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The Science of Hitting
The Science of Hitting
Articles (585) 

Unconventional Value Creation at Berkshire Hathaway

A look at the equity index put option contracts that Berkshire wrote in the mid-2000s

November 06, 2019 | About:

In 2004, Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) began entering into derivatives contracts tied to the long-term value of the S&P 500 plus three foreign indexes. Specifically, they were offering insurance for parties that wished to protect themselves against a potential decline in equity prices, with original terms of either 15 or 20 years (expiration dates between 2019 and 2027). In addition, the contracts were struck at market prices. As Warren Buffett (Trades, Portfolio) noted in the 2010 shareholder letter, the culmination of these agreements was 47 contracts with total premiums just shy of $5 billion. In every case, these were European-style options: “Neither party can elect to settle early; it’s only the price on the final day that counts.”

Berkshire received the cash up front when they entered into these deals, so there was no counterparty credit risk. In addition, only a handful of the contracts required Berkshire to post collateral under any circumstances, which meant they would be able to invest the premiums as they wished over 15 to 20 years before any potential payments were due. When Buffett spoke about these contracts in the 2007 shareholder letter, he didn’t mince his words:

“I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.” Put differently, he expected the deals to be profitable even when investment income on the huge amount of float provided was excluded in the calculation.

As Buffett noted in the same letter, the initiation of these contracts would result in some messiness for Berkshire’s reported results; unrealized gains or losses from the carrying value of the contracts would flow through the income statement. However, that didn’t bother him one bit:

"Our derivative positions will sometimes cause large swings in reported earnings… [Charlie] and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well."

Over the next few years, Buffett periodically updated investors on the state of the derivatives positions. As noted in the 2008 letter, the short-term impact became apparent in a down market:

"We have used Black-Scholes valuation methods to record a yearend liability of $10 billion, an amount that will change on every reporting date. The two financial items – this estimated loss of $10 billion minus the $4.9 billion in premiums we have received – means that we have so far reported a mark-to-market loss of $5.1 billion from these contracts."

The total amount at risk at that point, if all four of the indexes went to zero, was $37.1 billion.

Even then, after a tough year for equity markets around the world, Buffett remained confident that these were intelligent long-term bets:

“In my opinion, the valuations that the Black-Scholes formula now place on our long-term put options overstate our liability, though the overstatement will diminish as the contracts approach maturity.”

In 2010, at the instigation of a counterparty, eight contracts were unwound, equal to roughly 10% of Berkshire’s exposure. On those contracts, Berkshire had originally received $647 million in premiums. Ending them resulted in Berkshire paying $425 million, for a realized gain of $222 million (that does not account for value created through the unrestricted use of that $647 million for nearly three years). After completing that transaction, Berkshire was left with 39 equity put contracts for which they had received $4.2 billion in premiums.

At that point, based on market prices, the “settlement value” – what Berkshire would've owed if the contracts had expired at the end of 2010 – was $3.8 billion. Concurrently, the liability for those equity puts on Berkshire’s balance sheet was $6.7 billion. If nothing changed, the difference - $2.9 billion – would ultimately be recorded as a gain in the income statement over the coming years. As equity markets recovered from the depths of the financial crisis, the liability associated with the contracts declined further, resulting in even larger gains for Berkshire. And again, none of this captured the value associated with investing that float for more than a decade. As Buffett noted in the 2010 letter, “Since money is fungible, think of a portion of these funds as contributing to the purchase of BNSF.”

As the years passed, Buffett spent less and less time discussing the derivatives contracts. As far as I know, he has not mentioned them in the shareholder letters or at the annual meeting in years.

But now that we’re nearing the expiration of the remaining contracts (the weighted average life of unexpired contracts at September 30, 2019 was 1.3 years), let’s update the story. At the end of the third quarter, the liability on Berkshire’s books from the equity index put option contracts was down to $1.2 billion. In addition, the undiscounted liability (assuming the contracts were settled at September 30th, 2019) was down to roughly $600 million. When all is said and done, it appears nearly certain that Berkshire will make somewhere around $4 billion (or more) from these contracts – and that’s before considering the value created from investing the float for 15-plus years.

The fact that Buffett has rarely talked about this in recent years is telling. The derivatives, which came with some short-term pain in terms of Berkshire’s book value and quarterly swings in reported profitability, ultimately led to billions of dollars of gains for shareholders, possibly in excess of $10 billion after considering how the float has been invested. It is yet another example of Buffett and Charlie Munger (Trades, Portfolio) creating value through their willingness to do things that appear unconventional, but that make all the sense in the world if you’re focused on what truly matters.

Disclosure: Long BRK.B

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

raj123456789
Raj123456789 - 1 week ago    Report SPAM

Thank you for bringing up good points. But I still have one question. Is float really that valuble when BRK cannot invest what it already has? I am big fan of Buffett but float value is something I cannot fully understand.

Shapushki
Shapushki - 1 week ago    Report SPAM

I'm assuming you are referring to Buffett's recent reluctance to deploy his $128 billion cash hoard. Don't think of it as an inability to deploy the cash. Think of it as simply a time period in which no opportunities to deploy the capital at outsized returns exist.

The Science of Hitting
The Science of Hitting - 1 week ago    Report SPAM

Raj - I think it's worth remembering the following (from the 2009 shareholder letter), which is relevant to the float discussion in this article: "At year-end 2009, our cash was down to $30.6 billion (with $8 billion earmarked for the BNSF acquisition). We’ve put a lot of money to work during the chaos of the last two years." Hopefully that helps a bit. Thanks for the comment!

Niko4809
Niko4809 premium member - 1 week ago

Great article once again, It's nice to see unconventional methods being used by Warren. It goes to show that the principles of Value Investing, from Ben Graham will never cease to work. The applications change but the principles will always be the same.

Raj, you have to remember that Warren invests all of the float in Marketable Securities. Berkshire has around 220B in equities, and as The Science of Hitting pointed out in his last article, around 127B in float and 125B in Cash & Equivalents. That means that if Berkshire had no float it would have to deploy all of their cash and borrow another 2B to keep their equity portfolio at 220B.

The Science of Hitting
The Science of Hitting - 1 week ago    Report SPAM

Thanks for the kind words Niko! I'm glad you're enjoying the articles.

mike.david
Mike.david - 5 days ago    Report SPAM

As the years passed, Buffett invested less and less energy talking about the subordinate's contracts. Supposedly, he has not referenced them in the investor letters or at the yearly gathering in years. I am a Dubai Web Designer delivering our services in all over the seas!

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