The Digest #12

Published on March 11, 2020

In Today’s Issue:

  • Coping With Market Meltdowns
  • Berkshire’s Occidental Petroleum Investment
  • Markel Corporation – 2019 Annual Letter
  • Jefferson on Enduring Hardship

To read last week’s newsletter covering the Coronavirus correction, Daily Journal meeting transcripts, and the lack of margin of safety in treasury bonds, please click here.

Coping With Market Meltdowns

The significant volatility in financial markets continued this week with the S&P 500 falling 7.6% on Monday, its worst decline since December 1, 2008. Stocks rallied on Tuesday with the S&P 500 rising by 4.9%. At 2,882.23, the S&P 500 is now 14.9% below its February 19 record high of 3,386.15. Although the recent drop in the stock market has been sudden and severe, the decline at Monday’s low was still slightly less than the 20% traditionally used to mark the start of a bear market.

For millions of individual investors and thousands of professional investors, Monday’s huge drop in stock prices was their first taste of suddenly losing a large amount of money. However, despite the very real concerns that are driving recent volatility, it is unlikely that the intrinsic value of American business can possibly change by such large amounts on a daily basis.

To remain sane and to avoid panic selling, investors need to have a plan for coping with market meltdowns, the subject of a new article on The Rational Walk posted earlier this week which is an update of an earlier article that appeared near the 2009 bear market low. The principles have not really changed over the past eleven years and can be briefly summarized as follows:

  • Know Your Temperament. Successful investors need to have a temperament that permits independent thinking and analysis and does not allow the opinions or actions of others to dictate their own actions.
  • Know Your Investments. Successful investors know their investments.  They do not make investments based on talking heads on television, by reading newsletters, or by taking “hot tips” from their neighbor.  The problem is that knowing your investments takes significant time and effort.
  • The Market Is Your Servant, NOT Your Boss. Mr. Market is a manic-depressive who serves up all kinds of quotations for what you own on different days.  On some days, he is giddy with optimism and offers you a high price and you can choose to buy or sell.  On other days, he is depressed and marks everything down.
  • Understand Intrinsic Value.  What keeps me out of trouble is that I never listen to Mr. Market’s opinion on the value of my holdings.  I really don’t care what the market thinks.  Instead, I keep a spreadsheet of the intrinsic value of my holdings based on my estimates.
  • Don’t Invest the Rent Check!  No one can make intelligent decisions if they do not know where their next rent or mortgage payment is coming from.  The stress would make it impossible.  It makes no sense to put yourself in a situation where you must liquidate long term holdings for short term consumption needs.

Market veterans who lived through the 1987 crash, the 2000-01 dot com crash, and the 2008-09 financial crisis have an advantage over newer investors because they have seen similar volatility before and hopefully have developed ways to cope with meltdowns. There is no substitute for direct experience when it comes to these types of events although reading about the experiences of others cannot hurt. 

Read the full article on The Rational Walk

Berkshire’s Occidental Petroleum Investment

One of the reasons behind Monday’s stock market rout was a price war in crude oil that broke out over the weekend between Russia and Saudi Arabia and sent prices sharply lower. With crude oil in the low $30s, many U.S. based producers face extremely poor economics, especially those that rely on shale deposits.

The United States became the largest producer of crude oil in the world in 2018. In 2019, the U.S. produced over 15 million barrels of oil per day compared to 12 million for Saudi Arabia, with Russia in third place at 10.8 million. However, the cost of production for the shale deposits that have driven recent increases in U.S. oil production is higher than extraction through the traditional methods used in places like Saudi Arabia. The Saudis might not like oil in the low $30s but can still make money.  Many U.S. producers cannot. 

In May 2019, Berkshire Hathaway announced that it would invest $10 billion in newly issued preferred stock of Occidental Petroleum in order to help fund Occidental’s acquisition of Anadarko Petroleum. At the time, Berkshire CEO Warren Buffett said that the investment was a bet on oil prices in the long run stating that “if oil goes way up, you make a lot of money.”

