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Archive for August, 2006

Purchase of Marketable Securities

The selection of securities that Warren buys can be classfied under five categories: (1) long-term common stock investments, (2) medium-term fixed-income securities, (3) long-term fixed income securities, (4) short-term cash equivalents, and (5) short-term arbitrage commitments.

He has no particular bias when it comes to choosing from these categories. The aim is to achieve for the highest after-tax returns as measured by “mathematical expectation,” limiting himself always to investment alternatives that he can understand. His criteria have nothing to do with maximizing immediately reportable earnings; rather, is to maximize eventual net worth.

Common Stocks

In 1987, Mr Market was on a major rampage until Oct, when it had a sudden seizure. The net result was a gain of 2.3% for the Dow.

Many prestigious money managers now focus on what they expect other money managers to do in the days ahead, rather than on what the business will do. An extreme example of what their attitude leads to is “portfolio insurance”, where a downtick of a given magnitude automatically produces a huge sell order.

Considering that huge sums are controlled by managers following such practices, is it any surprise that markets sometimes behave in illogical fashion?

After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price?

Such markets are ideal for any investor – small or large – so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
Mr. Market will offer us opportunities – you can be sure of that – and, when he does, we will be willing and able to participate.


Warren continues to parking most of his money in medium-term tax-exempt bonds, with an aversion to long-term bonds. Even back in 1986, he is already not optimistic about the long term future of U.S. currency due to the enormous trade deficit.

The pileup of “claim checks” in the hands of foreigners will ultimately lead to an increased pressure on the issuer to dilute their value by inflating the currency.

While recognizing the possibility that he may be wrong and that present interest rates may adequately compensate for the inflationary risk, Warren retains a general fear of long-term bonds.

Market Rumours

It is often reported in the press about Berkshire’s purchase or sale of various securities. Warren does not comment in any way on rumors, whether they are true or false. If he were to deny the incorrect reports and refuse comment on the correct ones, he would in effect be commenting on all.

His advice for anyone who wants to participate in whatever Berkshire is doing, is to simply buy the Berkshire stock!

About Debt

It is likely that Berkshire could improve its return on equity by moving to a much higher, though still conventional, debt-to-business-value ratio. It’s even more likely that we could handle such a ratio, without problems.

However, “likely” is not good enough for Warren. He wishes to be “certain”. Thus he adheres to policies – both in regard to debt and all other matters – that will allow them to achieve acceptable long-term results under extraordinarily adverse conditions, rather than optimal results under a normal range of conditions.

Good business or investment decisions will eventually lead to economic gains, even without the use of excessive leverage. However, he is willing to borrow as long as the amount does not pose a threat to Berkshire’s well being.

His strategy is to finance in anticipation of need rather than in reaction to it. A business obtains the best financial results possible by managing both sides of its balance sheet well. This means obtaining the highest-possible return on assets and the lowest-possible cost on liabilities.

It is often that opportunities for intelligent action on both fronts do not coincide. Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Therefore, his action on the liability side should sometimes be taken independent of any action on the asset side.

This fund-first, buy-or-expand-later policy almost always penalizes near-term earnings. For example, Berkshire is now earning about 6.5% on the $250 million they recently raised at 10%, a disparity that is currently costing them about $160,000 per week.


Good Business Economics

Buffett has a view that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.

Other than improvements to products, services, etc, which should be done, other major changes means chances for major errors. A fortress-like business franchise usually the key to sustained high returns, one which would be difficult to build with frequent changes.

Indeed a Fortune study of 25 top companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics. Most of them sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both).

Flexible Operating Budgets

Charlie Munger and Warren Buffett do not believe in flexible operating budgets, as in “Non-direct expenses can be X if revenues are Y, but must be reduced if revenues are Y – 5%.” Should the news hole at the Buffalo News, or the quality of product and service at See’s be cut, simply because profits are down during a given year or quarter? Or, conversely, should a staff economist, a corporate strategist, an institutional advertising campaign or something else that does Berkshire no good be added simply because the money is rolling in?

The adding of unneeded people or activities because profits are booming, or the cutting of essential people or activities because profitability is shrinking makes no sense and is neither business-like nor humane.

Purchase of Securities

Whenever Buffett buy common stocks for Berkshire’s insurance companies (leaving aside arbitrage purchases, discussed later), he approaches the transaction as if he was buying into a private business. He looks at the economic prospects of the business, the people in charge of running it, and the price that he must pay. There is neither a time or price for sale in mind. Indeed, he is willing to hold a stock indefinitely so long as he expects the business to increase in intrinsic value at a satisfactory rate.

When investing, he views himself as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts. While an active trading market would provide many opportunities, it is not essential.

Benjamin Graham said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market’s quotations will be anything but. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains.

At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

And Mr. Market doesn’t mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

Mr. Market is there to serve you, not to guide you. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.

An investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.

As Ben said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give you the chance to buy more of a good thing at a bargain price.

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, Buffett will sell their holdings. Sometimes, also, he will sell a security that is fairly valued or even undervalued because he requires funds for a still more undervalued investment or one that he understands better.

Controlled Company

Owning a controlled company offers two advantages. The first is the ability to allocate capital. This point can be important because the heads of many companies are not skilled in capital allocation.

CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate by turning to their staffs, management consultants, or investment bankers (sometimes with unsatisfactory results). In the end, plenty of unintelligent capital allocation takes place in corporate America. (That’s why you hear so much about “restructuring.”)

The second advantage of a controlled company over a marketable security has to do with taxes, a point which I will not elaborate here.

The disadvantages of owning marketable securities are sometimes offset by a huge advantage: Occasionally the stock market offers us the chance to buy non-controlling pieces of extraordinary businesses at truly ridiculous prices – dramatically below those commanded in negotiated transactions that transfer control.

An interesting accounting irony overlays a comparison of the reported financial results of controlled companies with those of the permanent minority holdings.

Accounting rules dictate that only the dividends that minority companies pay are considered as income. On the other hand, accounting rules provide that the carrying value of these holdings owned, as they are, by insurance companies – must be recorded on our balance sheet at current market prices. The result: GAAP accounting reflects the up-to-date net worth underlying values of the businesses that are partially own, but not their underlying earnings.

In the case of Berkshire’s controlled companies, just the opposite is true. Here, the full earnings is shown in the income account but not the asset values on the balance sheet, no matter how much the value of a business might have increased since the purchase.

The way to approach this accounting madness is to forget about GAAP figures and to focus solely on the future earning power of both our controlled and non-controlled businesses.

As this letter is particularly long, I will cover the rest in a second installment.

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Interest Rates are Still Going Up

For once in a long time, we have interest rates going on an uptrend simultaneously in USA, Europe and Japan. Even in Singapore where I am, the inter-bank rates have gone up by a couple of percent in the past year.

Commodity prices are high, inflation is up and the central banks are trying to remove liquidity from the monetary system.

A high interest rate is bad for equities in two ways. One is the increased cost in borrowing for companies. The second is the lower valuation of equities (using a discounted cashflow model) due to the higher interest rate.

When interest rates are going up, it is also bad news for bonds.

For these reasons, I am very overweight in money market funds at the moment. I am looking to move some of it to bonds once there are signs of a stop in rate hikes.

For the Buffett-like investor, the movement of interest rates is another form of noise. There might be buying opportunities for stocks of companies with good fundamentals.