Our Take on Berkshire's Equity Put Option Positions--Page 2

What Do We Think about These Positions?
There are at least two ways to go about grappling with the risk in these positions. One way is to look backward, and another is to look forward.

Looking Backward
To simplify the discussion, let's assume Berkshire's options were all written on the S&P 500, at the peak of the S&P 500 (reached in October 2007, at 1,565), and they all expire in 2019 (the earliest date possible). In other words, these are options with 12-year time horizons. How likely is it that the S&P 500 in October 2019 will be below where it was in October 2007, based on past experience?

Since 1950, using daily data on the S&P 500 (adjusted to include dividends), there are roughly 11,850 days to compare where the index was relative to where it was 12 years earlier. The average 12-year return on the S&P 500 since 1962 was 165%. In other words, since 1962, the S&P 500 has on average more than doubled over any 12-year period. The S&P 500 actually fell below where it was 12 years prior on 58 days over that time frame, or about one half of 1% of the time. The average 12-year change in the S&P 500 for those 58 days was negative 3.5%. In other words, the S&P 500 declined over a 12-year period only one half of 1% of the time, and when it did, the decline was less than 5%.

Granted, we're only looking backward, but it's also worth looking at the distribution of those 12-year returns. In contrast to the distribution of daily returns, which are much closer to the "normal distribution" assumed in the Black-Scholes model, the distribution of past 12-year returns is far from normal. In turn, a look at the actual trailing 12-year returns since 1962 reinforces that we are not talking about a random process best modeled with statistical, probabilistic formulas.

Real economic and financial factors, not probabilistic formulas, determined the trends in long-term returns. Not to oversimplify, but the impact of the inflationary 1960s and 1970s on declining long-term returns into the late 1970s seems apparent, as do the effects of disinflation and related productivity improvement beginning in the early 1980s on returns into the late 1990s. From there, the bursting of the dot-com bubble and our current financial predicament leave us at the latest data point.

Looking at these data also reinforces how infrequently the 12-year returns have been below zero--and when they were, declines were modest. A single three-month period in 1978 accounts for almost all of the 58 times the 12-year return came in negative. In turn, given that we've had a few instances of negative 12-year returns in recent months, a naive look backward suggests the conditional probability of a negative 12-year return from 2007 to 2019, given that longer-term returns have collapsed since 2000, might be even lower than our experience on average since 1950 would suggest.

Of course, assuming Berkshire wrote a put option on the S&P 500 at the absolute peak of 1,565 in 2007 (an assumption heavily biased against the value of Berkshire's position), the fact that the S&P 500 has fallen about 40% since that time also comes into play. The value of Berkshire's position now is not what it was when they entered into it. But assuming the options expire in January 2019, from current levels, the S&P 500 would have to appreciate less than 6% on average over the next 10 years for Berkshire to begin to pay out on the position. In the 12,000 or so days since 1960 that have 10-year returns behind them, we've had average annual returns below 6% about one third of the time.

The S&P 500 dates only to 1950. We have data on the Dow Jones Industrial Average going back to 1928. The average annual return on the DJIA since 1928, even when including the 1929 crash and the dismal 1930s, has been 7%, in line with the rate of appreciation required for Berkshire to break even on the worst-case S&P 500 position we assumed. Even in the dismal 1931-1940 interval, the average annual return on the DJIA came in at a positive 3%.

But this is looking backward. We have to look forward, as hard as that is, because that's where the money is.

Looking Forward
It's hard to look forward without looking backward. Our expectations are products of experience. In capital markets and economics, one set of tools includes predictive models based on complex math fed with historical data. But the most complex tools are not necessarily the best things in the tool chest. Simpler, wiser judgments can easily trump complex math. On that score, an observation Buffett recently shared with a network TV audience may provide some valuable perspective: "Ever since 1776, betting against the American people hasn't been a good idea."

Back in 1776, the American people were throwing off the yokes of empire. Today, we may have some homemade empire-building to shed, but we've done it before, and we can do it again. Some of the indexes for which Berkshire wrote put options are outside the United States, of course. A hard recession has been under way, in the U.S. as well as internationally. But we've had recessions before, and we will have them again. Over the long run, economies grow, and shareholders prosper. We feel the longer-term prospects for corporate productivity and shareholder returns are in line with past experience, nationally and internationally. The odds of a sustained downward move in stock indexes from 2007 forward seem pretty slim, even after the decline we've had in the last year or so.

There is a small risk that these positions will prove a significant drag on the company. But on the flip side, even assuming a modest to moderate payout is required on those positions, at the bottom line they may well be a net positive contributor to Berkshire's value today. First, of course, is the fact that Berkshire has already received over $4 billion for its assumption of risk, money it can invest over time. Second, we can consider the positions in light of Berkshire's overall business portfolio. Its insurance operations regularly write catastrophe coverage, and these policies occasionally lose money, but paying off on those losses helps to feed Berkshire's long-run success. Berkshire Hathaway's equity options positions are part of a portfolio of risk assumed for others, not the isolated positions of a single option trader.

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