Warren Buffett’s Berkshire Hathaway’s stock (BRK-B) has been crushed along with the market this year, leading many observers to conclude that Warren has lost it. The last time this happened, in 2000, when Warren was chastised for not loading up Berkshire’s boat with technology stocks, BRK hit bottom. We’re probably getting close this time around, too.
The big Berkshire issue everyone is obsessed with this time is the put options Warren wrote on the major market indices near the peak. Berkshire received $4.85 billion for betting that the S&P 500 and three foreign indices would be above their 2007 levels at expiration dates beginning in 2019 and beyond.
Berkshire doesn’t have to post any collateral on these puts, and market history suggests it is unlikely to have to pay out anything when the put expiration dates arrive. In the meantime, however, the company does have to mark the derivatives to market, which, right now, means booking non-cash losses (unlike Stephen Schwarzman and other investors crying about the unfairness of this, however, Warren thinks this is fair–and says so).
If the market indices were all to go to zero and stay there, Berkshire would indeed be on the hook–for $37 billion. If that were to happen, however, we would all have more pressing things to worry about.
Whitney Tilson of T2 Partners has studied this issue closely. He owns Berkshire, so he has a vested interest, but he also owns Berkshire because he’s smart guy. Here’s what he has to say:
Buffett sold at-the-money puts on the four major world market indices sometime last year – we don’t know at what level, but let’s assume that these indices are down by 40% on average. If the indices rebound by 67% over the next 13.5 years (the average remaining duration of the puts), a mere 3.9% annually, then the puts will expire worthless and Buffett can pocket the entire $4.85 billion.
Berkshire ‘s maximum exposure is $37.0 billion, presumably if the four indices all fall to zero, but this isn’t going to happen so let’s look at more likely scenarios. We don’t know the details of how the puts are structured, but let’s assume the payouts are on a straight-line basis, such that if the indices are down 50% 13.5 years from now – another 17% from today’s levels – then Berkshire will have to pay $18.5 billion (half of the $37 billion maximum). That would be a painful loss, to be sure, but one that Berkshire could easily afford: the company’s earning power today exceeds $10 billion per year and, as of the end of October, its net worth exceeded $111 billion, both figures that will be much higher more than a decade from now.
It’s also important to understand that the loss in this doomsday scenario would not be $18.5 billion minus $4.85 billion because Buffett can invest the $4.85 billion for the entire period. If he earns a mere 7% return for 13.5 years, $4.85 billion becomes $12.1 billion (at a more likely 10% annually, it would be $17.6 billion). If we assume a 7% compounded return, Berkshire’s break-even point on this investment would be a 33% decline in the indices from the point at which the puts were written, meaning the indices would only have to increase less than 1% annually over the next 13.5 years to reach this from today’s level of down 40%.
I think it’s very likely that the indices will compound at 4% annually from today’s depressed levels, making it unlikely that Berkshire will have to pay out anything on these contracts. And given how much Buffett was paid to write them and his ability to invest the premium he was paid in any way he chooses, it’s even more unlikely that this will be a losing investment. Thus, even knowing what I know today, I think this was a fantastic investment and wish Buffett had written more of these contracts (perhaps he’s writing more today?).
It is critically important to understand that the derivative contracts Buffett sold cannot be exercised prior to expiration, nor does Berkshire have to post collateral when the CDS spreads widen and/or the indices fall. Thus, the company has virtually no liquidity risk.
So why do investors appear to have this concern? Most likely, they simply haven’t done their homework, or perhaps they are misunderstanding this disclosure in Berkshire ‘s Q3 10-Q:
Under certain circumstances, including a downgrade of its credit rating below specified levels, Berkshire may be required to post collateral against derivative contract liabilities. However, Berkshire is not required to post collateral with respect to most of its credit default and equity index put option contracts and at September 30, 2008 and December 31, 2007, Berkshire had posted no collateral with counterparties as security on these contracts.
I doubt Buffett would write any contracts that would require Berkshire to post collateral in the event of a downgrade, so I suspect that this disclosure relates to some of the legacy derivative contracts that Berkshire inherited when it acquired Gen Re. Buffett wisely shut down Gen Re’s derivatives business many years ago, however, and there are very few contracts remaining, so the risk here is immaterial.
