Buffett’s Big Bet

Over the past few days, there have been several stories written about Warren Buffett’s $14 billion bet on global stock markets. I believe these stories are all in reference to this excerpt form Berkshire Hathaway’s annual report:

“Berkshire is also subject to equity price risk with respect to certain long duration equity index put contracts. Berkshire’s maximum exposure with respect to such contracts is approximately $14 billion at December 31, 2005. These contracts generally expire 15 to 20 years from inception. Outstanding contracts at December 31, 2005, have been written on four major equity indexes including three foreign. Berkshire’s potential exposure with respect to these contracts is directly correlated to the movement of the underlying stock index between contract inception date and expiration. Thus, if the overall value at December 31, 2005 of the underlying indices decline 30%, Berkshire would incur a pre-tax loss of approximately $900 million.”

It’s impossible to evaluate what exactly this means for Berkshire or what it tells us about Buffett’s thinking without knowing more details. But, there are a few things I’d suggest you consider when reading the news reports.

First, the $14 billion headline number makes this bet look larger than it really is. According to the above disclosure, a 30% decline in the underlying indices would only create a $900 million pre-tax loss. One article stated that a decline in the indexes to zero was highly unlikely given historical trends. It’s a lot more than highly unlikely. But, since we don’t know the details of Berkshire’s exposure, we can’t evaluate the real risk of a very large loss.

A lot of these news stories have called Berkshire’s “long duration equity index put contracts” a bet on global stock markets. A few individuals have been quoted as saying Buffett has become bullish long-term. Buffett’s always been optimistic about the very long-term insofar as he recognizes how better things are today than they have been at any other time in history, and how that is likely to remain true for some time. Despite Buffett’s concerns about nuclear war, he doesn’t see a return to the Dark Ages and those kinds of anemic returns on capital.

That’s important to keep in mind, because I’m not sure this bet is much more than that. If you assume returns on equity will be similar to those achieved in the years since industrialization began, and you assume central governments will continue to cause inflation, a long duration equity index put contract isn’t much of a stretch.

Equity will earn returns, much of those returns will be retained by the businesses, and inflation will increase (nominal) stock prices regardless of whether the underlying businesses’ assets are increasing or remaining stable.

So, I’m not sure this is a bullish sign. In fact, it may be a bearish sign, because it suggests Buffett can’t find individual equities to buy, three of the four indexes are foreign, and someone wants to be protected against very large losses in a diversified group of holdings.

Remember, someone is paying for this protection. In my opinion, it’s not the kind of protection investors need. It’s long-term protection on an index. I suppose I can see why a pension fund might want this (to increase exposure to equities), but it seems like exactly the sort of thing an insurance company can make money selling. There’s fear of a very large loss, and a lot of factors that are hard to see that will tend to make that loss pretty unlikely.

We don’t know what premiums Berkshire is receiving, so we really can’t evaluate these contracts. If someone writes hurricane insurance it doesn’t mean they think hurricanes are unlikely, it just means they think someone is dumb enough to pay more than the protection is worth. Knowing the odds of a decline in global stock markets isn’t enough to evaluate Berkshire’s contracts, because we don’t know the price.

I’m not enamored with current valuations in the U.S., but looking out a couple decades it’s not all doom and gloom. Markets tend to overshoot in both directions, but there’s usually someone sane enough to buy when stocks get cheap enough.

What’s remarkable about the way investors move stock prices isn’t the magnitude of the truly major moves (up or down); it’s the frequency of meaningful moves when there’s no meaningful changes in underlying values. Think about the price range of an average stock in an average year – that’s the really irrational part of investor behavior. I wouldn’t want to have anything to do with a one-year contract on a single stock. That’s a very different situation.

