Monday, March 2, 2009

Warren Buffett's 2008 Letter - Alpha

A friend of mine, now a restructuring banker at a major firm, e-mailed me this today:
" The Berkshire letters are neither funny nor interesting any more (several years in a row). Too bad..."

Warren Buffett's recent letters as Berkshire Hathaway's chairman are not as funny. 2008 was a bad year, so a sober tone is understandable. In recent years, Buffett decried excesses. While he tried to avoid being shrill, he was not as entertaining.

While not as funny as past letters, Buffett's recent letters are still informative. His take on derivatives and the use of Black-Scholes for long-term valuations are lucid and thoughtful. One point he doesn't talk enough about is the corrosive aspect of debt: for non-financial companies in a downturn, debt is dangerous, and the previous juice from levering up and getting interest deductions (per the Modigliani-Miller propositions taught in finance courses) becomes hemlock. Investors should check out Richard Koo's work, "The Holy Grail of Macroeconomics," which discusses Japan's extended balance sheet recession.

The most interesting part of the letter is on derivatives. Here is how Buffett starts:

"Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books."
The rest is worth reading.

A large group of companies have such complicated derivatives books that no rational investor could value them. Transparency isn't just difficult (or potentially increasable), it's impossible. Today traders speculate based on the fiction of earnings numbers and the thrill of momentum. What Citigroup, Goldman Sachs, or JP Morgan (or their "cleaner" counterparts like Wells Fargo, a Berkshire-owned company) are worth, I don't know. And I challenge Buffett: NO ONE KNOWS (or can humanly know). I wish Buffett himself would eschew derivatives for speculative purposes (only 251 served!), and would only use them for business hedging (or not at all). Buffett himself seems to confuse insurance and speculation.

Insurance has a business purpose, the odds are fairly well known, and it creates social value. The buyer can lay off risks he doesn't want to keep, due to a lack of ability or expertise. Speculation has no business purpose, the odds often are not well known, and it usually doesn't create social value (it's often zero sum). Some speculators can create social value by intelligently taking on risk from companies.
They can be more informed about future values (and hence price movements), thus taking on volatility which corporations or farmers abhor or helping set futures prices that influence how much companies and farmers produce. But most speculators trade on gut feeling and momentum, not in-depth research.

Overall, Buffett's writing is crisp, clear, and logical. He admits mistakes. He presents results by coherent business groups, not a meaningless consolidated basis. I wish all CEOs were forced to write similar letters describing and explaining their business, and not just relying on 10-Ks and the pap of their MD&A sections. Read one here on page 40: Hartford Financial's 2008 10-K Report.

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