Buffett's 3 Unconventional Comments in 1997

Today when going over Berkshire’s annual letters, I found something interesting from the 1997 annual letter, in which Buffett talked about three unconventional comments. All of them look more like speculation to me, and they are against almost everything Buffett has said on investing. It was extraordinary and very rare.

Here is what Buffett wrote:

“If they are in the strike zone at all, the business ‘pitches’ we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun.“

Below are the three “unconventional comments” Berkshire made:

“When we can't find our favorite commitment -- a well-run and sensibly-priced business with fine economics -- we usually opt to put new money into very short-term instruments of the highest quality. Sometimes, however, we venture elsewhere. Obviously we believe that the alternative commitments we make are more likely to result in profit than loss. But we also realize that they do not offer the certainty of profit that exists in a wonderful business secured at an attractive price. Finding that kind of opportunity, we know that we are going to make money -- the only question being when. With alternative investments, we think that we are going to make money. But we also recognize that we will sometimes realize losses, occasionally of substantial size.

We had three non-traditional positions at yearend. The first was derivative contracts for 14.0 million barrels of oil, that being what was then left of a 45.7 million barrel position we established in 1994-95. Contracts for 31.7 million barrels were settled in 1995-97, and these supplied us with a pre-tax gain of about $61.9 million. Our remaining contracts expire during 1998 and 1999. In these, we had an unrealized gain of $11.6 million at yearend. Accounting rules require that commodity positions be carried at market value. Therefore, both our annual and quarterly financial statements reflect any unrealized gain or loss in these contracts. When we established our contracts, oil for future delivery seemed modestly underpriced. Today, though, we have no opinion as to its attractiveness.

Our second non-traditional commitment is in silver. Last year, we purchased 111.2 million ounces. Marked to market, that position produced a pre-tax gain of $97.4 million for us in 1997. In a way, this is a return to the past for me: Thirty years ago, I bought silver because I anticipated its demonetization by the U.S. Government. Ever since, I have followed the metal's fundamentals but not owned it. In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand. Inflation expectations, it should be noted, play no part in our calculation of silver's value.

Finally, our largest non-traditional position at yearend was $4.6 billion, at amortized cost, of long-term zero-coupon obligations of the U.S. Treasury. These securities pay no interest. Instead, they provide their holders a return by way of the discount at which they are purchased, a characteristic that makes their market prices move rapidly when interest rates change. If rates rise, you lose heavily with zeros, and if rates fall, you make outsized gains. Since rates fell in 1997, we ended the year with an unrealized pre-tax gain of $598.8 million in our zeros. Because we carry the securities at market value, that gain is reflected in yearend book value.

In purchasing zeros, rather than staying with cash-equivalents, we risk looking very foolish: A macro-based commitment such as this never has anything close to a 100% probability of being successful. However, you pay Charlie and me to use our best judgment -- not to avoid embarrassment -- and we will occasionally make an unconventional move when we believe the odds favor it. Try to think kindly of us when we blow one. Along with President Clinton, we will be feeling your pain: The Munger family has more than 90% of its net worth in Berkshire and the Buffetts more than 99%.”

So here we go. There was one macro-based comment involving the prediction of the direction of interest rates. Two quasi-macro-based comments were based on commodity prices in which the underlying assets have no “intrinsic value” by Buffett’s definition.

At first, it felt uncomfortable and even a little disturbing to read Buffett's above explanations. But these comments started to remind me of the answer Charlie Munger (Trades, Portfolio) gave me in 2017.

After the regular shareholder meeting of the Daily Journal Corp., Munger stayed around for almost three hours to answer questions from the groupies. I was extremely lucky to be one of the dozen groupies. Among the few questions I asked, the one on edge of competency was the one I was eager to hear Munger’s answer to.

"Me: Charlie, how do define the edge of circle of competency?"

"Munger: Well, each person is his own. It really helps (to know) what you can do and what you can’t. I don’t like to gamble against odds. I have not lost a thousand dollars in my life betting against racetracks, casinos. If the odds are against me I just don’t play. I won’t even amuse myself playing against the odds. Now I have occasionally played bridge against better players where I’m really playing for the instruction which I can afford, but that’s because I like the learning. I won’t do very much even of that. I do not like playing against the odds.”

Now let’s take a look at what Buffett said in 1997 again:

“A macro-based commitment such as this never has anything close to a 100% probability of being successful. However, you pay Charlie and me to use our best judgment -- not to avoid embarrassment -- and we will occasionally make an unconventional move when we believe the odds favor it. Try to think kindly of us when we blow one.”

From this perspective, what Berkshire did with those three unconventional comments was to make a move when the odds favor it. It turned out these comments were very profitable in the end. Munger may have been OK with them.