The Oracle Speaks – Words of Wisdom From Warren Buffett

Boy is this a tough market, even Berkshire Hathaway profits dropped 96%.

First of all, stop right now if you haven't read Warren Buffett's Chaiman's Letter in the Berkshire Hathaway Annual Report.  He can tell you a lot more about the state of the economy than I can.  Although I will go over some of the highlights of The Oracle of Omaha's 100-page report, you should read the whole thing – go ahead and read it, then come back – I'll wait… 

Berkshire Hathaway has produced a compounded annual gain in value of 362,319% since it's founding in 1964, about 10 times what you would have gotten investing in the S&P 500, roughly a 20% annual growth rate.  Included in that figure is a 9.6% decrease in book value last year, the first loss since 2001 and the second loss EVER.  The average S&P company dropped 37% of their book value in 2008 and this year is looking worse already.  "By the fourth quarter," says Mr. Buffett, "the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. The U.S. – and much of the world – became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear."

Buffett does not provide a positive outlook, he expects a rough 2009 and "for that matter, probably well beyond" but that does not shake his outlook that, over time, investments made today will pay off in the future.  He has a quote that is almost identical to one of mine: "Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down."

Commentary on the housing market was: "The 1997-2000 fiasco should have served as a canary-in-the-coal-mine warning for the far-larger conventional housing market. But investors, government and rating agencies learned exactly nothing from the manufactured-home debacle. Instead, in an eerie rerun of that disaster, the same mistakes were repeated with conventional homes in the 2004-07 period: Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work. It was Scarlett O’Hara all over again: “I’ll think about it tomorrow.” The consequences of this behavior are now reverberating through every corner of our economy."

About mortgage-backed securities, Buffett says: "Indeed, the stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn’t afford.  In short, universe “past” and universe “current” had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.  Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas."

Berkshire is a well-known, long-term holder of stock in some of America's greatest companies and this is a fascinating table of their top holdings, which I have adjusted, where possible, to reflect Friday's closing prices:

What's really shocking is, as I made the adjustments, how much money some of these holding have dropped in the first two months of 2009.  Berkshire lost $1Bn on AXP, $1Bn on KO, $1Bn on COP, $1Bn on PG, $800M on USB and $5Bn on WFC – $9.8Bn lost on 6 of America's top companies.  What chance can the average investor possibly have when Berkshire's top of the food chain virtual portfolio drops over 20% in two months?

Sadly, Buffett was not a PSW subscriber in 2007 and says in his letter: "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." 

Buffett is, however, enthusiastic about some of his new purchases: "On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits."  This is great advice for any fund manager or individual investor.

"The investment world has gone from underpricing risk to overpricing it," Buffett says. "This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary."

Starting on page 16, Buffett goes into a wonderful explanation of the derivatives market in which he concludes: "Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire  neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required." 

On pages 18-20, Buffett gives us specific examples of derivatives and hedges Berkshire uses to balance their risk and notes: "We have told you before that our derivative contracts, subject as they are to mark-to-marketaccounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie and me. Indeed, the “downs” can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealings will lead you to think similarly.   Again, this sums up our current investing philosophy quite nicely, especially when it comes to selling puts and calls on the crazy swings.

Buffett, in fact, goes into detail on page 20 about the flaws in the Black-Scholes formula that underlines options trading stating: "The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)."  As we are at PSW, Berkshire is using the manic/depressive nature of the market to great advantage, selling those volatile bets to others, bulls and bears alike.

Two things really stand out in this report.  Warren Buffett closes his letter out on page 24 with his acquisition criteria.  They are buying and looking to "make acquisitions in the $5-$20Bn range."  In addition to this, Buffett points out on page 89, that he has 99% of his net worth in Berkshire stock and Charlie Munger's family has 90% in the company.  "In recent years we have made a number of acquisitions. Though there will be dry years, we expect to make many more in the decades to come, and our hope is that they will be large. If these purchases approach the quality of those we have made in the past, Berkshire will be well served."

As I read this report I am reminded of the true value of stock ownership, something that many of us tend to forget as we add and delete electronic symbols on our screens.  There are companies out there that are good, solid businesses, many of which are having a hard time but many of which will also survive the next 45 years and here we are with an opportunity to buy some of these companies for far less than Warren Buffett paid for them over the past 45 years. 

I know the market looks scary, I know that stocks are knocking us for a loop but one day this madness will end and the World will continue to spin and a person will decide to buy a car and that person will go to a bank and get a loan and will pay for that car and the bank and the auto maker and the steel maker and even Berkshire's Geiko division will make a small profit.  At the moment, Berskshire is priced below their 1998 highs, wiping out all gains since 2004 as has much of the market but people still buy Coke and put gas in their cars and make Kraft macaroni and cheese for dinner and they probably will in 2014 as well.

These are hard times and Berkshire's report reflects that more honestly than any other report you are likely to read yet Mr. Buffett is buying – perhaps we should too.