Geoff Gannon writes a daily value investing blog and produces a twice weekly (half hour) value investing podcast at http://www.gannononinvesting.com

Buffett’s Bites: The Essential Investor’s Guide to Warren Buffett’s Shareholder Letters

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Investing strategies, market wisdom, and candid thoughts taken directly from Warren Buffett’s annual letters to Berkshire Hathaway shareholders. Even in today’s precarious stock markets, Berkshire Hathaway’s record of wealth creation continues to set new standards for successful, intelligent investing. Get the most insightful, canny, and candid thoughts from Warren Buffett’s annual letters to Berkshire Hathaway shareholders in Buffett’s Bites. L. J. Ritten… More >>

Buffett’s Bites: The Essential Investor’s Guide to Warren Buffett’s Shareholder Letters

Why Buffett?s Investment Strategy Won?t Work for Buffett Anymore ? But for you it Will Still Work!

You probably already know that Warren Buffett is the world’s greatest investor of all time. Starting with only $ 100, Buffett made an unprecedented journey in creating a personal fortune of $ 48 billon. A truly unprecedented accomplishment, especially when you consider he never started a company of his own and never invested a single penny in technology stocks. His complete fortune comes from investing in the stock market!

And, as a matter of fact, Buffett’s investment strategy isn’t that complicated: buy shares of quality companies when they are ‘on sale’. That’s all there is! With this straightforward strategy Buffett earned his billions of dollars. But, as we take a deeper look at Buffett’s returns over time something stands out…

The outperformance of Buffett compared with the S&P 500 diminishes over time. Between 1957 and 1966 Buffett outperformed the S&P 500 by a massive 14.5 times. In the most recent decade his outperformance has been diminished to ‘only’ 2.2 times the S&P 500. Of course, Buffett still shows that he is able to beat the indexes. But, now only at a fraction of the outperformance he achieved in earlier decades.

So, what’s the reason for this? Has Buffett’s system of buying quality companies on sale stopped working? Or has Buffett lost his ‘Magic Touch’? Twice the answer is negative.

The explanation behind the diminishing returns

The real explanation for the diminishing (relative) returns is actually quite simple. Nowadays, Buffett has to invest large amounts of money. Even investments of a few hundred million dollars aren’t worth the trouble anymore. Just, calculate along with me…

Buffett’s total investments currently have a value of approximately 110 billion dollar. So, should an investment still have some effect on the performance of the total investment portfolio this investment has to be at least 2 billion dollar. And that’s the problem.

As Buffett’s doesn’t want to influence a stock price too much (buying in large quantities drives the price of a stock up…) and wants to remain somewhat flexible, normally it isn’t possible to buy (or sell) more than 10% of the shares in a certain public company.

And, as the 2 billion equals 10% of the market capitalisation, we are speaking of companies with market capitalisations of at least 20 billion dollar. And, simply put, there aren’t that many companies with market capitalisations of over 20 billion!

And, besides the fact that there simply aren’t that many companies with market capitalisations that big, these companies are much more followed and researched by investment analysts and all kinds of investment professionals.

Because of this these companies are priced less inefficient. And voilà, here we have the second reason for the diminishing outperformance of Buffett.

Maybe you didn’t realize it, but as a consequence of this you have actually a considerably advantage over Buffett (unless you are Bill Gates…). After all, you aren’t limited to invest only in these giant, more efficiently priced companies. You can choose from a much, much greater supply of more inefficiently priced companies!

Buffett agrees with this reasoning:

“I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

–Warren Buffett, Businessweek, 25 th of June, 1999.

Also the returns of a couple of hedge fund managers show that it is an enormous advantage NOT to have too much money to invest. We will look at two of them: Joel Greenblatt and Mohnish Pabrai. Both of these top investors can be considered as Buffett copycats.

Joel Greenblatt

A few years ago, Greenblatt became known to a wider public as author of ‘The Little Book That Beats The Market’. In this book Greenblatt outlines a strategy in line with Buffett’s investment strategy. Greenblatt’s desire for stocks with high returns on invested capital accompanied by high earnings yields is essentially the same as Buffett’s desire for ‘quality companies on sale’.

