Warren Buffett Speaks: New Thoughts On Investing

For Berkshire Hathaway, 2005 was a mixed year. The company reported a respectable but unspectacular gain in net worth of $5.6 billion, a rise of 6.4%, and the stock was stagnant. Among the obstacles were losses for Berkshire Hathaway's insurance units rising from the aftermath of Hurricane Katrina, as well as an unusually large number of other lesser but still destructive natural disasters. These resulted in costs of nearly $3.5 billion. The company also had to face other major obstacles.

In 2004, Buffett became very bearish on the US dollar. He believed that a sharp decline in the exchange rate of the currency was inevitable because of the US budget and trade deficits. Therefore, in a first for him and his firm, he aggressively entered the currency markets, betting on a sharp decline of the dollar. However, it increased in value in 2005, resulting in a loss to Berkshire Hathaway of nearly $1 billion. This is further evidence that all market experts make occasional mistakes. For example, George Soros, perhaps the most famous currency trader of our time, lost between $1 billion and $2 billion in 1998 because he did not anticipate that Russia would default on its debt.

In February of this year, Buffett stepped down as a director of Coca-Cola Co. after 17 years on the board. In the 2005 annual report, Buffett noted that Berkshire Hathaway's 8.4% stake in that company, which peaked in value in 1998 at $13.4 billion, is now worth $8.1 billion, a loss of about 40%, but he was maintaining the position. News reports, in announcing Buffett's departure from the board, stated that he played a leading role in preventing Coca-Cola from purchasing Gatorade, which is now fueling growth at arch-rival PepsiCo. Despite these setbacks, Berkshire Hathaway's initial investment in Coca-Cola of $1 billion has multiplied eightfold.

The annual report shows that Buffett made two big stock buys in 2005, a $944 million purchase of Wal-Mart stock and a $2.133 billion purchase of Anheuser-Busch stock. Both stocks have subsequently declined in value. They are both solid blue-chips with leadership positions in their industries, selling at reasonable price/earnings multiples and with decent dividend yields. As Buffett is the classic long-term investor, the short-term moderate declines in value of his positions are not likely to concern him or his following.

The keystone to Buffett's stock market approach is to determine the intrinsic value of a stock and buy when the market value is below it. The difference between intrinsic value and market value is referred to by Buffett and other followers of Benjamin Graham, the founder of fundamental analysis, as the margin of error.

In his 2005 report, Buffett observed that intrinsic value can only be estimated. He explained, "I say %91estimate' because calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong." He added that "the more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base." For this reason, Buffett refuses to invest in high-technology firms or in startups; he sticks to well-established corporations with long track records of profit in industries that are not overly technical or otherwise complicated. This means that he has missed many high-flying stocks, such as Microsoft (run by Buffett's friend Bill Gates) and Oracle, but due to this approach he has also sailed unscathed through the bursts of the Internet and telecom bubbles of the late 1990s.

In the 2005 report, Buffett declared that "... it is difficult to overpay the truly extraordinary CEO of a giant enterprise. But this species is rare." More often, Buffett noted, "executive compensation in the US is ridiculously out of line with performance." In particular, he observed that even a corporate chieftain who has failed could receive a huge compensation package. Buffett declared, "Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure."

Other issues addressed by Buffett in his annual reports over the years include the trade deficit, the budget deficit, the role of the board of directors, tax policy, and accounting standards.

In the latest annual report, Buffett discussed the use of derivatives, observing that Mark Twain might have been talking about these financial instruments when he stated that "a man who tries to carry a cat home by its tail will learn a lesson that can be learned no other way."

Buffett's concern about derivatives centers on several factors. First is the difficulty in valuing them; because their worth at any particular time is merely hypothetical (based on various pricing models), they can be valued differently by both parties to a transaction, which invites abuse. Buffett noted that "it's a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable."

In light of the ambiguities associated with the use of derivatives, many firms could find themselves with unexpectedly large obligations that they cannot handle. For this reason, Buffett is in the process of extricating his firm's insurance units from obligations relating to derivatives, a costly process "because [of] their potential to explode." As a result, Berkshire Hathaway has lost more than $400 million on these transactions.

In regard to this matter, Buffett warned that "in a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted."

The characteristics of a soundly managed firm are set forth by Buffett in the latest report, in common with every previous report. In 2005, he asserted that "if we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither." He added, "On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous." Companies that improve their efficiency and enhance the products and services that they offer customers are, in Buffett's words, "widening the moat" that protects the enterprise.

James A. Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, The Massachusetts Law Review, and other magazines. His law journal articles have been cited in several legal decisions, including by the US Court of Appeals for the DC Circuit and by the US Supreme Court.

Graham, Benjamin [2003]. The Intelligent Investor, revised edition, Collins.

Maccaro, James [2002]. "Warren Buffett," Technical Analysis of STOCKS & COMMODITIES, Bonus Issue.