually entering, bankruptcy. USAir was to be no exception. Immediately after we purchased our preferred stock, the imbalance between the company's costs and revenues began to grow explosively. In the 1990-1994 period, USAir lost an aggregate of $2.4 billion, a performance that totally wiped out the book equity of its common stock. For much of this period, the company paid us our preferred dividends, but in 1994 payment was suspended. A bit later, with the situation looking particularly gloomy, we wrote down our investment by 75%, to $89.5 million. Thereafter, during much of 1995, I offered to sell our shares at 50% of face value. Fortunately, I was unsuccessful. Mixed in with my many mistakes at USAir was one thing I got right: Making our investment, we wrote into the preferred contract a somewhat unusual provision stipulating that "penalty dividends"- to run five percentage points over the prime rate-would be accrued on any arrearages. This meant that when our 91/4% dividend was omitted for two years, the unpaid amounts compounded at rates ranging between 131/4% and 14%. Facing this penalty provision, USAir had every incentive to pay arrearages just as promptly as it could. And in the second half of 1996, when USAir turned profitable, it indeed began to pay, giving us $47.9 million. We owe Stephen Wolf, the company's CEO, a huge thank-you for extracting a performance from the airline that permitted this payment. Even so, USAir's performance has recently been helped significantly by an industry tailwind that may be cyclical in nature. The company still has basic cost problems that must be solved. In any event, the prices of USAir's publicly-traded securities tell us that our preferred stock is now probably worth its par value of $358 million, give or take a little. In addition, we have over the years collected an aggregate of $240.5 million in dividends (including $30 million received in 1997). Early in 1996, before any accrued dividends had been paid, I tried once more to unload our holdings-this time for about $335 million. You're lucky: I again failed in my attempt to snatch defeat from the jaws of victory. In another context, a friend once asked me: "If you're so rich, why aren't you smart?" After reviewing my sorry performance with USAir, you may conclude he had a point. We continue to hold the convertible preferred stocks described in earlier reports: $700 million of Salomon Inc., $600 million of The Gillette Company, $358 million of USAir Group, Inc., and $300 million of Champion International Corp. Our Gillette holdings will be converted into 12 million shares of common stock on April 1. Weighing interest rates, credit quality and prices of the related common stocks, we can assess our holdings in Salomon and Champion at yearend 1990 as worth about what we paid, Gillette as worth somewhat more, and USAir as worth substantially less. In making the USAir purchase, your Chairman displayed exquisite timing: I plunged into the business at almost the exact moment that it ran into severe problems. (No one pushed me; in tennis parlance, I committed an "unforced error.") The company's troubles were brought on both by industry conditions and by the post-merger difficulties it encountered in integrating Piedmont, an affliction I should have expected since almost all airline mergers have been followed by operational turmoil. In short order, Ed Colodny and Seth Schofield resolved the second problem: The airline now gets excellent marks for service. Industry-wide problems have proved to be far more serious. Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity- type product, it's impossible to be a lot smarter than your dumbest competitor. However, unless the industry is decimated during the next few years, our USAir investment should work out all right. Ed and Seth decisively addressed the current turbulence by making major changes in operations. Even so, our investment is now less secure than at the time I made it. Our convertible preferred stocks are relatively simple securities, yet I should warn you that, if the past is any guide, you may from time to time read inaccurate or misleading statements about them. Last year, for example, several members of the press calculated the value of all our preferreds as equal to that of the common stock into which they are convertible. By their logic, that is, our Salomon preferred, convertible into common at $38, would be worth 60% of face value if Salomon common were selling at $22.80. But there is a small problem with this line of reasoning: Using it, one must conclude that all of a value of a convertible preferred resides in the conversion privilege and that value of a nonconvertible preferred of Salomon would be zero, no matter what its coupon or terms for redemption. The point you should keep in mind is that most of the value of our convertible preferreds is derived from their fixed-income characteristics. That means the securities cannot be worth less than the value they would possess as non-convertible preferreds and may be worth more because of their conversion options. Berkshire made five private purchases of convertible preferred stocks during the 1987-91 period and the time seems right to discuss their status. In each case we had the option of sticking with these preferreds as fixed-income securities or converting them into common stock. Initially, their value to us came primarily from their fixedincome characteristics. The option we had to convert was a kicker. Our $300 million private purchase of American Express "Peres" . . . was a modified form of common stock whose fixedincome characteristics contributed only a minor portion of its initial value. Three years after we bought them, the Peres automatically were converted to common stock. In contrast, [our other convertible preferred stocks] were set to become common stocks only if we wished them to-a crucial difference. When we purchased our convertible securities, I told you that we expected to earn after-tax returns from them that "moderately" exceeded what we could earn from the medium-term fixed-income securities they replaced. We beat this expectation-but only because of the performance of a single issue. I also told you that these securities, as a group, would "not produce the returns we can achieve when we find a business with wonderful economic