Greenblatt’s hedge fund earned annual returns of over 40% for over twenty years. In his first ten years he even achieved annual returns of over 50%. And, like Buffett, Greenblatt got the same problem as Buffett: too much money to invest. And that’s why Greenblatt choose to buy out all the external investors in his hedge fund and to continue investing only with his own, private money!

An example of a recent investment of Joel Greenblatt is his purchase of shares of Aeropostale, a highly profitable clothing retailer. Within only a few months shares of Aeropostale had appreciated over 40%. Greenblatt sold his shares already. With a market cap of around 1 billion dollar at the time of Greenblatt’s purchase, such a transaction would be unthinkable for Buffett.

Mohnish Pabrai

Pabrai, like Greenblatt, can be considered as a Buffett follower:

‘M r. Buffett deserves all the credit. I am just a shameless cloner .’ – Mohnish Pabrai

In 1999, Pabrai started his investment fund with only 1 million dollar to invest. Now, only eight years later, Pabrai manages over 500 million dollar. Of course, Pabrai’s performance justifies this enormous growth: an annualized return of over 28% (after all fees and expenses).

An example of a recent transaction of Pabrai is his purchase of shares of Cryptologic, a software supplier for casinos on the internet. Total market capitalisation of Cryptologic at the time of Pabrai’s first investment: less then 250 million dollar. Pabrai, meanwhile, has seen this investment increase in value over 50% in less than 6 months. Again, this would be totally unthinkable for Warren Buffett.

But, like Buffett, both Greenblatt and Pabrai will be confronted with the laws of financial gravity. Also their relative returns will diminish over time. For sure, some will claim that Greenblatt and Pabrai just had some good fortune and claim that Buffett’s investments strategy doesn’t work anymore.

But also in the future new Buffett’s will arise. And they will demonstrate the sceptic, once again, that it’s still possible to outperform the market. Simply by buying shares of quality companies when they are on sale!

Hendrik Oude Nijhuis is the cofounder of www.magicformulastocks.com and is an expert on value investing and a long-time value investor himself. He extensively studied the investment methods of Warren Buffett. More recently, he started studying other exceptional value investors like Joel Greenblatt as well. Hendrik holds an MSc in Public Administration from the University of Twente .

The website www.magicformulastocks.com is dedicated to explain private investors (free of charge) why to select stocks on combinations of Return on Capital and Earning Yield. You will learn exactly how to select the most promising and most profitable stocks.

Warren Buffett’s Management Secrets: Proven Tools for Personal and Business Success

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Even in today’s economic climate, when so many investors and major companies are failing, Warren Buffett continues to be successful in all aspects of his life. Mary Buffett and David Clark have written the first book ever to take an in-depth look at Warren Buffett’s philosophies for personal and professional management — what they are, how they work, and how you can use them.Through close examination of Warren Buffett’s life and career from his earliest days to now… More >>

Warren Buffett’s Management Secrets: Proven Tools for Personal and Business Success

Does Warren Buffett’s Purchase Show the Credit Crisis is Over?

Flight to Quality –Flight to Warren Buffet His Berkshire Hathaway How many of you purchased shares of BRKA (Berkshire Hathaway) when it was all over the news last November that shares were approx $150 dollars each. If you had purchased you would have seen your shares fall to a point in August of this year to approx $110 dollars a share, rather unsettling. However last week like a shooting star BRKA jumped to $147 dollars a share. Anyone can see this by just looking at a chart, but the point I want to make all of this volatility really does not matter in the long run. You are associating yourself with one of the most astute investors of all times.

This was accentuated by this week’s current activity of Mr. Buffett. He is buying shares of Goldman Sachs to the tune of $5 billion dollars. He is not buying just the basic shares but the preferred stock with a 10 percent dividend. Berkshire also gets warrants to buy $5 billion of common stock at $115 a share at any time in the next five years. The common stock closed yesterday at $125.05, providing Buffett with an instant paper profit of $437 million (Not a bad days pay for anyone including Mr. Buffett.). The last time Buffett invested on Wall Street was in 1987, when New York- based Salomon Inc. pleaded with him for a $700 million cash infusion to fend off an unwanted takeover. Buffet ever the value investor has picked up Goldman Sachs (GS) after its stock has dropped approx 42%.

