When to Buy

Now that we understand what companies to look at, we must answer the second question, at what price, or when to buy.  Warren sometimes has a philosophy of investing in companies when their prospects seem the bleakest. Warren thinks that if you have identified the companies that have excellent management or a great consumer monopoly or both, it is possible to predict that they will most certainly survive a recession and more than likely come out of it in a better position than before. Recessions are hard on the weak but they clean the field for the strong to take an even larger share when things improve. A good example of this is when Warren bought stocks of Wells Fargo bank. Wells Fargo had set aside loan losses of about $1.3 billion or $25 a share of its $55 a share in net worth. In 1991 the losses wiped out most of Wells Fargo’s earnings but they still had a small net profit. Wall Street reacted and the share price dropped from $81 to $41.3. They lost most of their share market price. Warren then bought 10% of the company – 5 million shares for a price of $57.8 a share. He saw that it was one of the best-managed money center banks. In 1997, the share price of Wells Fargo was $270. Warren ended up with a pretax annual compounding rate of return of 24.6%. Hence Warren says that an unfortunate recession can create an opportunity for the business perspective investor who has an eye in the long run.

Warren believes that the technical mechanics of the stock market can create situations that will whipsaw security prices regardless of the underlying economics of the businesses. He believes his irrational behavior can create situations that present excellent buying opportunities for the practitioner of business perspective investing. The stock market phenomenon is different from the short term perspective profit seeking. Instead it is a quirk in the stock market infrastructure that occurs because of the ways and methods that securities are bought and sold. Also portfolio insurance and index arbitrage are two strategies that try to exploit that price movement of the whole stock market. The panic of 1987 caused a liquidity crisis among market makers.

Warren would like to invest and own 100% of a business. But this is not possible. So he has other alternatives, which are long term fixed income securities, medium term fixed income securities, short-term cash equivalents, and Short-term arbitrage commitments.  However these are not his favorites nor do they bring him largest profits. But they do offer a profitable use of assets while he waits for a chance either to buy an entire business or to make a long-term common stock commitment.

Long term fixed income securities – Warren will never invest in long term fixed income securities (long term bonds) because they require long-term commitment of capital to an investment that offers a low rate of return. He also sees that inflation is very important part of this and could easily strip away the value of any investment in long term fixed securities. The only exception is when the market offers a unique circumstance that carries an acceptable amount of risk and an adequate rate of return. Warren’s investment in Washington Public Power Supply system bonds is a good example of this.

Warren purchased $139 million in WPPS bonds when they had just defaulted on $2.2 billion in bonds. His investment would give him a tax-free annual interest payment of $22.7 million. This was equal to an annual tax rate of return of 16%. Warren will invest only in bond situations that offer him an absolutely better opportunity to profit than other business ventures might.

Medium term fixed income securities – Warren always regarded medium term fixed income securities as a viable option to cash equivalents. Warren purchased $700 million in tax-exempt bonds most with a maturity of between 8 to 12 years. They were the best options to keep his assets in cash equivalents such as treasuries. He bought them with the intention of selling them, as he needs the capital for other investments. He could thus show a loss if he sells them after interest rates have risen. He thinks that any loss he makes can be offset by a good business he buys such as Coca-Cola.

Short-term cash equivalents – Warren will periodically hold large amounts of cash in short-term notes of the government, other select businesses and certain municipalities. None of them should have a maturity of over a year. Not very profitable but better than stuffing the money under the mattress at home.  Short-term arbitrage commitments – This is one of the most important tools in his arsenal.

When buying securities, a common method is to use portfolio theory, which is to diversify your stock holdings. It seems to be a very popular way to invest as it is mathematically proven to lower your risk without lowering your returns as well. However to Warren, diversification is a way to invest for people who do not know what they are doing. To Warren if people understood the business perspective of the stocks they were investing in, there would be no need for investors to put their money in randomly selected stocks. Thus Warren has adopted the concentrated portfolio approach, which means holding a small number of investments he really understands and intends of holding for a long period of time. So, to Warren, it becomes a very serious issue of what to invest in, and at what price that would decrease the risk. Warren has often said that a person would make fewer bad investment decisions if he were limited to making just ten in his lifetime.

