The things Buffett didn't say

PORTFOLIO POINT: Sometimes Warren Buffett’s ideas have been reduced to glib one-liners; sometimes he didn’t say them at all.

It seems there’s a Warren Buffett quote for every occasion. Whether we’re in the midst of a recession or a rally a gem of homespun wisdom from the world’s greatest investor is never far away. But in many situations it was the things Buffett didn’t say that were more important.

Things he didn’t say because his complex ideas had been reduced to meaningless one-liners or didn’t say at all because, well, there is no record of him actually having said it in the first place. In fact some of his comments – such as those on diversification – have been reworked and taken so far out of context that they resemble works of fiction!

There is no doubting that Buffett’s stock picking ability and the extraordinary long-term performance of his company Berkshire-Hathaway (whose returns compounded at 20% annually from 1965 to 2008) are two very good reasons why he has garnered so many followers. But another reason might be the way his ideas are drip-fed to shareholders hungry for that next Buffett tidbit promising untold riches.

Since 1970 Buffett has written Berkshire-Hathaway’s annual chairman’s letter to shareholders (click here), covering a range of topics that extends beyond the company’s performance and frequently run to 10,000 words or more. His occasional visits to universities are equally well documented and just as wide-ranging, providing much room for interpretation.

That Buffett himself was a student of Benjamin Graham’s is well known, and Graham’s highly regarded books Security Analysis and The Intelligent Investor have been thumbed through by his fans all over the world. But even with hundreds of books claiming to detail Buffett's life and reveal his investment strategy, the man himself has not found it necessary to put pen to paper and write the definitive guide to his style of value investing.

So the next time someone comes at you with a quote from the “Oracle of Omaha”, remember that it might pay to think beyond a quick quip '¦ and ask them to quote a source! The weighty tomes that formed the basis for his approach to investment suggest the secrets to his success cannot be summarised with the kind of snappy quote you might find in a fortune cookie.

“Be fearful when others are greedy and greedy when others are fearful”
– Chairman’s 2004 letter to Berkshire-Hathaway shareholders (click here).

Perhaps the most frequently repeated of all Buffett’s quotes is also the most misleading. But before the legions of Buffett followers release the hounds, let me explain why. In essence, the idea is just another way of expressing the investor’s maxim of “buy low and sell high” but without inserting the words “most greedy” and “most fearful” into this phrase it largely ignores the power of momentum on share prices.

When the first inkling of the subprime fallout began filtering through at the start of 2007, investors began lightening their holdings in an orderly fashion. But in just four weeks, from July 24, they knocked 1000 points off the index as they rushed the exit. If we hold Buffett to his theory, this was a buying opportunity and many interpreted it as such resulting in another 1400 point rally over the following two-and-a-half months.

The problem is that anyone who bought stocks during this rally, or the 12 months that followed, is still underwater almost four years later (I know because I got my head knocked off buying Wesfarmers at the time). Fear was everywhere but, as everybody knows now, the bottom wasn’t reached until the buyers began to outnumber the sellers in March 2009.

What Buffett doesn’t say is that you need to identify the moment the fear or greed has reached its absolute zenith or nadir before making the plunge either way '¦ a skill that ordinary investors like you and I are unlikely to pick up anytime soon.

“Derivatives are financial weapons of mass destruction”
– 2002 Chairman’s letter to Berkshire-Hathaway shareholders (click here)

It’s hard to believe that after delivering an 1800-word diatribe on the evils of these instruments in 2002 Buffett would turn around and not only embrace them but lose approximately $1.8 billion in the second quarter of last year. Hey, I suppose we’re all allowed to change our minds once in a while. But hang on a second. Isn’t General Re effectively in the business of selling put options to insurance companies around the world?

Think about it. General Re is in the business of reinsurance, which means it is paid premiums by insurance companies so that if certain events take place then General Re will need to make good on an agreed value as specified in the original contract. That’s awfully close to the definition of a put option! Because policy holders pay premiums upfront, General Re is an essential part of Buffett’s growth strategy as he deploys the cash in other, hopefully more profitable, businesses. Here’s hoping there’s enough in the kitty to pay out the likes of IAG and Suncorp!

“If you can identify six wonderful businesses, that is all the diversification you need.”
– 1998 speech to University of Florida Business School (click here)

Let’s forget the fact that Berkshire-Hathaway owns stakes in almost 100 companies and Buffett himself could possibly own stakes in hundreds. Let’s also ignore that modern portfolio theory suggests the sweet spot for reducing risk is to maintain 20–30 holdings. In fact, if we go back to the speech from which this quote is taken it becomes quite clear that he doesn’t believe this at all.

The quote comes from his answer to a question from the floor where a student asks him about the benefits or lack thereof in diversification. The first part of his answer is: “I believe that 98–99% who invest should extensively diversify and not trade, so that leads to an index fund-type of decision with very low costs.” So instead of advocating an active style of management by taking big positions, what Buffett didn’t say (or did say but was just ignored) was that all but a very small percentage of investors would be better served by buying the index.

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
– 2008 Chairman’s letter (click here)

In the second half of 2008 Berkshire-Hathaway started making bets on the future oil price. Big bets. According to SEC filings made at the time, Buffett increased his holding in the oil and gas major ConocoPhillips four-fold to hold shares worth $US6.15 billion just as oil reached $US147 a barrel. Unfortunately, history would show that steep rise in the oil price was an aberration, much like ConocoPhillips’ share price, and they both fell off a cliff.

Once all this became clear Buffett sold the shares at a multi-billion loss. Since he sold, shares in ConocoPhillips have since recovered substantially. With the price of North Sea Brent consistently nudging the $US100 mark ConocoPhillips may soon return to its 2008 highs of $94.26. The lesson here? As much as Buffett likes to buy things when they’re cheap it’s all relative when you’re in the grips of a commodity boom.

"You could take all the gold that's ever been mined or '¦ you could buy all of the farmland in the United States plus 10 ExxonMobils and have $1 trillion of walking-around money. Which is going to produce more value?"
– 2010 interview with CNN’s Ben Stein (click here)

Admittedly, this isn’t the much-repeated quote from a 1998 Harvard lecture in which Buffett supposedly said that gold “has no utility”. I use the word “supposed” because there is no record of him uttering these magic words. Instead we turn to a more recent interview where, like many who talk down gold, he bemoans the fact the gold is essentially inert, producing neither dividends nor contributing to GDP.

Needless to say the price of gold has appreciated by almost 360% or roughly twice as much as Berkshire-Hathaway’s share price over the 13 years that followed. It would be churlish of me not to concede that predicting the future values of commodities is a tough business. By the end of the year it’s quite possible that his stance on gold (and for that matter oil) could be proven 100% correct. But then again the market has an infinite capacity for surprise and as a wise man – who may or may not have been Warren Buffett – once said, “On a long enough timeline, we are all dead anyway”.