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. Book value per share, a measure of assets minus liabilities that Buffett highlights in his yearly letter to shareholders, slipped 9.6 percent for all of 2008, the worst performance since Buffett took control in 1965.
“The credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country” at the end of 2008, Buffett in his letter to shareholders today. “A freefall in business activity ensued, accelerating at a pace that I have never before witnessed.”
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 on derivatives linked to world equity markets widened by 49 percent to $10 billion in the three months ended Dec. 31, though the contracts don’t require Berkshire to pay out until at least 2019, if at all.
Berkshire shares have fallen 44 percent in the past year as the value of the firm’s top equity holdings dropped and losses increased on the derivatives. Nineteen of the top 20 stocks in Berkshire’s U.S. portfolio 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, and Buffett said in his shareholder letter that he made a “major mistake” in buying shares when oil and gas prices were near their peak.
The decline in book value per share, a figure Buffett provides in a chart at the start of his annual report, still outperformed the S&P. Berkshire’s only other annual decrease in book value during Buffett’s tenure was a 6.2 percent drop in 2001; the company outperformed the S&P in 38 of the 44 years he’s run the firm.
‘Worst Year Ever’
“You can call it the worst year ever if you want, but the fact is, the results compared to the 30 to 50 percent declines in the world stock markets show just how defensive Berkshire is,” said Tom Russo, a partner at Gardner Russo & Gardner, whose largest holding is Berkshire shares. “In the face of the maelstrom, he did alright.”
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 a decline at Berkshire’s insurance operations. 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, which owns National Indemnity Co., General Re Corp. and Geico Corp., said fourth-quarter profit from underwriting policies more than doubled to $1.18 billion.
Pretax underwriting profit at Berkshire Hathaway Reinsurance Group jumped four-fold, in part because Buffett booked $224 million after winning a bet with the state of Florida. Berkshire had pocketed the fee with the agreement that the company would buy bonds from the state if a hurricane forced the state to issue debt. No storms hit.
Profit from selling policies at car insurer Geico rose 18 percent to $186 million before taxes as premium revenue increased. The unit added about 206,000 new policyholders in the quarter and 665,000 for the year.
Earnings from Berkshire’s energy and utilities unit, which includes MidAmerican Energy Holdings Co. and PacifiCorp, more than tripled to $856 million in part from a breakup fee earned when Constellation Energy Group Inc. backed out of a deal to be acquired by Berkshire.
Berkshire’s equity derivatives were sold to undisclosed buyers for $4.85 billion as of Sept. 30. The derivatives are tied to four indexes — the S&P, the U.K.’s FTSE 100 Index, the Dow Jones Euro Stoxx 50 Index and Japan’s Nikkei 225 Stock Average. The indexes 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 Dec. 31 and can fluctuate with currency valuations. Buffett previously identified only the S&P.
Under the agreements, Berkshire must pay out if, on specific dates starting in 2019, the four benchmarks 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 liabilities on the derivatives are accounting losses that reflect the falling value of the stock indexes, not cash Berkshire has paid out.
“Derivatives are dangerous,” Buffett said in the annual letter. “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.”
The worldwide recession and global contraction of the credit markets are giving Buffett, 78, opportunities to invest some of the firm’s cash hoard, which was about $25.5 billion at yearend, down from $33.4 billion three months earlier.
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. In his letter, Buffett described the 10 percent yield on the Goldman and GE investments as “more than satisfactory.”
Goldman, Procter & Gamble
Berkshire spent $3.01 billion on fixed-maturity securities in the quarter amid a worldwide credit squeeze, according to the annual report. The firm sold $4.77 billion of equities to help fund the Goldman Sachs and General Electric deals. The sales included shares of Johnson & Johnson, Procter & Gamble Co. and ConocoPhillips, holdings that Buffett wrote, “I would have preferred to keep.”
“The fact that he ascribed those sales to needing the cash is just a little bit of a jaw-dropper, because you never think of Berkshire Hathaway of being in the position of needing the money,” said Jeff Matthews, author of “Pilgrimage to Warren Buffett’s Omaha” and founder of Ram Partners LP, a hedge fund in Greenwich, Connecticut. “But he wants to maintain Fort Knox, and keep a ton of money on the balance sheet.”
Berkshire also purchased $691 million of equities. Buffett’s equity sales, coupled with declining markets, reduced the value of the stock portfolio held by insurance units 35 percent to $49.1 billion from the end of September.
The firm increased its investment in Posco, Asia’s third- largest steelmaker, to 5.2 percent of the stock in 2008 as the South Korean company’s shares had their worst year since 2002. Buffett’s firm owned 3.95 million shares of the Pohang-based company at yearend, Berkshire said. That’s 13 percent more than Berkshire owned on Dec. 31, 2007.
“I like buying quality merchandise when it is marked down,” Buffett said in the letter.
The S&P Index will probably gain in three-quarters of the next 44 years, just as it did in the period since Buffett took over Berkshire in 1965, he said in the letter.
While Buffett and Berkshire Vice Chairman Charlie Munger can’t predict how stocks will perform in 2009, they’re certain “that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond,” he wrote.
Gross domestic product shrank at a 6.2 percent annual pace from October through December, the most since 1982, the Commerce Department said yesterday in Washington. Buffett said the consequences of the U.S. housing bubble are now “reverberating through every corner of our economy.”
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.
The worst housing slump since the Great Depression has hurt Berkshire’s building-related companies, including Acme Brick, Benjamin Moore paints and Shaw Industries. Profit at Shaw, the world’s largest carpet manufacturer, plummeted 79 percent to $23 million as sales to residential customers declined. Profit at furniture stores, jewelry shops and the candy business declined 34 percent to $91 million.
To contact the reporters on this story: Erik Holm in New York at firstname.lastname@example.org; Andrew Frye in New York at email@example.com.
Last Updated: February 28, 2009 13:19 EST
By Erik Holm and Andrew Frye