Geoff Gannon January 26, 2009

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?


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 terms as Berkshire. Individual investors were not.

Putting those two purchases aside, Buffett’s best moves at Berkshire have been simple and easy to copy.

Has Berkshire gotten special offers? Sure. But Buffett’s record on such special deals is much spottier than his record of investing on the same terms the little guy could get.

Frankenstein Securities

Why are Buffett’s preferred stock investments often inferior to his common stock investments?

Part of it is the hybrid nature of preferred stock. All of Buffett’s preferred stock purchases combined high yields with the chance to participate in the underlying equity (at some price).

Buffett does simple better than anyone.

Preferred stock is complex. There is a psychological trap of combining a mediocre bond element with a mediocre stock element and thinking you’ve got yourself a great deal. Generally, it is a bad idea to buy such a hybrid unless at least one of the two elements is attractive enough to fully justify the purchase on its own.

Buffett’s preferred investments in GE and Goldman fail this test – at least for an investor as demanding as Buffett. The yields on the GE and Goldman preferred are good, but they are just barely good enough to clear Berkshire’s lowest hurdle of a 10% pre-tax return.

Buffett has said he never considers buying stocks that do not offer at least a 10% pre-tax return. Neither the GE nor the Goldman investments offer much of a margin of safety. Instead they offer a guaranteed, mediocre return (for a long-term Buffett investment) with an equity option.

It’s hard to see how these preferred stock investments meet the same level of quality as Buffett’s big ideas in common stocks.

Most likely, Buffett saw the preferred stocks as good alternatives to fixed-income securities.

That was the logic behind the five preferred investments he made 15-20 years ago. Berkshire swapped lower-yielding securities with no convertibility for higher-yielding securities with convertibility.

That’s a good trade up as long as you don’t come to regret having less cash on hand. Since Buffett made the deals, his opportunity costs have gone up. The value of cash is higher, because stock prices are lower.

Does Buffett regret the deals? I doubt it. But the press has overhyped them. Preferred stock deals are a sign of having a lot of cash to deploy and not a lot of places to put it.

There are two very good reasons not to follow Buffett into GE and Goldman. One: you can’t get the deals he got. And two: the deals he got are not his best investment ideas.

Buffett’s Best Idea

I’m not going to argue for or against any one stock. I’m just going to give you the name of the investment Buffett seems to like most: Burlington Northern (BNI).

Berkshire owns almost 22% of the company. Even for Berkshire, that’s a big stake. And Buffett has kept buying BNI long after the position became public knowledge.

The last purchases I know of were done at $62.15 a share. But Berkshire had been a buyer at prices well above that. Buffett has been buying as recently as this month.

Originally, Berkshire started building positions in several railroads. Then Buffett focused on BNI. Why?

That’s his style. He doesn’t diversify. He concentrates. He doesn’t like small positions. He likes big positions.

And he obviously likes Burlington Northern.


You can ride along with Buffett on BNI or not. But don’t let press reports and hearsay lead you to GE and Goldman – or even worse, to American Express and Wells Fargo and other stocks that Buffett bought into a long, long time ago.

The time to ask whether you should Buffett-back ride is when Buffett is first building his position. This is not a guy who trades a lot.

In fact, he almost never sells. The only way you don’t have to worry about selling is if you do a spectacular job of buying.

So, if you’re looking to ride with Buffett, either buy Berkshire when it trades at a reasonable price – or go in with him on his best investment idea as he’s buying it.

Right now, the only name that fits the bill is Burlington Northern.