The internet is in love with Warren Buffett, and for good reason. He’s been a very successful businessman, and his firms (first Buffett Partners (BPL), then Berkshire Hathaway(BRK)) have handily beaten the market for over 50 years. That’s a solid resume, and there’s plenty to learn about how he did it.
What’s unfortunate about this internet man crush is that the object of affection is a fake person. The Buffett the internet loves bears only a passing resemblance to the real story. This is too bad, because the real story is far more interesting than the myth. This is especially true if you’re a speculator as opposed to an investor, because the Buffett fortune is actually built on a bedrock of speculation.
Here are a few aspects of the real story that usually get left out:
- Warren Buffett didn’t make his money by buying dividend stocks. Buffett’s fortune started with Buffet Partnership. Their two primary activities were merger/acquisition arbitrage and liquidations. Merger/acquisition arbitrage should have made my list of arbitrages, but for some inexplicable reason I left it out so I’ll explain here:
Say ABC corp agrees to buy XYZ corp. For each outstanding share of XYZ corp, ABC will pay $4.50 and one newly issued share of ABC corp stock. Based on this agreement, there’s a fixed pricing relationship that should exist between ABC stock and XYZ stock before the acquisition completes: ABC = XYZ – $4.50. This equation is adjusted by four additional factors: 1) The probability that the acquisition doesn’t go through due to funding or regulatory issues. 2) The expected prices of ABC and XYZ if the acquisition fails. 3) The probability someone else makes and even better offer for XYZ. 4) The expected price of that better offer.
Once you have all this information, you can adjust the cash value in the equation to take it into account. The result is a spread between two stocks where you know what the price “ought” to be. You then trade long one stock and short the other expecting price to converge on that value. Buffett called these trades “work-outs” in the original Buffett Partnership letters, because when the aquisition completed the trade would work out to a final resolution.
The other meat and potatoes of BPL was liquidating failing companies. When a stock’s price drops below the company’s liquidation value, it means no one likes the company well enough to see operations continue. In other words the whole world is pessimistic. When that happens, the low stock price essentially pays someone to manage the liquidation. BLP was happy to be that someone. And yes, this means BPL made a lot of money laying people off. Which is perfectly fine but isn’t what most people think of when they think Buffett.
- Dividend stocks are a last resort. Yes, BPL and BRK sought out dividend paying stocks. But this was not their first, or even second choice. Capital was allocated to merger arbitrage, liquidations, bond arbitrage – basically anything else first. The reason is simple – when you can earn 20%+ per year nearly risk free doing merger arbitrage, it doesn’t make sense to buy Coca-Cola for the 5% dividend. Even most dividend/growth plays aren’t an option. As is always the case, capital should be allocated to the best risk/reward options first, and then move to less attractive but more liquid options later. Coca-Cola’s merit is not the high return. It’s the high liquidity – you can actually buy a billion dollars of Coke stock.
- It’s all about leverage. The only reason those dividend stocks are of any interest is that Berkshire Hathaway has a very low cost of capital due to their insurance businesses. Here’s how it works: the customers pay insurance premiums. Eventually the make claims that on average are somewhat less than the premiums. But in the mean time, the insurance company gets to hold the premiums as reserves and invest them. This amounts to an interest free loan from the customers to the insurance company. That in turn lets the insurance company leverage up its investments effectively for free. Insurance regulators cap how far down this road you can go, but it still amounts to a massive 0% interest loan. This is how Buffett has returned about 20% per year by buying stocks that yield 5% per year – just buy 4x as much on the customer’s money. Let’s hear it for leverage.
- Warren Buffet is an unfortunate dude in Columbus, OH surnamed for the place you go to overeat. The guy you’re thinking of is Buffett.
- Buffett buys a stake in elite proprietary trading whenever he can get it. If there’s one thing in the world you usually can’t buy, it’s an equity stake in a top notch proprietary trading firm at a reasonable price. However, every once in a while even the top dogs find themselves short of capital. When that happens, Warren’s happy to buy in. He did it in 1987 with Solomon Brothers, in effect as a means to go long John Meriwether’s insanely profitable bond arbitrage department. And he did it again in 2008 by buying into Goldman Sachs. After Buffett’s investment, GS proprietary trading went on the biggest run in the history of the industry, having essentially no losing days for a couple of quarters.The point here is that while Berkshire’s positions are mostly easy to understand stock longs, Buffett is happy to buy into the most technical and complicated trading operations out there. He just likes to have all the messy stuff on someone else’s books
So by all means learn about Warren Buffett’s approach. The original BPL letters and later BRK letters are great reading. If you understand everything in those letters, you’ll be a long ways towards understanding both speculation and investment. But don’t get too wrapped up in what anyone other than Buffett and his documented actions have to say about Buffett. The real story has a lot of elements that you should be seeing as repeating themes on this site: leverage, speculation, arbitrage, the cost of capital. Master those things, and you stand at least a chance of duplicating Buffett’s performance. If you just buy Coke stock, you’ve got no hope.