It seems that Goldman was somewhat desperate and the cost to them, could be considered high.

What is the stamp of approval from Warren Buffett worth???

Most investors have been so shaken from recent events it is hard to find them under any rock. Now Goldman is planning to offer stock to the public (approx $2.5 billion dollars) as well as one of Japans largest banks Sumitomo Mitsui is considering investing.

So does this mean the credit crisis is over? Your guess is good as mine.

Still there are concerns present regarding Goldman. The leverage they manipulate is still large. For every dollar of shareholder equity, Goldman owned $23.70 of assets for every dollar of shareholder equity. That is 23.7 times but the leverage that regulators allow usually in the ball park of 20 times. Even with this said, in this environment is this too much leverage?

Time will tell and you will need to be patient with Mr. Buffett. In 1999 shares peaked at approximately $80,000 and then fell to $40,000 per share (unsettling). More so it took until 2004 to arrive back at $80,000. However long term investors have been amply rewarded exhibiting patience.

Andrew Abraham

My Investors Place



Andrew has been in the financial arena since 1990. He is a Registered Investment Advisor ad affiliate of Abraham Bedick Capital. Since 1993 Andrew has been a proponent of quantitative mechanical trading programs. Andrew’s major concern is not only total return on investment but rather the amount of risk that one would have to tolerate in order to achieve returns He focuses on developing quant models that encompass strict risk adherence and correlation. He has been a speaker at conferences as well as an author of numerous articles. Andrew has spent years researching ideas that have the potential to outperform indices as well as maintain fewer draw downs.

Some Lessons From Warren Buffett’s Annual Letter

Warren Buffett’s annual letter to Berkshire Hathaway shareholders was released over the weekend. Readers will find plenty of investing lessons among the twenty-three pages. Warren began this letter as he begins each letter, by stating Berkshire’s change in per-share book value:

“Our gain in net worth during 2005 was $5.6 billion, which increased the per-share book value of both our Class A and Class B stock by 6.4%. Over the last 41 years, (that is, since present management took over) book value has grown from $19 to $59,377, a rate of 21.5% compounded annually.”

Some may wonder why Buffett opens by announcing the change in per-share book value rather than the earnings per share number. Over long periods of time, the change in per-share book value should nicely approximate the returns to owners. You may remember that, in my analysis of Energizer Holdings, I applauded the company for reporting comprehensive income within the income statement. Although a company’s net income is often referred to as its bottom line, net income is, in fact, a (sub)component of comprehensive income. Energizer Holdings (ENR) literally reports comprehensive income as its bottom line.

FASB merely requires that “an enterprise shall display total comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements that constitute a full set of financial statements”. Unfortunately, despite the lack of attention paid to it by investors, the statement of changes in stockholders’ equity is considered “a financial statement that constitutes a full set of financial statements”.

Therefore, comprehensive income can be reported in a statement many investors either do not review or do not understand. Alternatively, a company may choose to report comprehensive income in a separate Statement of Comprehensive Income. This, of course, baffles many investors, who think they are reading a second copy of the income statement. After all, what is comprehensive income? Isn’t the net income number reported in a (traditional) income statement a comprehensive number?

No. The widely reported earnings per share number is not comprehensive. That isn’t to say the EPS number isn’t important. It is very important. In fact, for certain businesses, it may be the most useful figure for evaluating a going concern. This is especially true if the investor is only looking at the financials for a single year. A single year’s comprehensive income may actually be less representative of a business’ performance than a single year’s EPS number (both can be pretty unrepresentative).Remember, the earnings per share number does not tell you how much wealth was actually created (or destroyed). You need to look to the comprehensive income number to find that information.

