After teaming up with Charlie Munger, Warren Buffett often talked about the importance of an economic moat for companies that he would consider investing in. Just as a moat around a medieval castle kept the castle safe from intruders, an economic moat around a company keeps it safe from competitors and other profit-draining forces.
During the credit boom, some said Warren Buffett had lost his search for economic moats. However, after the promoter of Berkshire Hathaway (BRK.A) clinched a sizeable investment in Goldman Sachs (GS) in 2008, Wall Street"s strongest name then, investors knew what the master had been waiting for. Having clinched several successful deals last year in the financial sector in the midst of a subprime catastrophe that saw the demise of Lehman Brothers Inc., Buffett�s Berkshire now seems to be keen to shift its asset allocation to more sustainable businesses.
Although Berkshire Hathaway, which disclosed its December 2008 holdings this week, is not worried about its portfolio size shrinking by 25% in the fourth quarter of 2008, it certainly is adapting to changes. Little wonder then that the firm has reduced its exposure to ratings agency Moody"s (MCO) by 25% and instead bought shares in a diversified electric generation company NRG Energy (NRG) and a water treatment company Nalco Holding (NLC).
While the former is a Fortune 500 company with approximately 24,000 megawatts (MW) of power generation capacity, the latter is a global integrated water treatment solution provider. It is certainly not difficult to figure out what kind of �moats� the legendry investor is looking for in such uncertain times.
Janet Tavakoli is one of the top experts in the fields of structured finance. She is one of the most vocal critics of a system gone horribly wrong and saw disaster looming early on. She even tried to sound the alarm many times with an SEC that in retrospect looks to be on the wrong side of the subpeona issuance business.
The current multi-trillion dollar financial crisis didn�t come about due to any single act of brazen greed or stupidity, rather it was a case of many people all looking for a little extra. Pushing the boundaries at each level has a multiplier effect. Common sense and ethics went out the window as it was all mostly legal and appeared at each level to be just a little �extra� nudge.
Here is my diagram of how each level of the sense of �entitlement� to a little �extra� will cost a generation. The era of rules meant be bent and self-entitlement will haunt the world for years to come.
Actor
Extra
Self deluded Justification
Home Owners
Bedrooms, bathrooms etc.
The neighbors have it, the finance is available and everyone else is doing it. To paraphrase Kindelberger, �nothing will cause a person to lose their sense of economic rationality than to see the idiot neighbor/ relative get rich.�
Realtor/ Mortgage broker
Extra income from activity
We are putting people in beautiful dream homes and making a little on the side. Who cares about the loan forms, it�s the loan that counts.
Mortgage �packager� securitizer
Extra yield maybe 0.75% on a few loans via securitization
If the ratings agencies say it is AAA and there is a market for it, then it must be OK.
S&P, Moody�s etc.:ratings Agencies, who have a Government granted monopoly on truth.
Make a little extra income for rating new securitized instruments. An investment grade ratings could increase income by a factor 20x
The models indicate that the loans or OK. We are the original kids who never learned �just say no!� We can model anything and in the face of �free money� or having to say we are ignorant, we will take the money.
One of the problems with securitization as elaborated by Ms. Tavakoli so adroitly is the chain of responsibility and accountability that was broken between lender and borrower. Long term responsibility was packaged up and sold in a heart beat to the next yield hungry bidder looking for a little "extra". This is a classic agency problem.
Like any drama involving a major loss for an entire generation, this one has many systemic failings. No single actor failed totally, many failed just enough. This multiplied into what is still unfolding as the largest economic crisis in many generations. The reality still hasn�t hit main street America. Wait 6-9 months.
In any group human endeavor some greed, stupidity and laziness will be present. Most cultural institutions and systems are designed to handle these individual components. The crunch was a case of multiple actors giving way just enough to cause a cascading failure.Ms. Tavakoli uses her letters and relationship with Warren Buffett as an homage to Buffett"s ability to distill the basic essence of complex matters into simple facts of money and value. Buffett has the gift of simple language and metaphor to illustrate complex financial truths. He is the Richard Feynman of finance.
Ms. Tavakoli is an expert in the area of the most sophisticated areas of credit derivatives having authored such tomes as Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization. For Dear Mr. Buffett, she has opted for a simple approach to tell the tale of actors gone bad and trust abused at many levels. This book is an accessible popularization of the issues, and as such no heavy securitization math etc. to deal with. I agree with this approach as the story needs to get out to as many as possible.
It is a tale of oversight and minor characters who loomed large in their time, but will be seen as petty by future generations. Financial debacles and their actors rarely make sweeping historical reads.
The embodiment of the Wall Street tyrant appears to be Dick Fuld, a small man in many ways ,who is the essence of the bully standing atop in an empty castle with nothing to offer but an angry wimper. Mr. Fuld, Sandy Weill, Stan O�Neill, Angelo Mozillo etc. are the sorry human reflections of a failed culture.
Buffett comes across in classic form as modest and thoughtful in dodging the mess and politely not making too much money from it. His low ball bid for MBIA�s (MBI) good assets gets scant attention in the book. If the bid had been put forth by anyone else, it would have been seen as good business, but poor taste. Buffett can pull this stuff off and still look saintly.
