Thursday, January 22, 2009

Warren’s Worst Year

Morningstar's 2008 CEO of the Year

Wednesday January 7, 2009
By Paul A. Larson

The timing is impeccable.

As the headline above declares, the folks at Morningstar recently named their new “CEO of the Year.”

And this year, they bequeathed that honor on Warren Buffett, Chairman and CEO of Berkshire Hathaway.

You might be wondering why it took the Morningstar folks fifty years to give the award to the “Oracle of Omaha.” Even the folks at Morningstar admit there doesn’t seem to have been a good reason except that they never got around to it:

We have contemplated naming Warren Buffett CEO of the Year every year since we created the award, and this year we finally get the chance to officially acknowledge all that Buffett has done for Berkshire Hathaway (brk.a.A) (brk.b.A) shareholders, both over the decades as well as in 2008.

Now, Buffett might want to think about giving that award back.

After all, in 2004, Morningstar was too busy naming Herb and Marion Sandler co-CEOs of the Year to give it to Warren.

The Sandlers, of course, had spent forty years building Golden West Financial into the second-largest savings and loan in the country, thanks to the innovation—first stumbled on by Marion Sandler during an analyst stint at Oppenheimer—of variable-rate mortgages. And they would go on to even greater fame and fortune by selling out in 2006 at about as close to a top as ever existed, to Wachovia, for $25 billion smackers.

Unfortunately, that was about $25 billion too much. The fallout from that deal would later force Wachovia into the arms of Wells Fargo—ironic, considering Buffett’s Berkshire Hathaway is a long-time Wells Fargo shareholder.

And back in 2001, Morningstar cheerfully named Jorma Ollila of Nokia its CEO of the Year 2000, which was about as close to the peak of Internet/Telecom Bubble as, well, Golden West’s sale to Wachovia was to the peak of the Housing Bubble. (But don’t expect Berkshire to rescue Nokia any time soon: Buffett, as nearly everyone already knows, doesn’t do technology.)

Still, if any CEO deserves the Morningstar award, Buffett would have to be number one, or maybe two, behind Steve Jobs, on anybody’s short list.

After all, Buffett predicted the current financial calamity—if not its timing and its intensity—more than five years ago, when he warned against derivatives in his annual shareholder letter, calling those wildly popular financial innovations “ticking time bombs” and “financial weapons of mass destruction.”

And thanks to that foresight, his company, Berkshire Hathaway, is about the only financial entity still standing, in a landscape of horrific desolation, with much the same financial strength as it had before the bombs started going off. Indeed, Berkshire is now one of a handful of true Triple-A balance sheets left in the world.

So bad looks the landscape that the press has been having a field day coming up “Worst-Since” headlines: Worst decline in U.S. householder net worth since records began in 1952; Worst manufacturing orders since records began in 1948; Worst consumer confidence since the Pearl Harbor year of 1942; Worst home price declines since the Great Depression; Worst year for the S&P 500 since 1937.

But there's one “Worst Since” headline that hasn't made the list just yet, and won't until the Berkshire Hathaway annual report is released at the end of next month: Warren Buffett’s worst year since—well, since he began investing other people’s money in 1956.

Now, we are not talking about the decline in Berkshire’s stock price last year—it was down 32% in 2008, as CNBC reported breathlessly on the first day of the New Year, before adding quickly that he still “beat the S&P 500”.

We’re talking about what Warren Buffett cares most about: the annual increase (or, in this, case, decrease) in Berkshire Hathaway’s economic value—which Buffett measures by the company’s book value per share.

Near as our computers can calculate, Berkshire’s economic value declined something like $10 billion in 2008, or $6,500 per share—an 8% decline. That would be only the second time in Berkshire’s history that the company has suffered a decline in its net worth—the first being in the year 2000, when Berkshire’s book value per share declined 6.2%.

Don’t hold us to these numbers: only Buffett himself, and a few of the 19 individuals who staff Berkshire’s home office in Omaha, know for sure. Berkshire being an insurance company with many moving parts, including a very large derivatives book, we could be off on this.

Indeed, the folks at Morningstar seem to think Berkshire suffered not at all:

And while 2008 was an exceptionally difficult year for just about all investors, it was much less trying on Berkshire Hathaway and its shareholders. Berkshire's balance sheet equity should be roughly flat from a year ago once the books are closed on 2008 [emphasis added]….

We’re not sure where Morningstar is coming up with this “roughly flat” thing.

While Berkshire’s shareholder’s equity was roughly the same at the end of the third quarter of 2008 as at the end of 2007 ($120 billion or so), it would appear to have suffered a very large whack in the fourth quarter of 2008.

In fact, Berkshire foreshadowed the potential decline in its third quarter 10Q:

Subsequent to September 30, 2008, conditions in the pubic debt and equity markets have declined significantly resulting in exceptional volatility in debt and equity prices. Such volatility has impacted the fair value of Berkshire's investments in equity securities and derivative contract liabilities for equity index put option contracts. Based on equity and equity index prices as of October 31, 2008...Berkshire estimates that consolidated shareholders' equity would decline by approximately $9 billion.

Where things stood at December 31, 2008, we won't know until the annual report is out in a few weeks. However, based on our own calculations, the value of the common stocks held by Berkshire declined by what looks like a good $12 billion, and very likely more, in the fourth quarter of 2008.

Second, Berkshire has a huge derivative exposure that likely cost it billions of reported losses, which is ironic to some, given Buffett’s loudly voiced skepticism regarding these “ticking time bombs,” but understandable since Buffett never shies from attempting to make money where he sees opportunity.

As Berkshire reported in the paragraph quoted above, it saw a further significant unrealized, non-cash loss on derivatives—mainly on index puts Buffett sold in recent years—subsequent to the end of the third quarter. Given that markets got even worse after the 10-Q was issued, Berkshire should show an even stiffer unrealized, non-cash losses in the fourth quarter than the $2 billion or so already booked in previous quarters.

Based on our rough math, those equity and derivatives hits could add up to as much as a $20 billion in pre-tax losses. Adjusting for income taxes, we’ll call it a $15 billion reduction in Berkshire’s book value as of December 31, compared to the $9 billion Berkshire cited as of October 31.

Offsetting those large losses should be at least two pluses.

First, the earnings from Berkshire’s own businesses, which could be anything (Buffett does not tinker with earnings the way virtually all companies do; and insurance earnings are notoriously volatile) from a little to a lot. But we’ll guess—generously, we think, given that most of Berkshire’s businesses have suffered along with the economy in recent months—the 2008 fourth quarter earnings will come in equal to the prior year’s fourth quarter, at $3 billion.

Second, Berkshire should realize at least a $1 billion pre-tax gain from its aborted bid for Constellation Energy, and could also realize non-cash gains deriving from the odd fact that Berkshire’s creditworthiness came under question during the fourth quarter. Weird as this last may seem, the fact that the cost of insuring Berkshire debt rose substantially during the quarter could theoretically reduce the value of the Berkshire losses on its derivatives book. (How this actually will affect the company’s shareholders equity, we don’t have a clue).

So, in round numbers, the $15 billion hit Berkshire could take from equities and derivatives, offset by $3 billion in income plus at least a possible gain of up to $1 billion on other investments, nets out to a guesstimated $10 billion decline in Berkshire’s book value.

That’s a $6,500 decline in book value per share, or 8%, and only Berkshire’s second decline since Buffett took control in 1965.

More remarkably, it is only Buffett’s second down year in his professional life, because in the 13 years he ran his hedge fund before shifting his focus to Berkshire, he never had a down year.

(Yes, Warren Buffett ran a hedge fund. It was called Buffett Partnership Ltd, and the irony here is that Buffett likes to bash hedge funds for their egregious fee structures, which can reach a 2% management fee plus a 20% incentive fee on profits. Buffett's fee structure was a healthy 25% incentive fee on annual profits above 6%, but no management fee.)

Relative to the S&P 500—a measure Buffett provides in his annual report—Berkshire's 2008 decline, which we estimate at 8%, was quite benign. The S&P declined 37%, including dividends, hence Berkshire’s relative result, which Buffett also highlights in his annual report, was a 29% positive outperformance against the market.

So despite the down year in 2008, Berkshire has still underperformed the S&P 500 in only five years of the last 43. This has generally happened when the market was recovering from a weak market: 1967, 1975, 1980 (Oil Crisis), 1999 (the Internet Bubble) and 2003.

But Buffett has never lost this much money, assuming these numbers are close to correct, in his life.

Now, nobody’s crying for Warren Buffett.

His investors are as loyal as those Jonestown Kool-Aid drinkers—and for good reason. His track record has no match. And unlike Bernard Madoff, he’s as open about his methods as Paris Hilton about her sex life.

But Buffett is, above all things, competitive. (He told his first wife when they were married he wanted to be the richest man in the world; decades later she told Charlie Rose it really didn’t thrill her any—she had expected to marry a doctor or somebody who was going to help the world, not pile up money).

And if our numbers are right, Buffett just had his worst year since he started managing other people’s money back in 1956. Furthermore, it all pretty much happened in just three months.

Now, a good chunk of the “loss” comes from a derivatives book that Buffett is not selling any time soon. Assuming the world doesn’t come to an end, those near-term losses should reverse in future periods.

Furthermore, Buffett is famous for, among many other things, regarding a short-term drop in the value of an investment as a blip on the long-term scale. Once he’s made up his mind about the value of an investment, he doesn’t allow the market’s manic-depressive moods to affect his own perception of that investment’s value—an almost unique trait in a market of manic-depressive investors who see signals in every uptick and downtick on the screen.

But any decline in Berkshire’s net worth—even a modest 8% decline, even in a down 37% market—is, we’d bet, to the man who once said “The first rule of investing is not to lose; the second rule is not to forget the first rule,” unlikely to make him feel like the world’s best CEO right now.

Especially considering his early foresight, and consistent warnings, about the credit crisis that has engulfed the world, and damaged his substantial equity portfolio.

So it will be most interesting to be in Omaha at the annual meeting this year, and hear directly from the Oracle himself, what, if anything, he thinks of the recent Morningstar glory.

And how he expects he’ll get all that money back.

Jeff Matthews
I Am Not Making This Up

© 2008 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.


Mark said...

Warren Buffett ran a hedge fund... and the irony... is that Buffett likes to bash hedge funds for their egregious fee structures... Buffett's fee structure was a healthy 25% incentive fee on annual profits above 6%, but no management fee.


I seem to recall reading (in "Snowball", which is terrific) that Buffett also guaranteed to pay back any losses. If my recollection is correct, that's a hell of a fact for you to leave out! (And if my recollection's incorrect, I'd still rather have that deal than a straight "2 and 20", as Buffett gave you the first 8% "for free".)

cap vandal said...


"2008 10-Q, Berkshire reported a $9 billion unrealized, non-cash loss on derivatives"

The $9 billion isn't a loss, it's a liability. It was roughly $6 billion @ 12/07, so the "loss" YTD 3Q was in the $3 billion range. When the contracts were written, the $4 billion plus premium was booked as cash and an identical liability was setup. The total unrealized loss to date is the difference between the two.

These are European options, there is no "market", and are valued using Black-Scholes. The delta on these is in the low 20% range.

In addition to them having no cash impact for over a decade, it's hard to see how they could do much to the balance sheet.

BelowTheCrowd said...

As I noted some time ago, almost all these awards are given for "past performance" which of course has very little to do with "future results." In many cases, it has little to do with anything other than good PR.

Millionaire Maker said...

The meltdown has brought everyone to their feet.

Anonymous said...

I second Jeffs comment!

the straight 2 regardless of performance would be my major gripe - if you do well you win, if you do poorly, you still win some.

Jeff Matthews said...

Cap Vandal raises a point that, though incorrect (that $9 billion is not the balance sheet liability of the derivatives, it is a book loss discussed in Berkshire's 10Q as having occured post-September 30), brings up an error in our own calculataions.

The language regarding the $9 billion book loss post-September 30(from the 10Q, Page 26), which we took as applying strictly to the derivatives book, clearly applies to both the derivatives and equity book:

Page 26: "Subsequent to September 30,2008, conditions in the public debt and equity markets have declined significantly.... Based on equity and equity index prices as of October 31, 2008 applied to Berkshire's investment holdings and its equity index put option contracts, Berkshire estimates that consolidated shareholder's equity would decline by approximately $9 billion."

So the book value of Berkshire's equities AND derivatives was down $9 billion by October 30. Very likely it was down significantly more by year end.

We'll recalculate our numbers revise the column shortly.


invstmnt said...

I agree with you, Mark.

Does Jeff Matthews participate on the downside for his hedge fund investors?

Tahoe Kid said...

"...Berkshire hasn't unveiled any big new investments. Why? Our guess is that its once-enormous cash hoard has been depleted." -Barron's Jan. 24, 2009

Jeff Matthews said...

Before everyone gets all weepy about what a great hedge fund guy Warren Buffett was because he "guaranteed to pay back any losses," as Mark wrote and others have seconded, let's make clear that Buffett did no such thing.

The incentive fee for Buffett's first partnership (formed in May 1956, with seven friends and family members investing $105,000)was this: Buffett took 50% of the upside above 4%, and absorbed 25% of the downside.

Hardly a "guarantee" to pay back any losses.

(That fee structure later evolved as the various partnerships formed subsequent to the first were consolidated.)

Why would Buffett offer to absorb even 25% of any losses?

For one thing, by the time he started that partnership, Buffett had already made plenty of money in stocks and believed he could make much more if only he had more capital. He undoubtedly never thought for a minute there would be any losses to absorb.

For another, Buffett himself invested only $100 in the partnership--one-tenth of one percent--despite the fact that he was worth quite a bit more at the time. He had next-to-nothing to lose personally if the fund went down.

As it turned out, of course, Buffett's limited partners made out quite well--probably better than any other hedge fund investors ever did and ever will.

And Buffett himself did even better, as we point out in "Pilgrimage to Warren Buffett's Omaha": that $100 investment of his (and another $600 which he invested in six subsequent partnerships) eventually turned into about $25 million, thanks to the incentive fees he earned for running the most successful hedge fund of its time.

All in all, a terrific deal for everyone concerned, as a good hedge fund should be.


invstmnt said...


Many hedge fund managers feel somewhat defensive about Buffett's deal offered to investors. I am not sure why. It is what it is.

When you say the loss absorption clause is not a guarantee, can I assume you mean that given a loss environment, the Buffett partner possibly would not have been covered under Buffett's promise on the 25% portion?

There is no evidence in his history that Buffett would NOT have lived up to his word on this committment.

I think the hedge fund industry is defensive on Buffett's and Munger's regular attacks on the 2 and 20. His fee structure in the 60's and his lifetime investment record certainly gives him the high ground on the topic (maybe the same can not be said for Munger and his early record). It is self-revealing when anyone attacks him on this issue.

Go for it, Jeff. Why not offer the same fee schedule to your investors?

Jeff Matthews said...

"Invstmt": Nobody here is "attacking" Buffett on the incentive fee issue, at least not here. You seem to be reading an intent into "Warren's Worst Year" that is not in the text itself.

It is a simple fact that Buffett has frequently criticized the hedge fund industry over the years for its generous incentive fee structure. "Helpers," he calls them. "The 2-and-20 Crowd."

What really seems to gall him is that 2% management fee on top of incentive fees, which leave fund managers no risk: they make money even if their investors do not.

Yet it is a less well known fact that Buffett ran a hedge fund, with a very fat incentive fee structure, for 13 years.

Now, nobody has to invest in ANY incentive fee structure, whether it is the 2-and-20 Buffett mocks, or his own 50%-above-4%-with-25%-of-the-downside on his first fund, or the 25%-above-6% as it later become in Buffett Partnership, Ltd.

Buyer beware, as they say.

Unfortunately, as Buffett has been warning for years, and as many hedge fund investors found out in the last six months, too much emphasis was placed on the "buyer" part and not enough on the "beware".


Mark said...

Okay, I apologize for misremembering (from "Snowball") how much of his hedge fund losses Buffett agreed to absorb. (Yes, it was 25%, not 100%.) Nevertheless, Jeff wrote:

Buffett himself invested only $100 in the partnership... despite the fact that he was worth quite a bit more at the time. He had next-to-nothing to lose personally if the fund went down.

I guess that depends upon how you define "worth quite a bit more". According to "Snowball" he was worth $174,000 at the time that he formed that $105,000 partnership (see pages 200-201), so a $26,250 liability (25% of $105,000), considering that he had a family and no steady job (or management fee), was, I think, non-trivial.

whydibuy said...

I think Jeff is being a bit melodramatic on his read of Buffett getting down over the recent decline. According to Lowensteins book, Buffetts net worth as measured by his Berkshire holdings in ’73-74 fell by more than 50%. But people who dealt with Buffett said that you could not tell by conversing with him that he was even aware of it. It did not dampen his spirits at all.

And I doubt this decline will be any different in Buffetts mind.

And lastly, you omit one of Buffetts big tenents of stock market investing. Namely, that if you can’t take a 50% decline in the value of your holdings then you shouldn’t be in the market. Yes, stocks are that volatile.