Warren Buffett's 15-Year Old Advice on Derivatives Is Still Relevant

(GuruFocus) One of the great things about Warren Buffett is that so much of the advice he has issued over the years is timeless. Even though the financial world has changed significantly since he first started managing money for investors, Buffett's advice on how to find securities that are worth buying, and develop your investment skills and career, remains relevant today.

The investing world might have changed significantly over the past seven decades, but the principles underpinning investing have not. You can go back and read some of Buffett's early letters today, and they are still as relevant as when they were first issued -- the names of certain investment examples may have disappeared forever, but the principles behind every case given remain the same today.

One great example of the timelessness of Buffett's articles is his piece on derivatives in 2003. Derivatives have become a common sight in the financial world even though the use of these products nearly collapsed the financial system in 2008. However, despite their risks, they are still heavily used by companies around the world for many different reasons.

In his article, Buffett compared derivatives to "hell," saying that, like hell, derivatives are "easy to enter and almost impossible to exit." Much like the reinsurance industry, when you write a derivative contract, "you are usually stuck with it," and most strategies "leave you with a residual liability." Another commonality between reinsurance and derivatives is the overstatement of earnings, as Buffett explained:

"Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

"Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on 'earnings' calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and 'mark-to-model' is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth."

Most average investors will not use derivatives in their portfolios or investment lives. However, it is common for companies to use derivatives, and this is where it becomes essential to understand the impact they can have on balance sheets and on earning statements. Some companies will use derivatives heavily in their business models to help offset risk, which is fine right up until it isn't.

Derivative profit and losses can mask the underlying profit-loss in the underlying business, and they can also camouflage significant and growing risks on the balance sheet. Nine times out of 10 it is challenging to find these derivatives and the impact they are having on the balance sheet. Usually, you need to investigate quarterly and annual SEC filings: Derivative obligations are often left out of press releases.

Buffett has been able to establish such an impressive reputation for himself as an investor over the years because he is willing to go the extra mile when it comes to research and find these hidden weapons of mass destruction on company balance sheets. As I have written many times before, there is no substitute for research, and if you find the idea of looking for these hidden mines daunting, index investing might be a better option.


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