SEC to Warren Buffett: We Know How to Value Stocks Better Than You

Warren Buffett extolled the virtues of contrarianism when he summed up his own investing philosophy: “Be greedy when others are fearful and fearful when others are greedy.”

Such an approach benefits from human nature and the 24-hour news cycle. Markets tend to overreact to negative and positive news; investors who step back and look beyond the headlines will find plenty of profitable opportunities.

– Elliott Gue, Personal Finance

The Yiddish word “Chutzpah” is defined as unbelievable gall, insolence, or audacity. If it would help to use it in a sentence, here goes:

SEC Accounting Branch Chief Gus Rodriguez has CHUTZPAH.

I had to add the bold font and caps to the word because Mr. Rodriguez’ chutzpah is one of the most egregious examples this year, second only to President Obama calling the war in Libya a non-war “kinetic military action.” 

What did Mr. Rodriguez do that was so galling? He wrote a letter to Warren Buffett – arguably the greatest stock investor of all time – stating that the SEC knows how to value stocks better than Mr. Buffett!

Other-Than-Temporary Impairments Under GAAP Accounting

I know it’s hard to believe, but it all started with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Section 320-10-35-33. This arcane rule states that under U.S. generally accepted accounting principles (GAAP), a company must take a charge against earnings if it determines that one of its stocks has suffered an “other-than-temporary” impairment of value. An impairment of value means that the current market price of the stock is less than the original price that the investor paid for it.

The FASB rule does not define “other than temporary,” but expressly states that it does not mean “permanent,” nor does it require that the investor make a decision to sell the stock. In an effort to provide clarity, SEC staff issued its interpretation of the phrase. Specifically, it stated that the following factors were important considerations:

• The length of the time and the extent to which the market value has been less than cost; 
• The financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential; or 
• The intent and ability of the holder to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.
• Evidence exists to support a realizable value equal to or greater than the carrying value.

This “guidance” from SEC staff is clear as mud.  What length of time is too long? What percentage decline is too large? How are “near-term prospects” different from “temporary” prospects? How much “evidence” is enough to prove that a stock can recover and can’t reasonable people differ on future cash flows? If an investor has evidence of recovery potential and intends to hold the stock until this potential is realized, do these two factors overcome the length-of-time and percentage-decline considerations?

History of the SEC vs. Warren Buffett

Keeping this confused state of affairs in mind, this is what happened in the Buffett case:

November 5, 2010:  Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) files its third-quarter 10Q where it reports on page 9 that its publicly-traded equity portfolio has suffered $920 million in unrealized losses from Wells Fargo (NYSE: WFC) and more than $1.5 billion in unrealized losses from four “other” companies, all of which losses have lasted for 12 months or more.  

The company stated that it decided that none of these unrealized losses were “other than temporary” and, consequently, it did not take a charge against earnings for any of them:

In our judgment, the future earnings potential and underlying business economics of these companies are favorable and we possess the ability and intent to hold these securities until their prices recover.

December 10, 2010: SEC Accounting Chief Gus Rodriguez sends Berkshire Hathaway a letter seeking additional information about its decision not to take a third-quarter charge against earnings for some of its unrealized stock losses. First, Mr. Rodriguez argues that some of Berkshire’s stocks lost money during the first nine months of 2010 even though the overall market gained, insinuating that something must be seriously wrong with these laggard stocks that warrants a write down. This is a ridiculous accusation, since 2010 was a year where the Fed’s QE2 policy caused junk stocks to significantly outperform large-cap quality issues. Nine-month underperformance does not remotely suggest anything other than a purely temporary impairment.

Second, Rodriguez wants to know the names of the four “other” companies besides Wells Fargo that have unrealized losses for longer than 12 months. 

Lastly – and this is where the accounting chief’s chutzpah goes out of control – Rodriguez contests Warren Buffett’s judgment that the stocks of these companies will recover based on their favorable future earnings potential:

Your disclosure indicates that you consider “the current and expected long-term business prospects of the issuer,” including that “the future earnings potential and underlying business economics of these companies are favorable.” However, these factors appear to already be contemplated by and reflected in the quoted market price.

Unbelievable! How the Hell does a government bean counter like Gus Rodriguez know that the current market prices of these stocks reflect their long-term business prospects? What Rodriguez is really saying is that the marketplace is efficient and there is no way to outperform the market by purchasing undervalued securities!  In other words, Rodriguez is telling Buffett – the greatest value investor of all time – that value investing doesn’t work and he should just buy an index fund. What chutzpah!

