Warren Buffett: Try index funds

Leslie McFadden

It's not every day you get to see the world's second richest man lose.

But the shareholders of Berkshire Hathaway Inc., Warren Buffett's holding company, got to see it twice during the first weekend in May at the Berkshire Hathaway 2007 Annual Shareholders Meeting in Omaha, Neb.

First Buffett, whose net worth Forbes magazine lists at $52 billion, took on friend and Cleveland Cavaliers basketball star LeBron James in a game of "horse." Then he challenged an 11-year-old table tennis champion.

Suffice to say, Buffett probably ought to stick to investing.

Much of the weekend was filled with light-hearted fun. Shareholders who made the pilgrimage to Omaha this year got a chance to shop the merchandise of Berkshire's many subsidiaries, watch a company video of Buffett playing James and capture many Kodak moments of Bill Gates and Warren Buffett playing table tennis at the local mall.

Of course, the real reason people flocked to Omaha, had nothing to do with a desire to see Buffett's athleticism. People came to hear the Oracle of Omaha's comments on a range of issues affecting their lives.

Saturday, May 5, The annual meeting
The annual meeting, which attracted some 27,000 shareholders this year, is anything but a stuffy investors meeting. Beginning like a concert, singer Jimmy Buffett, introduced as "Mr. Buffett," performed a special version of "Margaritaville" -- "Wasting Away in Berkshire Hathawayville," which featured new lyrics about Berkshire and its directors.

The shorts-clad songster introduced the headliners of the event: Warren Buffett and Berkshire Vice Chairman Charlie Munger. The investing pair then sat down for a six-hour question-and-answer session with shareholders, who brought up topics ranging from global warming to Buffett's successor.

Some questions highlighted consumer finance and investing issues worth repeating here. We present some of his thoughts on various financial questions raised by shareholders and members of the press during separate question and answer sessions.

Gems about investing

Read and think before you invest. When a 17-year-old who was attending his 10th consecutive Berkshire annual meeting asked how to become a better investor, Buffett offered some simple but golden advice. Read everything on investing you can get your hands on and fill up your mind with various competing thoughts. After doing that, it's time to get started, as investing on paper and dealing with real money is like "reading a romance novel and doing something else."

He added that when you think about buying shares in a company, think about why you might buy the whole business. If you couldn't write an essay about it, then you shouldn't buy any shares.

Risk is tied to the type of business and ignorance of the investor. One investor from Los Angeles asked about using volatility as a measurement of an investment's risk. "Volatility does not determine the risk of investing," Buffett said, adding that risk comes with certain kinds of businesses and not knowing what you're doing. A better approach would be to understand the economics of the business you're investing in, he said.

Protect a portfolio from inflation. "The best protection against inflation is your own earning power," Buffett says, in response to a question about protecting a portfolio from the erosion of inflation. He says the next best thing is owning a wonderful business, adding that owning Coca-Cola or any name that people will always plunk money down to keep getting and that has low capital investment requirements is the best investment you can have.

What can be done about shorting stocks? "I have no problem with shorts," says Buffett. He added that he didn't think shorting stocks poses any threat to the world. He would be fine with it if someone wanted to short Berkshire stock.

Are managed futures funds a bad idea? In response to a question about his stance on managed futures funds, Buffett said, "It's a mistake to shrink the universe of possibilities," and that funds devoted to a limited segment are at a disadvantage. "There's no form that produces investment results."

Munger added that if you averaged out the annual returns of managed futures funds per dollar per year, they would be somewhere between lousy and negative.

How do you judge the right margin of safety to use when investing? We favor businesses where we think we know the answer, Buffett said. "If we can't come up with a figure, we move on to something we can understand." He also added that the margin of safety doesn't need to be huge, likening a great business to a fat person. It might be hard to tell whether the person weighs 300 or 325 pounds, he says, but you still would say the person is fat.

Munger chimed in saying that margin of safety comes down to getting more value than what you're paying.

Buffett and Munger on other consumer issues

Gambling -- a tax on the ignorant. When a shareholder asked about the future of gambling companies, Buffett remarked that they should do very well, provided that gambling remains legal. "People like to gamble," he said, adding that day-trading stocks comes close to gambling.

The fun of gambling aside, the Oracle had harsh words for the industry, saying, "Gambling is a tax on ignorance." He said it's revolting that the government takes advantage of its citizens' weaknesses rather than protecting them.

Will the subprime market meltdown affect the general economy? Buffett said his guess would be if unemployment rates and interest rates don't go up dramatically then it will be a big problem for those involved. He referred to subprime loans as dumb borrowing and dumb lending, since people who can only pay below-average payments will not be able to pay huge payments down the road. He added that he doesn't think the meltdown will result in any huge crisis in the economy. Real estate will take a couple of years to recover.

Highlights from a press conference

Index funds are appropriate for inexperienced investors. In response to a question about why Buffett recommends index funds to investors, he said that for "a know-nothing investor, a low-cost index fund will beat professionally managed money." He also said he had a standing offer to anyone who could name 10 hedge funds that will beat a low-cost index fund. No one has taken him up on his offer.

Asked later why he didn't take his own advice on index funds, he said he thought Berkshire could beat the S&P by a couple of percentage points, "just not a whole lot better."

The federal estate tax is a keeper. Buffett, a supporter of the federal estate tax, was asked whether he thinks it will fairly tax heirs who inherit estates worth just above $1 million, the threshold that will take effect after 2011 unless lawmakers pass new legislation. He countered that taxes are always unfair to someone and he'd like to know what would be a better way to raise $30 billion per year for the common good. He said that of the 2 million Americans that died last year, less than 2 percent of their estates, or 40,000, qualified for the tax. Buffett also noted that the average inheritance of people who had to pay the estate tax last year was $40 million or more and these people were not hurt by the tax.

When Munger asked him if he would support raising the threshold to $2 million, Buffett said he "didn't have a problem with the structure of it" but would support a progressive tax. He went on to say that he didn't believe in a "lucky sperm club" and that the estate tax helps redistribute some of that wealth. "Other than that, I have no opinion," he said.

Investing advice from Warren Buffett

Better to invest in businesses tough for competitors to enter. Asked about his interest in investing in Taiwanese high-tech companies, Buffett remarked that "change is wonderful, but not necessarily for investments." In terms of predicting how a business will perform, he said it's much easier to look at consumer behavior and businesses that have big barriers to entry, citing Gillette as an example of a company with a 70 percent market share for men's razors.

How important is return on capital? Buffet said the return on capital employed determines whether a company is good or bad. He also said it's better when you can produce the same returns as you increase the amount of capital employed. "We really love to see a business with increasing returns on capital employed that can use incremental capital and earn at that same rate. Such businesses are practically nonexistent."

Value investing -- what else is there? One person asked about whether Buffett's value investing strategy would apply in South Korea. Buffett said investing is all about value. "What other kind of investing is there?" he asked. "Are we going to have nonvalue investing? Are we going to have tipster investing … dream investing? I've never understood what the alternative is."

The tax code favors the superrich. In response to a question about excess liquidity, Buffett said the U.S. government has imposed comparatively low tax rates on investors making money through capital gains and dividends. "We have become the favored class," he said. "Apparently Washington has decided we are an endangered species."

As for excess liquidity, he warned that "we can easily have an event that changes everyone's perspective in a hurry. And we will have such an event."