Feb. 27 (Bloomberg) -- Berkshire Hathaway Inc. may report its worst results since Warren Buffett took over in 1965, based on a measure the billionaire chairman cites on the first page of his firm’s annual letter to shareholders.
Losses in Berkshire’s stock portfolio and writedowns on derivative bets tied to equity markets may have caused book value per share, a measure of assets minus liabilities, to fall by 8.5 percent, according to Gary Ransom, an analyst with Fox- Pitt Kelton Cochran Caronia Waller. That ratio declined only once before on Buffett’s watch, falling 6.2 percent in 2001.
Berkshire suffered as the benchmark Standard & Poor’s 500 Index turned in its worst year since 1937. The expected writedown on derivatives may reflect both that decline and the increasing volatility of equity markets, though the $35.5 billion in derivative contracts don’t require Omaha, Nebraska- based Berkshire to pay out until at least 2019, if at all.
“He’s warned us about this,” said Janet Tavakoli, founder of Chicago-based advisory firm Tavakoli Structured Finance and author of “Dear Mr. Buffett,” which contrasts the billionaire’s derivative bets with those that brought American International Group Inc. to the verge of collapse. “He’s said there could be fluctuations of $1 billion or more per quarter. We’re now in the ‘or-more’ stage.”
If Buffett’s 2008 report, expected tomorrow, follows the template from past years, the first sentence of the letter to shareholders will disclose the change in book value. In his “owner’s manual” for Berkshire shareholders, Buffett says he considers the figure to be an objective substitute for the best, albeit subjective, measure of a firm’s success: a metric he calls intrinsic value.
Intrinsic Value
“Intrinsic value is an estimate rather than a precise figure,” Buffett, 78, wrote in the manual on Berkshire’s Web site. “We give you Berkshire’s book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire’s intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value.”
Buffett doesn’t provide a number for intrinsic value. He didn’t respond to a request for comment left with assistant Carrie Kizer.
Berkshire, which has posted four straight drops in quarterly profit on declining insurance results and investment losses, will also disclose earnings for the three months ended Dec. 31. Buffett, who transformed Berkshire into an enterprise with operations ranging from underwear and ice cream to jet leasing and power plants, has downplayed the importance of quarterly results in evaluating the firm’s long-term health.
Berkshire’s share price has slipped 44 percent in the past 12 months through yesterday, compared with the 45 percent drop in the S&P.
400,863 Percent
Berkshire’s book value outperformed the total return of the S&P in 37 of the 43 years through 2007, according to the most recent annual report, and probably beat the benchmark index in 2008, Ransom said in a note to investors on Feb. 23. Under Buffett, Berkshire’s book value per share grew 400,863 percent through the end of 2007, compared with 6,840 percent for the S&P, according to Berkshire’s own calculations.
The growth reversed in the first 10 months of 2008, Berkshire said in a November statement. Nineteen of the top 20 equity holdings in Berkshire’s U.S. portfolio, valued at $51.9 billion as of Dec. 31, declined last year. Coca-Cola Co., Berkshire’s top holding, dropped 26 percent. American Express Co. plunged 64 percent. Oil producer ConocoPhillips fell 41 percent.
Fixed Returns
Berkshire’s derivative contracts were sold to undisclosed buyers for $4.85 billion. Under the agreements, Berkshire must pay out if, on specific dates starting in 2019, four market indexes are below the point where they were when he made the agreements. In the meantime, Berkshire can invest the cash. Buffett has been buying preferred shares and debt of companies including General Electric Co. and Harley-Davidson Inc. to lock in yields as high as 15 percent.
The indexes, which include the S&P and three others Buffett hasn’t identified, would all have to fall to zero for Berkshire to be liable for the entire $35.5 billion that’s at risk.
The liabilities on the derivatives -- those expected to have affected book value in the fourth quarter -- are accounting losses that reflect the falling value of the stock indexes, not cash that Berkshire has paid out.
“There’s the potential for significant losses on that position,” said Bill Bergman, an analyst with Morningstar Inc. who gives Berkshire five stars, his firm’s highest rating. “But this is what they do. They’re in the risk absorption business, and in the long term it’s hard to see how there are going to be significant losses in 2019 or later.”
More Information
Buffett said in November that he will provide more information on how he calculates losses on the derivative bets in the firm’s annual report. The document will discuss “all aspects of valuation” and cover “deficiencies in the formula” for pricing the derivatives, “which we nevertheless use,” Buffett said in an e-mail in November.
Results in the fourth quarter may also decline on Berkshire’s businesses tied to real estate. The worst housing slump since the Great Depression hurt results for those firms in the third quarter, including Acme Brick, Benjamin Moore paints and carpet manufacturer Shaw Industries.
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