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Buffett's guide to bottom fishing
Wondering which investing bet to make next? Just watch how Warren Buffett navigates the turbulent market while angling for lunker returns.
By Jim Jubak
We know what stocks Warren Buffett has been buying lately. In the third quarter, he added to his stakes in American Standard (ASD, news, msgs), Iron Mountain (IRM, news, msgs), Omnicom Group (OMC, news, msgs), Dover (DOV, news, msgs), Nike (NKE, news, msgs) and The Gap (GPS, news, msgs), according to Securities and Exchange Commission filings.
Typical smart Buffett buys. Companies with solid cash-flow businesses -- like plumbing maker American Standard and diversified manufacturer Dover. Or companies with global brand names in need of a turnaround, such as The Gap and Omnicom.
We also know what stocks hes been selling. Buffett cut his positions in Jones Apparel Group (JNY, news, msgs), Costco (COST, news, msgs) and Sealed Air (SEE, news, msgs) in the last quarter. Looks like Buffett might think the discount-retailing sector has seen the best of its run and that the court troubles at Sealed Air are serious.
And, most interesting of all, we know where this great value investor has been bottom fishing: the energy and telecommunications sectors.
Learning from the master
By watching Buffetts deals, we can put together what I call Buffetts rules of bottom fishing -- a guide to opportunities and risk in the most battered sectors of this market.
Rule 1: The biggest opportunities are in companies that are running out of cash.
For instance, MidAmerican Energy Holdings, a company affiliated with Buffett, bought Dynegys (DYN, news, msgs) Northern Natural Gas pipeline for $928 million plus the assumption of $950 million in debt. Dynegy itself had paid $1.5 billion plus assuming debt when it purchased the business.
Why the bargain price? Dynegy is selling off assets as quickly as it can to prop up an extremely shaky balance sheet that threatens to send the entire business into bankruptcy. That would put all the companys assets into the hands of creditors.
Other Buffett deals with Williams Cos. (WMB, news, msgs), Level 3 Communications (LVLT, news, msgs) and CenterPoint Energy (CNP, news, msgs) (named Reliant Energy until recently) have been with similarly cash-strapped companies.
CenterPoint, for example, had to pay off part of its existing debt to maintain its $4.7 billion bank credit line. No debt paydown, and the credit line would have expired on Nov. 15. No wonder CenterPoint signed a financing deal with Buffetts Berkshire Hathaway (BRK.A, news, msgs) and Credit Suisse First Boston on Nov. 8.
Rule 2: Get paid to take risk.
Investors can use the CenterPoint deal as a benchmark for the kind of return that Buffett is looking for in these deals. Berkshire Hathaway and Credit Suisse bought a $1.3 billion senior secured credit with a three-year term that pays a minimum of 12.75% a year.
A five-year Treasury, in contrast, now yields about 3%.
Rule 3: Do everything you can to reduce that risk.
Buffetts getting paid junk-bond returns on this deal, but hes not taking on junk-bond risk. Hes carefully worked to eliminate as much risk as he can.
First, he did away with interest-rate risk. The CenterPoint deal pays a floating rate of Libor -- short for an interest-rate benchmark called the London inter-bank offered rate -- plus 9.75 percentage points. If inflation kicks in and rates rise, so does Buffetts payout. If rates fall, Buffett still gets paid a minimum of 12.75%, since the credit guarantees a Libor minimum of 3%.
Second, he did away with much of the credit risk. His loan is secured by second-mortgage bonds on a CenterPoint Energy electrical-utility subsidiary. If CenterPoint itself goes belly-up, Berkshire and Credit Suisse stand a good chance of getting a major part of their money back.
Be like Buffett even without Buffetts bucks
Most of us dont have $1.3 billion to pump into a troubled utility or telecommunications company, but we can still profit from Buffetts deals if we understand what these three rules are telling us.
The best opportunity to maximize return and minimize risk, I think Buffetts deals say, isnt in common stock but in the debt market. Thats because the biggest challenge facing companies -- and one that a company will fork over a big premium to meet -- is how to pay down all that debt on the balance sheet.
The debt market is also especially attractive because debt instruments come in so many flavors. Theres unsecured debt, secured debt, floating-rate debt, convertible debt and more, and all these combinations help investors find a way to take on no more risk than theyre comfortable accepting -- or than theyre getting paid for.
If youre going to bottom fish, Buffetts deals say, cash is the best bait right now. And debt is the right equipment for reeling in high returns with controlled risk.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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