2 Noteworthy Points From Warren Buffett's Annual Shareholder Letter

Warren Buffett's annual letter is always a good read and the recently released 2007 version is no different. There are a couple points that Buffett mentions this year that I think are worth pointing out and commenting on regarding the current market environment; corporate creditworthiness and sovereign wealth funds.

Buffett is often criticized for speaking out against the widespread use of derivatives and at the same time, initiating derivatives positions for Berkshire. However, just because certain derivatives are extremely risky and may pose a serious threat to our financial system, that does not mean that every single derivative contract is bad. There are many derivatives that do not use tons of leverage and pose little threat, and those are the ones Buffett is using.

In the letter, Buffett points out that Berkshire has entered into 94 derivative contracts which fall into two categories; credit default swaps and long term short put positions on several equity indices. The former is interesting because corporate credit spreads have widened dramatically recently, and investors are worried that default rates are set to spike in coming years.

Buffett has decided to insure bondholders against default over the next five years, and in return has received more than $3 billion in premiums for these contracts. He is betting that actual corporate defaults are less than the rates currently implied by the market prices of credit default swap contracts. Given that current prices are artificially high for credit protection, due to the unstable credit markets, the implied default rates right now are well above typical historical loss rates at the end of an economic cycle.

What does this mean to individual investors? It means that high yield bonds are extremely depressed right now and many smart investors are betting that the market for corporate debt has swung too far into the pessimistic camp. If you agree and believe that although earnings might fall in coming years for certain companies, they will still be able to repay their debt, then high yield bonds and credit protection are interesting areas for investment. Investors can play this two ways.

First, you can simply buy high yield corporate bonds or bond funds. High quality managers are salivating at some of the yields currently available in the corporate bond market and are more than willing to wait out this economic downturn, collect interest payments, and get repaid several years down the road if their financial analysis proves accurate.

You can also invest in a company like Primus Guaranty (PRS), a small publicly traded writer of credit default swap contracts. Essentially, Primus is doing exactly what Buffet has done, but they do it for a living. As credit spreads widen and premiums rise for selling credit protection, Primus will do more business at more lucrative prices.

Another point Buffett raises in his letter that I think is interesting is the rise of sovereign wealth funds. For those of you who are unfamiliar with the term, these are simply government owned investment funds of foreign countries. As the global economy has expanded and the developing world sees increased economic prosperity, foreign governments are flush with cash, and like anyone else in that situation, are looking for places to invest it.

As the world's biggest market, it is not surprising that the U.S. has seen China buy a 10% stake in the Blackstone (BX) IPO and Abu Dhabi invest in Citigroup (C). Of course, some on Capitol Hill are worried about foreign money being invested in U.S. companies. Although these are passive investments, and bring with them no control of operations, national security concerns are being voiced by many.

Buffett makes the point that this trend is largely the product of our own doing. The U.S. is racking up huge deficits, issuing debt to any foreign country who will buy it, and the resulting weak dollar is prompting foreign investors to invest in U.S. equities. They are simply diversifying their investment portfolio. After a while, you can only buy so much U.S. debt without getting a little worried about our country's financial health. Many U.S companies, although navigating through tough times, look more attractive than the government does for investment dollar allocations.

As a result, foreigners want to buy equities as well as bonds. Buffett points out we certainly can't blame them for buying stocks rather than more bonds. And it is much easier for them to do so now because so many financial institutions are trying to raise capital after sub-prime mortgage blunders. In my view, as long as these remain passive investments, we really can't complain. When operational decision making becomes an issue, as it was when an Abu Dhabi firm wanted to run our ports here in the U.S. (the deal was squashed), then it makes sense to talk about national security threats, but only when a real threat is apparent.

Full Disclosure: No positions in the companies mentioned at the time of writing.

Comments

[texalope]

Primus is a good bet and here's my thinking.
You have to think like an owner of a privately held business with no daily quote.
They have a solid book. Spreads are going up so the income stream is rising. My company is getting paid quite well for the risk we're assuming (much like the Property and casualty business after hurricanes Katrina and Wilma).
My accountant comes in quarterly and tells me we're losing tons of money because he marks our holdings to market. My bank account is growing larger and larger and my prospects for continuation of this stream of money are very good in this cycle. I have no intention or need to sell my assets into this weak market, I'll hold them to term(about 5 years) until my insurance guarantee expires. My accountants' proclamations do not hold much value for me. My bank account does.
If a competitor came to me and offered half of book value for my good business with a growing stream of cash flows, I'd be a fool to sell it to him. Frankly, I'd buy his business under the same arrangement. So, these factors tell me Primus is a good buy here at 50% of economic book value.
The risk- a black swan event occurs with a huge bankruptcy that I couldn't predict. An outlier type event that can happen with any investment at any time.

I don't think that's enough to dissuade me from a bet that will double my money at the least($9 assigns no value to ongoing business) so this company is worth more. But,that amount is subject to debate.

[Erich Riesenberg]

Comparing BRK to PRS is a mistake. BRK has minimal credit default exposure, less than $2 billion in current value and $5 billion in notional value. It is a fraction of BRK's equity. I conclude the opposite, if Buffett saw credit default premiums as a great investment in the second half of 2007, he would have sold more.

And of course, PRS is making unhedged investments, it is impossible to know precisely why BRK is selling credit default protection.