Here's something interesting I found out in the 2007 Berkshire Hathaway annual report. By now, we all know Warren is a big bull in the stock market in the next 11 to 19 years. Looking by his actions, Berkshire sold puts on notional value of $35 billion. That's no chump change. It's a big bet! With actually very little risk. Let me explain but before, let's read what he wrote in the annual report.
"The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at year end of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, 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.
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."
Why are these derivatives low risk?
Simply, the obligation to pay up is only due between 2019 and 2027. In between time, losses and gains are only in paper. The risk that I am talking about is the opportunity loss risk. Will these derivatives cause a long term slow down of in Berkshire's earnings? If you're as optimistic as Warren as I am. Then, if at the very least, this $4.5 Billion in cash can be invested at the Index long term growth rate of 10%, by 2019, they will be worthy just under $13 Billion! Of couse, add the magic touch of Warren...it should be much higher than that. Say at a 15% rate of return, it will be worth just under $21 billion.
What caught my eyes...
What's even more interesting is this... "our derivative positions will sometimes cause large swings in reported earnings", I think this derivative item can only make BRK market price more volatile. Put options are leveraged investments which mean a small change in the index like S&P500, will magnify the change in the put value. It can work both ways, up or down. So a $4.5 Bil premium (or liability) can easily grow to 8 billion in a year if the indexes crash. If that happens, BRK’s earnings and book value will decline substantially. Share prices will FALL. Again, the upside to this is…the loss is a non-cash expense and has no liability until 2019 and 2027!!!! I think it will make room for future buying opportunity!