2002
Click here to read the letter.🧠 Key Takeaways
Selling covered calls on a stock you already want to trim or selling cash-secured puts on a company you want to own are perfectly fine strategies. But when Wall Street packages complex derivatives into shiny products and markets them as safe, reliable income, that’s when things get sketchy.
If you invest in good companies that are financially responsible and run by capable, honest people, things should work out over time. It doesn’t have to be rocket science.
In other words, if a company’s management team is visibly cutting corners in one area, that’s usually not the only place they’re doing it.
When a company emphasizes EBITDA, especially over net income (which can also be manipulated) or free cash flow (which is the most honest and hard to fudge), that’s usually a sign that the real economics of the business aren’t that great.
Put simply, if the information a company puts out is confusing, it’s usually because they wanted it to be that way. Honest and high-quality businesses don’t hide behind complicated language—subpar or dishonest ones do.
Companies put out earnings projections and growth expectations (mostly to satisfy analysts and investors who hate uncertainty), but when they put too much emphasis on these things, that’s usually a sign they’re more focused on creating a certain narrative than anything else.
✍️ Memorable Quotes
“Charlie and I believe Berkshire should be a fortress of financial strength - for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
When Buffett wrote this in 2002, he was voicing his concerns about a surge of complex and uncontrolled derivative activity among large financial institutions that were carrying all of these derivatives on their balance sheets.
On the surface, these derivatives looked profitable and sophisticated. But Warren and Charlie saw through that and understood that because so many of these contracts were unregulated and uncollateralized, a single failure could trigger a chain reaction across the entire financial system.
That’s why they called derivatives “financial weapons of mass destruction.” The danger wasn’t pertinent in the moment, but it was quietly building and could pop off at any time.
I actually think we’re seeing something similar bubbling today. Instead of big banks hiding derivatives on their balance sheets, now we have a wave of ETFs built entirely on complex derivative-based strategies.
Things like futures, swaps, leveraged options, and especially covered call ETFs have exploded in popularity. They’re practically everywhere.
When these products first came out, they were pretty tame—writing simple covered call strategies on the S&P 500 or Nasdaq to generate a little extra income for shareholders. But once more participants entered the market, the space got more competitive, and things escalated incredibly fast.
The race for higher yields pushed fund companies into riskier strategies. They started introducing things like more leverage, shorter durations, and exotic options strategies (like synthetic covered calls) just so they could slap a bigger yield on the fact sheet.
So far, we haven’t seen a full-blown blowup. The worst of it has been massive NAV decay and some subsequent reverse splits.
But if history has taught us anything, it’s that financial products get dangerous when they become popular with people who don’t understand them. And it seems like that’s what’s happening now.
These products are being bought by income-seeking investors (many of them just starting out) who just see an insanely high yield and think they have found a cheat code. But they have no idea what they’re actually putting their money into.
Having said all of that, derivatives aren’t inherently bad. Used responsibly, they can actually be a very useful tool.
Selling covered calls on a stock you already want to trim or selling cash-secured puts on a company you want to own are perfectly fine strategies. But when Wall Street packages complex derivatives into shiny products and markets them as safe, reliable income, that’s when things get sketchy.
“In stocks, we expect every commitment to work out well because we concentrate on conservatively financed businesses with strong competitive strengths, run by able and honest people. If we buy into these companies at sensible prices, losses should be rare.”
What’s interesting about Warren and Charlie’s approach—and what makes it so different from a lot of investors out there—is that they actually go into each investment asking, “How can we not lose?” instead of “How can we win big?”
In other words, they invert their approach to investing, which is something Charlie was famously fond of. Instead of being focused on hitting home runs with every investment, they’re more concerned with just getting on base first.
It’s a very risk-averse style of investing, and I think it makes a lot of sense. If you put yourself in a position where you’re less likely to lose, then the only other real outcome is that you win—which ties back to Warren’s #1 rule of investing: never lose money.
This quote also speaks to how simple their approach to business really is. If you invest in good companies that are financially responsible and run by capable, honest people, things should work out over time. It doesn’t have to be rocket science.
“Beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.”
In other words, if a company’s management team is visibly cutting corners in one area, that’s usually not the only place they’re doing it.
If they’re willing to stretch the truth or play games with one part of the business, there’s a good chance the same thing is happening behind the scenes wherever they think they can get away with it.
That kind of behavior is short-term thinking, which might make the numbers look better today and it might even please shareholders in the moment, but it never lasts.
Eventually, reality catches up. And when it does, it usually isn’t pretty. The chickens always come home to roost.
“Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business.”
Warren’s issue with EBITDA is that it conveniently ignores certain expenses, especially depreciation.
The argument for why this isn’t considered a big deal by many is that depreciation is a “non-cash” charge. The thought is that since it’s a non-cash charge, why would you count it along with other cash expenses like SG&A and R&D costs?
While that’s understandable, the depreciation was actually expensed up front when the company purchased the equipment, property, or assets in the first place.
In other words, the business had to write a real check on day one. And at some point in the future, it will have to write another check to replace those assets. Pretending that cost doesn’t matter just to make earnings look better, according to Warren, is misleading.
When a company emphasizes EBITDA, especially over net income (which can also be manipulated) or free cash flow (which is the most honest and hard to fudge), that’s usually a sign that the real economics of the business aren’t that great.
“Unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.”
Put simply, if the information a company puts out is confusing, it’s usually because they wanted it to be that way. Honest and high-quality businesses don’t hide behind complicated language—subpar or dishonest ones do.
“Be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers).”
The truth is that nobody actually knows what the future holds.
Companies put out earnings projections and growth expectations (mostly to satisfy analysts and investors who hate uncertainty), but when they put too much emphasis on these things, that’s usually a sign they’re more focused on creating a certain narrative than anything else.
That kind of emphasis usually comes from short-term thinking. Management starts doing things just to hit quarterly targets or keep Wall Street happy instead of making decisions that actually benefit the business long term.
Overall, you want your management to be thinking in decades and centuries, not weeks and quarters.
Memorable quotes and key takeaways from the 2003 Berkshire Hathaway shareholder letter.