Five key takeaways from Buffett's letter

The Oracle of Omaha is his usual wise and witty self in his latest shareholder letter. Here's what investors can learn from his comments.

By John Reese Mar 2, 2010 2:02PM

Warren Buffett released his year-end 2009 letter to Berkshire Hathaway shareholders over the weekend, and, as usual, the Oracle of Omaha's comments are filled with a good deal of wit and candor -- where else could you hear a Fortune 500 CEO say he enjoys issuing new stock "about as much as we relish prepping for a colonoscopy"?

Of course, Buffett's letters are also always filled with wisdom, and I pay particular attention to his words, since his approach forms the basis for one of my Guru Strategy computer models (up more than 50% last year and another 4.2% in 2010). This year's edition is no different, as Buffett lays out insightful thoughts on both current market conditions and long-term investing strategy. Here's a look at what I think are the five major takeaways investors should glean from Buffett's latest letter:


1. It's still all about the businesses -- the long-term businesses


Buffett once said, “As far as I am concerned, the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish.” He still means it, and all you need to do is read the very first page of Berkshire's report for proof. That's where Berkshire monitors its annual progress by listing the growth of its book value, not its stock price, something it always has done.

 

The reason? "Year-to-year market prices can be extraordinarily erratic," writes Buffett. "Even evaluations covering as long as a decade can be greatly distorted by foolishly high or low prices at the beginning or end of the measurement period."

 

Similarly, Buffett isn't concerned with what an individual stock's price has done in the past month, or year, or even the past few years. Instead, he's concerned with a business' long-term prospects, which you can see from one of Berkshire's latest investments, its purchase of a 50% stake in Berkadia Commercial Mortgage. "Though commercial real estate will face major problems in the next few years, long-term opportunities for Berkadia are significant," Buffett writes in explaining the purchase.


2. The financial crisis represented one extreme of a cycle -- not a permanent change.


Buffett has made no bones about the severity of the financial crisis and economic trouble. But while others have said the financial crisis will lead to a "new normal", and that things are "different this time", he's maintained that the economy will work things out and get back to "normal".

 

One part of his letter that illustrates this thinking involves his discussion of the housing market. Buffett says that while housing starts plummeted to the lowest levels in the 50 years of data available in 2009, that's good news now. The weak numbers were a reaction to a huge oversupply in homes, and now that we've had a few years for the excess capacity to get soaked up, "within a year or so residential housing problems should largely be behind us".

 

Yes, he says, prices will remain far below “bubble” levels. "But for every seller (or lender) hurt by this there will be a buyer who benefits," he adds. "Indeed, many families that couldn’t afford to buy an appropriate home a few years ago now find it well within their means because the bubble burst." In other words, on a broad level market forces are playing out, just as they always have.


3. Buy Amid Fear


Fear is a contagion in the stock market. Legitimate fears about an industry, sector, or the entire market often spread like wildfire, driving down the stock prices not just of troubled firms, but also of other companies who are in good shape. Buffett knows this well, and throughout his career he has made hay by buying up good stocks or good companies when other more fearful investors sat on the sidelines, passing over bargains.

 

That part of Buffett's approach was evident in late 2008 and 2009, as he used the financial crisis and bear market as opportunities to do some bargain shopping. "It’s been an ideal period for investors: A climate of fear is their best friend," he writes in his letter. "Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business -- through the purchase of a small piece of it in the stock market -- and what that business earns in the succeeding decade or two."


4. When it’s raining gold, reach for a bucket, not a thimble.


Those are Buffett's own words, which he uses in discussing what he says was his own failure to take full advantage of "very unusual conditions" that made some corporate and municipal bonds "ridiculously cheap relative to U.S. Treasuries" last year. "We backed this view with some purchases," Buffett says, "but I should have done far more. Big opportunities come infrequently."

 

This is something that sets Buffett apart from many investors -- his willingness to make large bets on particular investments. But he only does so after extensive analysis shows that it is "raining gold".


5. How you buy is more important than what you buy.


Of course, the key is knowing when it's "raining gold". And that brings me to the final takeaway.

 

To understand this point, I think it's helpful to look at Buffett's discussion of Berkshire's derivatives contracts -- something he's taken much criticism for. Detractors point out that Buffett himself has called derivatives "financial weapons of mass destruction". But in his latest letter Buffett stands by his derivatives buys. "The dangers that derivatives pose for both participants and society -- dangers of which we’ve long warned, and that can be dynamite -- arise when these contracts lead to leverage and/or counterparty risk that is extreme," he writes. "At Berkshire nothing like that has occurred – nor will it."

 

The message: Asset classes don't lose money by themselves -- bad decisions by investors do. Whether you are investing in stocks, bonds, derivatives, real estate, or any other type of asset, you need to have a good understanding of what you're investing in, and how the price of what you are paying for an asset compares to its real underlying worth. If you do your homework and pay good prices for solid assets, you're probably going to do well over the long haul -- whatever you invest in.

 

John Reese is founder and CEO of Validea.com, a premium investment research site, and Validea Capital Management, a separate account advisory firm. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies".

 

 

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