Sunday, March 1, 2009


Many investors, including me, spent Saturday and Sunday of this weekend reading Warren Buffett’s latest letter to the shareholders of Berkshire Hathaway. I was interested in his comments about the company and its quite poor 2008 investments. I have been a shareholder for many years and the stock is in the portfolio of the hedge fund that I help manage. However, my principal focus was on the implications I could draw from the 22 page letter to apply to our other investments and to share with you in this blog.

What follows are items that Mr. Buffett commented in the order of his comments and my reactions to the comments. As usual in most things that I write, my mission is to provoke tangential thinking on your part rather than the laying down dictum “according to Mike Lipper.”

Throughout the letter Buffett focuses on the financial and political abuses of our trust carried out on both the national and local levels. I agree with him that the after-inflation value in various governments’ paper is more questionable now than ever. In addition, Buffett also expects rising unemployment in 2009, and perhaps beyond. Despite those dour views, he intones that the best days for America lie ahead. Part of his optimism is probably based on his assumption that Americans are focused on saving money as never before. (With our oversized position in financial service securities that is good news in the long term.)

Turning to investing in securities, Buffett has a number of observations that may seem to be logically inconsistent, but actually recognize the complexities of investing. “When investing, pessimism is your friend, euphoria the enemy,” Buffett reminds us. Nevertheless, he points out that the S&P500 has gone up about 75% of the time in the last 44 years that he has been managing the company. The historic upward slant to the market has not prevented him from either buying securities or companies. However, his pricing decisions are different and insightful. He says, “We like buying underpriced securities, but we like buying fairly priced operating businesses even more.” I suspect this apparent dichotomy is based on the reality that good, privately-owned businesses managed by owner/operators instinctively know both their present and future values, and want their price.

It is my belief that in the public securities market, future prices are not primarily dictated by the operating results, but by the co-ventures in the security. When will they sell and what will prompt the sale? Thus, one needs to apply a discount from value for the irrational behavior of one’s co-ventures. Given the choice between the two; securities or operating businesses with management attached, Berkshire has a decided bias in favor of buying operating companies at fair prices over securities at a discount. A number of ultra high net worth investors have a similar bias.

Buffett issues some cautions regarding the future. He is suspicious of relying on past financial data, particularly price data in its many derivative forms. Two of his quotes are instructive. First, “Investors should be skeptical of history-based models. Beware of geeks bearing formulas.” Second: “If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.” Having really learned about security investing at the local race tracks, I have a more than skeptical view of those who have a “system” that can beat the odds repeatedly. Despite these cautions, I agree with Mr. Buffett in believing that after many years of under-pricing risk, we are now over-pricing risk. His major financial warning deals with derivatives, which he appropriately labels as dangerous, having spent $400 million to unwind the derivatives he bought at a very wrong price when he purchased General Re.

Despite these feelings, he has entered the market for credit default swaps (CDS). These securities are somewhat like the reinsurance policies that Berkshire manages brilliantly in most instances. On the other hand, in some cases these securities settle many years in the future, and it is the final price that matters, not any of the intervening prices. What makes this much more risky is that the counterparty can, and does change without the permission, or in some cases knowledge, of the other party to the trade. I believe Buffett is correct that until effective clearing houses and exchanges are established, the bulk of this business will rest with a concentrated group of dealers. In this case a handful or less of major banks will be dealers, which add to both risk and opportunity to those in and around the concentrated circle.

Finishing his securities insights, Buffett provides details of his sale of part of his positions in Johnson & Johnson, Procter & Gamble and Conoco, which I assume were largely at a profit. He did this to fund his high yield with equity kickers in Wrigley, Goldman Sachs and General Electric. I am much more confident in the return of all of his capital than I am of the value of the GE kicker. What is significant about these trades is that while Berkshire still had significant cash and debt-carrying capacity, Buffett felt that he should maintain these reserves and accepted the discipline of having to sell some favored positions to fund purchases of better bargains. I am particularly focused on the Conoco sale, made after adding to this position earlier this year. Yet in his letter he states he still believes oil will sell for higher prices in the future to which I concur.

As is appropriate, Mr. Buffett states his views on the current housing credit crisis. Though the letter doesn’t volunteer the information that he is betting on both sides, publicly he urges home buyers to look to their purchase for enjoyment and utility, not for profit and the opportunity to refinance. Less publicly stated, but in the innards of the letter, is the disclosure that the company owns the second largest real estate broker in the country, and that Berkshire will continue to buy local real estate agents at reasonable prices.

No summation of Warren Buffett, his letter, or his work would be complete without a recognition of how great a showman he is, and a genius at cleverly manipulating public opinion through skilled conversations with the press. His PR acumen will be demonstrated at this year’s annual meeting of Berkshire Hathaway, where he has invited three high profile journalists to pose questions to himself and vice chairman Charlie Munger. Included are Carol Loomis of Fortune (who has written more great insightful pieces than any author that I have read), Becky Quick of CNBC (which guarantees electronic media coverage), and Andrew Ross Sorkin of The New York Times (which fits Mr. Buffett’s political tendencies).

Bottom line: One can learn much from Mr. Buffett, but don’t try to copy him, you don’t have the same equipment. He and Berkshire Hathaway will survive. The economic outlook over the next couple years may be challenging, but as the structure of the new world departs from the old, the opportunities for investment bargains will be great.

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