Portfolio manager’s Letter May 2008
As any student of the Insurance business knows, the best time to be writing hurricane insurance is the next year or two after a there has been a lot damage from hurricanes. It is one of the profound ironies of life that the cost of insurance always goes up after the hurricane hits and the damage has been done. It should come as no surprise then that Berkshire Hathaway has jumped with both feet into the market for insuring Wall Street and other financial institutions against financial hurricanes. The financial insurance Berkshire Hathaway is currently selling is of two basic types, credit default swaps and long term equity put options on major stock indexes.
The puts are essentially financial insurance contacts that will pay only if the stock averages are lower when the contact matures than they were when the contract was written. Since these contacts are for 15 and twenty years and can only be exercised on last day of the contract it is very unlikely that Berkshire Hathaway will lose money. Also, this is Buffett’s favorite kind of insurance because it comes with a long tail, which means that Berkshire Hathaway gets to keep the upfront premium money (currently $4.5 billion) for a long time. $4.5 billion invested at 8% for 20 years becomes $21 billion.
The credit default swaps are insurance against the default of a particular company’s debt. Total exposure on these contacts in a worst-case exposure totals slightly more than $5.1 billion, of which $500 million has already been paid out.
To date Berkshire Hathaway has received $3.2 billion in premiums or about 60% of their exposure. A Wall Street journal article on May 3rd, pointed out even if all the companies covered by the swaps Berkshire Hathaway has written eventually go broke; the typical recovery on debt in bankruptcy is about 40% so this is a very low risk venture for Berkshire Hathaway. Anything short of total failure of all companies should provide a nice fat return. It should be kept in mind that Buffett has a decent long term record of being able to identify companies that will avoid going broke. In the mean time Berkshire Hathaway has the premium money to invest.
The Swaps contracts have a considerably shorter tail than the put contracts (the swaps contracts are generally for five years) the float they generate could still earn up to an additional $1.0 billion, or so. The nicest thing about this particular financial hurricane is that it brings with it investment returns that are much more attractive than those that are typically available after a regular hurricane. So it may turn out that this 7.8 billion in float currently provided by these derivatives is more valuable than normal financial insurance float.
Addition irony is provided by the accounting treatment of these transactions which required that Berkshire Hathaway report a $1.7 billion pre-tax loss in the first quarter because of these contracts, even thought Berkshire Hathaway’s cash out of pocket expense for the quarter was limited to $52 million; and even thought this business may eventually cause Berkshire Hathaway to start referring to derivatives as “financial weapons of massive profitability”.
It does tend to make one want to ruminate a bit about accounting rules, marking to market and transparency etc. I personally am not quite sure how the new accounting rules have improved the quality and transparency of Berkshire Hathaway’s financial statements. And Mr. Market seems more than just a little confused. The poor old fellow seems to feel the recent quarter was a downer, whereas to my feeble mind any quarter in which Mr. Buffett gets to spend $14.4 billion is a cause of considerable jubilation, and will eventually have a strong positive impact on Berkshire Hathaway’s intrinsic value.
We have reached a point where reported earnings are mostly meaningless for this year’s first quarter, and are likely to remain so at least for the next year or two. A review of the company’s Statements of Cash Flows gives us a better picture of what was actually going on in Omaha.
If you add this all up it comes to $13.7 billion a figure that is more than Berkshire Hathaway’s reported earnings for all of last year or any previous year. For the full year of 2007 Berkshire Hathaway invested $14.4 in the items listed above, for 2006 15.7 billion; and for 2005 $14.5 billion. The last three years have seen Buffett spend heavily on Equity investments and Acquisitions, yet so far in one quarter of 2008 Buffett has been able to commit almost as much money as he has in the a whole year for the prior three years.
The Cash Flow Statement lists cash flows from operating activities as $3.4 billion this includes reported earning and depreciation, and the derivative loss was added back in because it is a non-cash charge. But even this figure appears to understate Berkshire Hathaway’s actual cash flow. Berkshire Hathaway’s cash balance was only down by $8.8 billion in the quarter, so Berkshire Hathaway appears to be generating a lot of cash flow that never makes it to taxable earnings or operating cash flow.
The fact the Buffett was able to invest $13.7 billion and only reduce the company’s cash balance by $8.8 billion certainly reinforces the notion that the $940 million figure for reported earnings is not at all indicative of the real growth of intrinsic value during the Quarter.
In the past 3 years and one quarter Berkshire Hathaway’s total after tax earnings came to $33.7 billion, yet Buffett has been able to invest $58.3 billion. The Berkshire Hathaway’s cash balance at the beginning of this period (December 31, 2004) was $43.4 billion and on March 31, 2008 it was 35.6 billion. So Buffett has over spent earnings by $24.6 billion but only reduced his available cash by $7.8 million. A little Omaha investment magic.