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2008 Shareholder Letter

Published on 27 February 2009

· Value Investing

The original 2008 Shareholder letter can be found here (

GFC '08

Useful summary of what happened in the Great Financial Crisis of 2008. To sum up, WB was 100% confident that America will eventually prevail, just like it did for the last 100 years. Do not bet against America.

Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 211⁄2% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497.

Be greedy when everyone is fearful

To make above-average returns, a good investor needs to bet in a way that's different from what everyone else is doing, otherwise you're condemned to average returns. When there's chaos, it means that shares and the stock market probably have some mispricing, and that's when you can find opportunities.

Berkshire is always a buyer of both businesses and securities, and the disarray in markets gave us a tailwind in our purchases. When investing, pessimism is your friend, euphoria the enemy.

But like with many things, investing is mostly a matter of emotion, and unfortunately because it's an inexact science, you may feel less than 100% confidence about your choices, and make either mistakes of commission or mistakes of omissions: you buy stocks that you shouldn't buy, or you missed on stocks that you should have bought. WB himself admits to this:

During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. I will tell you more about these later. Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.

But as long as you have done the research, and go in at a reasonable price, you should still be fine. You will perform spectacularly on the good ones, and not lose a lot on the bad ones.

Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.

Derivatives are dangerous. Sort Of.

Again and again, WB has warned of the dangers of derivatives. But if you read between the lines, what he's warning about is what we at BTS have warned about: dont buy into anything that you're not confident of. If you do not understand derivatives, dont buy them. If you dont understand any company, dont buy them. Our ability to make spectacular returns rests on the fact that we have some understanding of the future. WB himself dabbles in derivatives, selling billions of put options.

Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds the money, which leaves us assuming no meaningful counterparty risk. As of yearend, the payments made to us less losses we have paid – our derivatives “float,” so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. 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.

While WB dabbles in 4 different types of derivatives, the easiest to understand is the selling of put options. A buyer of a put option essentially pays a seller of a put option an "insurance" premium, so that the buyer will get to sell his stock at a particular price (called a strike price) to the seller of the put option, if the buyer wants, at a pre-determined specified date (expiry date). The seller of the put option has an obligation to buy the stock at the strike price. (the seller is an "insurer"). Just like insurance, the seller gets to keep the premium regardless of what happens. In the event that the price of the stock is above the strike price at the expiry date, nothing happens (no one will want to sell his stock at a lower price). In the event that the price of the stock is below the strike price at the expiry date, the buyer of the put option will sell his stock to the seller of the put option at the strike price.

We have added modestly to the “equity put” portfolio I described in last year’s report. Some of our contracts come due in 15 years, others in 20. We must make a payment to our counterparty at maturity if the reference index to which the put is tied is then below what it was at the inception of
the contract. Neither party can elect to settle early; it’s only the price on the final day that counts. To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish.

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