Not the Opportunity of a Lifetime

[snailslug]

Thought this was interesting.  From the CNBC interview with WB this morning:

 

BECKY: All right. Brian from Santa Rosa, California, writes in. He says, "I'm a 33-year-old lawyer who has never taken a business class in my life.  Nevertheless, am I crazy to think that many, if not most, blue chip stocks at current valuations represent the opportunity of a lifetime?"

 

BUFFETT: Well, I don't know if I would say the opportunity of a lifetime, but I would say that most people who buy companies, believe they're well capitalized. You don't want to buy somebody that's leveraged to the hilt in this situation because they may not to get to play out their hand.

 

BECKY: Mm-hmm.

 

BUFFETT: But if you buy a cross section of good equities, generally well capitalized companies, you'll make money over 10 or 20 years. I haven't the faintest idea where you'll be in 10 months, but it really doesn't make any difference. When I bought that farm, I have not gotten a quote on it yet. I bought a quarter of interest in the Omaha Royals, I've never got a quote on it. I look at the attendance figures, I look at see if the billboards have ads on them and all that sort of thing, but I took to the performance of the Omaha Royals or the farm to determine whether I made a decent investment.  That's the way people really ought to look at stocks. They have a hard time doing it because they get these quotes thrown at them every day. Forget the quotes. Look at the business.

[snailslug]

Also, on a lighter note:

 

BECKY: Then why did you make your investment in Tiffany?

 

BUFFETT: Well, we lent Tiffany money at 10 percent. We did not buy the equity. But I think the chances of Tiffany not paying us back--and Tiffany's going to have a bad year now.

 

BECKY: Right.

 

BUFFETT: I mean, anybody that's in luxury goods is going to have a bad year now and then, and they may have a couple of bad years in a row. But the American economy's going to be stronger five, 10, 20 years from now. And if a guy can bring home a blue box and have somebody kiss him, I mean, you know, that all--there's always a market for that.

[zarley]

Buffett was on CNBC this morning.  Here are links to the transcripts (with videos):

 

Part 1:  http://www.cnbc.com/id/29595047

Part 2:  http://www.cnbc.com/id/29595412

Part 3:  http://www.cnbc.com/id/29595537

Part 4:  http://www.cnbc.com/id/29595993

Part 5:  http://www.cnbc.com/id/29596414

Part 6:  http://www.cnbc.com/id/29596605

Part 7:  http://www.cnbc.com/id/29596955

 

Snailslug quoted a couple of interesting points.  Obviously, there are many more.

 

On Derivatives:

JOE: Hey, Warren, you're talking about some of the investments maybe you regret. This wasn't made last year, but your what was it, a sale of puts, a long-term bet on the S&P that I think you have to mark at least a little bit to market once in a while, and it's up in the billions now. Do you regret that? Is that going to work out in the future? How long do you have now, where does the S&P have to end up?

 

BUFFETT: Well, the S&P has to end up 15 or 20 years from the time we did the deals at the price at which we did them. Although, if the S&P actually ends up, you know, 15 percent below or so, we still break even and we've had the use of the money for 15 or 20 years. So we're holding about $4.8 billion.  The first one comes due in the latter part of 2019. And obviously I would rather put those positions on now than having put them on a few years ago.  But if you--if you gave me the choice of not having the positions at all, and not being able to put them on or sticking with the positions we have, I would stick with the positions we have. I think--I think we will--the odds are good we will make money. And the thing I know for sure is we'll hold almost $5 billion for between 15 and 20 years in conjunction with it.

 

JOE: Hm.

 

BUFFETT: So I like...

 

JOE: Those are derivatives. You don't like derivatives, but you used them in that case, right?

 

BUFFETT: I--well, we've used derivatives for many, many years. I don't think derivatives are evil, per se, I think they are dangerous. I've always said they're dangerous. I said they were financial weapons of mass destruction. But uranium is dangerous, and I just went through a nuclear electric plant about two weeks ago. Cars are dangerous.

 

JOE: Yeah.

 

BUFFETT: But I mean, every American wants to have one. You know, the--a lot of things can be dangerous, but generally we regulate how they're used. I mean, there was a--there was some guard up there with a machine gun on me, you know, when I was at the nuclear plant the other day. So we use lots of things daily that are dangerous, but we generally pay some attention to how they're used.

