Berkshire Likely to Bounce Back After S&P Downgrade

By Don Miller
Associate Editor
Money Morning

Berkshire Hathaway Inc. (BRK.A, BRK.B) could lose its "AAA" credit rating from Standard & Poor's Inc. after the ratings agency lowered its outlook on the company to "negative" from "stable."

But it’s unlikely the change has anything to do with the fundamental health of the company. Pundits were quick to point out that the rating was more about the current economic upheaval, than it was Berkshire itself.

"Pretty much any company in the world has to have a negative outlook at this point.  It’s a reflection of the economy more than it is something that’s happening at Berkshire Hathaway,” American University finance professor Gerald Martin told Bloomberg News.

In fact, even as it issued the downgrade, S&P left the door open to revising the rating back to stable “if the value of the group's substantial equity investment holdings were to stabilize or improve … in a reasonable period of time.”

S&P late Tuesday assigned the lower rating to Warren Buffett’s Omaha, NE-based investment company, as well as its largest operating companies: Berkshire Hathaway Finance Corp., and Berkshire's core insurance companies, including Berkshire Hathaway Assurance Corp.

The downgrade wasn’t totally unexpected as it followed a recent one-notch downgrade by Fitch Ratings.   At the time, Fitch also hastened to temper its remarks about Berkshire, sounding almost apologetic in announcing the downgrade. 

When it announced the move on March 12, Fitch said Berkshire was part of a "broader review of insurance and financial services company ratings" that had been undertaken due to the "current stressful economic environment."

Fitch cited "large, concentrated equity investments" and "various derivative contracts" that have generated large "mark-to-market" losses in Berkshire's earnings numbers. In 2008, Berkshire profits fell 62% and the company’s net worth dropped 9.6%, making it the worst year for the firm since Buffett took over in 1965.

But while it is well known that Buffett is not a big believer in diversification, Fitch’s criteria would make it difficult for Berkshire, or any other financial company, to hold onto a triple-A rating in the current storm, no matter what it does or doesn't do.

Indeed, after General Electric Co.'s (GE) downgrade by S&P, only five companies including Berkshire still have triple-A ratings from both S&P and Moody's Corp.(MCO): American Data Processing (ADP), ExxonMobil Corp. (XOM), Johnson & Johnson (JNJ), and Toyota Motor Corp.(ADR: TM).

The Fitch announcement also acknowledged that Buffett is almost certain to make money on a Goldman Sachs Group Inc.(GS) deal and a similar investment in GE made late in 2008, each of which pays him a 10% dividend annually on his investment.

The release echoed Buffett's own prediction that long-term investments will rebound in value years from now so that "the ultimate economic effects, while uncertain, are likely to be significantly less than indicated by the marks." 

Nevertheless, there’s no denying Berkshire’s recent losses as fourth-quarter net income fell 97%, stemming mainly from paper losses on derivative contracts tied to stock market indexes, and Berkshire's equity holdings, such as American Express Co. (AXP) and Wells Fargo & Co. (WFC). 

Buffett himself has said that last year’s market performance was devastating, with losses in everything from corporate and municipal bonds, to stocks, real estate and commodities. He recently wrote in his annual letter to stockholders how “investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.”

In the mean time, there’s strong speculation on Wall Street as to why Moody’s – the third of the three ratings giants – remains silent, despite the recent downgrades.  There’s a strong feeling that the silence is related to Berkshire’s position as Moody’s biggest shareholder, owning 20% of its stock.

“On the subject of the conflict of interest built into the rating agencies' business model, Mr. Buffett has been uncharacteristically silent,” financial columnist David Segal wrote recently in The New York Times, suggesting no one's reputation is totally immune from the worst bear market in a generation – not even the "Oracle of Omaha."

Still, even though there has been an increase the “short interest” against Berkshire stock, not many are willing to bet against Buffett long-term.

Justin Fuller, a partner at Midway Capital Research and Management LLC, says that anyone buying shares of Berkshire now is getting the company at 2004 prices and everything that Buffett acquired since then for free.

“During the dot-com boom everyone said the old man had lost his touch,” Fuller told The Times, “When all the brick-and-mortar stock valuations improved, he was lauded as a genius again. He’s able to recognize these manias … and then comes in as lender of last resort and scoops up assets on the cheap.”

That strategy has paid off for Buffett and Berkshire over the years.  According to Berkshire’s Web site, the company’s shares show an overall gain of 362,319% from 1964-2008, which would have grown an original investment of $19 a share to $70,530, including splits.

News and Related Story Links:

• Bloomberg:
  Buffett’s Berkshire May Lose AAA Rating From S&P.

• Business Wire:
  Fitch Downgrades Berkshire Hathaway to 'AA'.

• Berkshire Hathaway:
  Shareholder Letters.

• New York Times:
  Buffett Is Unusually Silent on Rating Agencies.

• Money Morning:
  By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?

• Money Morning:
  Buffett’s Goldman Deal Has Big Benefits, but What Else is Berkshire Up To?

• Investopedia:
  Short Interest.