Today, Berkshire spokesperson Jackie Wilson confirmed to Reuters that the company has “nominal” collateral requirements that would take effect were credit rating agencies to reconsider its triple-A rating, and said that collateral requirements would total “far below 1 per cent of assets”. Assets were $282 billion as of Q3, so we now know that Berkshire ‘s total collateral requirements, in a worst-case scenario, are “far below” $2.8 billion.
Berkshire does have to book unrealized gains or losses every quarter on its derivative contracts (unlike changes in value in its much larger marketable securities portfolio), but these are noncash changes, as Buffett explained in the Q3 earnings release:
With very limited exceptions, gains or losses from marketable securities are recorded only upon sale. Berkshire has large amounts of unrealized gains, and sales are never made with an eye to their effect on reported earnings. During the first nine months of 2008, our unrealized gains fell by $7.5 billion (leaving us a total of $24.3 billion in unrealized gains at the end of September). That decline of $7.5 billion does not show in our reported earnings. What is included is a realised gain: $65 million pre-tax and $42 million after-tax.
In contrast, accounting rules require that any unrealized gain or loss from most of our derivative contracts be regularly recorded in earnings.
A final risk factor to consider is undisclosed risks – the type that have blindsided investors in so many other financial companies. It’s impossible to rule out unexpected surprises for any company, but anyone who’s studied Buffett will surely take comfort in his 50+ years of conservatism and openness with his investors.
To understand why it’s so unlikely that there might be hidden derivative bombs on Berkshire ‘s balance sheet, one needs to understand how Buffett thinks about risks like this. For example, here’s an excerpt from his 2002 annual report (page 14), in which he warns about the exact scenario that crushed AIG this year:
Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.
At $84,000, Berkshire ‘s stock today is the cheapest, by far, we have ever seen it, going back at least a dozen years (and it’s below $80,000 as I write this).
We estimate Berkshire’s valuation the same way Buffett does: we value the investment per share (cash, bonds and stocks) at market and then place a 12 multiple on the pre-tax operating profits of the company (for more details on this as well as our entire analysis of Berkshire, see our presentation, which is posted here). As of the end of last year, investments per share were $90,343 and our estimate of normalized pretax earnings was $5,500-$5,700/share, which resulted in an estimate of intrinsic value of $156,300-$158,700.
As of the end of the third quarter, investments per share had fallen to $86,000 due to declines in the prices of stocks Berkshire holds as well as Buffett investing tens of billions of cash in a wide range of operating businesses. In light of the severe market decline in October and so far in November plus additional investments Buffett has made, we estimate that investments per share might have fallen to as low as $76,000.
As for Berkshire ‘s earnings, they are obviously impacted by the weak economy, but this is offset by the many new businesses Buffett has purchased. Over time, the many investments and acquisitions Buffett’s made this year will lead to much higher earnings, but for the next 12 months, to be conservative, let’s assume that pretax earnings are $5,000/share (assuming the severe recession continues and a normal super cat year). This results in an estimate of intrinsic value of $136,000, 62% above today’s level.
This slide from our presentation (posted here) shows Berkshire ‘s share price over the past 12 years, with each year’s estimate of intrinsic value:
One can see that Berkshire’s share price has, at some point during every year, reached intrinsic value except for 2005 and so far this year. One can also see how far below intrinsic value Berkshire is today.
Another way to think about Berkshire’s value is to consider that Berkshire ‘s share price today exceeds investments by only $8,000/share (earlier today, it traded below investments!). Thus, today one can own a collection of fabulous businesses that Buffett has acquired over the years for less than two times pretax earnings.
In this environment, it’s not surprising to us that the stocks of companies with shaky balance sheets, poor business models and/or weak competitive positions are getting clobbered, but Berkshire ‘s freefall in the past few weeks is certifiably crazy – and a buying opportunity that will long be remembered.
Disclosure: Funds the author manages are long Berkshire Hathaway
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