Here’s a look at part of Warren Buffett’s ‘playbook’ of investment strategies that he has experimented with.
Historically, Buffett has dabbled in:
- Ben Graham’s “cigar butt” style of investing
- Ben Graham’s workout situations: merger arbitrage, tender offers, etc.
- Wonderful businesses at a fair price (TV stations, newspapers, companies with excellent managers, etc.)
- Float from insurance or Blue Chip Stamps
- Buying private businesses
- Buying businesses out of bankruptcy
- Buying commodity businesses at the bottom of an economic cycle (e.g. Cliffs Natural Resources)
- Trading commodity futures
- Preferred share deals with financial companies that have gotten themselves into trouble
- Deals with companies trying to avoid hostile LBOs
- Selling derivatives
- Hoarding physical silver. (This didn’t work out.)
- Short selling individual stocks. (Buffett has basically said that this is a terrible way of trying to make money.)
- Going more than 100% long and shorting a diversified basket of stocks as a hedge. (I believe Buffett has said that the risk/reward of doing this isn’t statistically superior to going 100% long.)
I find it incredible that Buffett is well-versed in so many things and has gone well beyond what he had learned from Ben Graham (and Phil Fischer). This blog post will look at just one segment of Buffett’s playbook: derivatives.
On this blog, I previously mentioned that Doug Dachille did an excellent lecture “Analysis of Buffett’s love-hate relationship with derivatives“. Please go see it if you haven’t already.
Example equity put option deal
There is a 2008 Lehman Brothers presentation that leaked onto the Internet (PDF) that I discovered from this Bloomberg article. Two of the slides contain details of a derivative deal with Berkshire Hathaway. Here is the slide that summarizes the deal:
Here’s why I think this deal is brilliant for Berkshire Hathaway.
Let’s look at the worst case scenario. Suppose Berkshire loses US$1 billion. It received $205M upfront. In effect, Berkshire “issued” a 20-year bond at an interest rate of 8.25%. That’s not so bad. For Berkshire to lose US$1 billion, one of the three indices would have to go t0 0. (Or one of the three would have to approach 0, with some currency losses making up the difference.) This worst case scenario is virtually impossible as it is unlikely that an index will approach 0 in 20 years. A more realistic Depression era-esque scenario won’t be as bad as I make it out to be.
The best case scenario is that Berkshire doesn’t pay anything and makes $205M. There is some minor opportunity cost as these derivative deals will tie up some capital (and/or affect Berkshire’s credit rating).
Overall, it is highly likely that the best case scenario will play out and that Berkshire will make an easy $205M. It is like Berkshire issued unsecured debt with a negative interest rate. I think it’s obvious that the equity put options are a wonderful deal for Berkshire. And for obvious reasons, Buffett does not want others copying the trade and has been pretty tight-lipped about Berkshire’s derivatives. I wouldn’t underestimate Buffett’s brilliance. (Then again, I don’t own any Berkshire shares…)
Derivatives are “weapons of mass destruction”
This deal is a perfect example of why derivatives are problematic. When the deal was struck, Lehman immediately marked the derivative to its model and recognized a “profit” of $16.5M. Later on, the current MTM of $380.5M implies a “profit” of $175.5M. In my opinion, these profits are largely an illusion and will not materialize.
After flipping through the presentation, I’m not surprised that Lehman Brothers went bankrupt.
Links (this section added 5/4/2014)
Berkshire Hathaway’s 2008 shareholder letter explains it better than I do. The discussion about the equity put option derivatives starts on page 18.