Berkshire Profit Plunges 96% on Stock Market Bets (Update1)

By Erik Holm and Andrew Frye
Bloomberg News
February 28, 2009

Feb. 28 (Bloomberg) -- Warren Buffett's Berkshire Hathaway Inc. posted a fifth-straight profit drop, the longest streak of quarterly declines in at least 17 years, on losses from derivative bets tied to stock markets.

Fourth-quarter net income fell 96 percent to $117 million, or $76 a share, from $2.95 billion, or $1,904 a share, in the same period a year earlier, the Omaha, Nebraska-based firm said in its annual report.

Berkshire, where Buffett serves as chairman, chief executive officer and head of investing, suffered as the benchmark Standard & Poor's 500 Index turned in its worst year since 1937. Liabilities widened on derivatives linked to world equity markets, though the contracts don't require Berkshire to pay out until at least 2019, if at all.

"This is an abnormal time," said Tom Russo, a partner at Gardner Russo & Gardner, in an interview before the earnings were released. The derivatives, Russo said, "are pegged to a market that's declining, so you're going to see some losses on those."

Berkshire shares have fallen 44 percent in the past year as the value of the firm's top stock holdings dropped and losses increased on the derivatives. Nineteen of the top 20 stocks in Berkshire's U.S. portfolio, valued at $51.9 billion as of Dec. 31, declined last year. Coca-Cola Co., Berkshire's top holding, dropped 26 percent. American Express Co. plunged 64 percent. Oil producer ConocoPhillips fell 41 percent.

Derivative Bets

Book value, a measure of assets minus liabilities, fell 9.1 percent in the three months ended Dec. 31 to $109.3 billion on the declines in the equity and fixed-income portfolios and the derivatives writedown. Berkshire's liability on equity derivatives grew about 49 percent in the quarter to $10 billion.

"Derivatives are dangerous," Buffett said in his annual letter to shareholders that accompanies the yearend results. "Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on the cake."

Book value per share slipped 9.6 percent for all of 2008, the worst performance since Buffett took control in 1965. The only other annual decline was a 6.2 percent drop in 2001.

'Owner's Manual'

In his "owner's manual" for Berkshire shareholders, Buffett says he considers book value to be an objective substitute for the best, albeit subjective, measure of a firm's success: a metric he calls intrinsic value. Buffett doesn't provide a number for intrinsic value.

Net income fell 62 percent to $4.99 billion for all of 2008, with storm claims from Hurricanes Ike and Gustav contributing to the decline. Industrywide, insurers faced $25.2 billion in claims on natural disasters in 2008, the most since the record storm season of 2005, a trade group said last month.

Berkshire's derivative contracts were sold to undisclosed buyers for $4.85 billion as of Sept. 30. Under the agreements, Berkshire must pay out if, on specific dates starting in 2019, four market indexes are below the point where they were when he made the agreements. Buffett, recognized as one of the world's pre-eminent investors, gets to use the money in the interim.

The worldwide recession and global contraction of the credit markets is giving Buffett, 78, opportunities to invest some of the firm's cash hoard, which was worth more than $30 billion on Sept. 30.

Goldman, Harley

Berkshire agreed in the past six months to purchase preferred shares of General Electric Co. and Goldman Sachs Group Inc., and made deals to buy debt in firms including motorcycle- maker Harley-Davidson Inc., luxury jeweler Tiffany & Co. and Sealed Air Corp., the maker of Bubble Wrap shipping products.

Berkshire is commanding yields as high as 15 percent at a time when potential rivals are no longer able to make such investments.

"He's been able to put a lot to work," said Russo, whose largest holding is Berkshire stock.

The derivatives are tied to four stock indexes -- the S&P and three others -- that would all have to fall to zero for Berkshire to be liable for the entire amount at risk, which was $37.1 billion as of November and can fluctuate with currency valuations. The liabilities on the derivatives are accounting losses that reflect the falling value of the stock indexes, not cash Berkshire has paid out.

Ice Cream, Jets

Buffett built Berkshire over the past four decades with dozens of acquisitions, buying companies that make candy, sell ice cream and lease corporate jets. The firm typically gets about half its profit from insurance operations, which Buffett has said are attractive because they offer a similar business model to the derivative agreements, allowing him to invest policyholder premiums until the money is needed to pay claims.

Declining investments and falling property and casualty rates caused fourth-quarter profit declines or losses at 21 of the 22 companies in the KBW Insurance Index that reported results so far.

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