After reading Warren Buffett’s 2010 letter (pdf) with the same interest as any other piece, I always peruse the media for various interpretations and observations. What I have read thus far, either paints Warren as a genius, having accumulated his wealth through methodical, long-term investing, or the complete opposite, making Mr. Buffett the villain and part of the financial meltdown problem — and just about everything in between.
I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars. I made some other already-recognizable errors as well. They were smaller, but unfortunately not small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”
What the above highlights is that he was concerned about the short–term impact of his investment decisions, that timing is important, and that he is fallible like everyone else. Having said that, it’s pretty obvious that his shortcomings are outnumbered by his success stories — and I admire the guy for his openness, although limited and rightly so. It’s not as if Warren Buffett knocks on our door and whispers his next move, and anyone who would expect that to happen is living in Wonderland. So, I do not give him “put downs” like my daughter would phrase it, but rather look into his style, and compare it with how the media portrays him.
Most everyone knows by now that he bought Berkshire Hathaway (BRK.A), a textile company, then transformed it into a holding company — threads were not his thing — and the rest is history. Not so fast, and Warren brought a little perspective to that story in his most recent letter, which may get lost in translation.
When I took control of Berkshire in 1965, I didn’t exploit this advantage. Berkshire was then only in textiles, where it had in the previous decade lost significant money. The dumbest thing I could have done was to pursue “opportunities” to improve and expand the existing textile operation – so for years that’s exactly what I did. And then, in a final burst of brilliance, I went out and bought another textile company. Aaaaaaargh! Eventually I came to my senses, heading first into insurance and then into other industries.
The lengthy “Argh!” is probably a realization of the time lost pursuing a non-workable investment — and I love the expression’s unassuming nature. But without going into all the details of his letter, a very telling piece that sheds some light on who Warren Buffett is as an investor is found on page 19 and refers to “equity puts.”
The future of these contracts is, of course, uncertain. But here is one perspective on them. If the prices of the relevant indices are the same at the contract expiration dates as these prices were on December 31, 2010 – and foreign exchange rates are unchanged – we would owe $3.8 billion on expirations occurring from 2018 to 2026. You can call this amount “settlement value.”
On our yearend balance sheet, however, we carry the liability for those remaining equity puts at $6.7 billion. In other words, if the prices of the relevant indices remain unchanged from that date, we will record a $2.9 billion gain in the years to come, that being the difference between the liability figure of $6.7 billion and the settlement value of $3.8 billion. I believe that equity prices will very likely increase and that our liability will fall significantly between now and settlement date. If so, our gain from this point will be even greater. But that,of course, is far from a sure thing.
On December 31, 2010, the S&P 500 (SPY) closed at 1,257, and the obviousness within the statement is that Warren Buffett is a bull going forward — well into the future — and when 2018 rolls around, we’ll see where we are. However one cannot take the “bull” position at face value because insurance is Warren's "thing" and he can use the premiums collected for the next 7 years, interest free! But at this juncture one can compare the above excerpt with an article published by Vanity Fair stating that he “had condemned derivative contracts as early as 2003, describing them as “time bombs, both for the parties that deal in them and the economic system,” when Warren told Charlie Rose on PBS “that such derivatives were nothing short of ‘financial weapons of mass destruction.’” Apparently he likes the weapons as much as the next guy because the leverage can be extremely rewarding.
Warren Buffett is not the sleepy investor, slowly accumulating dividends, and strictly banking on stock value appreciation, but rather a high stakes poker player and a potential bluff master. Good for him. But next time you think about picking up a copy of “The Buffettology Workbook: Value Investing The Warren Buffett Way,” co-authored by David Clark and Mary Buffett, (She gained her unique insight while married to Warren's son Peter for twelve years, according to her bio on amazon.com) think twice before buying into it, although it will only set you back $12. My take on Warren Buffett’s style is that he keeps the competition off balance as much as he can, and he’s fully aware that everything he says is read with avid interest.
Buffett’s investment rules are many, but potentially the most entertaining response that Warren could articulate is summarized by this Bloomberg article — and everyone ran with it as gospel.
“The single most important decision in evaluating a business is pricing power,” Buffett told the Financial Crisis Inquiry Commission in an interview released by the panel last week. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
I heard it differently and I translated that statement as literally saying “Now you go out and find those companies that actually have pricing power considering the global economic dynamics, and do your own homework while you’re at it, because I’m not telling you how I go about my business.” Does BNSF have the “pricing power” to raise prices 10% without a prayer? But that should keep them busy until the next conversation.
If there is one tip that he gave in his letter, it pertains to risk management, the selection of Todd Combs, and how thinking outside the box is the ultimate weapon.
It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.
One of my favorite passages is found in his 2000 letter (pdf), especially because it is preceded by the statement that he and Charlie never engage in speculation.
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.
And in the same 2000 letter, he offered yet more tips — and he chose to italicize the word “nothing” — while emphasizing the cash flow component, although he doesn't explain how to examine a cash flow statement, and not all cash flows are equal where some positives are actually negatives.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.
I do believe that up to a point, Warren’s driving force was about the money, just like most people. Now it’s about the game.