Is This the End of Berkshire Hathaway?

Nothing lasts forever. There's no such thing as a free lunch. If it sounds too good to be true, it is. If it can't keep going, it won't. Caveat emptor.

Call it what you will. Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) did something it hasn't done since Warren Buffett took the helm in the mid-60s: It had a terrible year.

Had to happen eventually
OK, maybe not terrible, but its worst ever by far. Per-share book value fell 9.6% in 2008, marking only the second time since 1965 it recorded negative results.

Berkshire's share performance, unfortunately, has been markedly worse. Shares are off 45% in the past year, falling back to 1998 levels.

Such is life. Most stocks are on a similar trajectory these days. Factor in investments in battered financials like Wells Fargo (NYSE: WFC  ) , American Express (NYSE: AXP  ) , and Bank of America (NYSE: BAC  ) , not to mention its dozens of operating subsidiaries waist-deep in industries like construction and retail, and a 45% plunge probably seems justified.

That, however, is hardly the main driver behind the recent nosedive. The growing fear is not necessarily over Berkshire's core holdings; above all, the worry is over a set of equity derivatives that, thought goes, could ultimately implode Buffett's track record of domination.

No one's perfect
Over the past few years, Berkshire sold a boatload of derivatives that effectively bet on the long-term strength of global stock market indices. By selling equity put options, it agreed to pay huge sums of money if the indices fell below levels they were initially struck at when the contracts expire -- which fall at various times between 2019 and 2028.

Since most of the options were sold in the glory days of yesteryear-- when indices were as much as twice as high as they are today -- Berkshire's current mark-to-market loss sits at $10 billion and grows by the day -- as global markets disintegrate.

Here's where the doomsayers come in: If indices fall to zero on and between 2019 and 2028, Berkshire could be on the hook for as much as $37.1 billion. That, even by Berkshire standards, would be a catastrophic loss.

It's all a bunch of ballyhoo
Nothing seems impossible after these last 12 months. Talk about stock markets becoming worthless, and rational people take you seriously. Still, let's be real: If major stock indices go to zero, Berkshire's liabilities won't be on anyone's mind. Guns, ammunition, canned food, and bomb shelters will be.

More importantly, the uproar ignores the most important part of the derivative contracts: that Berkshire received $4.9 billion up front, and won't be liable for a penny until they expire between 2019 and 2028. I know: $4.9 billion is peanuts compared to a potential $37.1 billion liability, but it's still a lot of money, and 10-20 years is a long time.

Long enough, in fact, that even if the derivatives do ultimately end up in the red, the future value of the $4.9 billion would likely offset even a massive loss. Using a 15-year timeframe (roughly the average time from now until 2019-2028), here's the pre-tax compounded value of $4.9 billion under different returns:

Annual Return

Value of $4.9 billion After 15 years

8%

$15.5 billion

10%

$20.5 billion

12%

$26.8 billion

15%

$39.9 billion

20%

$75.5 billion

And those returns are hardly out of reach. Since last fall, Buffett has put tens of billions of dollars to work in companies like Goldman Sachs (NYSE: GS  ) and General Electric (NYSE: GE  ) , with 10% yields and equity kickers offering ample upside. Just a month ago, Harley-Davidson happily sold Berkshire debt yielding 15%. When calamitous assumptions leave Berkshire with a $37 billion loss, and reasonable assumptions leave it with an offsetting $15 billion-$40 billion gain, the outcome of the derivatives -- even after last year's spectacular plunge -- seems like a far cry from lethal.

Bottom line
Make no mistake: Berkshire's hurting along with the rest of the economy. No one's claiming Buffet's 100% immune as the rest of the world flounders. Even so -- while less lucrative than they used to be -- the derivatives still embody what Buffett does best: Invest when the odds are in his favor. Keep a long-term perspective. Ignore short-term fluctuations. Repeat until wealthy.

For related Foolishness:                                                        

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Berkshire Hathaway and American Express are Motley Fool Inside Value recommendations. Berkshire Hathaway is a Motley Fool Stock Advisor selection. The Fool owns shares of Berkshire Hathaway and American Express. The Motley Fool is investors writing for investors.


