Warren Buffett (Trades, Portfolio) has a reputation for buying bargains and then holding them for long periods, sometimes even holding them “forever.”
But, there are exceptions. In chapter 15 of “The New Buffettology,” authors Mary Buffett and David Clark explored his selling moments. First, though, they listed three reasons why he might sell stocks:
- The price is high enough.
- A better opportunity emerged.
- Economics of the business changed, negatively.
How high is too high? Buffett believes stocks that traditionally sell for 10 to 25 times earnings are overpriced when their price-earnings ratios get above 40 times earnings. It’s his cue that it’s time to sell, near the top. More specifically, when stocks get above 40 times earnings, it is unlikely there will be earnings or earnings growth to support such a valuation.
Consider the case of Coca-Cola (KO, Financial) in 1998 (as the boom was heating up):
- Shares were trading for around $88.
- The price-earnings ratio was 62, well above Buffett’s alert line of 40.
- Earnings were $1.42 per share.
- Earnings were growing at an average 12% per year.
At the end of 10 years, the company could be expected to produce a compounded $24.88 in total. Is that good or bad? Buffett, who believes assets must be compared across classes, compared this return with what he would earn if he bought a corporate bond paying 6%. After 10 years, the bond would return $52.80 — obviously far more attractive than $24.88, meaning he would rather own corporate bonds than Coca-Cola stock.
Of course, all of these are dynamic numbers. Any change in any one of them will change the relationships. For example:
- The lower the price-earnings ratio, the more attractive the stock becomes, and vice versa.
- At some point, as the price-earnings ratio declines, the stock becomes more attractive than bonds, and vice versa.
- If earnings per share increase, the stock becomes increasingly attractive, and vice versa.
- The same dynamics hold for bond yield data.
Following up on one of these elements: The authors reported that if Coca-Cola’s earnings were growing quickly enough, say 30-40% per year, then the 62 times earnings might be rational. However, Buffett also knows that companies with durable competitive advantages rarely would achieve earnings growth of that magnitude.
At the time “The New Buffettology” was published in 2002, Buffett had made two major disinvestments. The first occurred in 1969 as a decade-long bull market was topping out, and before the stock market collapsed in 1973 and 1974. It was a prescient move; he sold stocks that had reached price-earnings ratios of 50 or more, and a couple of years later they were down in the single digits. This was the occasion in which Buffett told his investors everything in the market was too expensive and sold everything, to the regret of the investors who had done so well with him.
The second occasion came in 1998, when the dot-com boom was making everything in the market very expensive, including Coca-Cola at $88 per share. Again, some of the stocks in the Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) portfolio were trading at price-earnings ratios of greater than 50, and as we saw, Coca-Cola was trading at 62 times earnings. And it wasn’t the only one: American Express (AXP, Financial) was trading for 54 times earnings and Gillette was trading for 108 times earnings.
Selling these stocks would pose a problem: He had bought low and planned to sell high, which would have produced some wonderful capital gains, but also trigger large capital gains taxes. In addition, selling his stocks in large enough volumes to make a difference to his portfolio could cause those prices to collapse, which in turn would depress the share prices of Berkshire.
However, Buffett being Buffett, he came up with a creative solution. As the authors wrote, “He brilliantly sold a huge interest in the company’s portfolio for 100% of cash-rich insurance giant General Reinsurance in a tax-free transaction.”
The authors outlined the broad strategy this way:
“The solution was to find an insurance company loaded with bonds that would be willing to be acquired by Berkshire in exchange for its shares. Why bonds? Because bonds could easily be turned into cash at a value that was neither overvalued nor undervalued.”
General Reinsurance met that criterion, with $19 billion of bonds on its books.
Buffett called the CEO of General Re and offered to buy the whole company for $22 billion in Berkshire stock. That deal looked attractive to General Re’s management since their stock was currently trading for $220 a share, versus $283 per share for Berkshire. In addition to the other advantages for Buffett in the deal, he also gained 82% of the insurance company’s business.
As an aside, there was an interesting twist to this deal, which was that Berkshire shares were overvalued because many of its stocks were overvalued. The authors pointed to this as an example of Buffett’s slyness; however, it seems unlikely the always forward-thinking Buffett would make any deal that would produce ill will on the other side. Certainly, the General Re shareholders who kept their Berkshire shares would have enjoyed a wonderful ride over the following 20 years.
Finally, the authors told us Buffett managed to make this a tax-free merger, but did not provide specific information.
About
Mary Buffett and David Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor” (Mary Buffett is a former daughter-in-law of Warren).
This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.
Disclosure: I do not own shares in any company listed and do not expect to buy any in the next 72 hours.
