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Archive for December, 2006

Below Investment Grade Bonds & Junk Bonds

Below investment grade bonds can be divided into two types. The first types are bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times. These are referred to as “fallen angels”.

The second type, “junk bonds”, are those that were already far below investment- grade at the point of issue.

In the past Warren Buffett had bought a few below-investment-grade bonds with success, but those belonged to the “fallen angels” type.

He describes the second type as a mine field, because companies with huge debts would require only a small “business pothole” to turn into a disaster.

In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. The interest that they need to pay on their debts was even more than their gross revenue!

Buffett gives an interesting anecdote to explain the difference between a “fallen angel” and a junk bond:

The universes were of course dissimilar in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.

However, while he would never buy new issues of junks bonds, he finds it possible to find good investment ideas in junk bonds that were trading at huge discounts to their issue prices.

Such deals were few and far between, and at the end of the day, it still boils down to three words, “Margin of Safety”.

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About Banking Business

For most banking business, assets are commonly twenty times of equity. Thus, mistakes that involve only a small portion of assets can destroy a major portion of equity.

Because of this 20:1 leverage, any managerial strengths or weaknesses will be greatly magnified. Warren Buffett has no interest in purchasing shares of a poorly-managed bank at a “cheap” price. Instead, he prefers buying into well-managed banks at fair prices.

Attitude Towards Investments

What attitude should investors hold towards market fluctuations? If you will be buying businesses – or small parts of businesses, called stocks – year in, year out for as long as you live, declining prices for businesses benefit you, and rising prices hurt you.

Pessimism in a certain company or industry is one of the most common causes of low prices. This is a good time to buy stocks, because of the price it produces. Optimism, on the other hand, is the enemy of the rational buyer.

However, care has to be taken as a stock purchase is not necessary intelligent just because it is unpopular. A contrarian approach can be just as foolish as a follow-the-crowd approach.

At the end of the day, independent thinking is key.

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