Berkshire’s earnings constitution is always in flux, with major acquisitions, debt financing and personnel announcements unique to the conglomerate. In the past two years alone, the company bought the entire Burlington Northern Railroad, entered into preferred share and warrants agreements with GE and Goldman Sachs, and announced the retirement of long-time Geico float manager Lou Simpson and addition of Todd Combs.
One of the largest impacts on Berkshire’s financial statements results from large swin
gs in Berkshire’s derivative positions implemented in 2007 and 2008. Berkshire Hathaway sold put options on the S&P 500, the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. The put premiums collected totaled $4.9 Billion on $37.1 Billion in “exposure” at durations between 12 and 20 years. The puts are European-style options, meaning they are not exercisable prior to their expiration date.
Both exposure and duration are key. First, because the put options are based off indices, the likelihood that Berkshire is liable for the full amount of the put contact is low. We have a lot bigger problems to worry about than Berkshire put liability if any of these indices approach zero. The duration aspect is critical because Berkshire will have the time to put the contract premium to work. Even at a 100% loss on the contracts, Berkshire theoretically could recoup the payoff amount by obtaining a 12.25% annual return. Given Berkshire’s track record, this is doable. Thus, the deck is stacked heavily in favor of Berkshire and its shareholders as the first options approach expiration in 2018.
|Index Return||Payoff (Billions)||Required Premium Return|
The short-term paints a different picture because negative swings in the market mask otherwise solid earnings results at Berkshire’s operating companies. For example, the Burlington Northern purchase, totaling $27 Billion, contributed earnings of $603 million in net earnings in Berkshire’s second quarter. Contrast that with the put options: The equity derivatives produced a loss of $1.8 billion in three months, compared with a gain of $1.96 billion in the same quarter a year ago. These market swings based off the S&P and foreign indices approach three times the earnings power as the $27 Billion railroad. These same contracts are derivatives of indices over which Buffett and Munger have no control.
The market is still adjusting to the impact of these derivative positions on Berkshire’s results.
Commenting on the put positions in an interview with Bloomberg, Morningstar analyst Bill Bergman stated: “On the derivatives, we had a problem there in the second quarter. That’s clearly reflected in the bottom line.” The swings work both ways, however, and this quarter’s earnings are likely to be positively impacted in an amount that is not yet baked into Berkshire’s share price. The S&P posted price returns of 3.69% through the end of the quarter while the FTSE 100 and Euro Stoxx 50 are both higher. Only the Nikkei 225 is lower.
With the underlying indices net positive, mark-to-market results on these positions should swing to a substantial positive impact on Berkshire’s bottom line, making the company a great value investment right now.
Disclosure: The writer of this article might have a position in Berkshire Hathaway which could change at any time