Warren Buffett’s Berkshire Hathaway (ticker: BRK.A) announced yesterday that it will buy the battery maker, Duracell, in a deal worth approximately $4.7 billion from Procter & Gamble (ticker: PG).
In many ways, the purchase isn’t surprising since Duracell has many of the characteristics that Buffett likes: a strong global brand in an old, boring industry.
What’s interesting about this deal, though, is that Buffett isn’t using cash from his $68.3 billion hoard, but is instead swapping PG stock that he acquired through his 1989 purchase of Gillette stock, which PG purchased in 2005.
Buffett gets the Duracell business and $1.7 billion in cash and PG gets some of its outstanding stock back. Buffett has said that he would rather own businesses outright than shares of publicly traded stocks, so he’s reducing his publicly traded shares of PG for the outright ownership of Duracell.
This swap allows Berkshire to avoid paying the long-term capital gains that would occur if he sold his PG stock in the market. Analysts have estimated that Buffett’s cost basis for the PG stock is $336 million and the stake is currently worth $4.7 billion, so he’s saving at least $1 billion by trading stock for the business instead of selling his PG stake and buying the company with cash.
When I first read this, I was a little annoyed that Buffett could do deals that aren’t available to the general public (which happens all of the time actually), but then it occurred to me: we use the same technique when we buy exchange traded funds (ETFs).
Let’s go back for a second, to the time before ETFs and mutual funds dominated the investment landscape. If enough mutual fund owners want to redeem their shares, the mutual fund manager has to sell stock to raise cash to give to the fund shareholders that are liquidating their position. That can create capital gains for the remaining fund holders.
With ETFs, however, the structure is quite different. I’m going to simplify in order to keep this brief, but essentially, when ETF fund holders sell, the ETF doesn’t have to sell the stocks that it owns to raise cash for the liquidating fund holder: it swaps the underlying stocks in the ETF for shares of what’s called a ‘creation unit’ that it then cancels out.
I realize that this description doesn’t make perfect sense (here’s a video that explains the process nicely, but in a down-to-earth way), but the point is that the ETF is swapping out shares of stock that it bought in the past to avoid capital gains, in the way that Buffett swapped out shares of PG.
Some Buffett critics have come out complaining that his swap unfairly saves Berkshire $1 billion, but when you think about it, millions of Americans are pursuing the exact same strategy every day with ETFs without even realizing it.