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May 5, 2007 (James P. Miller - Chicago Tribune)
Investor Warren Buffett expects periodic turbulence in the stock market in the future, and warned that such normal disruptions are likely to be amplified by the hair-trigger buy-and-sell proclivities of the "electronic herd" of investment managers around the world.
Still, the fabled investor told 27,000 stockholders of his Berkshire Hathaway Inc. investment company this morning that Berkshire plowed $5 billion into the stock market in the first quarter of 2007.
Buffett said that, if he had to choose, he and investing partner Charlie Munger would rather own stocks over the next two decades, rather than buy twenty-year bonds.
AntiSpin: Warren Buffett once said, "You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ." It's no secret that Warren Buffett owes his success to a combination of method and access. The way to make money by investing in established companies in mature markets is so boring that not very many people are willing to do it. It demands the repeated, consistent application of a method of analysis over many years.
To make a new investment, first identify an industry, such as soft drinks or railroads, which are likely grow faster than the annual rate of inflation is likely to rise.
Next, identify the one company in that industry with the the most room to grow with the best sustainable differentiating advantage. That advantage can be entirely brand (e.g., Coke), or related to some macro trend, such as rising distance trucking costs (e.g., Burlington Northern). You will not see Buffett invest in a company that relies primarily on technology for differentiation–too much special knowledge is needed to evaluate pure technological advantage. Many experts get it wrong and the advantage may be fleeting.
Determine the fair market value for the stock of a hypothetical leader based on total available market revenue and profits potential over 10 years.
Identify all of the incumbent and insurgent players in an industry to determine the leader. If their stock is fairly priced relative to market share and total available market, keep digging.
Create a template to evaluate all of the major companies in the industry, listing the attributes of each. Attributes are industry specific.
Develop a set of questions designed to determine which company either has the most market share or is likely to acquire it, which has the most pricing power, and so on.
Now comes the part that prevents most people from investing like Warren Buffett: get direct access to management at the companies you are looking into to get your questions answered.
Use a team of analysts trained to know how to get the questions answered.
Verify that the answers are true.
Evaluate the companies using the template, weighing the relative advantages of each company.
If you find you've missed anything, or find two competitors are very close, go back with more questions.
Identify any factors, such as new technology or demographic shift, which may disrupt the order at some point in the future.
Repeat.
The result? During the period from 1980 to 2003, the stock portfolio of Berkshire Hathaway (NYSE: BRK-A) beat the S&P 500 index in 20 out of 24 years.
This approach will not work to determine the likely winner among early stage private companies in a nascent market. A venture capitalist, for example, is more concerned that a start-up company's founders have relevant experience, a clear vision of where they are going, and are highly motivated. But in the realm of large public companies, Buffet's is the way to pick a leader.
Buffett is methodical. He is also wise. Over the years, we find that most of his pet peeves are the same as ours. He knows the markets offer no free lunch. He doesn't like asset bubbles. He finds state gambling offensive. But he is not as focused on financial market and economic history as we, so there are areas where he comes to different conclusions.
In this analysis of his recent speech, we start where we agree.
Asked about gambling stocks, the plainspoke Buffett initially equivocated, but then warmed to his task.
"I'm not a prude," he said, "but to quite an extent gambling is a tax on ignorance." It is "revolting," he said, when a government preys on its citizens' weakness rather than trying to provide them with services. "
"It's not government at its best," he concluded.
The normally silent Munger, who provides gravitas and plays straight man to Buffett's loquacity, weighed in on the gambling industry as well. "It's a dirty business," the 83-year-old Munger said bluntly. "I don't think you'll see a casino in Berkshire's portfolio."
We hate state sponsored gambling. Our glossary defines the state lottery as "a regressive tax imposed by the state on those of its citizens it has failed to provide a basic education in the laws of probability.""I'm not a prude," he said, "but to quite an extent gambling is a tax on ignorance." It is "revolting," he said, when a government preys on its citizens' weakness rather than trying to provide them with services. "
"It's not government at its best," he concluded.
The normally silent Munger, who provides gravitas and plays straight man to Buffett's loquacity, weighed in on the gambling industry as well. "It's a dirty business," the 83-year-old Munger said bluntly. "I don't think you'll see a casino in Berkshire's portfolio."
"The nature of private equity isn't a bubble that bursts." But the trend will weaken eventually, when the currently narrow gap between junk debt and investment-grade bonds widens, he added.
Disagree. It's a bubble in the fashion of the mortgage and housing bubble. Both are driven by the same engine of leverage that Buffett warns about, specifically, CDOs. See Jim Finkel, CEO, CDO firm Dynamic Credit. Warren Buffett said on Saturday problems in the U.S. subprime lending industry were unlikely to pose a major threat to the overall U.S. economy.
Buffet is arguably the world's most capable investor, but he doesn't understand the long term implications of Risk Pollution. Credit toxins are oozing out of the financial system in the sub-prime segment of the mortgage market first, in its most vulnerable sector. Soon enough it will be oozing out everywhere. Buffett warned about the dangers of derivatives — financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates. The Federal Reserve’s efforts to regulate the use of credit to purchase securities have been made irrelevant by derivatives, he said.
“The introduction of derivatives just made any regulation of leverage a joke. It’s an anachronism,” he said. Because of them, “there will be some very unpleasant things that happen” in the financial markets. “We may not know exactly where the danger begins and at what point it becomes a super danger.”
Here's where Buffett needs to make the connection among the sub-prime mortgage market, derivatives, private equity, and the housing bubble. The impact and risks posed by the development of non-transparent derivatives has been known since at least 1999 when banking expert Martin Mayer wrote the article Somebody Turn on the Lights, Derivatives Strategy (Brookings Institution) on over-the-counter derivatives. Today, iTulip Select publishes our interview with Martin Mayer. more ($ subscription)...
“The introduction of derivatives just made any regulation of leverage a joke. It’s an anachronism,” he said. Because of them, “there will be some very unpleasant things that happen” in the financial markets. “We may not know exactly where the danger begins and at what point it becomes a super danger.”
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