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Saturday, 7 March 2009

Buffett's Losses: The Real Meaning for You

by James B. Stewart

"Pessimism is your friend, euphoria the enemy." -- Warren Buffett, in his 2009 letter to shareholders.

With the market averages now down to levels unseen since 1997, and panic selling sweeping the globe again this week, pessimism is rampant. If Buffett is right, we're in the friendliest environment for investors in my memory.

This seems small comfort when your portfolio is being ravaged by declines. Every recent purchase, even at what seem bargain prices, is greeted with the negative conditioning of a further decline; and the headlines are filled with economic woe. While I feel Buffett's homespun wisdom has never been more timely, in my experience it has never been more difficult to implement.

Buffett himself is a case in point. He acknowledges a "mistake of commission," pointing to his purchase of integrated oil giant ConocoPhillips (COP) "when oil and gas prices were near their peak," presumably last summer. I sold half my position in COP (and other energy positions) last year after pointing to all the signs that oil and commodities were in a bubble. If even I could discern the "euphoria" that Buffett warns about, surely he could, too. And yet he bought: over $7 billion worth, evidently, now worth even less than the $4.4 billion reflected in Buffett's letter. (He may have bought even more, since he reports that he sold some of the position to fund other investments.)

Buffett takes himself to task for this, but doesn't really get into the underlying psychology. How could the greatest investor of his time, the high priest of value investing, the Cassandra of overpriced markets, have done such a thing? Maybe he'll be more forthcoming at the Berkshire Hathaway (BRK.A) shareholder meeting, but whatever the reasons, it is a remarkable testament to the sheer power of the herd instinct that even Buffett could be swept up in the euphoria.

ConocoPhillips isn't Buffett's only big mistake. He reports that he's continued to build up his position in Burlington Northern Santa Fe (BNI) and now owns 20% or more of the shares outstanding. Because it hauls coal and other commodities, the railroad is sensitive to commodity prices as well as overall industrial activity, and its share price has closely tracked the commodities market. BNI traded as high as $114 a share in June; this week it was near $55. (I endorsed Buffett's purchase of BNI when he first disclosed it, but don't currently own any shares.)

And then there's Moody's (MCO), the bond rating firm which has become a poster child for the recent breakdown in regulatory controls, whose supposedly independent analysts "drank the Kool-Aid" when confronted with collateralized debt obligations and other sophisticated and now discredited securities. Buffett warns his readers to "Beware of geeks bearing formulas." Good advice, especially with benefit of hindsight. But didn't Buffett ever bestow that advice on Moody's? Given Buffett's fervor on this score, it seems highly ironic that Berkshire Hathaway owns more than 20% of Moody's. True, he reports that this is the result of buying shares years ago, and that he hasn't added to the stake since. At best, that qualifies as a sin of omission. Moody's shares reach $45 last year; this week they're about $16.

I say this as a long-term admirer of Buffett. There's much to commend in his letter this year, especially his calm, even cheerful, reaction to the market slump that has slashed prices in many cases to bargain levels ("Price is what you pay; value is what you get"). All investors (including myself) sometimes buy stocks that then go down. Nearly all of Buffett's long-term holdings are down this year, which is hardly surprising since nearly all stocks are down. But that's not necessarily a mistake in the sense that you've bought something against your better judgment. COP, BNI and MCO leap out because Buffett's actions in those three investments seem to so clearly contradict his words.

Of course no one's perfect. If even Buffett can succumb, then the rest of us shouldn't be too hard on ourselves. At the same time, we should learn from his and our mistakes. So if you're feeling some pressure to sell into the current pessimism, stop and think: If pessimism is your friend, euphoria your enemy, is this the time to sell?

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