Warren Buffett at Berkshire Hathaway: Pessimism's Your Friend, Euphoria the Enemy

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When the world’s most successful investor pens a letter following the market’s worst year since the 1930s, it pays to read it carefully. The effort’s well worth it, as he has insights on all the questions investors are now asking: Did he avoid 2008’s devastating losses? What was his sell strategy? Will the market rebound? Wither the economy? Is temporary refuge in cash the answer? And last, but certainly not least, does he have any stock tips?


The bottom line is that while his investment vehicle Berkshire Hathaway suffered its worst year ever and lost billions, he actually fared better than the market due to broad diversification, significant earnings on his investments and his non public holdings. Despite 2008’s relentless declines, Mr. Buffett did not bail on his holdings, but used the lower prices to buy more at what he perceives to be bargain prices.


While he has nothing but near term pessimism for the American economy, he refuses to believe that means the stock market won’t fare better this year, believing that insight on the economy does not translate into a crystal ball on equity prices. Longer term he’s an unabashed bull. Cash is a big mistake. Finally, he appears particularly bullish on well known franchises in the financial services and energy sectors.


Mr. Buffett Takes a Beating


Mr. Buffett’s Berkshire Hathaway lost billions in 2008. The media reported it as his worst year ever, as its share price dropped from 147 to 80, a decline of 32%, slightly better than the S&P 500’s drop of over 38%.


Mr. Buffett fully owns up to the losses, so the first lesson for investors is that your misery has company. If the world’s greatest investor couldn’t make money in 2008, you shouldn’t be too hard on yourself over your own results. He’s honest, he’s human, so remember that when your brother in law gloats that he got out of the market at the start of last year.


But his tough results have many more lessons for investors. First, he doesn’t point to his stock price as the ultimate verdict on his progress. Rather, he points to Berkshire Hathaway’s book value as the superior indicator. By that measure, his results start to look really good, at least against the major market averages, as it eased just 9.6% versus the prior year. So, investors should spend more time focusing on the internal fundamentals of their investments, which may or may not be well reflected in volatile stock prices.


And although that book value drop represents $11.5 billion in losses, which would be enough to cause a heart attack in most younger investors, this 78 year old avoided a seizure by keeping it in perspective. First, he views it as a percentage, not an absolute dollar amount. Second, he takes the long view, which shows his book value increasing by 20.3% on average each year for the last 43 years. The average investor should also look at his own track record over many years, and express any gains or losses in percentage terms, not dollar amounts, to keep things in perspective.


Mr. Buffett also takes in stride the occasional strike out, confessing to some “dumb things.” For example, he loaded up on ConocoPhillips right when the energy market hit its peak last summer; by the end of the year the stock price was cut in half, he’d lost “several billion” and his forecast on higher energy prices was “dead wrong.” He further suffered an 89% loss on a $244 million investment in two Irish banks. But, these were “smaller” investments, thus emphasizing the virtue of diversification.


What Was Mr. Buffett’s Sell Strategy?


Many investors are chagrined that they did not read the writing on the wall, and sell when their holdings or the market dropped to preserve capital and avoid further principal loss.


What was Mr. Buffett’s sell strategy? It was to buy when everyone else was focusing on selling! That is probably the most important lesson to be gleaned from his annual report. As he put it: “Pessimism is the friend of the long term investor, euphoria the enemy.”


So, Mr. Buffett didn’t sell anything in the face of such a relentless bear? Actually, he confessed to trimming his positions in Procter & Gamble and Johnson & Johnson in 2008’s fourth quarter. But, this, according to him, was so he could buy securities in General Electric and Goldman Sachs.


This type of move really underscores his investment philosophy. Not only was he investing in the most volatile part of 2008, October and November, he was rebalancing his portfolio away from what was generally perceived to be the only safe areas of the market, health care and consumer nondurables, into financials and industrial cyclicals.


