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On Buffett’s Big Blunder

Warren Buffett is getting a lot of criticism for a big blunder. He sold put options on four stock indexes – including the S&P; 500.

Buffett described these derivatives in his 2007 letter to shareholders:

“Last year I told you that Berkshire had 62 derivative contracts that I manage (We also have a few left in the General Re runoff book). Today, we have 94 of these…”

Financial Weapons of Mass Destruction

Before criticizing Buffett, we need to take a moment to praise him. After all, the guy had the foresight to clean out the General Re derivatives before the credit crisis hit.

Yes, Berkshire took a loss. And, yes, Buffett clearly overestimated both the rationality and morality of the human capital over at General Re – much as he had at Salomon.

Buffett was never well-liked at Salomon. And I’m sure there are some folks (or ex-folks) at General Re who don’t find him quite as avuncular as he is reputed to be.

I would say they simply don’t understand each other, if I didn’t think the truth was exactly the opposite. Buffett got to know Salomon and General Re better with time – and the better he knew them, the less he liked them.

The General Re derivatives were a disaster averted. Had Berkshire kept the book intact or never acquired General Re, we’d be hearing a lot more about what was in that book.

Is it a mere coincidence that Buffett, the CEO who made the decision to unwind the General Re book, called derivatives “financial weapons of mass destruction”?

No. Buffet saw something in that book. And he did something about it. Most CEOs did not.

Style Drift

Enough praise. Back to the blunder:

“Over the past five years, Buffett frequently called derivatives ‘financial weapons of mass destruction’, comparing derivates to ‘hell…easy to enter and almost impossible to exit.’ Yet, he has, very much out of character, immersed himself in a large and, thus far, unprofitable derivative transaction. His investment successes have not been in speculating in the market (something he has been critical of) but rather by purchasing easily understandable companies with dependable cash flows…”

That’s Doug Kass writing lasting year about Buffett’s style drift. He goes on to write:

“It immediately occurred to me after gazing at Buffett’s style drift (manifested in Berkshire Hathaway’s large first quarter derivate losses) that he might be increasingly viewed as the New Millennium’s Ben Franklin, a man who wrote ‘early to bed and early to rise’ but spent many of his evenings in France, whoring all night…”

Not surprisingly, Kass is negative on Berkshire stock. I won’t argue that point. Berkshire has fallen. And short sellers have made money.

Kass presents Buffett’s derivative transaction as “speculating in the market”.

Insurance

Let me offer an alternate explanation.

Berkshire Hathaway has substantial insurance operations. It is, in fact, a huge insurer of large, often unusual risks. In some cases, Berkshire prefers to keeps such risks to itself instead …

On Buffett Back Riding

Warren Buffett is best known for his work at Berkshire Hathaway (BRK.A) where he grew book value per share 21.1% a year over the last 42 years.

But Buffett was a money manager long before he was a CEO. He earned his super-investor stripes by running an investment partnership. Buffett Partnership Ltd. beat the Dow every year from 1957 to 1969, never had a down year, and posted annual returns of 29.5% a year. The Dow managed just 7.4%.

Those numbers are phenomenal. And Buffett’s record is all the more phenomenal for its length. How many investors have a track record stretching back half a century?

But past results are no guarantee of future returns. And Berkshire’s size is a guaranteed headwind.

So can you really Buffett-back ride your way to investment success?

Maybe.

But there is a right way to do it and a wrong way to do it.

Common Mistakes in Preferred Stock

The wrongest of the wrong is to buy common stock in companies where Buffett holds preferred shares.

Don’t buy General Electric (GE) and Goldman Sachs (GS) because Buffett told you to. He didn’t. He took a senior position with a double-digit yield. If he wanted to buy the common, he would have bought the common.

Buffett has bought preferred stock before. And, to be honest, it is not his strong suit. One of his worst investment decisions was buying preferred stock in US Air. Berkshire nearly lost everything. The investment worked out, but it was a big mistake – and Buffett knows it.

Another, lesser mistake was buying preferred stock in Gillette.

That investment worked out great. But it would have worked out even better if Buffett bought the common stock instead of the preferred.

For details read Buffett’s 1995 letter to shareholders.

Buffett says he “was far too clever” to take the easier, more profitable route – instead insisting on the more complex, and ultimately less profitable preferred stock.

When Buffett makes a preferred stock purchase, he is actually signaling that he does not like the common stock. He may like the company. He may not. But he certainly does not like the stock.

If he did, he would buy the common stock.

So why did Buffett take preferred shares in GE and Goldman?

Some will argue these are sweet-heart deals pure and simple – and that’s why Warren took them. Buffett certainly got in on special terms.

But, it’s not clear those terms were better than what he could get by buying common stock in a business he loves when market prices are low.

In fact, almost all of Buffett’s biggest successes were either common stock purchases or preferred stock purchases that would have worked out as well or better if Berkshire had bought the common stock instead.

I can think of only two exceptions. Berkshire got some GEICO (now fully owned) and some Freddie Mac (long ago sold) in ways that individual investors could not. Other institutions were offered the same …

On Keynes, the Stimulus, and Old Ideas

John Maynard Keynes was a genius. We can all learn from his example. And the first thing we should learn is to end our foolish love affair with his ideas.

Keynes would not have spent his days warming up some dead man’s leftovers. Keynes would have understood the importance of all we have learned in once disparate fields and what this means for macro-economics.

Complex Problems, Simple Solutions

Economies are complex. But macro-economic solutions remain stubbornly simple.

What exactly is the case for government stimulus?

I don’t mean generally. I mean in this specific situation – right now, today, what is the case for government stimulus?

Forget ideology. Forget theories. Forget models. Think only of the situation we face and the actions we might take.

There will be plenty of time for theories later. But to start by imposing a framework, especially a framework that assumes a special case belongs to a general population, is dangerous.

Why do we assume that special cases belong to populations we know something about?

Because that is what experience teaches us. Our everyday experiences teach us to expect normal distributions. More than that, our everyday experiences encourage us to think that all differences are merely quantitative differences – simply matters of degree – rather than qualitative, systematic differences.

To the extent that the problems, populations, and systems we are dealing with are simple and unplanned I have little problem with making such leaps of faith – extrapolating from a few specific cases to create sweeping general theories.

But when we are dealing with complex, planned systems – systems with actors who learn and adapt, systems with actors who make new mistakes, actors who remember pain and pleasure as vividly as we humans do – when we are dealing with such systems, general theories are dangerous precisely because they are so elegant.

In a complex science, general theories are just special theories that win wide acceptance. If wide acceptance within an academic community was convincing evidence of utility, I would say stick with general theories.

A quick check of human history shows that, no, popularity is not a good indicator of utility. A few bad ideas always slip through – and worse yet, most good ideas – ideas like Keynes’ – outlive their usefulness.

The Burden of a Great Idea

Intellectual lifecycles can be painfully long. First, a great man like Keynes leads the way. Then a lot of not so great men follow. They don’t how to think up the new and useful principles the way the great man did; instead they keep applying old principles to new problems – problems the poor, dead man never saw.

Had he seen different problems, he would have found different solutions. But, he’s dead and his ideas aren’t. So the best a follower can do is warm up the dead man’s leftovers.

Ideas are limiting. The great ones are the most limiting of all.

Warren Buffett was limited by Benjamin Graham’s thinking. He had to learn to …

Microsoft is Cheap

Go to 24/7 Wall St. and read great coverage of the Microsoft (MSFT) earnings call.

Here is what I wrote about Microsoft in May of 2006:

What price would I be buying Microsoft at? Like I said, this isn’t normally the kind of company I would be buying. It is definitely in an industry where there is a lot of uncertainty – at least beyond the Windows franchise (which I do think is completely secure).

For the most part, this is a stock I wouldn’t be able to value well enough to buy, because of the future and my lack of understanding of the business.

Having said that, I would certainly buy shares if they reached $17. Before that, I would have some trouble making a decision. The margin of safety simply wouldn’t be wide enough in an area I don’t understand that well. Maybe I will get a better feel for the company and its competitive position as I look into the stock some more (and write about it here). But, unless and until that happens, it would be hard for me to buy at a price much greater than $17 (where I think it would pretty much be a sure thing).

Because of share buybacks and other changes since 2006, my sure thing price would now be more like $17.50.

Earnings power in terms of free cash flow is probably around $1.75 a share.

No entrenched, wide-moat business this size trades for 10 times its cash earnings power.

Is Microsoft a growth stock?

No.

Is it cheap?

Yes.

If you need to buy a big cap stock, buy Microsoft at $17.50 or less.…