Buffett Watch

Barron's Spotlights Buffett's $4.5B Bullish Bet on Stocks

Billionaire investor Warren Buffett helps Democratic presidential candidate, Sen. Hillary Rodham Clinton, D-N.Y., raise campaign funds in San Francisco, Calif., Tuesday, Dec. 11, 2007. Bufffett, who has said he would be happy with either Clinton or Sen. Barack Obama, D-Ill., as the next president, already helped Clinton raise at least $1 million during a June event in New York. (AP Photo/Paul Sakuma)
Paul Sakuma

Warren Buffett's big multi-billion dollar bet that stocks won't end up lower years from now gets some attention and analysis in this weekend's Barron's.

In an article headlined Here's How Buffett Spent 2007 (paid subscription required until Monday afternoon when it becomes free content), writer Andrew Bary points out that "for someone who has been publicly lukewarm on the equity market, Warren Buffett has been buying a lot of stocks for Berkshire Hathaway."

Bary notes that during 2007, Berkshire bought just over $19 billion dollars of equities, twice last year's $9.2 billion.  That's an average of $75 million in buys for each business day.  Berkshire's net stock purchases (stocks bought minus stocks sold) during the year totaled $11 billion.

But Berkshire is not just buying individual stocks.  Barron's underlines the section on page 16 of Buffett's annual in which he describes "various put options we have sold on four stock indices (the S&P 500 plus three foreign indices.)"

Essentially, Berkshire is using long-term options contracts as a way of selling 'catastrophe' insurance.  In this case, however, the potential catastrophe isn't a hurricane or a flood, it's the possibility that stocks will wind up lower after 15 or 20 years.

In exchange for premiums totaling $4.5 billion, Berkshire promises to pay the buyers of the options if, 15 to 20 years in the future, "the index in question is quoted at a level below that existing on the day" the option contract was written.  It doesn't matter if stocks fall in the near-term.   The options only become worth something to the buyer if the stock indexes are lower when the options expire between 2019 and 2027.

If stocks end up higher, and that's been the long-term historical trend, then Berkshire keeps the premiums it's been paid, along with all the money it's made investing those premiums over the years.

In his letter to shareholders, Buffett notes that due to accounting rules, the current value of those options, based on where the stock indicies are trading at the time, must be "applied each quarter to earnings," sometimes causing "large swings" of $1 billion or more.  

Buffett argues that the short-term volatility in reported earnings is easily tolerated, in exchange for "greater gains in net worth in the long run."

Barron's says the options "look shrewd" because they only require actual money to be paid out when they expire, not anytime before.  And it notes that buyers are essentially trusting Berkshire to make the payments, because they're not insisting that Berkshire set aside money to guarantee it will be good for the payout, should it become necessary.  It's a "testament to Berkshire's financial strength."

The article also notes that Berkshire has brought in $3.2 billion in premiums for insurance against the default of some high-yield ('junk') bonds.  Bary writes, "Memo to Buffett watchers:  The Great One seems increasingly bullish about depressed junk bonds" and he calls Buffett "one of the sharpest investors in junk debt" even though he doesn't always get a lot of credit for his talents in that area.

And Bary concedes that while Berkshire stock has dropped since his Barron's "Sell Buffett" cover story in December, it has outperformed the S&P and financials.

Current Berkshire price:

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