Portfolio manager’s Letter December 2004
Trying to estimate Berkshire Hathaway’s profits from its foreign exchange transactions is difficult because we do not know exactly which currencies Warren Buffett has taken a position in, and because these are short-term contracts (generally one year or less — the mix may have changed substantially in the last 12 months). In last year’s annual report there is an interesting table on page 67, “Estimated Fair Value Assuming a Hypothetical Percentage Increase (Decrease) in the Value of Foreign Currencies Versus the Dollar.”
This table appears to be Warren’s attempt to help us estimate gain or loss in the currency position. The table says that a 10% drop in the dollar would leave Berkshire Hathaway with a gain of $1.235 billion. At the time there was about $11 billion in notional value in the FOREX positions, according to the third quarter report these positions now amount to $20 billion. This is an increase of 81%. If we multiply the $1.235 billion times 81%, a 10% percent drop in the dollar would bring Berkshire Hathaway $2.235 billion or a $223 million gain for each 1% loss by the dollar.
Depending on the currency index that you use, the dollar has fallen somewhere between 5.5% and 7.1%. So far in the fourth quarter, using the estimate from the annual report, Berkshire Hathaway’s gain is probably somewhere between $1.4 billion and $1.7 billion before taxes, YTD. The interesting thing is that most of that move has come since the dollar broke support in early October.
Since then, it has been falling at the rate of about 1% every week and a half. While the currency’s position has had only a small impact on Berkshire Hathaway’s earnings so far, the impact in the fourth quarter will be much larger if the present trends continue. As we would expect the rational and wondrously efficient Mr. Market does not seem to have a clue.
Warren Buffett’s recent move into Foreign Exchange is remarkable for many reasons, first because of its size, which, at last report, amounted to $20-some billion in notational value. To say that this is a large bet is obviously an understatement. More remarkable still is the fact that this is the latest in a series of large macro bets: the purchase of S&P 500 puts, junk bonds purchases, and fixed income sales.
These actions are so wonderfully out of character for the world’s greatest value investor, as to suggest that by some mysterious process Kiewit Plaza had been magically transported to Lower Manhattan and George Soros has taken position of the oracle’s body.
Almost as remarkable as the nature of these transactions is the size of the profits they have generated. While it is way too early to judge the outcome of the FOREX positions, they have the potential to dwarf his earlier adventures. Warren Buffett himself has characterized the transactions as a hedge for Berkshire Hathaway’s wholly owned businesses against the decline of the dollar. But for Its shareholders, Berkshire Hathaway itself has become a hedge against the sort of disaster that could result from the sudden collapse of the dollar.
By this I mean that if the dollar where to suffer a sudden catastrophic decline, the result might well be a sharp increase in interest rates and subsequent decline in the stock market. Berkshire Hathaway’s intrinsic value would increase not just because of huge profits in its FOREX positions but if the market decline is prolonged and sharp enough Berkshire Hathaway would find its huge cash pile much more valuable, because of the opportunity to swallow large elephants whole.
So far the decline of dollar, while accelerating since the beginning of the forth quarter, has been orderly. but there is no guaranty that it will stay that way. Most analysts place the blame for the dollar’s decline at the feet of the individual foreign investors who have lost faith in the dollar, and are converting their dollar positions into local currencies.
It is important to understand that the dollar has been in a steady decline for three years and is currently trading more that 30% below were is was in 2001. One measure of the extent of the over valuation of the dollar is fact the even after a 20% to 30% decline in the dollar (depending on which currency index you use) the US trade deficit is still growing.
The main casualty of this decline, so far, is our equity markets. It appears that some of the foreign capital sucked in here by the “Great Tech Bubble” has already left the building. Foreign central banks have been absorbing dollars sold by their locals by buying US Treasury securities. Evidence of this is the fact that domestic long-term rates have remained stable as the dollar has fallen; this is so because of huge purchases of long bonds by these central banks. The three-year decline has left these foreign central banks with a huge net loss on US Bonds they have purchased.
Yet their purchases have accelerated as the dollar has declined. This does not seem to me to be a stable situation, maybe these central banks will continue to buy our bonds forever, but if they ever decide to cut their losses and dump their American bonds, the result could be quick and dirty: a further sharp drop in the value of the dollar and a sudden perhaps spectacular rise in our long-term interest rates. Interest rates are basically the price of money, and if our bonds loose their biggest buyers, we are going to have to pay a lot more to refinance our debt.
Most international holders of US debt are currently suffering a negative return (the dollar’s decline is larger than the interest they receive) for the privilege of letting us use their money, and one wonders how long they will tolerate this. A story in the Wall Street Journal of December 6, 2004 pointed out that “if current trends continue the Central Banks of Japan and China will have upped their dollar reserves from an estimated $1.4 trillion at the end 2004 to about $3 trillion by the close of 2008.
“Granted, the foreign central banks have a different agenda than the individual investor, but “the risk of a loss due to a drop in the dollar would at that point, far outweigh any benefit gained from continuing of finance US consumption”. The longer these banks continue to buy and hold US treasuries the more out of balance the dollar becomes.
It is an imbalance that will eventual have domestic consequences. The central bank purchases keep long-term interest rates in this country artificially low and is blowing a nice bubble in our real estate market. The bigger this bubble gets, the more pain there will be when it eventually pops.
Losch Management Company’s current accounts deficit says that the dollar is still way overvalued. I have no idea how or when this imbalance will correct, but logic would indicate that sooner or later it will. “If something cannot go on forever, it will stop,” and the longer these central banks support dollar (and the bond market) the more likely it is that the eventual correction will be painful.
Warren Buffett has very skillfully placed Berkshire Hathaway in a position to benefit from any financial crisis that erupts. In view of this I think that any investor with positions in US equities should consider hedging the risks now inherent in domestic equity prices with a sizable position in Berkshire Hathaway.