Read/Post Comments (19) | Recommend This Article (60)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 02, 2009, at 12:00 PM, ChuckFullOfNuts wrote:

    [quote]not to mention its dozens of operating subsides waist-deep in industries like construction and retail[/quote]

    I hope you meant to say dozens of operating subsidiaries not subsidies.

  • Report this Comment On March 02, 2009, at 12:34 PM, FinancialFellow wrote:

    I think its a bit premature to even hint at the end of Berkshire. Let's keep things in perspective. Yes, the Dow has fallen from 14,000 to sub 7,000. Yes, this is a horrendous financial disaster that is probably going to continue to get worse. That said, I think Berkshire will, along with the rest of the economy come out of this.

    That said, Buffet himself recently said that 2009 will be horrendous and it will take many, many years for the economy to recover. So, we may be in this thing for quite some time.

    If you're in it for the long term now is a great time to buy, though: http://financialfellow.com/2009/03/02/tradeking-offering-up-...

  • Report this Comment On March 02, 2009, at 12:43 PM, rominosj wrote:

    Come on fool guys. Stop it with the Buffett articles that finish advertising your newsletters.

  • Report this Comment On March 02, 2009, at 1:01 PM, catoismymotor wrote:

    Is this the end of BRK-A? Not likely. Warren is very smart and has billions to invest. A few well placed chunks of dough by him will result in the BRK-A’s return to glory and greater fortune. I would not be surprised if BRK-A does not start to grow by 20-30% a year starting in 2011.

  • Report this Comment On March 02, 2009, at 1:14 PM, Groovetoon wrote:

    >>Come on fool guys. Stop it with the Buffett articles that finish advertising your newsletters.

    +1,000, No kidding

  • Report this Comment On March 02, 2009, at 1:16 PM, whereaminow wrote:

    If only Berkshire had lost $61B instead. The government would have lent him some money, and his stock would be up 10% today while the rest of the market gets destroyed.

  • Report this Comment On March 02, 2009, at 1:18 PM, cope2001 wrote:

    I am relatively new to investing, but is it just me, or does it seem like a good time to get in on this stock? Clearly, Buffett knows what he is doing even though he made a mistake.

  • Report this Comment On March 02, 2009, at 1:30 PM, cope2001 wrote:

    also, why are there two stock symbols (BRK-A & BRK-B)?

  • Report this Comment On March 02, 2009, at 1:57 PM, spankda wrote:

    cope2001:

    There only use to be BRK, but individual shares were getting too expensive for the average investor, so back in the mid-90's, they created 2 classes. BRK-A (original) and BRK-B. BRK-B has 1/30th the value and 1/30th the voting power as BRK-A.

  • Report this Comment On March 02, 2009, at 2:08 PM, Muhammad4M wrote:

    Its a market for traders not a value investors.

    Buffetts gift was his exit strategies which he got awfully wrong on this occassion.

    Now may be an awful time to buy shares-lots of potential danger out there,the kind Buffett himself never had to endure in his stellar career

  • Report this Comment On March 02, 2009, at 2:28 PM, spankda wrote:

    Muhammad4M:

    "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." -Warren Buffett

    Everyone agrees (even you), there is a lot of fear in the markets right now, yet I think Warren is doing exactly what HE says, not what you say...

  • Report this Comment On March 02, 2009, at 2:56 PM, Rasbold wrote:

    The End Of Berk?? Please.

    That would be a financial calamity unparalelled....wait.

    Ok, anything is possible. Fortunately I have my weapons and ammo in place! This market is a petesachit for everyone, even the Oracle.

    Dow 6.8K....Tell the stewardess to send back some of those bags.

  • Report this Comment On March 02, 2009, at 3:19 PM, SteveTheInvestor wrote:

    I thought BRK-B was way overpriced when it was pushing $5K/share. Guess I never realized just how overpriced it was. I have yet to buy any (why would I?).

    Yep, got enough guns and ammo to last a long time. Still working on building a food surplus, but getting there. The one thing I'm not buying is stocks. That would be pointless right now.

  • Report this Comment On March 02, 2009, at 3:45 PM, calbears85 wrote:

    Didn't Buffett say that derivatives are a fool's game?

