On Buffett-Back Riding

Warren Buffett is best known for his work at Berkshire Hathaway (BRK.A) where he grew book value per share 21.1% a year over the last 42 years.

But Buffett was a money manager long before he was a CEO. He earned his super-investor stripes by running an investment partnership. Buffett Partnership Ltd. beat the Dow every year from 1957 to 1969, never had a down year, and posted annual returns of 29.5% a year. The Dow managed just 7.4%.

Those numbers are phenomenal. And Buffett’s record is all the more phenomenal for its length. How many investors have a track record stretching back half a century?

But past results are no guarantee of future returns. And Berkshire’s size is a guaranteed headwind.

So can you really Buffett-back ride your way to investment success?

Maybe.

But there is a right way to do it and a wrong way to do it.

Common Mistakes in Preferred Stock

The wrongest of the wrong is to buy common stock in companies where Buffett holds preferred shares.

Don’t buy General Electric (GE) and Goldman Sachs (GS) because Buffett told you to. He didn’t. He took a senior position with a double-digit yield. If he wanted to buy the common, he would have bought the common.

Buffett has bought preferred stock before. And, to be honest, it is not his strong suit. One of his worst investment decisions was buying preferred stock in US Air. Berkshire nearly lost everything. The investment worked out, but it was a big mistake – and Buffett knows it.

Another, lesser mistake was buying preferred stock in Gillette.

That investment worked out great. But it would have worked out even better if Buffett bought the common stock instead of the preferred.

For details read Buffett’s 1995 letter to shareholders.

Buffett says he “was far too clever” to take the easier, more profitable route – instead insisting on the more complex, and ultimately less profitable preferred stock.

When Buffett makes a preferred stock purchase, he is actually signaling that he does not like the common stock. He may like the company. He may not. But he certainly does not like the stock.

If he did, he would buy the common stock.

So why did Buffett take preferred shares in GE and Goldman?

Some will argue these are sweet-heart deals pure and simple – and that’s why Warren took them. Buffett certainly got in on special terms.

But, it’s not clear those terms were better than what he could get by buying common stock in a business he loves when market prices are low.

In fact, almost all of Buffett’s biggest successes were either common stock purchases or preferred stock purchases that would have worked out as well or better if Berkshire had bought the common stock instead.

I can think of only two exceptions. Berkshire got some GEICO (now fully owned) and some Freddie Mac (FRE) (long ago sold) in ways that individual investors could not. Other institutions were offered the same terms as Berkshire. Individual investors were not.

Putting those two purchases aside, Buffett’s best moves at Berkshire have been simple and easy to copy.

Has Berkshire gotten special offers? Sure. But Buffett’s record on such special deals is much spottier than his record of investing on the same terms the little guy could get.

Frankenstein Securities

Why are Buffett’s preferred stock investments often inferior to his common stock investments?

Part of it is the hybrid nature of preferred stock. All of Buffett’s preferred stock purchases combined high yields with the chance to participate in the underlying equity (at some price).

Buffett does simple better than anyone.

Preferred stock is complex. There is a psychological trap of combining a mediocre bond element with a mediocre stock element and thinking you’ve got yourself a great deal. Generally, it is a bad idea to buy such a hybrid unless at least one of the two elements is attractive enough to fully justify the purchase on its own.

Buffett’s preferred investments in GE and Goldman fail this test – at least for an investor as demanding as Buffett. The yields on the GE and Goldman preferred are good, but they are just barely good enough to clear Berkshire’s lowest hurdle of a 10% pre-tax return.

Buffett has said he never considers buying stocks that do not offer at least a 10% pre-tax return. Neither the GE nor the Goldman investments offer much of a margin of safety. Instead they offer a guaranteed, mediocre return (for a long-term Buffett investment) with an equity option.

It’s hard to see how these preferred stock investments meet the same level of quality as Buffett’s big ideas in common stocks.

Most likely, Buffett saw the preferred stocks as good alternatives to fixed-income securities.