Berkshire’s investment in Occidental closed on August 8, 2019 and a summary of the terms is as follows (Sources: Berkshire Hathaway 10-K and Occidental Petroleum 8-K):

  • $10 billion invested in newly issued Occidental Cumulative Perpetual Preferred stock. Dividends accrue at 8% per annum. The preferred stock is redeemable at the option of Occidental starting at the 10th anniversary of issuance at a redemption price of 105% of par.
  • Dividends can be paid in cash or in Occidental common stock, at Occidental’s option.
  • If Occidental misses a dividend payment, dividends will begin accruing at 9% per annum and will remain at 9% even after the accrued dividends are paid.
  • Warrants to purchase up to 80 million Occidental common shares at $62.50, exercisable in whole or in part until one year after the redemption of the preferred stock.

Berkshire also initiated a position in Occidental common stock in Q3 2019 and reported holding 18,933,054 shares as of December 31, 2019.  

Following this weekend’s crash in oil prices, Occidental common stock declined a stunning 52% on Monday to close at $12.51. On Tuesday, Occidental announced a dividend cut and a reduction in 2020 capital spending and the common stock rose 14.6% to close at $14.34. 

Obviously, Berkshire’s warrants are far out of the money given the current price of Occidental stock and the common stock position is showing heavy losses. However, Occidental’s move to curtail its dividend on the common is positive in terms of its prospects for paying dividends on the preferred stock. Occidental also has significant long term debt of $38.5 billion according to its recently filed 10-K. It is difficult at this point to judge whether Berkshire’s investment in the preferred is secure or not without undertaking a full analysis of Occidental.

Carl Icahn was very outspoken in his opposition to Occidental’s acquisition of Anadarko and has been making bearish statements regarding the stock long before the recent crash in crude oil prices. He has been cutting back on his ownership of the common but still held nearly 22.6 million shares as of December 31, 2019. 

Berkshire’s investment in Occidental might still turn out well but the road ahead is almost certainly bumpier than Warren Buffett anticipated last year.

Markel Corporation – 2019 Annual Letter

Markel recently released its 2019 annual letter to shareholders written by co-CEOs Tom Gayner and Richie Whitt. Markel’s annual letters, which are archived on Markel’s website, have long been known for their candor with respect to the company’s objectives and performance. 

Although Markel has a long history of successful operations, the company suffered a setback with its acquisition of CATCo for $205.7 million in December 2015 which was discussed on The Rational Walk in May 2016. CATCo’s operations involved insurance linked securities (ILS), a complicated financial instrument that was discussed in more detail in the article. The acquisition did not go as planned and CATCo is currently in run-off. 

It is natural for most managers to want to discuss their successes and gloss over failures so it was refreshing to read Markel’s candid assessment of what went wrong at CATCo over the past few years.  Markel has not abandoned the ILS market by any means and its more recent acquisition of Nephila might be seen as “doubling down”.  

Markel is often thought of as a “mini” Berkshire Hathaway due to the company’s successful insurance operations and its Markel Ventures group which consists of a number of non-insurance subsidiaries. Although this article published on The Rational Walk is over three years old, it provides an overview of what Markel has done with its Ventures group.  

Markel may or may not turn into a “Berkshire Hathaway” a decade or two from now but it is worth following closely due to management’s obvious desire to emulate Berkshire’s strategy.

Jefferson on Enduring Hardship

“When we see ourselves in a situation which must be endured and gone through, it is best to make up our minds to it. Meet it with firmness and accommodate every thing to it the best way practicable. This lessens the evil, while fretting and fuming only serves to increase our own torment.”

– Thomas Jefferson writing to his daughter Maria, January 7, 1798

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Copyright and Disclosures

Nothing in this newsletter constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC. 

The Digest #12