Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street

by Janet M. Tavakoli

  I mentioned that Comedy Central’s The Daily Show with Jon Stewart often has better news analysis than what tries to pass as news shows on other channels. Warren hadn’t watched the program, but asked if he should. I said Stewart’s interviews of leading world figures might be of interest, and later occasionally sent a link. Warren had not yet gotten around to getting a TiVO. Neither had I.

  Warren displays an open mind to all new ideas. Warren and I both love our newspapers, but we love news more, wherever we find it. The challenge is to find reliable news. I was about to discover that some of the information I had read about Warren Buffett was incorrect, and the coming years would reveal more inaccuracies.

  Dustin Hoffman once remarked on a story he read about how he and Tom Cruise were holding up shooting because they were a couple of prima donnas. The story was fabricated: “but if I wasn’t making a movie with him and I just picked up the paper, I’d believe it. That’s interesting, isn’t it?”3 There is a reason we call it the “Information Age,” not the “Age of Wisdom.”

  Financial research often ends where the Internet begins. Articles are frequently incorrect, urban legend is sometimes presented as fact, and trivial errors sometimes become viral financial lore. Benjamin Graham, Warren Buffett’s Columbia School professor and mentor, founded a hedge fund in the 1920s. Warren says that Graham’s hedge fund was the earliest as far as he knows, though there may have been another before it. Yet, most media report that the first hedge fund founded in the United States was done so in 1949 by A. W. Jones.4 Financial journalists rarely mention Benjamin Graham’s fund. Apparently there are no Google references to the 1920s.

  On a televised talk show, Ben Bradlee, vice president and managing editor of the Washington Post, held that he didn’t think newspapers would ever be supplanted by the Internet. Some Internet sources are excellent, but it is still unclear if they can make enough revenue to continue putting out quality information, and new competitors keep popping up on the Web. He is probably correct that there will always be a demand for newspapers; but newspaper revenues are already being partially supplanted as they lose chunks of lucrative classified ad revenues to the Internet.

  Unlike Bradlee, Warren does not let nostalgia get in the way of a good business strategy. On November 21, 2005, Cathy Baron Tamraz, the founder of Business Wire, a San Francisco-based distributor of online press releases, sent Warren a letter in which she told him, “We run a tight ship and keep spending under wraps . . .” She describes a business with no secretaries or management layers, and they invest most of what they have to stay abreast of technology. By the time he finished reading the letter,Warren had decided to acquire a business perfect for his investment style: it has dedicated management, eliminates unnecessary overhead, produces a product people need and has huge potential for revenue growth. By March 2006, Warren had closed the deal, making Business Wire, an Internet phenomenon, a wholly owned subsidiary of Berkshire Hathaway.

  An assistant handles Warren’s e-mail. This is because Warren molds technology to his lifestyle rather than letting it mold him. He joked that Bill Gates offered to send him an attractive young female computer expert to show him the ropes.Warren, however, is quite comfortable with the computer. He plays hours of online bridge, and he asked me about my bridge-playing skills: “Do you play online?” Warren encouraged me to, but I like to see the other players. I responded: “Audrey Grant, a master bridge player I met, says bridge is about luck, skill, and your relationship with your partner. I like to hear the bidding with all the inflections.”

  At the mention of Audrey Grant,Warren’s eyes twinkled with delight; he knows her. I had already told him “Tavakoli” is my ex-husband’s name, and Warren asked: “Have you read Audrey’s nonbridge book, Ex Etiquette?” No? He jumped up and called out to his assistant: “Let’s buy Janet that book!”We walked to his assistant’s desk and she searched Amazon. The book had been published in 1988 and was out of print. Undeterred, Warren had his assistant order it from the used books option to be delivered to me at a later date. (I saw Audrey again in July 2006, when she came to Chicago to give a bridge lesson. After I handed her the book to sign, she flipped it over in confusion, having completely forgotten it. She no longer even had a copy of her own and was astonished that Warren remembered it.)