That was the logic behind the five preferred investments he made 15-20 years ago. Berkshire swapped lower-yielding securities with no convertibility for higher-yielding securities with convertibility.

That’s a good trade up as long as you don’t come to regret having less cash on hand. Since Buffett made the deals, his opportunity costs have gone up. The value of cash is higher, because stock prices are lower.

Does Buffett regret the deals? I doubt it. But the press has overhyped them. Preferred stock deals are a sign of having a lot of cash to deploy and not a lot of places to put it.

There are two very good reasons not to follow Buffett into GE and Goldman. One: you can’t get the deals he got. And two: the deals he got are not his best investment ideas.

Buffett’s Best Idea

I’m not going to argue for or against any one stock. I’m just going to give you the name of the investment Buffett seems to like most: Burlington Northern (BNI).

Berkshire owns almost 22% of the company. Even for Berkshire, that’s a big stake. And Buffett has kept buying BNI long after the position became public knowledge.

The last purchases I know of were done at $62.15 a share. But Berkshire had been a buyer at prices well above that. Buffett has been buying as recently as this month.

Originally, Berkshire started building positions in several railroads. Then Buffett focused on BNI. Why?

That’s his style. He doesn’t diversify. He concentrates. He doesn’t like small positions. He likes big positions.

And he obviously likes Burlington Northern.

Conclusion

You can ride along with Buffett on BNI or not. But don’t let press reports and hearsay lead you to GE and Goldman – or even worse, to American Express and Wells Fargo and other stocks that Buffett bought into a long, long time ago.

The time to ask whether you should Buffett-back ride is when Buffett is first building his position. This is not a guy who trades a lot.

In fact, he almost never sells. The only way you don’t have to worry about selling is if you do a spectacular job of buying.

So, if you’re looking to ride with Buffett, either buy Berkshire when it trades at a reasonable price – or go in with him on his best investment idea as he’s buying it.

Right now, the only name that fits the bill is Burlington Northern.

Comments

[CloroxCowboy:]

The author makes a very important point in his conclusion. I experimented with riding some of his picks earlier in '08. Some, like BNI and NSC, worked out well for me, but others are still floundering. Above all, it taught me that my investing style does not match Buffett's. I'm not inclined to buy a company and hold it forever, even if it would have worked out well 5-10 years down the road. It's just not the way I like to do things. Make sure you understand that Buffett is buying stocks that he thinks will pay off according to his timeframe, and that if your timeframe doesn't match his you should avoid this play.

Jan 27 09:16 AM

[ilovesum:]

He bought USG preferred shares as well . I would guess Buffett won't make the same mistake twice , unfortunately us little guys can't get the sweetheart deals he does.

Jan 27 09:31 AM

[Jolly_Rancher:]

Can you list a few other shares he has purchased recently? I think ETN is a new position.

Jan 27 10:01 AM

[mattune:]

Your say they were bad choices. But he's mad out on mostly all of his picks !
I'd say that's pretty good!! He is in the positive even if it is preferred stock.

Jan 27 11:03 AM

[Nick Waddell:]

Regarding the yield equation: I wonder if, on average, dividend paying stocks are priced inordinately higher than those that don't pay a dividend. Is there research on this?

It seems to me that every time the market hits a tough patch investors are told to reflexively flock to "high quality dividend producing stocks". It makes me wonder if people are giving up too much on the equity side and if high quality companies that don't pay a dividend, such as DELL, could be better bets.

Jan 27 11:33 AM

[ArtfulDodger:]

Mr. Gannon:

You are right about not being able to piggyback Buffett on his investments, but you missed another reason: he's ultra-secretive about what he buys and when. And there's always the Buffett bounce that's normally already in a stock by the time us mere mortals hear he's bought in.

Another thing about Buffett I'll mention is that a late friend of mine did a very thorough study of Buffett's investments back about 20 years ago when he was worth something around $20b.

He found that Buffett's stock selections were not that great; that he had made over 80% of his loot through deal making, i.e., buying whole companies.

This makes sense, because he comes off as an Andy Griffith-type investor, one who happens to have money but doesn't know very much about the fundamentals of it. Which is definitely wrong.

