Intelligent Investor Club

Purchase of Marketable Securities

The selection of securities that Warren buys can be classfied under five categories: (1) long-term common stock investments, (2) medium-term fixed-income securities, (3) long-term fixed income securities, (4) short-term cash equivalents, and (5) short-term arbitrage commitments.

He has no particular bias when it comes to choosing from these categories. The aim is to achieve for the highest after-tax returns as measured by “mathematical expectation,” limiting himself always to investment alternatives that he can understand. His criteria have nothing to do with maximizing immediately reportable earnings; rather, is to maximize eventual net worth.

Common Stocks

In 1987, Mr Market was on a major rampage until Oct, when it had a sudden seizure. The net result was a gain of 2.3% for the Dow.

Many prestigious money managers now focus on what they expect other money managers to do in the days ahead, rather than on what the business will do. An extreme example of what their attitude leads to is “portfolio insurance”, where a downtick of a given magnitude automatically produces a huge sell order.

Considering that huge sums are controlled by managers following such practices, is it any surprise that markets sometimes behave in illogical fashion?

After buying a farm, would a rational owner next order his real estate agent to start selling off pieces of it whenever a neighboring property was sold at a lower price?

Such markets are ideal for any investor – small or large – so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.
Mr. Market will offer us opportunities – you can be sure of that – and, when he does, we will be willing and able to participate.

Bonds

Warren continues to parking most of his money in medium-term tax-exempt bonds, with an aversion to long-term bonds. Even back in 1986, he is already not optimistic about the long term future of U.S. currency due to the enormous trade deficit.

The pileup of “claim checks” in the hands of foreigners will ultimately lead to an increased pressure on the issuer to dilute their value by inflating the currency.

While recognizing the possibility that he may be wrong and that present interest rates may adequately compensate for the inflationary risk, Warren retains a general fear of long-term bonds.

Market Rumours

It is often reported in the press about Berkshire’s purchase or sale of various securities. Warren does not comment in any way on rumors, whether they are true or false. If he were to deny the incorrect reports and refuse comment on the correct ones, he would in effect be commenting on all.

His advice for anyone who wants to participate in whatever Berkshire is doing, is to simply buy the Berkshire stock!

About Debt

It is likely that Berkshire could improve its return on equity by moving to a much higher, though still conventional, debt-to-business-value ratio. It’s even more likely that we could handle such a ratio, without problems.

However, “likely” is not good enough for Warren. He wishes to be “certain”. Thus he adheres to policies – both in regard to debt and all other matters – that will allow them to achieve acceptable long-term results under extraordinarily adverse conditions, rather than optimal results under a normal range of conditions.

Good business or investment decisions will eventually lead to economic gains, even without the use of excessive leverage. However, he is willing to borrow as long as the amount does not pose a threat to Berkshire’s well being.

His strategy is to finance in anticipation of need rather than in reaction to it. A business obtains the best financial results possible by managing both sides of its balance sheet well. This means obtaining the highest-possible return on assets and the lowest-possible cost on liabilities.

It is often that opportunities for intelligent action on both fronts do not coincide. Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Therefore, his action on the liability side should sometimes be taken independent of any action on the asset side.

This fund-first, buy-or-expand-later policy almost always penalizes near-term earnings. For example, Berkshire is now earning about 6.5% on the $250 million they recently raised at 10%, a disparity that is currently costing them about $160,000 per week.

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