Tuesday, November 08, 2011
Is Warren Buffett a Hypocrite? Must Read.
3rd Quarter Results:-
On 4th Nov.,2011, Berkshire Hathaway Inc came out with 3rd quarter results and posted a fall in Net Profit by 24% due to bets in derivative markets. The media is crying foul over Mr.Buffett’s play in derivative market.
While talking about derivatives in an interview with BBC on March 4, 2003:
Mr. Buffett argues that such highly complex financial instruments [derivatives] are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system. Some derivatives contracts, Mr. Buffett says, appear to have been devised by “madmen”. In his letter Mr. Buffett compares the derivatives business to “hell…easy to enter and almost impossible to exit”…
Media’s conclusion: - The same person who was talking against derivatives is investing in them! He is hypocrite!!
As a regular reader you must be aware that we have an eye for objective information and we do not conclude on the face value.
So, we had gone into the matter of derivate play. We have referred the company discussion on the 3rd quarter results and here is our finding.
But before I go further into derivatives, let me deal with basics of the same.
What Is A Derivatives?
A Derivative as the name suggest, the term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else.
What is a Put Option? (A kind of Derivative)
A put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity. One party, the buyer of the put, has the right, but not an obligation, to sell the asset at the strike price by the future date, while the other party, the seller, has the obligation to buy the asset at the strike price if the buyer exercises the option. In European Style Put, you have to settle the contract on the settlement day only.
(Read the Red marked words carefully)
E.G.:- If you feel that particulate shares or index will go down….you can buy put option on the same. Suppose you feel that Reliance can go down further from here….you can buy Put Option on the same.
Now Reliance has the current price of 884(as on 8th Nov.,2011). If you expect that price of Reliance will go down, you buy 900 Strike price put at a premium of Rs.28.50 (last price). The Seller gives you the write to sell him reliance at Rs.900 on Settlement Day (last Thursday of the month in NSE) and in turn he gets Rs.28.50 per shares from you. Now lot of Reliance is 250 unites, so you paid total premium of Rs.7125 (28.50*250 - excluding commissions) to the seller.
In the above case, you profit only if the spot price of reliance ( yesterday’s price was 884) remains below 871.50. (You have already paid Rs.28.50 to the seller out of Rs.900 strike prices…900-28.50.)
Now the catch…if the price remains at 900 or goes above 900……you will lose your Rs.28.50 !! The Put Seller or Writer gets that 100%. Understood?
What Mr.Buffett has done?
He has sold European Style Put Option on equity index. From the company filings to SEC…
“The equity index put option contracts are European style options written on four major equity indexes. Future payments, if any, under these contracts will be required if the underlying index value is below the strike price at the contract expiration dates which occur between June 2018 and January 2026. We received the premiums on these contracts in full at the contract inception dates and therefore we have no counterparty credit risk. We entered into no new contracts in 2010 or 2011.
At September 30, 2011, the aggregate intrinsic value (the undiscounted liability assuming the contracts are settled on their future expiration dates based on the September 30, 2011 index values and foreign currency exchange rates) was approximately $6.7 billion.
However, these contracts may not be unilaterally terminated or fully settled before the expiration dates and therefore the ultimate amount of cash basis gains or losses on these contracts may not be determined for many years. The remaining weighted average life of all contracts was approximately 9.25 years at September 30, 2011.”
Let us understand what he has done….point to point….
1. He has sold the index contracts.
2. He has got the full premium in advance….in the above example seller of reliance got Rs.28.50 in advance for month….Mr.Buffett got USD 884.90 Crs. from such selling……now the real part.
3. He entered majority of the contracts around 2008-2009. He has not entered into any contracts in 2010-2011. ( as per the balance sheet)
4. As on today The remaining weighted average life of all contracts was approximately 9.25 years at September 30, 2011.
5. As you all know….the market was at rock bottom in 2008…..the chances of going it further down was minimum….and in 10 years….the market would surely be a better than the 2008 levels !! So, Selling Put (in other words…he did Teji by selling put in 2008).
6. He as got USD 884.90 Crs in premiums for 10 years to invest and that to interest free!!
7. Do you need an MBA to understand now?
But Original Concern remains….why he said not to go for the derivative in 2003 and gone for the same in 2008?
The company reports answers the same………
“Derivative contracts are used primarily by our finance and financial products, railroad and utilities and energy businesses. As of September 30, 2011 and December 31, 2010, substantially all of the derivative contracts of our finance and financial products businesses were not designated as hedges for financial reporting purposes. These contracts were initially entered into with the expectation that the premiums received would exceed the amounts ultimately paid to counterparties.” (What are the chances that market will be lower than 2008 in coming 10 years ??? Contracts expires from 2018 to 2026!!!)
(Read twice….he has done a pure business deal and not a hedge!!)
Caution:- Next time when you listen to any high profile media analyst from any company........ do not believe at face value….do your own study.
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Hitesh Parikh.
P.S:-Read our past reports and blogs on www.hiteshmparikh.blogspot.com.