Essentially, Buffett is reporting Berkshire’s earnings in that opening line. He is simply using a more comprehensive income figure. He’s saying here’s how much wealth we created, and here’s how much capital it took to create that wealth. When he writes “Our gain in net worth during 2006 was $5.6 billion, which increased the per-share book value of both our Class A and Class B stock by 6.4%” he’s really saying Berkshire earned $5.6 billion and a 6.4% return on equity. He prefers using comprehensive income rather than net income, because comprehensive income includes non-operating earnings such as changes in the market value of available for sale securities.

If you still have doubts about the idea that Buffett is essentially reporting Berkshire’s comprehensive income in that formulaic opening line of his annual letters, compare the change in net worth numbers Buffett has reported in past years to the comprehensive income numbers found in Berkshire’s annual reports. For the past three years, Berkshire’s reported “gain in net worth” and Berkshire’s reported “comprehensive income” were $5.6 billion vs. $5.5 billion, $8.3 billion vs. $8.2 billion, and $13.6 billion vs. $13.4 billion. I hope this helps explain why I like it when public companies prominently report comprehensive income instead of presenting net income as if it were the Holy Grail of investing.

Of course, there is no such Grail. Neither net income nor comprehensive income captures the true economic changes to an owner’s share of the business. There is no truly comprehensive income number – and there never will be. A review of the financial statements alone is not sufficient to determine how a business’ competitive position has improved (or deteriorated) over the course of the year.

“Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.”

It is to these actions and their effects that an investor must look when he is forming his qualitative assessment of a business. After all, a company may lose money and yet improve its competitive position. In fact, that is exactly what a great many young businesses do. The question, of course, is whether those present losses will be more than offset by future gains after accounting for the opportunity costs incurred.

All costs are opportunity costs. It makes no sense to evaluate a year’s losses as if the alternative was to stop time. The available returns on the lost capital must be considered as well. That is why when one of Berkshire’s units has consumed capital, the loss has weighed heavily on Buffett.

Over Berkshire’s history, the cost of any losses also included the over twenty percent compound annual gain that was foregone. Buffett has always been painfully aware of the fact that, for Berkshire, losing $1,000 today would be much the same as losing over $7,000 ten years from today or over $125,000 twenty-five years from today. Berkshire will no longer grow its per-share book value at over 20% a year. So, these particular figures are outdated. However, if you refer to Buffett’s thoughts at the time when the Buffalo News was losing money (and when Berkshire’s textile operations were losing money), you will see just how heavily these opportunity costs weighed on him.

Still, it is possible that a business operating at a loss is actually improving its competitive position and creating wealth for its owners. One very difficult question that must be answered is exactly what the assets (often the intangible assets) that have been gained at great expense are actually worth. In some very special businesses, huge expenses are fully justified.

“Auto policies in force grew by 12.1% at GEICO, a gain increasing its market share of (the) U.S. private passenger auto business from about 5.6% to about 6.1%. Auto insurance is a big business: Each share-point equates to $1.6 billion in sales.”

“While our brand strength is not quantifiable, I believe it also grew significantly. When Berkshire acquired control of GEICO in 1996, its annual advertising expenditures were $31 million. Last year we were up to $502 million. And I can’t wait to spend more.”

This excerpt helps explain why I think all the money PetMed Express (PETS) puts into cable TV ads is money well spent. Pet medications, like auto insurance, is a highly fragmented business. Sales volume is important. Obviously, name recognition is as well. PETS can spend a lot on cable advertising and still spend less per sale than its competitors. It’s also important to remember that pet medications are rarely the sort of thing a customer buys once (just like auto insurance). While you won’t be able to retain all your customers, you will have a much easier time getting a current customer to stick with you than you will getting a new customer to switch from a competitor.

I’ll end this post with one of Buffett’s best lessons:

“Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.”

Geoff Gannon writes a daily value investing blog and produces a twice weekly (half hour) value investing podcast at Gannon on Investing.