As the dot-com bubble was well underway, Warren Buffett (Trades, Portfolio) was one of the few investors who was able to speak out against investors' seeming insatiable demand for stocks.
In his 2000 letter to investors, Buffett warned the outsized returns experienced by technology investors in 1998 and 1999 had dulled them into complacency, writing, "After a heady experience of that kind normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities... will eventually bring on pumpkins and mice."
Further, in his 1999 letter,Ă‚ he wrote:
"Right now, the prices of the fine businesses we already own are just not that attractive. In other words, we feel much better about the businesses than their stocks. That’s why we haven’t added to our present holdings. Nevertheless, we haven’t yet scaled back our portfolio in a major way: If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price.
Our reservations about the prices of securities we own apply also to the general level of equity prices. We have never attempted to forecast what the stock market is going to do in the next month or the next year, and we are not trying to do that now… equity investors currently seem wildly optimistic in their expectations about future returns
Berkshire will someday have opportunities to deploy major amounts of cash in equity markets — we are confident of that. But, as the song goes, “Who knows where or when?” Meanwhile, if anyone starts explaining to you what is going on in the truly-manic portions of this “enchanted” market, you might remember still another line of song: “Fools give you reasons, wise men never try.”Â
What's interesting about this period in the "Oracle of Omaha's" investment career is that, after the bubble burst, Buffett started buying not bust stocks, but bust bonds, specifically, the bonds of internet retailer Amazon.com Inc. (AMZN, Financial).
Buying junk
In his 2002 letter to shareholders of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), Buffett wrote:
"Last year we were ... able to make sensible investments in a few 'junk' bonds and loans. Overall, our commitments in this sector sextupled, reaching $8.3 billion by year-end.
Investing in junk bonds and investing in stocks are alike in certain ways: Both activities require us to make a price-value calculation and also to scan hundreds of securities to find the very few that have attractive reward/risk ratios.
...
Purchasing junk bonds, we are dealing with enterprises that are far more marginal. These businesses are usually overloaded with debt and often operate in industries characterized by low returns on capital. Additionally, the quality of management is sometimes questionable. Management may even have interests that are directly counter to those of debtholders. Therefore, we expect that we will have occasional large losses in junk issues. So far, however, we have done reasonably well in this field."
One company that had previously attracted Buffett's attention was Amazon following its decision to account for stock options as an expense. According to an article in the Chicago Tribune, Buffett acquired $98.3 million of Amazon's junk bonds in 2002 following the collapse of the dot-com bubble. The estimated payoff on this debt: "$16.4 million profit on the investment in high-risk, high-yield debt if Amazon repurchases the 10 percent senior notes next month."
What's also interesting is this wasn't his only tech investment at the time. Berkshire (Geico) also bought $63 million in Nextel Communications Inc. notes, $35 million in notes of AOL Time Warner Inc. and $9 million in debt of AT&T (T, Financial). In addition to these deals, Berkshire, along with Longleaf Partners Funds and Legg Mason Inc., invested $500 million in Level 3 Communications Inc., "the data-network company that has had 19 consecutive quarterly losses."
With Buffett's Amazon deal, it is clear he saw something in the business, something different, which inspired his initial investment in the first place. However, it seems he was not wholly convinced by the business at this stage and was only willing to buy the securities with the best risk-reward ratio. It is also interesting to note the other investments he made at the time, which show Buffett is not afraid to invest in any sector, as long as he sees a clear route to profit.
Disclosure: The author owns no stocks mentioned.
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