  I was not prepared for Warren. I am accustomed to a business world in which most of the men are not “nice kids,” and I have long been used to prudently dealing with disrespect by lesser men (not twice). If Warren had simply avoided overt rudeness, it would have been an upgrade from most finance professionals, and it would have given me bragging rights: I met Warren Buffett, and he was civil!

  It is hard to explain how Mr. Buffett managed to thoroughly win me over. He seemed to look away for an instant and then looked back with an almost imperceptible nod. It was as if he considered the totality of his impressive experience, and then concentrated on me with a compelling bias in my favor—as if he had exactly the impression of me, that at my personal best, I hoped to impart. In that moment, Mr. Buffett became Warren and seemed to convey that I should believe in myself the way he believed in me.

  It seemed as if our conversation up until now had been a test drive. Warren trotted out his well-worn clichés reported over the years in magazine articles. Now he picked up the pace and asked a lot of questions. We must have covered over one hundred topics.

  I lived in Iran for a year? Warren met Farah Diba, the late shah of Iran’s third wife, at a Washington dinner party. I am grateful to be back, grateful for the opportunities, and relieved to again enjoy my rights as a woman born in the United States? So was Rosa Blumkin, the Jewish Russian emigrant furniture sales entrepreneur who sold her business to Warren and died at the age of 104. Inspired by his late wife, Susie, Warren is a major supporter of Planned Parenthood and a woman’s right to choose. I do most of my work out of my home office? Warren likes the idea of keeping overhead low, especially since I rent conference offices when needed—he had worked out of his home office for years running his first highly successful investment partnership. I wear casual clothes to work unless I am meeting clients? Warren had considered that, too, but in his position as CEO of Berkshire Hathaway, it isn’t practical. I attended a fundraiser in Chicago and met Ted Kennedy? Warren knows Ted Kennedy, but on a much different plane. I read Forbes? Warren knew the late Malcolm Forbes, son of the magazine’s founder, B. C. Forbes. California housing and politics? Warren had advised Arnold Schwarzenegger, and another of Warren’s personal friends was throwing him a birthday party in California, where Warren has a house. I had worked my way through my MBA as a chemical engineer? A chemical engineer and his wife, Donald and Mildred Othmer, had invested $50,000 with Warren in the 1960s and it was worth $750 million when Mr. Othmer died in 1995 (Mildred Othmer died in 1998. Today their holdings would be worth more than $3 billion). I was born in Chicago? Warren had owned and later sold retail stores in parts of town I probably didn’t visit. I think the rating agencies’ opinions are unreliable? Warren doesn’t rely on them either for his investment decisions. Derivatives sometimes present opportunities? Warren had taken on a large derivative position on the dollar weakening (and later reduced it and put on another). I know large business owners? Warren is looking for good foreign businesses—preferably family owned—of $1 billion or more in size.

  When Matteo Ricci studied at the Jesuit College in Rome in the late 1500s, he created a memory palace in his mind. Each item in the palace represents a series of concepts. The rooms and locations within the palace serve as directories and files do on a computer. Ricci later rose to elevated status in Ming dynasty society, because he was able to instantaneously learn, retain, and retrieve hundreds of new Chinese kanji to the astonished delight of the Chinese nobles. I felt as if Warren were giving me a private tour of his memory palace.

  As we conversed,Warren seemed to find new knickknacks to place on a memory mantelpiece. Aristotle believed a trained memory is essential for developing logical thought pr
ocesses. Warren does not rely on finance nursery rhymes like “diversification reduces risk,” in fact, he often rejects them in favor of logic. Renowned professors like Yale’s Benoit Mandelbrot urge investors to broadly diversify as a way around the fear and greed driven fluctuations of what Benjamin Graham called the manic depressive “Mr. Market.”5 Mandelbrot, who popularized fractals, seems resigned: “It is, in my view, premature to be hoping for serious gains from fractal finance.There is still too much we do not know.”6 Mandelbrot is correct about fractal finance, but he might be surprised to learn that Warren Buffett is not a big fan of diversification for the sake of it. Diversification does not guarantee that you will not lose money; it only makes it less likely you will lose it all at once.

