17 March 2009
Has Warren Buffett just been lucky all these years?
It feels like sacrilege, but in light of recent events, including his shocker of a 2008, I have to ask the question. After all...
- His company, Berkshire Hathaway (NYSE: BRK-A), has reported $10 billion in writedowns on its equity put options -- i.e., derivatives.
- His hefty positions in financial shares, including Wells Fargo (NYSE: WFC), US Bancorp, and American Express (NYSE: AXP), have been absolutely throttled in this banking crisis.
- He loaded up on shares of oil titan ConocoPhillips (NYSE: COP) at the height of the oil bubble last summer -- a mistake for which he expresses regret in his letter to shareholders.
I'm not the only one questioning the Oracle of Omaha's investing prowess. One of the ratings agencies took away Berkshire's pristine AAA debt rating. The price of Berkshire credit-default swaps (which are basically insurance against Berkshire defaulting) is at levels more usually found with companies rated as junk. And finally, shares of Buffett's holding company are trading at half of last year's prices.
So is it time to conclude that Buffett's investing legend has been nothing more than extreme luck and excessive risk-taking -- the ultimate bubble waiting to pop?
Luck Or Strategy?
Buffett's entrance into derivatives, which he famously described as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal," might lead you to believe he's both hypocritical and risk-happy.
After all, since he made that claim in 2002, Berkshire has participated in four types of derivatives contracts, including taking $4.9 billion to write $37.1 billion worth of equity put options.
Still, believe it or not, Buffett's not being hypocritical, he's not being overly risky, and he hasn't made terrible deals.
Unlike many investors (and investment banks), he uses derivatives very carefully. In the equity puts, for example, Buffett has bet that stock markets in the U.S., Europe, and Japan won't utterly collapse over the long term.
He gets the $4.9 billion up front, and he has to pay up only if the markets are lower when the various contracts expire between 2019 and 2028. But under mark-to-market accounting, he has to record those bets as losses because of the short-term plunge of the worldwide stock markets.
Buffett prices and monitors each contract himself. There are certainly risks involved, but those risks aren't as dramatic as they seem. In the case of the $37.1 billion in equity put exposure, world markets would have to fall to zero for Berkshire to pay out the full amount -- and the markets have between a decade and two decades to make up the $10 billion in paper losses. In the meantime, Buffett gets to invest and grow the $4.9 billion in premiums.
Anyone who considers these long-term bets on the stock market "too risky" should steer clear not just of Berkshire Hathaway, but of the stock market in general.
What About Buffett's Shoddy Investments?
It's true that Buffett has taken some investing hits lately. His exposure to the banks, and his ill-timed purchases of ConocoPhillips, led to Berkshire Hathaway's worst-ever annual performance. Its per-share book value dropped 9.6% in 2008.
Many of Buffett's share positions are much worse off than they were just months ago, but it's worth noting that Berkshire's own share-price drop has more than priced in these missteps. Furthermore, Buffett has been doubted often in his nearly half-century at the helm of Berkshire Hathaway -- you'll recall the assertions during the tech bubble that Buffett's investing style was obsolete -- only to be proven right time and time again.
Any Risk In The Rest Of The Business?
None of the concerns we've already discussed bother me. I'm not worried about his derivatives, I'm not worried about his exposure to financials, and I certainly don't think Buffett's lost his investing acumen.
But looking at the company as a whole, two things do bother me.
The first is Berkshire's reinsurance business. Quite simply, Buffett and his trusted associates are in the business of pricing catastrophic events, which feature "very large transactions, incredible speed of execution, and a willingness to quote on policies that leave others scratching their heads."
Yes, Berkshire pools this risk and generates very attractive rates for it, but a few mistakes could blow the whole operation. Just like GE Capital has crippled General Electric (NYSE: GE), adverse events in Berkshire's insurance operations could take down the whole conglomerate.
The second problem is that, contrary to the hype, Buffett is mortal. Buffett is Berkshire Hathaway. It may not seem like it at these prices, but there is a considerable premium baked into Berkshire shares because he's the one running it.
So Is Berkshire A Sell ... Or A Buy?
If this financial meltdown has taught me anything, it's that we should question everything and everyone -- even our heroes. All that said, I still believe in Buffett.
Buffett remains the greatest allocator of capital on this planet, and he's getting some great opportunities thrown his way. Down-on-their-luck companies from Goldman Sachs (NYSE: GS) to GE to Harley-Davidson have sought his financial help and reputation, at very, very favourable terms.There is plenty of risk in Berkshire shares, but at current prices, I believe that Berkshire Hathaway is worth the risk.
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