On Posco, Berkshire, and Buffett
Berkshire Hathaway (BRK.B) released its annual report today – by now I expect most of you have read Warren Buffett’s annual letter to shareholders. I’ll discuss the letter as a whole in another post. For now, I’d like to focus on just one line.
First, I’ll need to include the paragraph that precedes that line. Here’s what Buffett wrote before presenting his familiar table of Berkshire’s top common stock holdings:
“We show below our common stock investments. With two exceptions, those that had a market value of more than $700 million at the end of 2006 are itemized. We don’t itemize the two securities referred to, which had a market value of $1.9 billion, because we continue to buy them. I could, of course, tell you their names. But then I would have to kill you.”
I direct your attention to line nine of the table (listed alphabetically) which reads:
3,486,006 POSCO 4.0 572 1,158
Okay. Now, what does this mean? The best way to follow along with this post is to go to Berkshire’s website and open the letter for yourself. The table appears on page 15 of the letter – which is available only as a PDF.
Obviously, this line means that Berkshire owns stock in the South Korean steelmaker, POSCO (PKX). Using an appositive in the previous sentence may be grammatically incorrect, but it is rhetorically honest as POSCO is the South Korean steelmaker. No one refers to it as “a South Korean steelmaker”.
Anyway, this stake in Posco (I don’t capitalize the name, because English speaker don’t capitalize such mixed acronyms – it would actually be “PoSCo” if you used our usual practice and “PoSCo” just looks too weird to print) isn’t all that surprising. From past statements, we knew that Berkshire (had once) owned some Posco, that Buffett was comfortable enough with the name to cite it specifically when referring to South Korean stocks, and that in such statements he more or less said it wasn’t going to go out of business tomorrow.
We also knew that Posco was dirt cheap. Everyone knew that. Every analysis I read that ended with “don’t buy Posco” didn’t argue it was fairly priced, just that it was Korean, a steel company, etc. The argument most often used was that it wasn’t the right time in the cycle to buy Posco. The one argument I never read was that Posco was fairly priced when the ADRs were trading below $65 a share.
Even now, most articles I read trying to explain the improvement in Posco’s share price don’t make much mention of just how cheap this stock was – and it ain’t exactly expensive today, even after quite a run up.
However, I did read one interesting comment today. Apparently, “an official at Posco” told Reuters that Posco didn’t know when Berkshire bought shares in the company. That remark is interesting solely because it suggests (though obviously does not guarantee) that Posco’s management did not approach Berkshire as part of a takeover defense strategy.
Long before I read Buffett’s letter, the thought had crossed my mind that Posco might want Berkshire to take a sizeable position in the company as part of a takeover defense. Buffett is a well known and well respected foreign investor who takes passive stakes and has immediate access to a cash hoard at Berkshire that is close to unrivaled. Years ago, he was involved in several situations where he acted as something of a “white knight”. The U.S. market has never since seen valuations that would make such chivalry an area of extraordinary profitability – but Korea certainly has.
For those who don’t follow Posco or Korea, the company could really use a well known friendly foreign (read “Western”) investor. Obviously, no one compares to Buffett in this regard. Posco’s management would like to discourage a takeover without being accused of being either xenophobic or value destroying. Basically (and I hate to say this) they don’t want to be accused of acting like Korean executives.
So, it’s interesting that the comment from “a Posco official” to Reuters seems to indicate Posco didn’t approach Berkshire. That’s not all that surprising, because Posco’s management wouldn’t naturally think of Berkshire. They’d probably think of Korea, Japan, and the worldwide steel industry as possible sources of assistance. Anyway, I thought it was worth noting that the appearance of the name “Posco” in Buffett’s letter is likely to receive attention on the other side of the world as well as here at home.
Look to the line in which Posco is mentioned (and it’s important to note Buffett does not mention Posco anywhere in the body of the letter – it only appears in this one line):
3,486,006 POSCO 4.0 572 1,158
You’ll want to disregard the first number you see, because it will only confuse you. If you type “Posco” or “PKX” anywhere on the web, you’ll likely be directed to information on the ADR. Berkshire wouldn’t buy the ADR – so, that’s not the security this line is referencing.
Berkshire owns 4% of Posco. That’s what the “4.0” means. This isn’t a particularly large stake for Berkshire (Buffett seems to really like 5-15% ownership stakes). There are rules about foreign investment in Korea that differ considerably from what we are accustomed to in the U.S. I’m not going to discuss them here.