  Warren is a fan of index funds for people who want low fees, want to invest in the market, and do not have the time or inclination to learn about companies. But diversification simply for the sake of it is false prudence. By ignoring discrete risks, diversification can unnecessarily add risk to an investor’s portfolio. Like all defensive strategies, diversification is most effective if you understand what you are defending against. Warren advocates diversifying only into assets you understand well.

  Highly skilled managers diversify less and perform better than less skilled managers. Warren seeks investments with a long-term competitive advantage in a stable industry run by decision makers with a “here-today, here-forever” outlook. Warren does not discriminate between value companies and growth companies; he looks for businesses that throw off tremendous cash flows and have high revenue growth potential. Warren is delighted when the market hands him a good company at a cheap price, but he is content to buy a good company at a fair price.

  At the time we met, Warren trounced both “growth” and “value” managers. According to Sandford C. Bernstein, Inc.’s mutual fund performance results from 1969 to 2004, value managers outperformed growth managers. Berkshire Hathaway handily beat both growth and value managers. For example, Berkshire Hathaway’s annualized return for the period 1969-2004 was 24.1 percent versus only 12.3 percent for the value managers; it beat value managers by 11.8 percent on an annualized basis. Any way one sliced the time periods, Berkshire Hathaway’s performance far exceeded the mutual funds (Table 2.1).

  Table 2.1 Total Return BRKA vs. Growth and Value Managers

  Source: Sanford C. Bernstein, Inc., Strategic and Quantitative Research Grp.;Tavakoli Structured Finance,Yahoo! Finance.

  The Yale Endowment, headed by David Swensen, might be a better comparison.Yale is renowned for its investment acumen, ranking in the top one percent of large institutional investors. In the 10-year period ending June 30, 2003,Yale’s private equity investments earned 36 percent annually, chiefly due to its venture capital investments. But the overall Yale portfolio earned 16.0 percent, and during the same 10-year period Berkshire Hathaway returned 16.8 percent. (From June 20, 2003 to June 29, 2007, Yale had annualized returns of 23 percent; Berkshire Hathaway had annualized returns of 10.8 percent for the same time period.) The average individual investor does not have access to Yale’s tax-exempt endowment but can purchase Berkshire Hathaway’s tax-efficient equity on the open market. Moreover,Yale is considerably smaller than Berkshire Hathaway. Berkshire Hathaway produced higher sustained returns on a portfolio that was huge in comparison to Yale. Warren feels it is easier to produce higher returns with less money under management.Yale had only $11 billion in assets, whereas Berkshire Hathaway had almost $173 billion in assets at the end of June 30, 2003.7

  I suggested one might use a computer program to sort data, identify companies that have a low price-to-earnings ratio and a high return on assets, and then look for value from the companies that make the cut. Warren said: “No, I don’t do that.” I repeated that it might save time to sort this way, thinking of my own portfolio.

  Time slowed, and Warren’s eyes seemed to darken as he silently watched me. It was as if we had been jogging, and I had suddenly stopped to tie my shoes. He was waiting for me. It isn’t ideal to have to stop for a running partner, but if they can keep pace with you, you jog in place and wait.

  I opened a familiar door in my memory. What had Benjamin Graham said? If you want a “MARGIN OF SAFETY,”8 the business’s past ability to generate earnings well in excess of all requirements (including interest on debt) protects investors if there is an unforeseeable problem that causes future net income to decline. But Graham was not a fan of arbitrary metrics. A stock is not a good investment just because it is trading near its asset value—a nice price tag is not enough. The enterprise has to be in a strong business position relative to competitors, have a strong financial position (low or very manageable debt), and has to have good management (no ratio can tell you that).The business’s favorable long-term economics includes a “satisfactory ratio of earnings to price . . . and its earnings will at least be maintained over the years.”9 Benjamin Graham did not distinguish between “value” stocks and “growth” stocks. He knew that value and growth are inseparable.

  I finally grasped what Warren was saying. Warren has such a wide body of knowledge that he does not need to rely on “systems.” His further point was that I do not have to, either. I read the financial reports of each corporation, and high return on assets and low P/E ratios can be temporary distortions that do not necessarily indicate financial health. I have enough experience to identify opportunities myself. Thump! I threw a pair of crutches that I clearly didn’t need out of a window of my mental memory palace.