One small critique I have of the book is Ms. Tavakoli�s light treatment of Buffett in regards to Moody�s rating agency. Buffett talks in his book with regards to his holdings in Moody�s, but there needs to be a house cleaning among the entire NRSRO system. My suggestion would be to eliminate it and all SEC mandates referring to ratings. Better no risk system than chasing a flawed one.
Ratings agencies are the pimps of Wall Street, dressing up securities to happily service Bankers and Fund managers too lazy to do their own due diligence. The average fund manger is happy to look for a little yield with minimal effort at due diligence or god forbid independent thought. The coming storm in the Muni-bond market will be eye opening for those managers who buy alphabet soup from the rating agencies and sell "extra" basis points to their investors as performance without knowing what is under the hood of their funds.
The game the ratings agencies play with Municipal bond ratings would make any mafia member�s eyes swell with envy as a protection racket. The ratings agencies are an in-built American systemic failure in a system that causes catastrophic �normal accidents�. The U.S.S.R. had Pravda and we have the NRSRO to separate state truth from fiction for us.
A word of warning about reading this book, it will make you angry. If it doesn�t, read it again until you understand it. The more one understands the nature of what caused this hyper-accident, the more blame there is to go around.
A fitting touch at the senate testimony was the happy coincidence that Mr. Spitzer put on his special show as Client #9 only hours before his testimony. We can only be thankful that Mr. Spitzer�s attempts at cornering the market on self-righteousness have been doused as his powers of heightened self importance seemed to be getting out of hand.
Mr. Dinallo, the New York insurance superintendant appears to be genuinely trying to making the best of a bad situation. My own opinion is that the bond insurers still have a role to play in the credit debacle as Municipal bonds start defaulting and the insurance they so happily offer is seen to be as valuable as Joe Brown�s piercing insights into MBIA�s own solvency or lack thereof.
Stay tuned, this will play out in the next 6-9 months as municipalities across the country start defaulting and the bond insurers get handed from the State level up to the Feds. TARP which should be Latin for financial herpes, really is the taxpayer gift that keeps giving.
The story Ms. Tavakoli shares is not a simple one, the actors are all intelligent and each plays their role in inflating the credit bubble. None are innocent and yet all profess to be victims in retrospect. The saying is that success has a thousand fathers and failure is an orphan. The credit bubble that is engulfing the world was a web of greed that reaches down from Government to Wall Street across main street and right to the front door of your neighbors.
Everyone was entitled to bigger homes, free money etc. a few players highlighted in Ms. Tavakoli�s book delivered that little �extra� that now engulfs the world.
Warren Buffett"s holding company Berkshire Hathaway (BRK.B) has been the single greatest investment of our lifetimes.
His compounded annual gain from 1966 to 2007 was 21.1% for an overall gain of 400,863%, compared to 10.3% and 6,840% for the S&P 500.However, Buffett experienced a rare earnings letdown during the second quarter of this year.
Although revenue increased 10% to $29.3 billion, insurance related write-downs hurt the company"s bottom line.Still, the shortfall was far from cataclysmic. For the quarter, earnings fell 7.6% to $2.88 billion.Despite the shortfall, the company still maintains a top-notch credit rating and has over $28 billion in cash, a war chest for the world"s greatest investor.
How has Warren Buffett"s investment strategy been so successful? He takes a disciplined value approach to investing. And he sticks with it.
Buffett also makes concentrated purchases within his investment strategy. For its size, Buffett"s portfolio has few stocks. But once a downturn comes, he buys millions of shares of solid businesses at reasonable prices.
Berkshire is a major player in the markets for insurance, soft drinks, chocolates, shoes, jewelry, publishing, furniture, steel, energy, homebuilding and private jets.
Besides buying large chunks of Swiss Re (SWCEY.PK), a major reinsurer, Buffett has been buying unloved - but sound - financial stocks.
He"s increased his position in the Midwestern banking powerhouse U.S. Bancorp (NYSE: USB). (Documents show Berkshire is now the company"s largest shareholder.)
Many household financial stocks have imploded in 2008. Bear Stearns and IndyMac, for example, are gone. Lehman Brothers is down 80% this year. Yet USB has held steady.
Buffett is also buying more Burlington Northern (NYSE: BNI), acquiring shares during the recent market weakness.
Warren Buffett"s Investment Strategy & The Economic Downturn
Why is Buffett buying companies if, by his own admission, the economic downturn is likely to be deeper and longer lasting than generally expected?
First off, because he knows that nobody can accurately or consistently predict something as big, diverse and dynamic as the global economy.
Second, he knows that even if you somehow knew what was going to happen in the economy, you still wouldn"t necessarily know what is about to happen in the stock market. Perversely, stocks sometimes fall during good times. They often rally during bad times.
Third, Buffett knows that the stock market is a discounting mechanism. It takes the news and reflects it into stock prices immediately. Who in their right mind would sell their stocks today because he realizes the economy is slowing down? We"ve known that for months now.
Buffett knows that nothing beats the long-term returns available in equities. Where else can you put your money to work today? With real estate caught in a death spiral? In bonds that pay less than 5%? In money markets yielding 2%?
When we first recommended Berkshire Class B shares in February 2001, they were trading at $2,295. At the peak, shares traded as high as $5,059 in December 2007, a 123% return in a little more than seven years.
Yet the B shares are currently trading at $3,860, off 24% from the 52-week high and 20% year-to-date.
History shows that when Berkshire is down 24%, it"s not just a good buy�
