BERKSHIRE HATHAWAY’S TOBACCO HISTORY

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I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty.                   Warren Buffett

INTRODUCTION

No industry has come closer to having the qualities Warren Buffett looks for in an investment, yet he has been cautious about linking his name to tobacco businesses. Devin LaSarre has written an excellent article about Berkshire Hathaway’s investments in tobacco over the last 43 years LINK:

Looking at the historical filings, Devin asks, “Just what was the Oracle of Omaha up to?” I have added some comments.

R. J. REYNOLDS – A SITTING DUCK   1980

     LaSarre says:

Beginning in 1980, Berkshire Hathaway began to buy R. J. Reynolds’ shares. Buffett spelled this out in his Letters to Shareholders 1980-83. In 1984, Buffett would sell the RJR stake with about a 27% gain, excluding dividends.

Those are the summary facts, but there is a background story. Warren Buffett, as always, probably dug deep into the RJR numbers.  Over four years, he accumulated shares until he reached 5% ownership in 1984. He shared this in his annual letter, but he was still relatively unknown outside professional investment circles, and Reynolds’ management hardly noticed his RJR holdings.

My book, Going Down Tobacco Road, describes a conversation with Tylee Wilson, an RJR executive who would become the CEO four years later. He asked about the low price of our stock (I worked in the pension investment group). I said, “Our market value is only $3.6 billion. We are a sitting duck. A buyer could get RJR for little more than the value of our oil company.” Ty’s response was, “Yes. If we’d let them.” He was surely aware of our precarious situation. An RJR analyst had prepared a report for Ty that valued the oil company at $2.3 Billion. (In 2017, George King shared that report with me.) Ty was planning to sell Aminoil even as he and I talked, and it was worth much more than I thought.

In 1980, at $35.42 a share, the tobacco business was valued at only $5.50 a share, less than 1 x annual earnings. Ty Wilson became CEO in 1984 and divested the oil and shipping businesses. As the stock price rose, the tobacco business was valued much higher but only at 5 x earnings in late 1983. It did not become ridiculously overpriced until the Leveraged Buyout drove the stock to $109 in 1988.

In 1984, my PIMCO friends said, “Warren Buffett says that RJR is the best bargain in the market now.” I asked my boss, “Do you know who Warren Buffett is?” His answer - “Not until last week. He just bought 5% of the company.” Buffett, being Buffett, was surely more aware than most of the real values locked up in RJR. For details - LINK.

Why Buffett sold his RJR in 1984, we can only guess. Perhaps he thought that the stock was no longer undervalued. His return was 20% a year.  But, had he kept the stock another four years, he would have received a 4-year annualized 44% return when the buyout drove the stock to nose-bleed prices. The stock he bought for $269 million would have been worth $1.6 billion, an 8-year return of 32% annually.

RJR NABISCO BONDS – JUNK IS NOT ALWAYS JUNK 1989

      LaSarre says:

In 1988, KKR engaged in the infamous leveraged buyout. RJR Nabisco was saddled with enormous debt. In 1989, its bonds traded at deeply depressed levels. Buffett acquired $440 million of the bonds yielding 14.4%. Still dubious about junk bonds, he wrote in his 1990 Letter to Shareholders:

We feel RJR's credit is considerably better than generally perceived and that the yield we receive, as well as the potential for capital gain, more than compensates for the risk (though that is far from nil). RJR has added major amounts of equity, and in general is being run well.

While he wouldn’t have minded sitting on the bonds, RJR redeemed all its junk bonds at face value the following year, netting Berkshire a ~$150 million profit.

I estimate that Buffett made 34% on those bonds in only a few months.  My partner and I made 60% on the same bonds. How did we outfox the Oracle of Omaha? We didn’t!

We bought the bonds before Buffett did.  We paid $82 for the bond, and he paid $96.  KKR redeemed the bonds at $120. However, Buffett noted that a “major amount of equity” had been added to RJR.  This was because KKR had fallen into a trap when they issued the bonds.  They had overlooked a “reset” demanded by the bond buyers - that at a certain date, IF the bonds did not trade at a price that yielded 14%, KKR must reset the interest rate to force the bond price to face value. That new interest rate would have been about 25% and could have forced RJR into bankruptcy. KKR injected $1.7 billion cash to the RJR balance sheet. Buffett surely was aware of this. He did not buy until that money was added, making the bonds less likely to default.

We had foolishly overlooked RJR’s inability to pay its debts. We bought at a much lower price, but with far more risk than Buffett took a short while later. So, “risk adjusted” Buffett made a better investment than we did. We were lucky; he was smart!

In a future post, we will discuss a great tobacco investment that Buffett and Charlie Munger declined and their ethical dilemma with tobacco investments.