Warren Buffett (Trades, Portfolio)'s letter to the shareholders of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) in the aftermath of the 2008 banking crisis provides valuable lessons for investors. Despite experiencing a significant decrease in net worth (down by $11.5 billion), the guru emphasized the factors that can bring long-term value growth for investors through navigating turbulent times..
This discussion explores Buffett's perspective on several crucial investment aspects of the 2008 banking crisis.
First, Buffett said he favors maintaining a strong financial position; for instance, he referred to Berkshire Hathaway's financial position as "Gibraltar-like," with substantial liquidity and manageable near-term obligations. Investors should evaluate a company's financial stability and levels of cash reserves while making investments, as these factors play crucial roles during times of crisis and allow a company to weather the storm and take advantage of possible opportunities.
Second, he emphasize the importance of identifying moats around businesses that can create durable competitive advantages. A moat refers to the unique qualities and barriers that protect a company from competition; for instance, the dominance of Coca-Cola (KO, Financial) despite severe competition in the industry, especially from PepsiCo (PEP, Financial). By focusing on businesses with strong competitive positions, investors can ensure their investments in companies can withstand economic downturns and generate consistent earnings.
Notably, consistent earnings support companies in immunizing their market valuation from a series of market-wide problems that lead to consistent positive returns over the long term. For instance, over the past 44 years (as of 2009), Berkshire's stock yielded a 20.3% compound annual return.
Further, Buffett highlighted the importance of diversification. He mentioned acquiring and developing new earnings streams, indicating the value of expanding the investment portfolio beyond a single sector or asset class. Diversification helps reduce risk by spreading investments across different industries and asset types, thereby minimizing the impact of any single economic event.
Finally, Buffett's letter also provides valuable perspective by reminding investors of past challenges that America has overcome. He highlights the American economy's resilience and the country's long-term growth potential. It serves as a reminder to investors to maintain a long-term view and not be swayed by short-term market fluctuations.
Unveiling strategies amid economic turmoil
Buffett emphasized the impact of economic conditions on businesses within Berkshire Hathaway. He acknowledged that some of the businesses were affected by the economic downturn, particularly those tied to residential construction. However, he also highlighted that their manufacturing, service and retail businesses still earned substantial sums and continued to strengthen their competitive positions. It teaches investors the importance of analyzing individual businesses and their ability to weather economic storms rather than making generalized assumptions based on overall market conditions.
Also, Buffett, being a contrarian investor, sees pessimism in the market as an opportunity and mentions that Berkshire took advantage of the market's disarray to make favorable purchases. It teaches investors to resist the temptation of following the crowd and instead capitalize on opportunities when others are fearful.
Further, Buffett stressed the concept of buying quality assets at discounted prices. He said he enjoys price declines when they have funds available to increase their positions. It aligns with his value investing approach, where the focus is on the intrinsic value of an asset rather than short-term price fluctuations. Events like the 2008 banking crisis allow investors to capture quality assets at lower prices by focusing on the value of an asset rather than its price. For instance, during the crisis, Berkshire Hathaway invested $5 billion in Goldman Sachs (GS, Financial), which turned out to be a lucrative investment.
Source: ft.com
The guru focused on the importance of sensible lending practices and the need for borrowers to carefully assess their ability to make mortgage payments based on their income. He criticized the past practices of the manufactured home industry, where borrowers with low credit scores (usually designated "subprime") were given loans they could not afford, leading to staggering industry losses. This teaches investors that the root of the crisis is the risky lending practices (at the institutional level) of ignoring the borrowers' financial capacity.
Finally, the investor highlighted the impact of government guarantees (FDIC-insured deposits) on lending practices and borrowing costs. He pointed out that entities with government backing enjoy minimal borrowing costs, while highly rated companies like Berkshire Hathaway face higher costs despite their strong credit position. Investors should comprehend the influence of government policies and regulations on the lending environment and the potential implications for borrowers and lenders.
Avoid the herd mentality
The Oracle of Omaha warned investors against seeking approval or following investment strategies that are applauded by the masses. He advised against being sedated by approval, as it can hinder critical thinking and prevent investors from reassessing their conclusions based on new information. Rather, he encourages independent thinking and the ability to go against the crowd when necessary.
For instance, Buffett highlighted the purchases made by Berkshire Hathaway in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric (GE, Financial) during the 2008 crisis despite the massive selloff in the market. These investments provided not only high current yields, but also included substantial equity participation. He underscored the importance of seizing attractive investment opportunities when they arise, even if it requires selling other holdings.
The derivatives story
Buffett then highlighted the dangers associated with derivatives, stating they have significantly increased leverage and risks within the financial system. He emphasized that derivatives make it challenging for investors to comprehend and analyze the portfolios of large commercial and investment banks. For instance, Fannie Mae (FNMA, Financial) and Freddie Mac (FMCC, Financial) engaged in massive misstatements of earnings for years, mainly due to the complexities of their derivative contracts.
Additionally, he asserts that no reporting mechanism is capable of fully describing and measuring the risks within complex derivative portfolios. Auditors and regulators need help understanding and regulating these instruments effectively. The lack of transparency increases uncertainty and makes it difficult for investors to assess the financial health of institutions involved in derivatives.
Notably, the regulatory oversight of Freddie Mac and Fannie Mae is done by the Office of Federal Housing Enterprise Oversight. Despite being heavily regulated and overseen by a dedicated federal agency, these institutions engaged in massive accounting irregularities that went unnoticed for years. Investors must consider the impact of derivatives on the earnings of the enterprise.
For instance, according to Bear Stearns, highlighting the counterparty risk inherent in derivatives transactions, when counterparties discover that their hedges or risk protection mechanisms are ineffective, it can lead to a chain reaction and market dislocation. Investors should assess the concentrated interdependence among large financial institutions that may pose significant risks and can prompt government intervention to prevent a systemic meltdown.
Limitations of the valuation models
Investors should also carefully comprehend the limitations of the valuation models. For instance, the Black-Scholes formula is widely used for valuing equity put options. When the formula is applied to extended periods, it results are absurd. In Buffett's extreme example, the formula suggests an excessively high premium for a 100-year put option on the S&P 500, which leads to the irrationality of such valuations and highlights the formula's shortcomings when dealing with long-term investments.
Buffett emphasized the significance of taking a long-term view when evaluating investments. He argued that over a century, the value of most companies in the index will likely increase significantly due to retained earnings. He asserts the probability of a decline in the index over such a long period is extremely low. By considering the potential returns and compounding interest over time, Buffett suggested that even a worst-case scenario would not justify the premiums dictated by the Black-Scholes formula.
Further, he questioned the relevance of volatility in estimating the probability-weighted range of future values of American businesses. He likens using historical volatility to assess long-term options to relying on a manic-depressive neighbor's daily quotes to predict the value of a farm a century from now. Investors should recognize that including volatility in the formula can lead to an overstatement of liabilities and undermine its accuracy in valuing long-term options.
Takeaway
Buffett's 2009 letter to shareholders provides investors with valuable lessons on navigating turbulent times and achieving long-term value growth. His emphasis on maintaining strong financial positions, identifying competitive advantages, diversifying investments and avoiding the herd mentality highlights the importance of strategic decision-making and independent thinking.
By learning from Buffett's insights and applying them to their own strategies, investors can better prepare for economic downturns and capitalize on opportunities that arise during challenging times.
