The case for more Buffett
In this day and age, it is easy to get lost amid the noise. By now, you have heard many arguments from research analysts and other observers on why Home Capital Group Inc. shareholders should vote against a second tranche investment from Warren Buffett’s Berkshire Hathaway Inc. While some shareholders have weighed in, many of the “experts” opposing the second tranche have little to no ownership in Home Capital.
The fund and accounts t hat Kingsferry Capital manages began buying Home Capital shares after the 65- per- cent stock price plunge at the end of April. We currently hold a 2.8-percent stake ( post- dilution from Berkshire Hathaway’s first- tranche investment) and virtually 100 per cent of my personal liquid assets are invested into the same fund and accounts. As such, I believe my interests are 100- per- cent aligned with what is best for Home Capital going forward.
It is easy to reject the second- tranche investment proposal right off the bat because of the heavy dilution. However, as a value investor, I try to apply what Howard Marks has famously called “second- level thinking” — that means trying to go beyond what is conventional or easy. While of course it is best if Berkshire can increase its offer price for the second tranche, which is expected to be put to a shareholder vote in September, rejecting the proposal solely based on the cost without considering the potential value of Mr. Buffett having more “skin in the game” is reckless.
Ultimately, it comes down to the additional value of Berkshire owning an extra 18 per cent of Home Capital. First, let’s look at the numbers. The first-tranche investment cost Berkshire approximately $153 million — a drop in the bucket when it comes to Mr. Buffett’s US$ 100 billion war- chest. A 19.99- percent stake in Home Capital would simply be classified as part of Berkshire Hathaway’s marketable securities portfolio. This level of ownership would likely limit them to a more passive role in the future development of Home Capital. While I don’t think Berkshire would start unloading Home Capital shares after the four- month lockup period — or within the next few years, for that matter — it would be entitled to change its mind. If it did, it could exit Home Capital without too much hassle with 19.99- per- cent ownership. As Mr. Buffett clarified in his 2016 annual letter to Berkshire shareholders: “It is true that we own some stocks that I have no intention of selling for as far as the eye can see …. But we have made no commitment that Berkshire will hold any of its marketable securities forever.”
Now let’s look at the alternative scenario where Berkshire invests an additional $247-million and holds 38 per cent of Home Capital. Although the $ 400 million total investment would still be an insignificant portion of Berkshire Hathaway’s total assets, a 38- per- cent stake would make Berkshire a substantial and fully-committed shareholder. Berkshire’s reputation would be on the line and we can assume it would provide any reasonable support that Home Capital needs. With Berkshire Hathaway’s financial support, industry knowledge and ability to attract world-class talent, Home Capital could easily expand its market reach either organically or via acquisitions. As Berkshire’s first investment in a major Canadian financial institution, Home Capital could also serve an important role in assisting Berkshire Hathaway to expand its other operations in Canada. However, before any of these can happen, Berkshire needs to be fully motivated and a 19.99- per- cent stake just doesn’t cut it.
Some “experts” have also urged shareholders to reject the second- tranche investment on the basis that the terms of the new credit facility with Berkshire are only marginally better than the previous credit facility. They say that Berkshire is taking advantage of Home Capital’s equity holders due to the high interest rates on the new credit facility. We don’t agree with this argument for the following reasons: First, with the liquidity raised via asset sales, Berkshire’s equity injection and recent surge in GICs (Guaranteed Investment Certificates), it is unlikely that Home Capital would need to draw down on the new credit facility for a prolonged period. As such, the facility only serves as a liquidity backstop for Home Capital, which will only pay a oneper- cent standby fee on the facility. Second, the cheapest and most sustainable source of funding for Home Capital remains the GICs. It would be unwise to fund low-return mortgage loans with Berkshire’s capital, which has high opportunity costs. Berkshire is one of the world’s largest and most successful corporations because its CEO, Mr. Buffett, is a master capital allocator. Lastly, the new credit facility is designed to keep new management and directors on their toes in regards to maturity mismatch on Home Capital’s balance sheet. To avoid drawing down the costly credit facility, Home Capital will need to ensure its mortgage loan maturity schedule matches its liabilities maturity schedule going forward. Maturity mismatch was a primary contributor to Home Capital’s liquidity crisis, where depositors were pulling out short-term HISA deposits and Home Capital’s short- term assets were insufficient to cover.
Some shareholders are satisfied with just having the Buffett aura but we must not be short- sighted. Mr. Buffett has built one of the most successful decentralized conglomerates in the world by ensuring that people running the companies have a vested interest in their continued performance. We as shareholders of Home Capital should apply the same logic on Berkshire to ensure it has meaningful “skin in the game.” As a Home Capital shareholder, I encourage all fellow shareholders to vote in favour of Berkshire Hathaway’s second-tranche investment.