  Warren’s vast knowledge of corporations and their finances helps him identify derivatives opportunities, too. He only participates in the derivatives markets when Wall Street gets it wrong and prices derivatives incorrectly. Warren tells everyone that he only does certain derivatives transactions when they are mispriced. He even states this in his shareholder letters. He plays fair and doesn’t seek to take advantage of anyone; he warns Wall Street that if they are trading with him, they got the price wrong.

  I was aware of this, but it did not really sink in until I met him. Looking back, I may not have actually believed it until I met him. He cheerfully filled me in.

  Warren says “everyone [in the finance business] has an IQ of at least 140”—I imagined a disintegrator in the elevator that measures and eliminates those who did not meet the threshold (and I had only worried about adjusting my skirt)—but a high IQ is not necessary to be a good investor. Warren is a highly intelligent polymath, but does not credit his investment success to that fact. Consistently following basic financial principles is much more important. Charlie Munger, his long-time partner, tells Warren that the challenge both of them have is staying anchored.

  Warren takes advantage of the fact that many Wall Street derivatives traders construct trading models with no clear idea of what they are doing. I know investment bank modelers with advanced math and science degrees who have never read the financial statements of the corporate credits they model. That is true of some credit derivatives traders, too. The global business has grown too fast, and there is a dearth of essential experience. Modelers manipulate a large body of data, without knowing how to interpret the results.

  Warren maintains that long dated (15- or 20-year maturity) equity index puts on the FTSE (a UK stock index) and the DOW, among other indexes, are mispriced. Investment banks price the options based on volatility, irrespective of the absolute level of the indexes. Investment banks enter into these very long-dated put options struck at the market—today’s market level—and they are European puts, exercisable only once—at the expiration date many years in the future.

  Most of the option models assume that prices vary around today’s level, and the models do not take into account the probable growth of the economy. Even if a model takes growth into account, it usually woefully underestimates it along with the future value of the stock market. This is a common error, and when Warren finds someone willing to do these mispriced trades with him in size, he jumps on the opportunity.

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p; Options are a natural fit for insurance companies that are part of the Berkshire Hathaway conglomerate. When Warren sells a put buyer the right to make him pay a specific price agreed today for the stock index (no matter what its value 20 years from now), Warren receives a premium. Berkshire Hathaway gets to invest that money for 20 years. Warren thinks the buyer, the investment bank, is paying him too much. The stock index could have a lower than today’s market price (fat chance), but unless there is a global economic disaster, it is highly unlikely. Furthermore, Berkshire Hathaway invests the premiums that will in all likelihood cover anything it might need to pay out, and it is most likely, it will never pay out anything at all, since the stock index is likely to be higher than today’s value.

  It is as if the models were predicting the future net worth of an entire Harvard MBA class based on their first job out of school. It is possible they won’t be worth more in 20 years, but it isn’t likely, since their earning power is likely to rapidly grow.

  Warren doesn’t need a complex option model to tell him that the options are mispriced; he only has to look at the strike price, the proposed level of the index, to know that the other guy’s model is wrong. Warren takes large upfront premiums in exchange for agreeing to make a payment in 15 or 20 years that in all probability will never need to be made. In the meantime, he employs the cash premiums for the benefit of Berkshire Hathaway.

  In the 2007 shareholder letter, Warren told shareholders: “We have received premiums of $4.5 billion, and we recorded a liability at year end of $4.6 billion.” Another winning feature of this trade is that Berkshire Hathaway has zero credit risk. In the unlikely event that a payment is made 20 years from now, the put buyer is relying on Berkshire Hathaway to make a payment. Berkshire Hathaway is not depending upon an investment bank to make him a payment if the market is so troubled that stock index level is below today’s level; an investment bank would probably be wiped out. Berkshire Hathaway, on the other hand, is likely to be doing much better than other companies in that scenario. Even the required payment on the put option in 20 years will be buffered by the fact that it is only a small part of Berkshire Hathaway’s portfolio and it is partially offset by the value of the premiums in 20 years.