Now that we understand what companies to look at, we must answer the second question, at what price, or when to buy.  Warren sometimes has a philosophy of investing in companies when their prospects seem the bleakest. Warren thinks that if you have identified the companies that have excellent management or a great consumer monopoly or both, it is possible to predict that they will most certainly survive a recession and more than likely come out of it in a better position than before. Recessions are hard on the weak but they clean the field for the strong to take an even larger share when things improve. A good example of this is when Warren bought stocks of Wells Fargo bank. Wells Fargo had set aside loan losses of about $1.3 billion or $25 a share of its $55 a share in net worth. In 1991 the losses wiped out most of Wells Fargo’s earnings but they still had a small net profit. Wall Street reacted and the share price dropped from $81 to $41.3. They lost most of their share market price. Warren then bought 10% of the company – 5 million shares for a price of $57.8 a share. He saw that it was one of the best-managed money center banks. In 1997, the share price of Wells Fargo was $270. Warren ended up with a pretax annual compounding rate of return of 24.6%. Hence Warren says that an unfortunate recession can create an opportunity for the business perspective investor who has an eye in the long run.

Warren believes that the technical mechanics of the stock market can create situations that will whipsaw security prices regardless of the underlying economics of the businesses. He believes his irrational behavior can create situations that present excellent buying opportunities for the practitioner of business perspective investing. The stock market phenomenon is different from the short term perspective profit seeking. Instead it is a quirk in the stock market infrastructure that occurs because of the ways and methods that securities are bought and sold. Also portfolio insurance and index arbitrage are two strategies that try to exploit that price movement of the whole stock market. The panic of 1987 caused a liquidity crisis among market makers.

Warren would like to invest and own 100% of a business. But this is not possible. So he has other alternatives, which are long term fixed income securities, medium term fixed income securities, short-term cash equivalents, and Short-term arbitrage commitments.  However these are not his favorites nor do they bring him largest profits. But they do offer a profitable use of assets while he waits for a chance either to buy an entire business or to make a long-term common stock commitment.

Long term fixed income securities – Warren will never invest in long term fixed income securities (long term bonds) because they require long-term commitment of capital to an investment that offers a low rate of return. He also sees that inflation is very important part of this and could easily strip away the value of any investment in long term fixed securities. The only exception is when the market offers a unique circumstance that carries an acceptable amount of risk and an adequate rate of return. Warren’s investment in Washington Public Power Supply system bonds is a good example of this.

Warren purchased $139 million in WPPS bonds when they had just defaulted on $2.2 billion in bonds. His investment would give him a tax-free annual interest payment of $22.7 million. This was equal to an annual tax rate of return of 16%. Warren will invest only in bond situations that offer him an absolutely better opportunity to profit than other business ventures might.

Medium term fixed income securities – Warren always regarded medium term fixed income securities as a viable option to cash equivalents. Warren purchased $700 million in tax-exempt bonds most with a maturity of between 8 to 12 years. They were the best options to keep his assets in cash equivalents such as treasuries. He bought them with the intention of selling them, as he needs the capital for other investments. He could thus show a loss if he sells them after interest rates have risen. He thinks that any loss he makes can be offset by a good business he buys such as Coca-Cola.

Short-term cash equivalents – Warren will periodically hold large amounts of cash in short-term notes of the government, other select businesses and certain municipalities. None of them should have a maturity of over a year. Not very profitable but better than stuffing the money under the mattress at home.  Short-term arbitrage commitments – This is one of the most important tools in his arsenal.

When buying securities, a common method is to use portfolio theory, which is to diversify your stock holdings. It seems to be a very popular way to invest as it is mathematically proven to lower your risk without lowering your returns as well. However to Warren, diversification is a way to invest for people who do not know what they are doing. To Warren if people understood the business perspective of the stocks they were investing in, there would be no need for investors to put their money in randomly selected stocks. Thus Warren has adopted the concentrated portfolio approach, which means holding a small number of investments he really understands and intends of holding for a long period of time. So, to Warren, it becomes a very serious issue of what to invest in, and at what price that would decrease the risk. Warren has often said that a person would make fewer bad investment decisions if he were limited to making just ten in his lifetime.