But imagine the weapon that disarming charm was before Buffett became a name known by every day laborers as well as investors.

He could have bought the White House for a farthing. And God knows we'd have been a hell-uv-a lot better off if he had of bought it!

Jan 27 12:42 PM

[CaptainJJack:]

I have owned BRK for years, and while I did not follow Buffet into GE and GS, I would have done the deals, and I still think they will work.

What I look for is high ROE with low P/E's; i.e. good stocks at cheap prices.

I believe the ROE is the single biggest test of competitive advantage, and if the ROE is consistently high for long periods of time, there is a reason for it. I think GE and GS would fit that bill today, as would GE.

However, there are three things that are SIGNIFICANTLY different from the eras where Buffet made great picks:

1. The credit system is not functioning, and even strong companies can get killed if they cannot get financing. This is a system that may be permanently damaged, and it threatens GE, GS, WFC, USB, and AMEX.

2. The crisis is global, and it is occurring across all asset classes. It is the most serious crisis in my lifetime, and it will last for as long as it takes to get in the financial system leverage down.

3. The role of government has gone from a passive, referee to an active investor with objectives that include a lot more than getting a good return.

We are in uncharted waters, and Buffet is basically making the bet that things will work out. He has the staying power to make that bet work, but it is certainly not without significant risk.

Jan 27 01:06 PM

[Chris B:]

As the author points out, if you don't have a timeframe that stretches well into the next decade, you'll probably end up selling when that 10% loss becomes too much to bear. The Buffet mentality on common stocks, in contrast, can be summed up as:

-If I do my homework and due dilligence, I'll buy the right companies.
-If I buy the right companies I never have to sell.
-If I never have to sell, I never have to pay capital gains taxes.
-If I never pay capital gains taxes, my equity and dividend yields can continue growing indefinitely.
-I could care less if Mr. Market offers to buy my companies for 50% less than I paid because I've done my homework and know exactly what the present value of their future earnings is.

Jan 27 04:32 PM

[najdorf:]

Artful Dodger: You're simply wrong about Buffett's stock selections. First of all, he was nothing but a stockpicker in his early days when he achieved returns in the high 20% range. Secondly, take a look at the table on page 15 of www.berkshirehathaway..... I realize that it's not up to date, but I think it pretty effectively makes the point that Buffett has done very well with some stock selections: Washington Post, Coke, and AXP/WFC if they ever come back (doing better than other financials anyhow - we'll see). He made a great medium-term trade in PetroChina a few years back. He started in GEICO as a stock investor, although he eventually made it a fully-owned BRK company. He played FNM/FRE very intelligently and got out at the right time. Of course everything he's bought in the last couple years is down, when every stock is down, but that doesn't mean stock picks haven't been effective. Think about the investments that 20 years of Coke dividends have funded.

More importantly, I can't think of a major Buffett stock holding that has totally blown up. He has achieved the returns without taking big risks. Anybody can buy a basket of pharmaceuticals with drugs in testing or trade tech startups during the bubble and possibly get lucky - but they're going to also lose big chunks of money at times. Buffett hasn't picked positions that lost big sums of money.

Jan 27 04:46 PM

[User 305589:]

Jeremy Siegel has shown in a study spanning 110 years that 97%(!) of the returns generated by stocks came from - the dividends.
The point here is not to buy the highest yielding stocks but those with robust, durable moats that have a high earnings yield and strong cash flow because sooner or later these earnings will translate into (growing) dividend payouts.


On Jan 27 11:33 AM Nick Waddell wrote:

> Regarding the yield equation: I wonder if, on average, dividend paying
> stocks are priced inordinately higher than those that don't pay a
> dividend. Is there research on this?
>
> It seems to me that every time the market hits a tough patch investors
> are told to reflexively flock to "high quality dividend producing
> stocks". It makes me wonder if people are giving up too much on the
> equity side and if high quality companies that don't pay a dividend,
> such as DELL, could be better bets.