 

BUFFETT: Yeah. Although we benefit less these days than before. But AIG had this AIG financial products. I--when I bought Gen Re, they had something called GenRe financial products.

 

BECKY: Right.

 

BUFFETT: They had 23,800 contracts. Hell, I, you know, I couldn't understand 22,000 of them, probably. I spent--and I know I couldn't get my mind around it. You--that--and people recorded profit every--you know, that section made a profit every year, supposedly, and the guy that ran it made a lot of money and everything. You know, it probably would have busted the company if they--if they'd kept it around. Anything where you use the credit of a great institution to go out and start doing all kinds of things that--enormous leverage gets you in trouble.

 

Emphasis mine.  I think this puts Buffett in the "regulated derivatives market" camp.

 

 

[sfwusc]

Yea it does.

 

I still think the puts change Berkshire balance sheet though.  Before the puts, then something wiping out Berkshire was near impossible.  The puts create a chance though very very small.  If SP500 is way down in those years (say 100-200), then Berkshire is going to have to pay out cash.  That cash outlay is likely larger than cash on hand, so we will be selling assets in a huge down market.

A SP500 at that level 10 years from now would mean the economy has been very bad for a very long time.  That economy would mean AXP, WFC, and other equity positions are likely to be way below current levels with some maybe being zeros.

 

 

 

I am not saying it was a poor decision, but Berkshire assumed a lot of risk (with a small chance of happening) that a lot of shareholder seem to disregard. They were very well paid for it, but the risk is there.  To put it another way... we shorted a lottery ticket and were paid way above the IV to short it.  Yet if it hits it big, then we could be royally screwed.

 

I would not put 100% of my money in Berkshire due to those puts along with other reasons.  It does little good to be the last man standing if everyone ends up dead. Again very very small chance of it happening, but I am not a big fan of taking chances that can sink the ship.

 

-SFWUSC

 

 

[Viking]

sfwusc, I do not mean to sound disrespectful.

 

Based on you logic it almost sound like one should not get out of bed in the morning. On your way to breakfast, you may slip on that banana peel and bang your head. You may get into a car accident on your way to work....

 

Insurance companies should close up shop. The big earthquake may hit the West Coast and put all insurers out of business...

 

To not do something because their is a very small chance you may lose is not a good decision. The key is what you are getting paid to take on the risk. 5 billion in premium is not chump change.

 

Yes, there is a risk. BRK likely will do very well with this investment. Bottom line, lets perhaps start evaluating it in about 10 years...

[StubbleJumper]

Agreed Viking.  BRK is in the business of selling risk reduction. 

 

The most amusing example of BRK shorting a lottery ticket was when BRK insured a contest by Pepsi Cola a few years back where some lucky Pepsi drinker could have won $1b.  This was exactly a process of shorting a lottery ticket!  However, the advantage in that particular circumstance is that the probabilities of winning (losing?) the contest were readily calculable, so defining an appropriate price should have been easy.

 

The current situation with the put options is not quite the same simple process of evaluating the precise probability of loss and the precise magnitude of loss.  For this reason, people seem to have gotten their knickers in a knot!  However, as we have discussed at length on this forum, in a historical sense the probability of these things finishing in the money is low...from a logical economic sense, the probability of these things finishing in the money is low, the magnitude of any cash settlement is likely to be low, and the original proceeds are likely to have grown significantly.

 

All the noise that we hear is from people who are uncomfortable with the uncertainty....did WEB charge enough?  Frankly, I'm comfortable with this investment, but I must confess that I enjoyed the Pepsi contest more....

 

SJ

[sfwusc]

Hey,  I do risk arb, so I am all about taking risk.

 

I just think a lot of people use Berkshire as an index replacement. There are a lot of people that have 100% of their net worth in Berkshire Hathaway and are old enough that rebuilding isn't going to be easy or possible. 

 

The put options make this not such a great idea anymore due to the total wipe out risk.  Losing X% on a wonderful bet is ok.  Losing everything on a wonderful bet isn't so smart (unless you are young and net worth is a low compared to future earnings)

 

What does the owner's manual say... they wont risk what they have for something they don't need?    In the past.... I couldn't think of an event that could sink the ship.  Now there is an event that could.  That is a big change.

