Berkshire Hathaway
Put Float

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By rclosch
February 10, 2009

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Morningstar in a recent story about Berkshire's Puts, ran the statistics for the last 58 years discovered that,

"Since 1950, using daily data on the S&P 500 (adjusted to include dividends), there are roughly 11,850 days to compare where the index was relative to where it was 12 years earlier. The average 12-year return on the S&P 500 since 1962 was 165%. In other words, since 1962, the S&P 500 has on average more than doubled over any 12-year period. The S&P 500 actually fell below where it was 12 years prior on 58 days over that time frame, or about one half of 1% of the time. The average 12-year change in the S&P 500 for those 58 days was negative 3.5%. In other words, the S&P 500 declined over a 12-year period only one half of 1% of the time, and when it did, the decline was less than 5%."

In other words if the last 58 years can be used as guide Berkshire's approximate chance of taking any loss on this position is one in two hundred. In terms of risk this deal is probably way safer than the typical reinsurance contract. But nice as this discussion sounds it is still missing the real point. What these puts are about is float, and not just any float but float with a nice beautiful long tail. The real point that we should focus on is what Buffett can do with the $4.5 billion that he gets to keep for 15 to 20 years.

1. One thing we know for sure is that he was getting 10% plus an equity kicker in October, and that today that yield has risen to 12%- 15%. $4.5 billion at 10% for 17 years equals $22 billion.

According to the press release that accompanied last year's first quarter 10Q the Puts where written to cover a period of either 15 or 20 years, but since this statement also said that some of the puts expire in 2019 that means that some of them have been around for a while. Those that expire in 2019 must have been written in 2004. This makes it somewhat more difficult estimate Berkshire's return because we do not know how many of the puts where written in what year, and it is likely that the eventual return for the puts written 2004 will be lower than for those written more recently.

2. We do not know yet if Buffett has bought any junk bonds, but we do know that in 2002 Buffett bought $8 billion in high yield debt. So with current junk bond yields above 18% it is certainly possible that he has by now found a home for a few billion in this area.

3. In 1995 Berkshire bought the 51% of GEICO they did not already own for 2.3 billion. The purchase would have placed a total value on GEICO of about $4.5 billion. In 1995 GEICO's pretax earnings where $302 million by the end of 2007 their pretax was about $1.7 billion for annual return of 15.75%. If the value of the company grew at the same rate for the 12 years it would have been worth $26 billion by the end of 2007. That's only 12 years the same rate of return if carried for 17 years leaves you with $54 billion plus all annual dividends that have been paid by GEICO to Omaha. So if Buffett gets the same return on the put float it would yield an eventual profit $54 billion

4. Maybe GEICO is not representative of future expected returns. So let's look at returns on float that has been used to buy common stock.

For 2007 Berkshire's Undistributed Investee Operating Earning where $2.6 billion.

In addition Berkshire received directly $1.67 billion in dividend income. Keep in mind that dividend income is one Buffett's favorite ways to receive income because Tax Law provides that 85% of all dividend income received by a corporation is exempt corporate income tax. This rule applies to both common and preferred stock, but does not apply to interest paid by debt obligations.

$2.6 billion Plus 1.7 billion =$4.3 billion. Investment gains on Berkshires stock portfolio in 2007 was $5.4 billion so the company's total return on its stock portfolio in 2007 was $9.7 billion divided by the cost total basis for all open positions of $39.2 billion means that Buffett's pre-tax return on stock investing in 2007 was 24.7%. The investment gains were high in 2007 because of the PetroChina sale; let's use the average of investment gains for the last five years to get a more reasonable figure. Total investment gains in the last five years were $17.5 billion so the average annual gain for the last five years would be $3.5 billion. $3.5 billion plus $4.3 billion, divided by $39.2 billion = 20%. $4.5 billion invested for 17 years at 20% equals 99.8 billion.

The bottom line is that these puts which are currently raising hell with Berkshire earnings statements actually carry very little risk. The statistics provided by Morningstar show one chance in two hundred that there will be any loss on the puts.

Further that in that one in two hundred happening the actual loss would likely be less than $2 billion, whereas, against this risk Berkshire is more or less certain to earn somewhere north of $22 billion and realistically quite bit more than that on the float.

This example may well exaggerate the possibilities, and I readily admit to the strong bias of someone with a large long position but it seems to me that the accounting rules as applied here misrepresent, distort and obscure what is actually going on. The impact of this very poor rule is made worse because it is happening in a period where people tend to believe the worst and are easily panicked. I am disturbed by what appears the obvious conclusion that people have been able to use this distortion to make money on the short side.

Mostly though I wanted to post these examples because there has been a great deal of discussion in the press and on TV about the risk associated with writing these puts, there has been very little talk about what Buffett can do with this very nice long tailed float, a point of view that to me is exactly ass backward.

I am happy when I see Buffett say, "Berkshire presently holds lots of financial derivative contracts," because while they have indeed been weapons of mass destruction, in Buffett's hands they will become a means of rapidly expanding the bottom line.