Its that time of the year again - where the king of capitalism, the “Oracle of Omaha” himself - Warren E. Buffett sends out Berkshire Hathaway’s (his listed investment and holding company) annual report and with it, his annual letter to shareholders. The letter serves as a de-facto “State of the Economy” address for the United States but also significantly for a number of other markets. In this year’s letter, which is embedded after the break, apart from discussing the operations of Berkshire’s various businesses, also goes into a discussion and explanation of various kinds of financial transactions and instruments. While he does try to stick to generally “Layman’s” language, sometimes he does delve into jargon territory. We’ve tried to explain some of the broad level stuff here before you read the actual letter (which is 22 pages long).
Insurance Business
Buffett spends a great deal of time explaining the insurance business, which is Berkshire’s bread and butter. The insurance business works by taking fees or “premiums” to insure certain events or transactions for a certain amount. For example, one pays a fixed monthly or yearly fee for Life insurance of a certain amount. The trick is to price the premiums such that the premiums and the income generated from investing those premiums are more valuable than the probability-weighted payout. So if the probability of a payout for a certain event, say a car accident, is 1% and the amount of insurance (the payout) is $1000, then the premiums that you collect + the investment income from those premiums, should be more than $10. This calculation is simplistic, but when aggregated over millions of insurance policies, creates the difference between the pay-in and pay-out, which is your profit.
The money that you collect through premiums before you pay anything out is called “float”. This is essentially money in your bank that you can invest wisely and make a good return on. You will probably have to pay a lot of it back in payouts, but only at a later date from when you received it. So the difference between what you get + what it earns and what you have to pay out at a later date is your insurance profit.
This is a big secret of Buffett’s success. His investment ability allows him to earn huge amounts by investing the float from all his insurance businesses. This float is invested either in listed stocks or bonds or for buying operating businesses.
Derivatives
Another subject that Buffett discusses extensively is derivatives. Derivatives are secondary contracts that are ‘derived’ from primary contracts. For example, the simplest form of a derivative is an option. An option is a contract to buy or sell a stock at a given price on a given date. Here, the primary contract is the buying or selling of a stock and the secondary contract is the option to execute that first contract. Contracts can be hugely complicated (the right to buy or sell a stock linked to a currency price linked to a date linked to the creditworthiness of a company can be a derivative contract). These are notoriously hard to value and are considered one of the prime causes behind the current credit crunch.
The letter is after the link. Happy reading.
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He is the richest man in the world! He is also the world’s most respected investor and rightly so, his estimated net worth is $62 billion…Yes, it’s ok to say WOW! He is a man that I greatly admire. Not for his wealth but for his simplicity and pure business genius.