January 11, 2011: Berkshire reveals that the four “other” companies are Kraft Foods (NYSE: KFT), U.S. Bancorp (NYSE: USB), Swiss Re (Other OTC: SWCEY.PK), and Sanofi-Aventis (NYSE: SNY). The letter concludes:

Berkshire management continues to believe it is reasonably possible that the market prices for each of these five securities will recover to at least cost within the next one to two years assuming that there are no material adverse events affecting these companies or the industries in which they operate.

Accordingly, since Berkshire has both the ability and current intent to hold these securities until this occurs, Berkshire does not believe it to be prudent to record an impairment charge.

See the table below for the current market price of these securities compared to the highest price Buffett paid for them:

In response to Rodriguez’ belief in the efficient market hypothesis, the letter states:

Berkshire wishes to address the Commission’s inference in its comment letter that at any point in time the quoted market prices reflect future earnings potential and underlying business economics of an issuer of a security. Berkshire management does not believe that the validity of the efficient market hypothesis as suggested by the Commission can either be proven or disproven. Information made available by the issuer of a security including current results and expectations regarding the future will likely be interpreted differently by individual investors.

Buffett is being way too modest in this response. Sure, financial information can be interpreted differently by investors, but talented investors like Buffett interpret the information correctly and others interpret it incorrectly. You want proof that the efficient market hypothesis is bunk? Just take a look at Berkshire’s 46-year track record in which Buffett has outperformed the S&P 500 by 10.8% annually! That’s simply amazing. And Buffett is not alone. Just read Buffett’s 1984 speech at Columbia University Business School to understand why value investors generally outperform:

I’m convinced that there is much inefficiency in the market. Value investors have successfully exploited gaps between price and value. When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.

February 4, 2011:  After “conversations” with SEC staff, Berkshire was persuaded (i.e., coerced) to take write downs on Sanofi-Aventis, U.S. Bancorp, and Swiss Re. Apparently, the market prices of these three stocks remained substantially below Buffett’s purchase prices after more than two years of impairment. Even with these three stocks, however, Buffett wrote that “it is likely that the market prices of each of these securities will recover to a level equal to or greater than our cost basis.”

In contrast, Berkshire held firm against taking write downs on Wells Fargo and Kraft Foods. Although both the Wells Fargo and Kraft investments had been impaired for more than two years, the severity of the impairments was not sufficient to warrant a write down. Interestingly, in Kraft’s case, Buffett wrote:

We believe it is probable that the market value of Kraft Foods will increase to a level that at least equals the cost of the portion of our investment that is currently impaired in a relatively short period of time.

It sounds to me that the oracle of Omaha is telling us that both Wells Fargo and Kraft are good buys right now. Kraft, in particular, should move up sooner rather than later. With Kraft currently trading for $31.18 and Buffett’s impairment ending if the stock reaches a price of $34.98, get ready for a quick 12% gain!

February 28, 2011: Berkshire files its annual 10K and on page 74 reveals that the average write down made on Sanofi-Aventis, U.S. Bancorp, and Swiss Re was 20% each. This suggests that — in the short term — investors should not expect these stocks to rise above $36.02, $27.74, and $59.72, respectively.

Although agreeing to take a charge against earnings, Berkshire leveled a parting shot against the SEC by stating that “fair value” of these securities has not changed and that the company will offset the charge against earnings with “a corresponding credit to other comprehensive income.”

Touche Mr. Buffett!

Find the Best Value Stocks with the Help of Personal Finance

Unlike SEC Accounting Chief Gus Rodriguez, Elliott Gue of the market-beating Personal Finance investment service agrees with Warren Buffett that the efficient market hypothesis is bunk. Elliott has proved time after time that he can beat the market on a consistent basis by choosing undervalued stocks. Ever the historian, Elliott recently wrote to subscribers:

In June 1815 many feared Great Britain and her allies would lose their campaign against Napoleon’s forces in northern Europe. Across the English Channel, panicked investors sold British government bonds en masse.

Financier Nathan Mayer Rothschild had helped finance the military effort and learned of a decisive British victory a day before the official word arrived. Amid the panic, this intelligence fell upon deaf ears. While others contemplated the end of the world, Rothschild bought British bonds at fire-sale prices, and his family fortune multiplied twentyfold after news of Napoleon’s defeat at Waterloo reached London.

Rothschild famously remarked, “Buy when there’s blood in the streets, even when that blood is your own.”

According to SEC Accounting Chief Gus Rodriguez, anyone holding British government bonds should have written down their value significantly because their market prices were down significantly during the sell panic. Wrong! There’s a good reason that accountants make lousy investors; they only see what’s immediately in front of them and don’t have “vision.” Great investing is about a company’s future business prospects, not past market movements based on human emotion!

Elliott’s favorite industry sectors include energy, materials, industrials and technology. To find out the specific names of his favorite undervalued growth stocks in these industry sectors, try Personal Finance risk-free today!