Opinion

James Saft

Warren Buffett’s bubble cash-out strategy

August 21, 2013

Aug 21 (Reuters) – Here is Warren Buffett’s pension fund
management advice in a nutshell: Be patient, buy only a few
things, ignore the stock market until it becomes irrationally
optimistic, at which point sell.

A recently released 1975 letter from Buffett to Washington
Post owner Katharine Graham on the subject offers new insight
into how early Buffett was to grasp both the difficulties of
pension fund management and the inability of Wall Street to
provide adequate solutions.

Perhaps even more valuable is the way the letter throws
light on Buffett’s approach to value investing. Buffett tries to
act not like a typical fund manager but like a company owner
thinking about buying another company. The crucial ingredients:
patience, to get a good purchase price; courage, to stick with
your investment if the business is doing well but the market
doesn’t agree; and a willingness to sell into a bubble when, as
so often happens, one comes along.

First, let’s talk about Buffett’s letter to Graham. It’s a
nice little story.

When Amazon.com founder Jeff Bezos bought the Washington
Post for $250 million earlier this month, he bought a lot of
problems, but none of them had to do with pension funds. That’s
in large part because the Post was lucky enough to have Buffett
as a board member, investor and adviser for many years, and
smart enough to take his advice. The result: a pension fund with
$1.4 billion in obligations and $2.4 billion in assets.

In 1975, not long after he had joined the board, Buffett
sent Katharine Graham, then chairman and CEO, a 19-page private
letter, recently published by Fortune magazine, outlining his
concerns about pension fund problems and his approach to their
solution. here

It is well worth reading in its entirety, but in it he lays
out exactly how grave, permanent and hard to keep are pension
promises and – and this from a money manager – how difficult it
is to find someone who can beat the market on your behalf.

“If above-average performance is to be their yardstick, the
vast majority of investment managers must fail,” Buffett writes.

“Will a few succeed due either to chance or skill? Of
course. For some intermediate period of years a few are bound to
look better than average due to chance just as would be the case
if l,000 ‘coin managers’ engaged in a coin-flipping contest.”

PORTFOLIO APPROACH

Buffett also points out that, while it may be possible that
someone is good at securities selection in a sustainable way,
and just about possible that you might be able to select him,
that person will almost certainly soon be flooded with so much
money that his ability to beat the market will be swamped.

Interestingly, it seems as if the Post’s pension fund may
have done well precisely because Buffett was able to pick
winning managers. Here’s Donald Graham, Katharine’s son and
successor, speaking in a presentation to investors in 2011:

“Kay Graham describes in personal history how in the late
1970s, Warren sent her an extensive memo about corporate pension
funds, urging that we change from our then investors to two
investors he recommended, who just knocked it out of the park
for the ensuing 35 years.”

All right for some, but what do the rest of us do?

Having dispensed with index funds, active managers, star
managers and bond-only strategies in the letter, Buffett goes on
to outline what he says he favors: treating portfolio management
decisions like business acquisition decisions.

The keys he cites here are taking a long view and buying
not just because a company has good prospects or you think the
market will drive its stock up, but because you rate the company
highly and you can get shares at a good value.

“General stock market considerations simply don’t enter into
the purchase decision,” Buffett writes.

Once you own shares, you need to treat them like a business
owner rather than a securities investor. That means
concentrating on how the business is doing longer term, rather
than obsessing about how the stock market price is moving week
to week or quarter to quarter.

Of course, this is something that Buffett, or Graham, can do
but the average fund manager cannot. The average fund manager
has to grapple with career risk – the risk that a period of
underperformance gets her fired – rather than simply focus on
the fundamentals.

As for when to sell, Buffett advises to wait for the market
to get frothy, referring to the “periodic tendency of the stock
market to experience excesses” allowing for a shareholder exit
price better than what one could sell the company for as a
whole.

It has been a good 38 years for bubbles since Buffett wrote
his letter. To judge by his performance, he has taken full
advantage of them.

(At the time of publication, James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Douglas Royalty)

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