I will, however, take a moment to say that the reason Berkshire’s Posco stake hasn’t been widely discussed (in fact, smaller Berkshire stakes get much more attention) is because of rules on disclosure. Buffett, if fully unfettered, would disclose as little as possible about Berkshire’s operations in marketable securities. Domestically, he’s often unable to maintain the high level of secrecy he prefers. Overseas, the situation is a bit different and Berkshire’s Posco stake is evidence of this fact.
The last two numbers in the above line give the cost of Berkshire’s position in Posco and the market value of that position. From these numbers, we can see that Berkshire’s 4% stake in Posco was acquired at a total cost of $572 million and has a market value of just under $1.16 billion.
Berkshire has a gain of 102.45% on its investment in Posco. So far, Posco has been a winner for Buffett – and yes, it would definitely be Buffett who picked Posco. Here, I should mention something that many (but not all) of my readers already know. Some of Berkshire’s positions are not the result of decisions made by Buffett himself. There’s an excellent stock picker at Geico named Lou Simpson (Buffett references him in this year’s letter – in fact, Buffett references him in just about every letter) who also buys stocks for Berkshire. Occasionally, some of these stocks are erroneously reported as having been bought by Buffett.
Lou Simpson is a great investor; so, I wouldn’t worry too much about whether Buffett or Simpson is the one buying any particular stock – you should take both of them seriously. However, in this case, it seems obvious Posco was Buffett’s decision. Even at cost, we’re talking about a $572 million stake. Also, Posco (at least at the time of purchase – and I’m guessing the bulk of it was in 2005) would have had the kind of profile that Buffett can get comfortable with. While Posco is certainly no cigar butt, it’s much more of a value purchase than the blue chip stocks most closely associated with Buffett’s name in the mainstream media.
Buffett is a much more versatile investor than many people give him credit for. His hands are tied by having a lot of capital to deploy at Berkshire. But, he still manages to surprise by mixing in a USG (USG), Moody’s (MCO), PetroChina, or Posco with the likes of American Express (AXP), Coke (KO), Procter & Gamble (PG), and Wells Fargo (WFC). A lot of people who think they know Buffett couldn’t come up with the first group – almost anyone could come up with the second group.
Finally, let me say that despite the amount of space in this post devoted to a discussion of Posco and its desire to avoid a takeover, I don’t think there’s necessarily any reason to believe that played a part in Berkshire’s investment. Buffett can handle himself in such situations. That’s not why I’m downplaying the white knight idea.
I’m downplaying it, because Posco was just so unbelievably cheap. It wasn’t just cheap relative to other steelmakers, or cheap relative to other huge corporations, it was just absolutely cheap beyond belief. I have no doubt that Posco’s utter cheapness was Buffett’s main motive for buying – he saw a ridiculously cheap stock and he knew he could get a meaningful amount of it for Berkshire. That doesn’t happen everyday – it takes a cheap stock the size of Posco to really interest Buffett these days.
I mentioned in my last post that I started a quarterly newsletter along with this site, but closed up shop after just two issues, because during the third quarter of 2006 the supply of bargains in the market went from a trickle to a slow drip at best. Anyway, the first issue of the newsletter (April 2006) ended with a discussion of Posco. At the time, the ADRs were trading at $63.80. Today, the ADRs are trading over $90.
Now that my newsletter is defunct, I can share the name of Posco with you (I know, $27 a share later, thanks a lot!) and reprint something I wrote about the stock in July of 2006.
I won’t share the original write-up with you, because it’s far too long for a blog and is filled with lots of boring graphs on steel consumption and production by nation and other such tidbits that are likely only of interest to one reader at most (myself included).
But, I will share the short follow-up I included in the July ’06 issue, which includes some of my thoughts on the share price (here, I’m writing about the ADRs – again, that’s not what Berkshire holds):
(NOTE: Remember, this piece was originally published in July of 2006)
There is little point in reviewing the most recent quarterly performance from Posco (PKX). The Korean steelmaker makes news when it reports earnings; but, not because of what those earnings say about the condition of the company itself. The financial media has a strong tendency to take micro stories and turn them into macro stories. In Posco’s case, this actually makes a lot of sense.
In fact, it’s quite difficult for me to find much to write about in any Posco earnings release. Steel is a commodity. Wild price fluctuations are part of the game. There will be good times and bad times. It makes little sense to focus on whether times are good or bad today, because neither elevated prices nor impressive trends will last.