prospects." Unfortunately, that prediction was fulfilled. Finally, I said that "under almost any conditions, we expect these preferreds to return us our money plus dividends." That's one I would like to have back. Winston Churchill once said that "eating my words has never given me indigestion." My assertion, however, that it was almost impossible for us to lose money on our preferreds has caused me some well-deserved heartburn. Our best holding has been Gillette, which we told you from the start was a superior business. Ironically, though, this is also the purchase in which I made my biggest mistake-of a kind, however, never recognized on financial statements. We paid $600 million in 1989 for Gillette preferred shares that were convertible into 48 million (split-adjusted) common shares. Taking an alternative route with the $600 million, I probably could have purchased 60 million shares of common from the company. The market on the common was then about $10.50, and given that this would have been a huge private placement carrying important restrictions, I probably could have bought the stock at a discount of at least 5%. I can't be sure about this, but it's likely that Gillette's management would have been just as happy to have Berkshire opt for common. But I was far too clever to do that. Instead, for less than two years, we received some extra dividend income (the difference between the preferred's yield and that of the common), at which point the company-quite properly-called the issue, moving to do that as quickly as was possible. If I had negotiated for common rather than preferred, we would have been better off at yearend 1995 by $625 million, minus the "excess" dividends of about $70 million. In the case of Champion, the ability of the company to call our preferred at 115% of cost forced a move out of us last August that we would rather have delayed. In this instance, we converted our shares just prior to the pending call and offered them to the company at a modest discount. Charlie and I have never had a conviction about the paper industry-actually, I can't remember ever owning the common stock of a paper producer in my 54 years of investing-so our choice in August was whether to sell in the market or to the company..., Our Champion capital gain was moderate-about 19% after tax from a six-year investment-but the preferred delivered us a good after-tax dividend yield throughout our holding period. (That said, many press accounts have overstated the after-tax yields earned by property-casualty insurance companies on dividends paid to them. What the press has failed to take into account is a change in the tax law that took effect in 1987 and that significantly reduced the dividends received credit applicable to insurers. For details, see [Part V.H.].) Our First Empire preferred [was to] be called on March 31, 1996, the earliest date allowable. We are comfortable owning stock in well-run banks, and we will convert and keep our First Empire common shares. Bob Wilmers, CEO of the company, is an outstanding banker, and we love being associated with him. Our other two preferreds have been disappointing, though the Salomon preferred has modestly outperformed the fixed-income securities for which it was a substitute. However, the amount of management time Charlie and I have devoted to this holding has been vastly greater than its economic significance to Berkshire. Certainly I never dreamed I would take a new job at age 60-Salomon interim chairman, that is-because of an earlier purchase of a fixed-income security. Soon after our purchase of the Salomon preferred in 1987, I wrote that I had "no special insights regarding the direction or future profitability of investment banking." Even the most charitable commentator would conclude that I have since proved my point. To date, our option to convert into Salomon common has not proven of value. Furthermore, the Dow Industrials have doubled since I committed to buy the preferred, and the brokerage group has performed equally as well. That means my decision to go with Salomon because I saw value in the conversion option must be graded as very poor. Even so, the preferred has continued under some trying conditions to deliver as a fixed-income security, and the 9% dividend is currently quite attractive. Unless the preferred is converted, its terms require redemption of 20% of the issue on October 31 of each year, 1995-99, and $140 million of our original $700 million was taken on schedule last year. (Some press reports labeled this a sale, but a senior security that matures is not "sold.") Though we did not elect to convert the preferred that matured last year, we have four more bites at the conversion apple, and I believe it quite likely that we will yet find value in our right to convert.

Answer 1

Topic 1: Making money in AIrline Industry

-Start with explaining why the airline industry has been a net loss making business for its investors

-Then go on to discuss case of USAir which Buffet had bought and why he considered it a bad investment

-Discuss about how cost structures of the airline industry in US were primitive and had not caught up with the market dynamics of the industry

-Discuss how businesses such as airline which were previously regulated, need to change their strategy and operations to operate in a competetive unregulated enviornment

-Further talk about how difficult it is to be better than your competitor in a commoditized business and costing is the only variable on which you can be better

Topic2: Preferred Dividends

-Start with mentioning how Berkshire has a lot of investments in preferred stocks of companies such as USAir, GIllette, Salomon ect.

-Discuss why Buffet and Munger consider Preferred a good bet compared to other fixed income securities, as they provide better yeilds

-Then discuss how the value of preferred is not just the value of the underlying stock but also on the basis of its conversion option which can be very valuable

-Discuss how its not always better to buy preferred when you know that the underlying business is really promising such as Gillette as a common can give better returns in such case

-After that, discuss how holding preferred stocks can also be counter productive as they might not be really good investments even if they gve good yeild due to the king of time required to monitor them