 

-SFWUSC

 

 

[cheapguy]

How about some calculations ?

 

Let us assume the 4.8B will earn 10%/pa.

In roughly 7.2 years it will be   9.6B

Another 7.2 yrs       it will be  19.2B

 

the puts are expiring in 15-20 yrs

 

So not knowing any more details, let us assume another 3.2 yrs of full growth (total of about 17.6 yrs)

 

So in 3.2 yrs it will be about $26B

 

(i did'nt put tax considerations).

 

So as per WEB, if the indexes are 15% down, he has to pay 4.8B

As per some article, the total liability is 37B if indexes all go to zero.

 

So based on a "linear" or a straight line assumption, WEB will break even until the indexes falling 81%

(assuming 10% tax free growth ofcourse).

 

 

So as per my rough calculations 81% drop of indexes should be fine.

 

So if all the indexes go to zero, Berkshire is on hook for about $11B.

That is the probable full loss, which Berkshire can fully pay without getting hit big time

 

(please refine this simple calculations, maybe assume deflation, assume 2-3% interest rates...??).

[benhacker]

Cheap guy, I'm a big fan of the puts... but you can't assume Buffett compounds 10% pa in an environment where the indexes drop >50% over a 20 year period.

 

PErsonally, I don't think you can assume the S&P will be at 200 either like SF is in 20 years becuase that doesn't even pass the sniff test.

 

I think you can assume buffett is doubling his money on that $4.x Billion over time (safely) AND the worst case that we care to think about in the market would be maybe a 0% GDP/GNP growth for 20 years and a valuation of 35% of GNP for the overall markets at that time.

 

I think that puts the S&P 15-20% below where it is today... (totally swagging right now)... implying a pretty bad 1-2% pa return for stock investors from here...

 

Buffett makes a net profit on this deal or we are all slaves to an alien race. (hey, maybe both...  ;D)

 

Ben

[cheapguy]

With the preferred deals like right now, 10% is good assumption.

For the HOG it is 15%

 

So even if the indexes, go down, if WEB can lend money at 10% that would be great.

 

Don't know in a deflationary or a prolonged recession with very low interest rates what can be earned

(like in japan, with close to zero rates).

[arbitragr]

puts should be good if markets stay at this level or up ...

 

looks like volatility is back again ... seems like markets are responding to good news ... people want to pick the bottom again ...

[Mungerville]

Buffet echoed my views that this is not 1974-type valuations or 1981 for that matter for the market overall.  Grantham also confirms it in his March 4 paper at www.gmo.com

 

This does not mean that the market can not rally big time here like plus 50% or that individual securities are cheap.  I think ORH right here is a no-brainer for example.

 

 

 

 

 

[StubbleJumper]

I just think a lot of people use Berkshire as an index replacement. There are a lot of people that have 100% of their net worth in Berkshire Hathaway and are old enough that rebuilding isn't going to be easy or possible. 

 

The put options make this not such a great idea anymore due to the total wipe out risk.  Losing X% on a wonderful bet is ok.  Losing everything on a wonderful bet isn't so smart (unless you are young and net worth is a low compared to future earnings)

 

What does the owner's manual say... they wont risk what they have for something they don't need?     In the past.... I couldn't think of an event that could sink the ship.  Now there is an event that could.  That is a big change.

 

-SFWUSC

 

This is an interesting perspective, and gives insight into why you might be a bit uncomfortable with the puts.  I would offer a few comments:

 

1) BRK is not and has never been an index replacement.  If people are thinking about it that way, it is a serious mistake.  I personally take concentrated positions in my portfolio, but I am completely comfortable with the idea that I could be wiped out (but ouch, that would be bad!).  Even with my tendency to take concentrated positions, it would be a really rare circumstance where I would ever consider "going all in" with 100% in a single security (I would never even go with 100% in a single currency).  If people go 100% into BRK and get wiped out that is THEIR FAULT, not WEB's fault for taking the put option position.

