Reflection on Warren Buffett letter to shareholders

Reading Warren Buffett letter to shareholders makes me feel like going to church listening to sermon. He preaches the same sermons over and over again. Like church, you will see multitude of real greenhorn(new convert) or retirees(guys(gals) that finally mature after graduated from hard-knock school) keep nodding their heads agreeing to the gospel “truths”. Rebellious teenagers will flee finding the preacher is very preachy and boring. They like to prove the old chap is wrong, obsoletes and irrelevant to financial engineering innovation. The can’t even use computer properly except yelling for help - hapless. Their tools belong to Stone Age and Greek illiterate. I was one of those rebellious teenagers but humbled by “Society University” and finally return to the root and a home called Kampung Intelligent Investing.

Ever since I can get his letters on-line, I always spend time thinking over what he says in his letters. I don’t like to turn my reflections into an essay competition about Warren Buffett. I am sure countless of articles already flying around the Internet over the last few days. My inner contrarian normally will prevent me writing a guy that already very popular. But for Warren Buffet, it’s always a pleasure. So let's get started.

Intrinsic Value. Berkshire Hathaway 2008 book value fell by 9% vs. S & P 500 37% but share price of Class A lost almost 31%. Seems like some mis-match here. Warren Buffett finally openly talk about how to value Berkshire.

per share investment ( Bond, Equity and cash equivalent) + per share earnings from other sources(operating units)

2008 Intrinsic value of Berkshire = 77,793 + 39,210 ( 10 X EPS) = 117,003 or 3,900 per Class B share.

In my opinion, Berkshire is undervalued now.

Derivatives. Yes the multibillion put option contract he wrote. Since he explains better than I do, I will reproduce the whole explanation here:

The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.

If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.

It’s often useful in testing a theory to push it to extremes. So let’s postulate that we sell a 100- year $1 billion put option on the S&P 500 at a strike price of 903 (the index’s level on 12/31/08). Using the implied volatility assumption for long-dated contracts that we do, and combining that with appropriate interest and dividend assumptions, we would find the “proper” Black-Scholes premium for this contract to be $2.5 million.

To judge the rationality of that premium, we need to assess whether the S&P will be valued a century from now at less than today. Certainly the dollar will then be worth a small fraction of its present value (at only 2% inflation it will be worth roughly 14¢). So that will be a factor pushing the stated value of the index higher.

Far more important, however, is that one hundred years of retained earnings will hugely increase the value of most of the companies in the index. In the 20th Century, the Dow-Jones Industrial Average increased by about 175-fold, mainly because of this retained-earnings factor.

Considering everything, I believe the probability of a decline in the index over a one-hundred-year period to be far less than 1%. But let’s use that figure and also assume that the most likely decline – should one occur – is 50%. Under these assumptions, the mathematical expectation of loss on our contract would be $5 million ($1 billion X 1% X 50%).

But if we had received our theoretical premium of $2.5 million up front, we would have only had to invest it at 0.7% compounded annually to cover this loss expectancy. Everything earned above that would have been profit. Would you like to borrow money for 100 years at a 0.7% rate?

Let’s look at my example from a worst-case standpoint. Remember that 99% of the time we would pay nothing if my assumptions are correct. But even in the worst case among the remaining 1% of possibilities – that is, one assuming a total loss of $1 billion – our borrowing cost would come to only 6.2%. Clearly, either my assumptions are crazy or the formula is inappropriate.

I’ve written about how shrewd and innovative he is when come to generating float. In this case, you are loaning him money at 0.7% compounded annually. Even his bets gone soured, he is paying at a maximum of 6.2% financing cost. Let's say this old tiger lost its hunting skill, say, he can only generate 10% annual compound return for next 100 years, still you are letting him grow his net worth at very cheap financing rate. In 100 years later that 2.5 million will grow to 71 million (worst case), 18 billion (1% chance of 50% decline below agreed index) or 34 billion (99% chance of not paying anything)

Back to his real money bet. 4.3 billion premiums he received so far on put contract, he is likely to create additional 25 billion wealth and not like what most believe that is the beginning of the end of Berkshire Hathaway. Honestly, do you believe that S & P will go from 900 to 450 or 0 on 31 December 2028(I pick the date from the air of European style settlement in 20 years time)? It is always frightening when you hear the media report he has 14.9 billion losses on derivatives(based on mark-to-market).

Enough of hard stuffs? Now you know the old man that you know is a complex man. He is just too humble and decided to come down to our level. Give him that respect. Will be back soon on his other subjects soon. Stay tuned……….