Friday, August 10, 2012

Berkshire Hathaway: Earnings and the Derivatives Portfolio

Berkshire Hathaway's (BRKalatest quarterly results revealed that operating earnings grew to $ 3.7 billion from $ 2.7 billion in the same quarter a year ago.

On the surface looks pretty good, right?

Yet net earnings dropped to $ 3.1 billion from $ 3.4 billion.

Less impressive.

So what number better represents the economics of Berkshire?

Berkshire's operating earnings exclude gains/losses from derivatives and other investments. The generally non-cash gains/losses associated with derivatives mean little economically in the near term. It's "scorekeeping" where the "goals" are reversed time and time again. The gains and losses reveal practically nothing about the actual cash that is (or will) changing hands.

So these very lumpy, but economically pretty much meaningless, gains and losses are usually distractions at best.*

From Warren Buffett's 2007 Berkshire Hathaway shareholder letter:

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire's balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

The quarterly gains and losses may mean little, but the cash Berkshire is paid up front is a very useful source of "float". It's good to be aware of these contracts and understand what they may ultimately effect Berkshire economically (good or bad) a long time down the road, but otherwise is essentially worthless information.

Net earnings was reduced to $ 3.1 billion when including investment and derivative gains (losses) in the most recent quarter primarily because of a just under $ 700 million derivatives loss.

These one time gains and losses create lots of noise (on the upside and downside) that mask how Berkshire's operating businesses are really doing. So it is more useful to focus on the operating earnings while separately keeping an eye on the other stuff.

Buffett has said he believes Berkshire's derivatives position will ultimately be rather profitable (based upon recent shareholder letters it's difficult to not come to a similar conclusion).  If these work out for shareholders, it will be mostly because the contracts were priced right in the first place for the risk. They will also have worked out because little or no posting of collateral was required.

From the 2011 letter:

Though our existing contracts have very minor collateral requirements, the rules have changed for new positions. Consequently, we will not be initiating any major derivatives positions. We shun contracts of any type that could require the instant posting of collateral. The possibility of some sudden and huge posting requirement – arising from an out-of-the-blue event such as a worldwide financial panic or massive terrorist attack – is inconsistent with our primary objectives of redundant liquidity and unquestioned financial strength.

A small percentage of contracts in the past have called for posting of collateral but not anywhere near enough to matter in the context of Berkshire's resources.

To better understand what the derivatives portfolio really means (or may mean) economically for shareholders (as opposed to just the accounting treatment) check out some of the recent letters.**

The Derivatives section (bottom of page 16) of the 2008 letter isn't a bad place to start.

Here's also a post that I did a while back on Berkshire derivatives, if interested.

Given the arcane nature of derivatives it might be best to save that subject for another day. Obviously, it's important to understand this stuff as a shareholder. I'm just saying that it's Friday and there must be something more fun to read going into a weekend.

Related posts:
Buffett on Derivatives: The 'Chain Reaction' Threat
Munger on Derivatives
Buffett on Derivatives

In the end, the quarterly "scorekeeping" of Berkshire's derivatives portfolio doesn't mean much.

It creates noise but offers little perspective.

The derivatives positions held by Berkshire also make understanding the company's financial results more difficult even when Buffett does his best to explain the positions.

Berkshire's financial reporting isn't actually all that complex but certainly requires a bit more work than some other companies.

Adam

Long position in BRKb established at lower than recent market prices

* The problem here isn't so much with mark-to-market accounting. The problem stems more from the limitations of the Black-Scholes formula when it comes to very long-term options.
** Berkshire's largest derivatives positions are generally either tied to equity markets or high-yield bond indices.
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