Dec. 08, 2011 |
Article from Guru Focus
Dated back in 1986, Warren Buffett had discussed different categories of investment and his simple reasoning following each type of investments. It would be extremely helpful with only several page of reading for any Buffett wannabes. At that time, Buffett’s insurance arms had purchased around $700 million of tax-exempt bonds, with the maturity from 8-12 years. Readers might think that huge amount of money indicated his enthusiasm for bonds. But that was not the case. He explained that at best, the bonds were mediocre investments. They just seemed to be the least objectionable alternative at the time he bought them.
As any new money came in, Buffett said that there would have only five choices: (1) long-term common stock investments; (2) long-term fixed income securities; (3) medium-term fixed income securities; (4) short-term cash equivalent; and (5) short-term arbitrage commitments. Buffett seemed to prefer common stock the best. He commented: “Common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests. This statement in no way translates into the stock market prediction: we have no idea – and never have had – whether the market is going to go up, down, or sideways in the near – or intermediate term future.”
He believed on the boom and burst cycle, happening occasionally in the market, along with the fear and greed, which he described as “two super-contagious disease." That would forever occur in the investment community. However, even knowing it would happen, no one can predict the timing of those events accurately, it was so unpredictable. That is why he never try to anticipate the arrival or departure of either disease. A simple goal was stated once again: "To be fearful when others are greedy and to be greedy only when others are fearful.”
Even in the short-run, the bull could make the stock market advance like crazy, and everybody loved the market just so much. But the very fundamental truth was that the stock couldn’t outperform businesses indefinitely. Actually, the stockholders as the whole over the long run would underperform the companies that they own if taking into account the transaction costs and the investment costs they have to bear. “If American business, in aggregate, earns about 12% on equity annually, investors must end up earning significantly less. Bull markets can obscure mathematical laws, but they cannot repeal them.”
The second investment category was the long-term bonds. Buffett said he didn’t get interested in those type of investments except it was very special situation such as the Washington Public Power Supply position that Berkshire Hathaway had purchased before. He stated: “Our aversion to long-term bonds relates to our fear that we will see much higher interest rates of inflation within the next decade. Over time, the behavior of our currency will be determined by the behavior of our legislators. This relationship poses a continuing threat to currency stability – and a corresponding threat to the owners of long-term bonds.”
In addition, Berkshire Hathaway sometimes employed cash in the arbitrage field. But according to Warren Buffett, it was not like common arbitrageurs, who purchased a lot of securities each year. Berkshire only bought a few, restricting to some large deals that have been announced publicly and not betting on the outcome. That was why the potential profits might be apt to be small, but along with the luck, the disappointments would also be few.
He discussed that arbitrage could be considered to be the alternative to Treasury bills as a short-term packing place for money — a choice that combined potentially higher return with higher risks. Till the time of writing, the returns for Berkshire Hathaway from arbitrage positions had been many times higher than if leaving it into Treasury Bills. But the risk was that “one bad experience could change the scorecard markedly.”
Buffett at that time view medium-term tax-exempt bonds as an alternative to short-term Treasury holdings. Buying those bonds, he would run a risk of significant loss if he had to sell many of them well before maturity. Nevertheless, he believed that the risk was more than counter-balanced because of several points.
First was because much higher after-tax returns currently realizable from these securities in the comparison to Treasury bill, and second, because the possibility that sales would produce an overall profit rather than a loss. “Our expectation of a higher total return, after allowing for a possibility of loss and after taking into account all tax effects, is a relatively close call and could well be wrong. Even if we sell our bonds at a fairly large loss, however, we may end up reaping a higher after-tax return than we would have realized by repeatedly rolling over Treasury Bills.”
About the author:
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam