Monday, March 12, 2007

2006 Berkshire Letter Review, Part 3: International Investing

Warren Buffett is a big critic of the US Trade Deficit. In fact, he made a well-documented bet against the US Dollar in 2003 precisely because he thought our deficit spelled bad news for our currency.

According to's currency converter, a dollar could buy about 1.14 Euros back on March 11, 2002. Today, a dollar only buys about .76 of a Euro, 33% less than it did back then. Buffett got it right. A dollar bought .7 of a British Pound on 3/11/02, where it only buys about .5 of a pound today. Again, he got it right, and the case holds up against most other currencies.

Buffett updated this bet in his current shareholder letter. He says that BRK has "come close to eliminating our direct foreign-exchange position..." which has earned the company about $2.2 billion since 2002. The largest portion of that, $839 million, came from betting on the Euro. The number 2 gainer was (of all things) the Canadian dollar, which earned the company $398.3 million since 2002.

He still thinks that there is a high probability that the US Dollar will continue to weaken over time due to its trade imbalance. As he says "I fervently believe in real trade - the more the better for both us and the world. We had about $1.44 trillion of this honest-to-God trade in 2006. But the U.S. also had $.76 trillion of pseudo-trade last year- imports for which we exchanged no goods or services.... Making these purchases that weren't reciprocated by sales, the US necessarily transferred ownership of its assets or IOUs to the rest of the world. Like a very wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced."

However, he is not playing the US Dollar weakness via direct foreign currency ownership anymore. Why? Again, I quote: "When we first began making foreign exchange purchases, interest-rate differentials between the US and most foreign countries favored a direct currency position. But that spread turned negative in 2005. We therefore looked for other ways to gain foreign-currency exposure, such as the ownership of foreign equities or of US stocks with major earnings abroad. The currency factor, we should emphasize, is not dominant in our selection of equities, but is merely one of many considerations."

As a side note, Buffett says he doesn't think this is going to ruin America or Americans' standard of living every time soon, but he thinks that "at some point in the future, US workers and voters will find this annual "tribute" [ie paying a portion of their production to foreign countries we are indebted to] so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict- but to expect a "soft landing" seems like wishful thinking."

The final interesting point in this whole foreign currency discussion is Buffett's mention that all of the direct currency profits the company has made "have come from forward contracts, which are derivatives." He says they have also entered into other types of derivatives contracts as well.

When I read that, I thought it was very strange, since Buffett has gone out of his way to criticize the use of derivatives. Anticipating that thought, he went on to explain: "The answer is that derivatives, just like stocks and bonds, are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts- few in number but sometimes for large dollar amounts. We currently have 62 contracts outstanding. I manage them personally, and they are producing tax-free profits in the hundreds of millions of dollars.... Though we will experience losses from time to time, we are likely to continue to earn- overall- significant profits from mispriced derivatives."

So what I got out of that section was that 1) Buffett expects the US Dollar to decline, but isn't making direct currency bets anymore 2) Buffett thinks there will be "a severe political backlash" against the trade deficit... and it will be ugly and 3) Derivatives aint so bad if you use them correctly.

I'm still very curious as to the exact derivatives Buffett has bets on at the moment, and how he valued them.

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