mpauls

The following is only a small part of the attached document/b] Image quality is bad due to file size restrictions. pm or email me for the higher quality file. Berkshire Hathaway is Misunderstood & Inexpensive Buffett goes out of his way to make Berkshire Hathaway’s Annual Report as easily understandable as possible. However as Berkshire Hathaway has grown, complexity followed. This makes putting a price or value on Berkshire increasingly difficult for both the average and professional investor. Complexity coupled with Buffett’s advancing age, not to mention skittish markets, certainly play a role in Berkshire Hathaway’s depressed market price. I will try to break down Berkshire Hathaway’s separate components of value below. The discrepancy between price and value should become very apparent. The 4 major sources of value may be specified as follows: Insurance business Utilities and Energy Business Service, Manufacturing, and Retail Business Finance and Financial Products Business The Utilities & Energy businesses and Service, Manufacturing, & Retail businesses are fairly straightforward as far as we are here concerned. The real complications derive from the insurance businesses and the Finance and Financial Products Businesses. Part I Finance and Financial Products Over the past 2-3 years, Berkshire made a few investments in derivatives contracts, which leaves many people scratching their heads. Mark-to-Market, “Fair Value” accounting (Used for Derivatives) causes wide variations in the balance sheet and income statement and produces misleading results. There are four different types of derivative contracts in which Berkshire has entered. i) Equity puts ii) Credit Default Insurance on a high yield index of 100 companies iii) Credit Default Swaps on individual companies iii) Tax Exempt (Muni) Bond Insurance Contracts (Structured as Derivatives) Equity Puts Berkshire Hathaway sold equity puts. Equity puts are very similar to selling insurance-the purchaser pays a premium and in return is protected from future loss. The loss in this case is a decline in the general stock market. Berkshire sold puts and collected premiums up front which Buffett invested. These premiums, like insurance, are invested until the contract expires. These are European style contracts, meaning the seller is liable only for losses that exist on the expiration date of the contract, which is in no less then 15 years. In the meantime Buffett gets the benefit of the use of this money. Specifics: 2006 seems to be the first year that Buffett personally entered into equity puts. In 2006 the S&P 500 closed at around 1400, as of early March 2009, the S&P 500 stands at 830. Premiums received for these contracts, $4.9 billion. Max loss if the index is zero upon expiration, 15 years hence (at which point money would be all but worthless anyway,) $37 billion. Credit Default Insurance on a High Yield Index of 100 Companies First expiration is due in September 2009 and the last expiration due is in December 2013. Premiums received, $3.4 Billion. The amount of actual losses paid as of December 31, 2008: $542 million. Meaning, net, Berkshire has the benefit of the use of $3 billion. This might be considered as “Credit Default Insurance (high-yield index,) Float”. Estimated future losses (loss reserve) are $3.4 billion. These contracts seem the most likely, of the 4 types of derivatives, to produce a “Derivative Underwriting Loss”. Credit Default Swaps (CDS) on Individual Companies Counter party risk exists to the extent the purchasers of these contracts are able to pay the full $4 billion premiums over the 5 year life of the contracts. Annually Berkshire receives $93 million for premiums on these contracts. Berkshire is liable for 42 corporations. Should any of them default on their loans, Berkshire is liable for the decline in the market value of the debt relative to value of the debt specified in the CDS contract. I am confident that each of these corporations has substantial amounts of tangible assets or have sustainable earning power well in excess of their respective interest obligations, both of which protect Berkshire from loss. Asset protection protects the price decline in the market value of debt upon default and earning power from default. Tax Exempt (Muni) Bond Insurance Contracts (Structured as Derivatives) These are mostly second-to-pay contracts meaning Berkshire is liable to pay only what the first insurer cannot. Berkshire received premiums of $595 million in 2008 on contracts extending as far as 40 years. These premiums should be expected annually for the duration of individual contracts. Berkshire has a total “Derivative Float” of about $8.1 billion primarily from Equity Puts and Credit Default Insurance (high yield index). Current accounting requires Berkshire to record an excessive liability on its balance sheet for the Mark-to-Market changes in the liabilities that accompany derivate float. Accounting for Derivatives Derivatives contracts not designated as a hedge, for example sold European Style Equity Index Puts receiving (premiums up front) are accounted by recording premiums as “other liabilities” on the balance sheet. Changes in the “fair value” of these contracts are adjusted quarterly with changes reflected in the income statement as derivative or “unrealized” losses and correspondingly in the in the balance sheet account as an increase or decrease in “derivative contract liabilities”. A more detailed discussion on Berkshire’s Derivatives and the accounting is discussed on page 8. What follows here is a more general, less confusing explanation. The $8.1 Billion Berkshire received in premiums (“Derivative Float”) was initially recorded as a liability on the balance sheet and declines in the “Fair-Value” of “Mark-to-Market” securities are subtracted from earnings in the period of loss, irrespective of actual economic gains or losses. Due to Mark-to-Market changes in the derivatives that Berkshire holds, their liabilities increased to $14.6 billion in 2008 and as a consequence a pretax loss of $6.821 billion was recorded as negative revenue (expense) understating reported earnings in 2008. For similar reasons, earnings were overstated by $5.5 billion in 2007 and $2.6 billion in 2006 again due to the nature of Mark-to-Market ,“Fair Value” accounting. Personally I believe markets will recover in a few years, let alone 15 years, but let’s first consider the contrary. In December 1929 the Dow Jones Industrial Index was at about 370. In 1934, 15 years later, the index had fallen a total of 60% i.e. a 6% annual loss. In equivalent terms, Berkshire’s Equity puts would require payment of about $22 billion. To break even on this transaction Berkshire Hathaway would need to compound $4.9 billion at about 10.5%. Buffett’s track record is well above 15% over the last 50 years and his current investments are certain to out live him-and I expect will exceed the breakeven 10.5% (Note the yields on “Other Investments” below). If on the other hand in 15 years the stock market has at least recovered, there is no payment for loss and the derivative float will explicitly become equity. In this case, the value of “Equity Put Float” will have definitely compounded at a rate exceeding 15%. It appears reasonable to me that Berkshire’s “Equity Put Float” is today worth about $12.5 billion. In the event that the market closes down 60% in 15 years, while (assuming) Berkshire continues to compound investments as it has in the past, the Equity Put Float would have a current value between $4 billion and $5.5 billion. The below table shows Earnings and Net Worth as reported and adjusted for the affects of derivatives:

Oh to clarify, the "on another note" in the above post was regarding Berkshire Hathaway.

2% return on assets. On another note: At current market prices buyers should expect a 5 year annual return of about 20%, and a 10 year annual return of about 17%.

I'll throw you guys (and gals) a few out of appreciation for the new site: Ambassador's Group (EPAX), Soapstone (SOAP), be careful w/ this one: Arcandor AG (ARO GR). Oh and BRK-A.

Hey that's great! Don't worry about people talking badly about Buffett or about Berkshire. The more the merrier! It's likely to drive down Berkshire's stock price, which are certainly cheap right now, but I wouldn't mind buying more for less. Those interested in a quick run down of Berkshire's Value PM me with your email address and I'll email you something I put together for a few of my clients.