Buffett Author Explains Derivatives

Snowball: Warren Buffett and the Business of Life is a book that I definitely do not recommend. Buffett achieved success because he was focused and frugal; this biography fails because it is unfocused and verbose.

(As I said in a previous post, Buffett: Making of an American Capitalist is the best biography on the great investor.)

That said, The Snowball is not entirely without value. Here is Schroeder at her best, explaining derivative contracts (on pages 544 and 545):

Derivative contracts work like this: In the Rockwood Chocolate deal, the value of hte futures contract was "derived from" the price of cocoa beans on a certain date. If the beans turned out to be worth less than the price agreed to by the contract, the person who had bought the futures contract as insurance "won." Her losses were covered. If the beans were worth more, the person who had sold the futures contract as insurance "won." The contract entitled him to buy below the then-current market price.

Suppose that in the weight deal Buffett had made with Howie for the rent on his farm, he didn't want to risk Howie's actually losing weight, which would drop the rent. Since this was under Howie's control, Warren might want to buy insurance from someone else.

He could say to Susie, "Lookit, I'll pay you a hundred bucks today. If Howie loses twenty pounds and keeps it off for the next six months, you'll pay me the two thousand dollars of rent that I'll lose. If he doesn't keep it off for the whole six months, you don't have to pay me the rent and you get to keep the hundred bucks."

The index that determined the gain or loss was "derived" from Howie's weight, and whether or not Buffett would make such a deal was based on a handicap of the odds that Howie would be able to lose the weight and keep it off.

Anather example: Suppose that Warren made a deal with Astrid to give up eating potato chips for a year. If he ate a potato chip he had to pay her a thousand bucks. This would not be a derivative contract. Warren and Astrid were simply making a deal. Whether Warren ate a potato chip was not "derived from" anything. It was under his control.

However, if Astrid and Warren made that agreement and then Astrid paid Warren's sister Bertie a hundred bucks as insurance, in exchange for a thousand dollars if Astrid lost the bet, the deal with Bertie would be a derivative contract. It would be "derived from" whether Warren ate the potato chips, which was not under either Bertie's or Astrid's control. Astrid stood to lose the hundred bucks to Bertie if Warren didn't eat the chips, and Bertie would lose a thousand bucks if he did.

Buffett: The Sleuth Investor

I've been reading The Snowball: Warren Buffett and the Business of Life the past couple of days. Here's an interesting excerpt, from pages 194 and 195:

Visiting management was part of Warren's way of doing business. He used those meetings to learn as much as he could about a company. Getting personal access to management played to his ability to charm and impress powerful people with his knowledge and wit. And he also felt that by becoming friendly with the management of a company, he might be able to influence the company to do the right thing.

Graham, on the other hand, did not visit managements, much less try to influence them ... He felt that by definition being an investor meant being an outsider, someone who confronted managements rather than rubbing shoulders with them. Graham wanted to be on a level playing field with the little guy, using only information that was available to everyone.

Following his own instincts, however, Warren decided to visit the Union Street Railway on a weekend.

"I got up at about four a.m. and drove up to New Bedford. Mark Duff was very nice, polite. Just as I was about ready to leave, he said, 'By the way, we've been thinking of having a "return of capital" distribution to shareholders.'" That meant they were going to give back the extra money. "And I said, 'Oh, that's nice.' And then he said, 'Yes, and there's a provision you may not be aware of in the Massachusetts statutes on public utilities that you have to do it in multiples of the par value of the stock." The stock had a $25 par value, so that meant it would be paying out at least $25 per share.* "And I said, 'Well. That's a good start.' Then he said, 'Bear in mind, we're thinking of using two units.' That meant they were going to declare a fifty-dollar dividend on a stock that was selling at thirty-five or forty dollars at that time." So if you bought a share you got all your money back right away, and then some. And afterward, you still owned the slice of the business that represented your share of stock.

"I got fifty bucks a share, and I still owned stock in the place. And there was still value in it..."

You don't have to read The Sleuth Investor to see the importance of such exclusive information, but if you're interested in learning more on how to get it, I can recommend the book highly--more highly than Snowball in fact.

(Roger Lowenstein's Buffett: Making of an American Capitalist remains the best book on the great investor's life, despite having less access to Buffett's family and friends--or perhaps because of it.)