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March 01, 2009

Warren Buffett Loses His Way
by Mike Shedlock

Bloomberg is reporting Berkshire Profit Plunges 96% on Stock Market Bets.

Warren Buffett's Berkshire Hathaway Inc. posted a fifth-straight profit drop, the longest streak of quarterly declines in at least 17 years, on losses from derivative bets tied to stock markets.

Fourth-quarter net income fell 96 percent to $117 million, or $76 a share, from $2.95 billion, or $1,904 a share, in the same period a year earlier, the Omaha, Nebraska-based firm said in its annual report. Book value per share, a measure of assets minus liabilities that Buffett highlights in his yearly letter to shareholders, slipped 9.6 percent for all of 2008, the worst performance since Buffett took control in 1965.

"The credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country" at the end of 2008, Buffett in his letter to shareholders today. "A freefall in business activity ensued, accelerating at a pace that I have never before witnessed."

Berkshire shares have fallen 44 percent in the past year as the value of the firm's top equity holdings dropped and losses increased on the derivatives. Nineteen of the top 20 stocks in Berkshire's U.S. portfolio declined last year.

'Major Mistake'

Coca-Cola Co., Berkshire's top holding, dropped 26 percent. American Express Co. plunged 64 percent. Oil producer ConocoPhillips fell 41 percent, and Buffett said in his shareholder letter that he made a "major mistake" in buying shares when oil and gas prices were near their peak.

Berkshire's equity derivatives were sold to undisclosed buyers for $4.85 billion as of Sept. 30. The derivatives are tied to four indexes -- the S&P, the U.K.'s FTSE 100 Index, the Dow Jones Euro Stoxx 50 Index and Japan's Nikkei 225 Stock Average. The indexes would all have to fall to zero for Berkshire to be liable for the entire amount at risk, which was $37.1 billion as of Dec. 31 and can fluctuate with currency valuations. Buffett previously identified only the S&P.

Under the agreements, Berkshire must pay out if, on specific dates starting in 2019, the four benchmarks are below the point where they were when he made the agreements. Buffett, recognized as one of the world's pre-eminent investors, gets to use the money in the interim. The liabilities on the derivatives are accounting losses that reflect the falling value of the stock indexes, not cash Berkshire has paid out.

"Derivatives are dangerous," Buffett said in the annual letter. "Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake."

The worldwide recession and global contraction of the credit markets are giving Buffett, 78, opportunities to invest some of the firm's cash hoard, which was about $25.5 billion at yearend, down from $33.4 billion three months earlier.

According to the Wall Street Journal Buffett's exposure on those derivatives now stands at $10 billion up from $6.7 billion at the end of the third quarter. See Berkshire Hathaway Reports Worst Year Ever for more details.

I do not buy Buffett's "accounting loss" defense that looks only at cash paid out. That defense smacks of the same logic that says Bear Stearns and Lehman were well capitalized and that Citigroup, Ambac, and MBI still are.

Of course Berkshire Hathaway has enough capital at this point to weather the storm. However, the fact remains Buffett made a major mistake in the timing of those derivative bets. Conceptually, this is a far bigger mistake than his ill-timed buy of more ConocoPhillips at the peak. ConocoPhillips is not going to zero, many of the financial companies in the S&P will.

I still wonder what he possibly could have been thinking to make such a bet right as the entire world was entering a recession. There has not been a recession in history where equity prices did not decline substantially, yet he made his bets before the recession was even acknowledged.

Buffett claims the bet frees up cash. It actually does no such thing. It ties up cash even though he claims by agreement it doesn't. Cash will only be "freed up" when he is ahead on the bet. That may or may not happen.

Had he been "freeing up cash" now instead of when he did, he would have $10 billion more "free cash" instead of being billions of dollars in the hole.

Warren Buffett is clearly an incredibly bright man. And while everyone makes mistakes, what strikes me most is his attempt to defend an indefensible derivatives play made at the worst possible time, while simultaneously stating "Derivatives Are Dangerous."

Regardless of what eventually happens, there is no frosting on Buffett's derivatives cake. Warren Buffett has lost his way.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Michael "Mish" Shedlock is a registered investment advisor representative for SitkaPacific Capital Management. Visit http://www.sitkapacific.com/ to learn more about wealth management for investors seeking strong performance with low volatility.