High prices lead to increased production. Strong demand and high prices for the output lead to strong demand and high prices for the input. An investor is bound to take too much from any single earnings release. He will look for trends where none are sustainable. Each time, he will convince himself this time is different.
In the short-run, the macro environment trumps the micro environment. In the steel industry, a rising tide will lift all boats. Both the best companies and the worst companies will enjoy tremendous results when times are good.
The truly important questions, those dealing with a company’s competitive advantages, are difficult to answer in the short-term. These company specific competitive forces only assert themselves over longer periods of time. Each steelmaker is judged by its bottom line. Of course, it would probably make more sense to judge each company by the one thing it has at least some control over – the cost of production. A successful steelmaker is a low-cost steelmaker. This doesn’t mean the company sells cheap steel. It means the company produces the same product at a lower price than its competitors. That’s how a steelmaker has to be measured.
In a few cases, a company possesses some competitive advantages other than low-cost production. Posco is one of those cases. The company operates as a virtual monopoly within the lucrative South Korean steel market. Posco accounts for approximately 75% of Korea’s domestic steel production. Sales within Korea generate the majority of Posco’s revenues. Only about 26% of the company’s annual revenues come from exports. Posco’s two largest export markets, China and Japan, combine for about 15% of the company’s sales. Here too Posco has an advantage. The company can ship to those countries much more quickly (and hence more cheaply) than many of its competitors.
From an investor’s perspective, Posco is the world’s finest steel company. It operates as a near monopoly in an enviable market. The company has a rock solid balance sheet maintained by extraordinarily consistent and robust cash flows. For these reasons, Posco is among the most interesting foreign investments around.
An investment in Posco isn’t a bet on steel. In fact, it isn’t even a bet on Korea. If you had to make a macro bet, you could certainly do worse than steel and Korea. However, you don’t have to make a macro bet. You can instead choose the much simpler task of buying a specific company at a specific price. That’s what led to the inclusion of Posco in the portfolio. It’s a bet on Posco – nothing else.
(NOTE: Remember, this piece was originally published in July of 2006)
Having said that, it’s worth checking in with the steel industry to see if there have been any earth shattering surprises. So far this year, everything has gone about as expected. Posco looks set to post a decline of slightly less than 50% in net income. At least that is what the first half of the year had suggested. Right now, it looks as if the second half of the year may be a bit stronger than I had earlier suspected. The environment in 2007 looks solid. Obviously, this could change.
China is the biggest threat to Posco. Is it an economy out of control? Has it been juiced up with easy money and undisciplined capital allocation? The answer to both of these questions may well be yes. That’s troubling, because a slowdown in China (and hence Chinese demand for steel) would likely coincide with an Asian steel glut. It’s certainly something to watch for over the next few quarters.
For Posco’s shareholders, changes in Chinese steel production may prove to be more important reading than Posco’s own earnings releases. Although Posco primarily serves the Korean market, a slowdown in China coupled with a steel glut would be very unfortunate, because it would affect both Posco’s domestic sales and its export sales. This scenario was my greatest concern in April; it remains my greatest concern in July.
Suggestions
Suggest Buying: $74.00
Consider Selling: $93.00
Best Guess: $124.00
Suggest Selling: $190.00
Okay. First, let me remind you yet again that the above was first published in July 2006 – so, it’s woefully out of date.
Second, a few words are necessary regarding those prices at the end of the piece. In my newsletter, I started using four “suggested prices” with each stock I recommended.
“Suggest Buying” meant: “when the stock is below this price, I suggest you buy it.”
“Consider Selling” meant: “Don’t even think about selling below this price!” This is usually (but not always) the price at which qualitative judgments about future growth and profitability start to play a meaningful role in the buying decision.
“Best Guess” meant: “This is my best guess as to the intrinsic value of the stock”.
“Suggest Selling” meant: “This is the absolute upper limit of a true investment. Once you go beyond this price, you enter truly speculative territory”.
The wide discrepancy between my best guess price ($124/share) and my suggest selling price ($190/share) for Posco is due to my being extremely conservative on the best guess price. Posco at $124 a share probably is fairly valued as a steel company – however, it’s probably not fairly valued as Posco, because Posco is a great steel company even if it isn’t a truly great business.
The one thought I’d like to leave you with is the one that will remain the same regardless of changes in stock prices and steel prices: “From an investor’s perspective, Posco is the world’s finest steel company”. I’ll stick with that statement.