A couple of weeks ago, it was announced that Fitch, a small credit rating agency, downgraded Berkshire Hathaway’s (BRK-B) credit rating. Standard and Poor reportedly is following suit. I’ve heard Warren Buffett brag on numerous occassions, including in his most recent shareholder letter, that Berkshire is one of only 6 non-financial companies with a AAA credit rating (the others are Automatic Data Processing, Exxon Mobil, Johnson and Johnson, Microsoft and Pfizer – General Electric recently loss theirs as well). Now that credit rating is in jeopardy.
The reason Fitch gave for the lowered rating was based on potential liability for the book of derivatives owned by Berkshire, as well as the the company’s aging leadership. I’ll address these issues one at a time. Derivatives are basically an insurance contracts that mirror a specific asset. Buffett’s derivatives are reportedly tied to the overall performance of the market. His potential liability is great, but based on what I’ve read, the market would have to go all the way to zero for Buffett to incur the maximum liability. Derivatives are very complex intstruments that are difficult for investors to understand. Buffett himself, has said that when a book of derivatives gets large enough, no one can understand it. Buffett feels that he understands the small book of derivatives at Berkshire. That’s enough for me. I would bet that Buffett is in a better position to assess the risk of his specific investments than an analyst (or team of analysts) at Fitch or Standard and Poor. I think you have to side with Buffett here. He’s previously called derivatives, “financial weapons of mass destruction” on multiple occassions. He understands the risk involved in investing in derivatives.
As for the aging leadership, this is of course a legitimate concern when it comes to investing in Berkshire. Buffett is 78 (he’ll be 79 this August). Charlie Munger is 85. Lou Simpson (CEO of Geico and Buffett crony) is 86. All the people at the top of the Berkshire pyramid are very old, and let’s face it, Buffett is Berkshire. You’re not investing in their product, or their competitive advantage (Buffett is the competitive advantage) or even necessarily in their financials. People invest with Berkshire because they believe in Buffett’s investing style and philosophy, because they believe he can still beat the market with billions under management. I would however, say that I’m not sure this affects their creditworthiness. They’ll still own the same assets. One of the best money managers in the world – whether we already know his/her name or not, will take over Buffett’s spot (there are reportedly 4 candidates that are being kept a secret for now). Buffett is on the record as saying that if Berkshire isn’t AAA, then he doesn’t know of a company that is. Like any father, he may be a little biased towards his own, but this is coming from a man who became the richest man in the world by properly valuing companies. When Buffett steps down or dies, I’m sure Berkshire’s share price will take a hit, but the assets they own will still be worth whatever the market is valuing them at.
On a final note – why does anyone care what the credit rating agencies are saying? How did their rating for Freddie Mac work out? Lehman Brothers, CitiGroup, Bear Stearns…the list of their mistakes is long. They don’t necessarily have the best track record. Prices and yields seem to disagree with the ratings agencies on a regular basis. Their business depends on the companies they give ratings to, leaving some questions about their incentives. One of the biggest rating agencies, for example, is Moody’s – which is owned by Berkshire and interestingly has not downgraded Berkshire’s credit rating. I’m not suggesting impropriety on the part of our stories hero, but that’s not necessarily a set up I would endorse (ask me to grade my wife – how can I give her anything but an A+?). Please leave your thoughts in the comments or send them to me by email. Thanks for reading.
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