The bottom line is Mr. Buffett espouses a contrarian investment philosophy. Not only is he buying, not selling, when markets are declining, but he’s buying in some of the most beaten down areas, financials and industrials, while lightening up in those sectors in which others are seeking a safe haven.As Mr. Buffett put it: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”


Mr. Buffett’s Outlook for the Economy and the Market


Mr. Buffett has historically dismissed economic forecasts, opining that God put economists on earth to make astrologers look good. Indeed, nearly all the economists misforecast this latest downturn.


However, that didn’t stop Mr. Buffett from opining that the economy would be in “shambles throughout 2009 -- and, for that matter, probably well beyond….." But, what was most interesting his is failure to follow that up with an admonition to avoid the market. Instead, he says his conclusion on the economic outlook “does not tell us whether the market will rise or fall,” and that neither he nor his partner Charlie Munger has the ability to forecast whether any year will be a good year or a bad year in the market.


How can we reconcile his pessimism on the economy yet agnosticism on the market? Indeed, one might characterize him as outright bullish on the market given his late 2008 buying spree.


Mr. Buffett believes that low prices already discount a tough near term outlook. After all, as he puts it, “price is what you pay, value is what you get”. If the economic shambles haven’t eroded the value of an investment as much as the low price reflects, it’s a buy in Mr. Buffett’s book. His check on whether prices are low is sentiment. When others are “fearful,” prices will be low to reflect that, and that’s when he wants to become “greedy.”


Despite Mr. Buffett’s belief that 2009’s economy will be in “shambles,” he is an unrepentant optimist longer term. He believes that America’s current problems pale compared to those it has overcome in the past, arguing that despite those travails American living standards advanced seven fold in the 1900s, while the Dow rose from 66 to over 11,000. Can we be as optimistic looking forward? Buffett asserts because of our economic system: “America’s best days lie ahead.”


Cash Is Trash


Mr. Buffett writes with disdain about the “smugness” and social “approval” of those who would “cling” to cash, Treasury bonds, or Government guaranteed products. He believes that the Treasury market is in a bubble, given the record low yields, and that the natural by product of all the Government stimulus may well be overwhelming inflation. That cash will “surely find its purchasing power eroded over time.”


Stock Tips!


Mr. Buffett’s three biggest publicly disclosed investments in 2008’s second half involved Conoco Phillips, General Electric, and Goldman Sachs. Because the market valuation of all three have declined significantly since investment, and Mr. Buffett shows no sign of reversing course on them, these may be considered solid Mr. Buffett buys. However, their fundamentals have declined markedly since his investments, so none of them can be considered a slam dunk.


Mr. Buffett loaded up on Conoco last summer when crude oil prices reached record highs, and he admits he overpaid, perhaps paying $90 per share. The stock price is now at $36. A quick rebound looks unlikely since energy prices have fallen by two thirds since then. Yet, Mr. Buffett is quite sanguine that energy prices will rise again.


Mr. Buffett bought preferred stock in General Electric last October, with a yield of 10%, plus warrants that would allow purchase of GE common shares at $22.25 apiece. By investing in high yielding preferred stock as opposed to common shares, Mr. Buffett avoided the subsequent decline suffered by the common stock, which is now at $7.


However, his warrants are now virtually worthless, and he would be unlikely to be able to sell his preferred shares for anywhere close to what he paid for it. Further, GE’s fundamentals have eroded significantly since then, and it’s had to cut its dividend by more than half. Prospective investors in GE must consider whether a two thirds reduction in the stock price adequately discounts the bleaker outlook.


Mr. Buffett’s investment in Goldman Sachs was similar to GE’s. He received high yielding preferred stock, with warrants to buy Goldman’s common stock at $115/share. He has fared better than investors buying the common at $125 at the time, as the stock has since declined to $75. Undoubtedly, Mr. Buffett would counsel prospective buyers of Goldman to analyze whether a stock price drop of nearly 40% adequately compensates for today’s heightened risks in the financial system and Goldman’s prospects.


To sum up, for investors looking for inspiration to invest or stay invested in the current market, Mr. Buffett’s letter on his ups and down in 2008 offers inspiration that the best times are still ahead of us.



David G. Dietze, JD, CFA, CFP™

President and Chief Investment Strategist

Point View Financial Services, Inc.

Summit, NJ

March 7, 2009

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