Oxstones Investment Club™By Tony Keller
From Friday’s Globe and Mail
Warren Buffett’s bond is nearing maturity. The greatest investor who ever lived just turned 80, and while he’s in excellent health—thanks to a steady diet of hamburgers and cherry Coke—he’s making succession plans and preparing to hand Berkshire Hathaway
over to a new crop of managers. “I’ve reluctantly discarded the notion of my continuing to manage the portfolio after my death,” he joked a few years ago, “abandoning my hope to give new meaning to the term ‘thinking outside the box.’ ”
Despite that promise, Buffett is still making giant investment decisions, with consequences that will long outlive him. The biggest are several monster bets, using derivatives, on future levels of world stock markets. Yes, Buffett once called derivatives “financial weapons of mass destruction,” but between 2004 and 2008, he also sold almost $36 billion worth (all currency in U.S. dollars) of put contracts tied to future values of the Standard & Poor’s 500 and three other major stock market indexes. Most of the puts come due between 2019 and 2028. In each case, if the value of the index on the due date is below the value when the contract was written, Berkshire has to pay the difference.
The strategy’s main accomplishment so far, however, has been to sap Berkshire’s net earnings. When stocks plunged in 2008, mark-to-market rules forced Berkshire to account for these long-term obligations as if they were debts that would have to be paid immediately. Paper losses on those derivatives reduced the company’s profit by $6.8 billion in 2008; in the first half of 2010, they shaved off another $1.8 billion. Buffett once said, “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.” Some observers are now wondering whether Buffett has turned into that idiot.
This summer, Stifel, Nicolaus & Co. analyst Meyer Shields put an almost-unheard-of sell recommendation on Berkshire, largely because of the derivatives. “I don’t know that any investors that I’ve spoken to think that this is the best use of capital,” he said. Keefe, Bruyette & Woods also criticized the strategy. “It brings an element of volatility to quarterly results that I think people don’t like,” said insurance analyst Clifford Gallant.
Buffett’s response: guilty as charged, with a Cheshire cat grin. As he’s explained in annual report after annual report, the puts are supposed to deliver short-term earnings volatility. It’s the whole point of the trade. Buffett is renting out earnings stability to other companies—and being paid ridiculously large cash premiums for the service. In exchange, he’s accepting higher volatility in Berkshire’s short-term earnings, in the form of non-cash accounting charges brought on by fluctuations in the value of the long-dated contracts. But the premiums are so fat that they will boost Berkshire’s real, long-term returns.
Remember last year, when Manulife shares went for a dive, because outgoing CEO Dominic D’Alessandro had tried to juice long-term earnings by not hedging key segments of his company’s stock holdings? Buffett is doing likewise, squared. Instead of hedging, however, he’s the one selling the hedges, doubling down on his equities-heavy portfolio. He’s taking on the type of risk that regulators wish Manulife had off-loaded.
So why is Buffett’s move clever, whereas D’Alessandro left Manulife under a cloud, with Canadian regulators crawling over the books and his successor forced to slash the company’s sacrosanct dividend? Berkshire has so much capital that it isn’t worried about a solvency crisis, and its counterparties paid up front for the hedges. If markets decline in the short term, most of the puts don’t require Berkshire to post collateral, either. It only has to pay up—if ever—at the end of the contract. Because the puts were written before stricter U.S. financial laws passed this summer, they also appear to be exempt from new rules on collateral.
Most importantly, Buffett believes that the people on the other side of the trade were, in layman’s terms, idiots. They overpaid—big time. “Each contract we own was mispriced at inception,” Buffett wrote in 2008, “sometimes dramatically so.” The hedge market has too many buyers (especially Manulife’s insurance industry peers) chasing not enough sellers. So Buffett decided to be this particular desert’s water salesman.
Berkshire was paid about $5 billion in premiums up front. Let’s assume that Berkshire can earn an 8.3% annual return on that money. (That’s the average annual increase in Berkshire’s book value per share over the past 10 years—its least successful decade ever.) Also assume that the contracts have an average maturity of 17.5 years. (They were written with maturities of between 15 and 20 years.) For Berkshire to lose money, stock markets in 2019-’28 would have to be down more than 50% from 2004-’08 levels.
What if the indexes are 25% below their pre-2008-crash peaks? Berkshire’s profit will exceed $10 billion—on an initial investment of zero. Every cent invested was somebody else’s money.
The long-dated equity puts are classic Buffett: a patient, low-risk strategy that exploits mispricing and market irrationality, and that’s brave when others are fearful. Consider it one last shot of Buffett magic into the engine of post-Buffett Berkshire.
Tags: be greedy when others are fearful, collecting upfront premiums, long-dated equity puts, low risk strategy, market irrationality, mispricing, Warren Buffett