Jan 28 04:30 AM

[User 305589:]

btw: I'll likely never understand why people want to piggyback Buffet's stocks when they could easily do so first hand by buying Berkshire's stock -especially at times like now, when it trades at a substantial discount (30-40%) to intrinsic value.

Jan 28 04:32 AM

[James Wilson:]

Buffet invest in things he believes will succeed and I saw his investment when the market dropped as him helping old friends recover but make a profit at the same time.

When you have billions a few billion here or there if it helps freinds and possible your country then why not.

Buffet could lose he investments make the last 2 years and still not feel any pain.

I just bought into all the banks at their lows and am setting on them. No where to go but up for them now.

Jan 28 05:08 AM

[ralgie:]

I normally pay attention to Geoff however I am not sure what he was thinking when he wrote this:

But don’t let press reports and hearsay lead you to GE and Goldman – or even worse, to American Express and Wells Fargo and other stocks that Buffett bought into a long, long time ago.

WRONG WRONG WRONG WRONG

Here is an extract from an interview in August 2008 !!!!

QUICK: American Express, Wells Fargo, those are two of your big holdings...

BUFFETT: Right.

QUICK: ...in the financial arena. If you see prices come down and something you've already decided you like this business, if the prices come down, do you buy more?

BUFFETT: Sure.

QUICK: Are you buying more?

BUFFETT: Well, I bought more of one of those, you know, in recent--in recent months.

Here is the link

www.cnbc.com/id/263373.../

Jan 28 05:33 AM

[long_on_oil:]

The GE pick was brilliant because of the products the company makes. GE has to have a financial arm if it wants to sell multi million dollar products like train engines, aircraft engines, nuclear reactors, cat scan machines and on and on. There is no way the Government is going to let GE fail, we are all to dependent on products they make.
When Warren locked in a 10% return the market was in the tank and most of us would have killed for a 10% return. I own BRK and as long as I am alive I will continue to own it because I am not smart enough to second guess Buffet. I subscribe to the old saying, "if you can't beat em, join em."

Jan 28 09:10 AM

[Conservativ...:]

BRK.B is kicking around somewhere near $3M right now, and had peaked at $5M just when Buffett warned "we're not going to see those profits again for a long while." Since he likely views BRK as eternal, he's still not worried about timing.
If you are not, and you admire the method of investing you see in Buffett and company (keep in mind, his staff is small, but he and Charlie none the less have a staff), why not buy the B shares at this price, and forget about mirroring what he does, just buy what he has done?
Makes sense to me.


On Jan 28 04:32 AM User 305589 wrote:

> btw: I'll likely never understand why people want to piggyback Buffet's
> stocks when they could easily do so first hand by buying Berkshire's
> stock -especially at times like now, when it trades at a substantial
> discount (30-40%) to intrinsic value.

Jan 28 11:48 AM

[auto44:]

The bigger brk gets the harder it is to deploy that much capitol in places that will show the types of gains he was capable of making. He has said that if all he had was a million dollars he could double it every year. But the small caps he would have to buy to do that would't even tickle the bottom line of a company as big as brk.


On Jan 28 04:32 AM User 305589 wrote:

> btw: I'll likely never understand why people want to piggyback Buffet's
> stocks when they could easily do so first hand by buying Berkshire's
> stock -especially at times like now, when it trades at a substantial
> discount (30-40%) to intrinsic value.

Jan 28 02:07 PM

[Ricard:]

Great article, spot on the preferreds. Unless the average joe could also purchase GS or GE preferred yielding 10%, the average joe would do well to stay away from GS and GE stock.

Jan 28 03:22 PM

[klarsolo:]

Does nobody remember that these are convertible preferreds, not just simple preferreds? So he does have almost full upside exposure, all the while maintaining protection against government dilution. I'd call that smart.

Jan 28 03:43 PM

[Anthony Alfidi:]

Berkshire has often used 10-year Treasuries as the centerpiece of its cash management toolbox. With yields on the 10-year under 3%, even a substandard preferred deal looks good to Uncle Warren.

Jan 28 08:02 PM