Berkshire hathaway (warren buffett’s company) is having their annual meeting over this weekend. This meeting is called the woodstock of capitalists. I have been reading and following buffett for the last 10 years and tend to read his every interview, speech and the Q&A session of the annual meetings.
You can find a great compilation of everything buffett here
His letter to shareholder are a must read and I would recommend reading them multiple times.
Berkshire declared their quarterly results and reported a 65% drop in profits. Although as an indian investor, we cannot invest in this company, I would recommend reading the letter to shareholders and analysing the company to learn how a great company works and what it means to be shareholder oriented (the company is a gold standard).
I cannot explain the company in detail here. However if you have been following the company and have an idea about it, below is my analysis of the cause of the drop in profits.
Buffett has called derivatives as financial weapons of mass destruction and has cautioned against them. I am pretty sure that media, seeing a drop in profits due to derivatives, would crow about how the world’s greatest investor has himself got burnt by the same. However one has to understand that though buffett has warned against using derivatives if the company cannot understand the risks behind it, he himself understands them better than most and clearly knows what he is doing.
The quarter’s loss have been due to mark to market loss on the put options and CDS written by buffett. The put option buffett has written is similar to supercat insurance written by the company. The company gets a premium and insures a low probability event. if the event occurs then the company has to pay the insured amount. now over the years buffett has indicated the they could lose money on specific policies, but over a long term , they work with the odds on their side and would make a profit.
In case of the put, although we do not have the specific details, i would assume a similar approach. In addition buffett has indicated that he looks at the exposure also (total max loss) and no matter what the odds would never risk a huge amount. The puts are deep puts and the odds of the markets being lower 20 years later is low (we dont know what is the strike price of the puts, but they are based on the index and not on a company).
Berkshire accounts for MTM losses or profits which are accounting or book keeping losses/ profits if the options are closed today (unlikely to happen). So the company gets to keep the premium, invest it and get a good return from it for the next 20 years. This is on a low probability event that the market would be way lower 20 years later, in which case the company may well exercise the put and buy the index at the ultra-low valuations.
You would think that if the above is such a good deal, then why are other companies not doing it?
It is explained in the current year’s letter to shareholder and I can think of the following reasons
- The accounting as we can see in this quarter is very volatile. There are almost no companies which would risk a billion dollar hit to their results via such derivatives. The CEO would lose his job for such results
- There is counter party risk too. The buyer of the put option should believe that the company writing the put will be around 20 years later to pay up. Very few companies can do that
ofcourse media is going to make a show about this drop as they dont understand the company or how the options in this case are different from the one's written by banks and other financial institutions.