Friday, April 13, 2007

Lessons from Buffett

Every February Berkshire Hathaway invites a hundred or so Wharton students - graduates and undergraduates - to visit the firm and listen to "The Oracle of Omaha." Buffett who delights in mentoring his young admirers, did not disappoint the group of students who arrived, excited.

In all his conventions, there'll be new advice, extension of his previous advice or wisdom, which we can learn from him. An advice for those who meet him for the first time: Don't ask him to predict the market - he won't and he doesn't believe in looking from the macroeconomic dimension. He believes that there're always opportunities to find undervalued stocks and sometimes the entire market is so mispriced - either way excessively - that profitable trades await savvy investors.

Threats to the Market

He told one in the group he thinks that risk premiums are too low and that events like 9-11 - or worst - can happen at any time. He said that the probability that a nuclear device could be triggered by a terrorist in Manhattan or in Washington cannot be ignored and probably is not factored into the market.

Warren was asked whether he would be a buyer if such terrorism materialized, and, he pondered for a moment and said "yes." Despite his concern for terrorism, Buffett maintains a long-term bullish view of American equities.

Buffett also thinks the large and growing U.S. trade deficit is a big treat to the markets. His concerns were one of the reasons he had taken a sizeable short position on the dollar several years ago. Although he has since pared his position, he still believes that the U.S. saves too little and consumes too much. As a result, the government has to issue more debt (bonds) - which he termed as "pieces of paper" - to pay for these imported goods and services. Eventually, the bonds-holders will have future claims on U.S. resources. He believes this huge deficit is a threat to the dollar and invites future inflation.

His retractors will think otherwise. Some believe many Asian countries want to run trade surpluses and are perfectly happy to continue buying U.S. government bonds. Certainly the dollar may decline yet further but the greenback is already cheap when compared against major world currencies on a purchasing power basis. Betting against the dollar is not a sure thing like where it was a few years ago.

Warren thinks that preventing cross-border mergers is an act of foolishness - such as the political opposition to the Chinese oil company, CNOCC's bid for Unocal last year. Some believe that any actions that discourage the foreign flow of capital have far more serious consequences for the dollar and capital markets than the trade deficit itself.

Buyout Surge

He then commented negatively on the recent buyout surge and drew some comparisons with a similar phenomenon in the late 1980s. He denounced private equity that sweeps down and buys firms, "gussies them up," (to use his term) by stripping and leveraging their assets and firing employees, and then spits them out to the public at a higher price.

However, he wouldn't say that all buyouts are bad for shareholders. The current craze certainly has not gone as far as the late 1980s, when exotic debt instruments, such as non-cash P.I.K. (paid-in-kind) bonds burst onto the scene. Indeed part of the reason for today's buyout frenzy is that straight debt is very cheap. Moreover, with the market flushed with cash, it creates a situation where the more ”are” chasing after the “less" and thus indirectly causing the "less" more "appealing" and at the same time drives up prices. No doubt, for owners who want to sell their business without any regard for the well being of his creation, this is the time to sell to private equity. However, Berkshire operates and behaves in the exact opposite manner of private equity - Berkshire does not chase after equity nor do they participate in an auction. But for owners who care about his business's future and want their company to remain intact after selling, and are willing to accept a deal below top price, Berkshire is the obvious “buyer of choice” to such owners.

Long Term Capital Management

One student asked about Berkshire's role in the Long-Term Capital Management (LTCM) crisis that rocked the financial markets in 1998. It was obvious that Warren wished he had been able to buy LTCM's positions when the Federal Reserve forced a resolution of the crisis that was crippling the government bond market.

The LTCM crisis was an example of Warren's philosophy of buying firms when the economics were right, yet fear ruled the market. He noted that "off-the-run" (non-benchmark) government bonds were selling to yield 30 basis points more than the "on-the-run" (benchmark) bonds that were maturing just six months later. He claimed that this made no sense economically. And he was right.

LTCM had taken a huge leveraged position in these bonds when the spreads were much smaller, but didn't have the collateral to hold on to it when the spread widened. Buffett quoted John Maynard Keynes, who wrote in 1931 that, "The market can stay irrational longer than you can stay solvent -" in other words, one can be right in the long run but died in the short run. As the spread widened, Keyne's dictum became devastatingly relevant to LTCM. But Berkshire, with its huge cash hoard, could withstand the pressure of even more market irrationality before the spread eventually return to normal.

Unfortunately, he was not able to consummate the deal. He had been invited by Bill Gates to vacation in Alaska wilderness when the crisis broke and it was hard to negotiate when he was almost cut off from any communication means. Eventually, a consortium of banks holding the collateral made a deal with LTCM.

Warren is philosophical about the loss of this opportunity, noting that it was the most expensive holiday he ever had. "Bill Gates costs me about $3 billion," he shrugged in jest. But that incident certainly has not soured his friendship with Bill. Neither did it prevent him from giving the Bill and Melinda Gates Foundation the lion's share of his wealth.


Another student asked him whether, despite his enormous success, he ever made a mistake. Warren said that fortunately most of his mistakes were small. He noted his ill-fated purchase of Dexter Shoe in 1993, a buy that was made far more costly when he paid for this money-losing business with Berkshire stock.

But Warren does not stew about past mistakes. He wisely counsels that anything that happens to your finances is secondary to the important things in life - picking a suitable and compatible mate, developing a relationship with your children, and doing something that you enjoy.

After listening to what Warren said, it is easy to see that he is not only the world's best investor, he is also a consummate mentor, and an exquisite thinker. Although most come to hear Warren Buffett for his financial wisdom, they come away with an appreciation of how financial success fits into a broader perspective on life. Cold and snowy Omaha is, but it cannot take away the wealth of ideas and warm feelings that were generated at Berkshire.

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