A recent Reuters story headlined Is Warren Buffett losing his touch? based its case on two thin reeds:
- Recent price action — Berkshire Hathaway shares have fallen some 23% since the beginning of this month. The report speculated that the fall in BRK price might be due to mounting losses on its derivative contracts. BRK had previously entered into contracts insuring against the default of some junk bonds and had sold put options on some market indicies (i.e. betting that markets will be higher at contract expiry than when the contracts were entered into).
- The cost of insuring BRK’s AAA-rated debt has soared recently.
The reporter didn’t seem to have read the Berkshire Hathaway annual reports. In the 2007 report, Warren Buffet mentioned that he expects the derivative contracts to be profitable on premium revenues alone and noted that investors should be cognizant of the accounting treatment of derivatives:
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He 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.
You would think that business reporters would have a stronger case before writing off Buffett but fools continue to rush in where angels fear to tread.