 

2) In recent weeks, on this board we have been kicking around the "total wipe out risk" for BRK that has arisen from taking this position.  You have correctly pointed out that if the S&P500 is at 100 or 200 in 2023, BRK will have a big liability....which might contribute to financial distress for the company.  However, let's probe this idea a little more.  What would the US economy look like if the S&P500 were to fall from 1400 in 2007 down to 100 or 200 in 2023?  Under what circumstances would this occur?  The depression to end all depressions?  If returns to capital including inflation were that low for such a long period of time, what would be the associated impact on the GDP per capita and unemployment?  I would propose that under these economic circumstances most companies, including BRK would be toast, puts or no puts. 

 

On the other hand, we have kicked around more modest declines in the S&P500, and found them to be manageable, particularly in the context of the potential compounding of the original option premium.

 

3) If you could not have thought of an event that would sink the ship prior to WEB taking the put position, I would respectfully suggest that you have not been thinking creatively enough!  WEB himself noted that a dirty bomb could have wiped out BRK before they excluded terror from their insurance contracts (ie, pre-2001).  Going forward, on an extremely improbable basis, I could see wipe-out potential from a) a ridiculous increase in litigation for some product that would make asbestos pale in comparison (ex, high fructose corn syrup is discovered to cause XYZ disease), b) a ridiculous biblical series of uncorrelated mega-cats (ie, a super west coast earthquake, 3 or 4 large east coast cities taking a direct hit from a hurricane, plus some other big cats all in the same year), c) political instability in the US (ie, the "Wing-nut Party" wins an election and legislates that all treasury bonds are written down by 50%), d) we experience the mother of all pandemics and nearly knocks us back into the stone age, e) fraud or mismanagement in BRK (Warren's successor comes from AIG or Enron).

 

Overall, I think you are excessively concerned about the risks associated with these puts.  As Scott Sagan said, "...things that have never happened before happen all the time."  Fortunately, the really extreme stuff is very, very rare.

 

SJ

[watsa_is_a_randian_hero]

To not do something because their is a very small chance you may lose is not a good decision. The key is what you are getting paid to take on the risk.

 

Yet even Buffett has said there are risks he will never take, regardless of what he is paid to take it on.  Assuming sfwusc's analysis is correct** for the sake of argument, going long with BRK with your entire net worth is no different than Citigroup's risk managers ... one is getting paid to take a 1 in 100 year event risk and completely brushing it off.  I am always worried when people bet against Black Swans with their entire institutions/portfolio.

 

** Big assumption

 

What makes WEB's S&P & CDS plays bets against black swans with their entire institutions.  I disagree with this.  Its not as though the risk is unlimited.  There is a limited amount of risk here.  WEB has the funds to pay if need be.  

[sfwusc]

Well, you go to enough message boards related to value investing, and finding people all in on Berkshire isn't hard to do. Buffett isn't given almost perfect view like he doesn't make mistakes.  He is way smarter than me in business, but he isn't perfect.

 

 

I am not saying that the black swan will happening, but I think it is very different than anything else ever underwritten by Berkshire Hathaway.  They were paid through the nose for it too.  I mean no one else could write such a policy and the buyer think they would be able to pay off on it.

 

Yes,  an A bomb or mass natural events could have done it as well.  Yet after 9/11 they wrote all contracts to avoid acts of war/terrorism.  I was still poor pre 9/11, and didn't have money to invest :).  So that was before my time. 

 

The puts are very correlated to other investments.  If we had mostly treasuries like FFH did, then it wouldn't have been so bad from a risk point of view.

 

We are debating a massively rare event.  I think saying that people going super overweight in Berkshire now is more crazy than before due to the puts.  Still, if the puts kill them, then only gold, silver, guns, ammo, and food are likely to be winners.  Mostly, the ammo and food :).

 

-SFWUSC

 

 

[Rabbitisrich]

SFWUSC, I'm also not a big fan of the puts for the reason that the method of payment is so closely related to the cause of payment. But solvency risk isn't really much of a concern. If Berkshire does have to pay, it will pay the difference between the indices and the strike prices X notional value. So you don't have to worry about Berkshire setting aside a massive cash outlay to purchase the actual notional value. There is no counterparty risk.

 

As far as the disaster scenario, where Berkshire is forced to pay for a substantial portion of the notional amount, the main risk involves opportunity cost, since much of Berkshire's equity will be liquidated just as market prices collapse.

 

It's possible that the recent moves into fixed income are meant to diversify Berkshire's liquidity away from the market. Pretty unlikely, but I like knowing that operating cash flows might be ridonculous going forward.