    Why did he put such a huge risk in them?.

    I believe the derivatives effect on the economy is going to be vastly greater than the real estate crisis.

    There is virtuely no regulation in this "industry" and no real product. It's gambling with our future.

  • Report this Comment On March 02, 2009, at 4:07 PM, Inept wrote:

    Buffett explicitly indicates why he purchased the derivatives (that this article talks about) in his letter. The Black-Scholes model of valuing derivatives makes a lot of sense in the short term but grossly misprices options in the long term.

    What that means, and what this particular article tiptoes around, is the fact that he collects a premium right now that is disproportionate to the risk he is taking on for doing so. He is basically borrowing money for an extended period of time at an impossibly low rate, even considering very unfriendly and unlikely outcomes on the contracts, and investing it.

    Read the letter in the annual report. It explains everything in simple terms.

  • Report this Comment On March 02, 2009, at 7:05 PM, cvcoco wrote:

    Thats one the most blatantly unfair articles I have read on FOOL. After months of barraging people with BUY in the crisis, now you say 'such is life'? You kidding? The fact you never once said NOT to buy demonstrates a huge lack of expertise and foresight here. Not buying anything, or selling, makes the crisis worse, according to FOOL. But in truth, buying made people lose money because the zombie companies indeed need to fail so that we can see the bottom of the crisis and plan the next steps. Its so unfair to now say, "its just life." You sure didnt talk that way 5 months ago.

  • Report this Comment On March 02, 2009, at 7:16 PM, xetn wrote:

    I just wish the writers of these Motley articles would stop repeating the tired ole comments about BAC and F and GM and C. We all know all too well about them. And it makes no sense to keep dredging up their names. It reminds me of all of the talking heads in the media constantly using and reusing the term "financial meltdown". Is there no originality any where?

  • Report this Comment On March 03, 2009, at 7:07 AM, kipnoll wrote:

    ULTIMATE CAPITULATION

    I worked for Buffet and Munger back in '87 when they owned Cap Cities (parent of the ABC TV and Radio Networks). Good guys, but sure was sweet to take big bucks outta their hides with the Black Monday Crash of October '87. Cap Cities was then second highest priced stock on the NYSE, second only to their Berkshire Hathaway. Over $800 a share. Yet, being big time gamblers at heart, they were selling way out-of the-money puts on Cap Cities for peanuts: 1/8, 1/16, etc. Loaded up, spending 20 grand of my peon's salary. Three weeks out, tight time frame. Black Monday hit and those options were soon worth lotsa dough: half a million bucks. Elated at my take, 'specially considering its source.

    'Course, you've got to play buying cheapie puts very sparingly, as they bite ya in the ass 84% of the time, expiring worthless. That's Warren's and Charley's gambit - play the odds, just like the casinos. Thousands of tiny draws against every hit. It's why options are sold. They're usually profitable.

    The real gain for Warren came when selling ABC and Cap Cities at some four times what he had paid for 'em a mere ten years earlier. Turned $4&1/2 billion into $20 billion by finding a greater fool in buyer Michael Eisner at Disney.

    The problem today is there just aren't any Greater Fools out there. . . only governments. Nothing that can be sold is worth buying. People realize that. Governments cannot.

    Eventual collapse, as Warren, Doc Roubini and a few others have warned will - just as death - erase ALL. Stocks, bonds, the dollar, francs, gold. All will be subsumed. (I tell my friends to seek out the wisdom of the ancients: Gaius Plinius Secundus is a good place to start.)

    Societies die, sometimes quickly, just as individuals. Nothing, but nothing can go on forever.

    Get used to losing all - even life itself. If you must have solace, perhaps Emerson:

    "If my bark sink, 'tis but to another sea. . ."

  • Report this Comment On October 08, 2009, at 9:33 AM, bigmopig wrote:

    Some of the analysis in this article is seriously flawed. If the derivatives contract ends up in the "red" which will mean the markets are lower in the future years 2019-2028, it will be very difficult (and I say impossible) to earn a positive return on the $4.9mln, let alone an 8%-20% return as shown in the table.

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