Letter to shareholders from Warren buffett – Some thoughts

Warren buffett as most of you must be aware is considered as one of the foremost investors. He is the chairman of Berkshire Hathaway and publishes an annual letter to shareholders which is a must read for any aspiring or seasoned value investor. You can access his letters here. The 2008 letters was published more than a week ago and I downloaded it the moment it was posted and read through it immediately (yes I am a complete fan !).

Some thoughts –

The options bet

One of most discussed topic about buffett is the options bet he has taken. The argument goes like this – Buffett has claimed that derivatives are a weapon of financial mass destruction and yet he has gone ahead and invested in the same instruments. He is being irresponsible and has doomed his company by this bet

Those who write the above are highlighting two points of their own ignorance

- Derivatives are dangerous for those who don’t know what they are doing. This is similar to giving a knife in the hands of a child. I don’t think any journalist, no matter how anti – buffett would consider him to be a novice investor. He has clearly spelled out what kind of bet he has taken in the letter and what are the risks associated with these instruments.

Following is the comment by buffett on the same above point in a recent CNBC interview

JOE: Those are derivatives. You don't like derivatives, but you used them in that case, right?

BUFFETT: I--well, we've used derivatives for many, many years. I don't think derivatives are evil, per se, I think they are dangerous. I've always said they're dangerous. I said they were financial weapons of mass destruction. But uranium is dangerous, and I just went through a nuclear electric plant about two weeks ago. Cars are dangerous.

JOE: Yeah

BUFFETT: But I mean, every American wants to have one. You know, the--a lot of things can be dangerous, but generally we regulate how they're used. I mean, there was a--there was some guard up there with a machine gun on me, you know, when I was at the nuclear plant the other day. So we use lots of things daily that are dangerous, but we generally pay some attention to how they're used.

- They are getting confused between the possible and the probable. Let me explain – It is possible I will become a billonaire in the next 10 years and will have a personal jet . The probability of that happening is 0.0000001%. Buffett’s option bet stands to lose 37 billion dollars if the 4 indices on which he has written the puts go to zero. Let me tell you this – If these four main markets go to 0 in the next 10-15 years, money would be least of our worries. I for one be forced to work on a farm or forage for food as the markets as we know would not exist.

When I first read of these puts, my thought process was that these were akin to an insurance contract based on a long term event with the premium paid upfront (similar for CAT insurance written by Berkshire hathaway). Buffett has explained it in a similar manner in detail in the annual report. I would recommend you to read the explaination in detail.

In addition, the option bet is equivalent to taking a long term loan where the interest rate of the loan can vary depending on the final payout.

Drop in profits
Most of headlines are screaming a major drop in profits. Buffett in clear, uncertain language has written that the profits of his company are very lumpy and will vary depending on the sale of investments. In certain years, buffett sells off overvalued investments and those gains are realised in the net profit. In the subsequent years, in absence of any such gain the year on year comparison looks bad (look at page 28 of the annual report and the explainatory note at the bottom)

The company’s operating business had a approximate cash flow of 9 bn. However various write offs and other change has result in a drop in the quarter’s net profit. The bad economy has definitely affected the company, but the results are not as bad as they appear on the face of it.

Mea culpa
Buffett has admitted to two mistakes - his timing on purchasing Conco phillips and two irish banks. I have been reading and following buffett over a decade and have seen his mistakes to be sometime more profitable than most of the successes of other people. In any case, these could be genuine mistakes and could cost Berkshire 1-2 % of their networth in the worst case scenario.

Looking closely
If you look closely at the results and compare across the years, you will see that the insurance subs and utilities are doing well. Float continue to increase at a steady rate with cost of the float being below zero (which is more important than premium growth) . Both these subs which form a major portion of Berkshire’s business have actually done well compared to the overall economic environment.

The other business are doing quite fine considering the horrible economic environment (see pg 61 of the 2008 annual report)

But the price has dropped ?
Yes the price has dropped and the CDS spreads have widened. Do you always believe the market to be right and the price to be aribiter of value ? Well then we are speaking different language. The markets are often but not always right.

Berkshire CDS spreads are at record levels signalling liquidity or credit issues. To validate that, look at the balance sheet of the company and you will find that the company has 25 billion of cash and equivalents (after all the investment which buffett has done last year). Do you really think a company with 11Bn+ operating cash flow and huge cash reserves will go bankrupt ?

Buffett fan ?
You can rightly accuse me of being a Buffett fan. However to that name, please add the names of Seth klarman, Phil fischer, Charlie munger, Marty whitman, Bill miller, eddie lampart, Rakesh jhunjhunwala and Chandrakant sampat.

I am follower of all great value investors and try to use every opportunity to learn from them. I have never blindly followed their picks or tried to imitate any of these investors, but I always try to learn from each one of them, even if they have been wrong a few times.

Let me ask you this – If you wanted to learn how to play cricket or golf or tennis, would you learn it from sachin tendulkar or Tiger woods or Roger federer (if they were ready to teach someone) ? Sure these players make mistakes and lose matches, but does that take away the fact that these players are the one of the greatest sportsmen in their fields?

It is easy for armchair players or armchair investors to critize from the comfort of their seats, especially after the event with a 20/20 hindsight. Majority of the criticism I have read about buffett and the other investors lacks rigrious detail and analysis and is usually along the lines – The stock price has dropped and hence he is doing something wrong !!.