Warren Buffett’s Mea Culpa

Here is an extract from Warren Buffett’s latest Annual Report, in which he admits to a number of mistakes during 2008. One measure of how serious the current crisis has become is that last year Berkshire Hathaway, Buffett’s holding company, had its worst year’s performance since it began life in the late-1960s, with its book value per share falling 9.5% (against the S&P 500’s 37% decline). Shares in Berkshire have taken an even bigger hammering, falling 30% or so.

As someone who has followed this great investor’s doings for 18 years, my advice is simple: beware of those who try to write him off as over the hill, or out of touch, or any similar comments. it is true that Buffett is no longer a young man – he is approaching 80 – but bear in mind two things. One is that he is virtually alone among profesional investors in admitting to mistakes of any kind. Such honesty is a refreshing contrast to the self-serving excuses that you will find in the average fund manager’s report to the fundholders.

The second is that his rare errors of judgment – of which buying shares in two Irish banks last year must surely rank as one of the most extraordinary – are invariably more than cancelled out by successes on the other side of the equation. His self-disparaging remarks have always to be seen in the context of his extraordinarily succesful long term track record. The earnings performance of Berkshire’s operating businesses last year was remarkably good in the context of the year’s deteriorating economic backcloth.

“I told you in an earlier part of this report that last year I made a major mistake of commission (and maybe more; this one sticks out). Without urging from Charlie or anyone else, I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars”.

“I made some other already-recognizable errors as well. They were smaller, but unfortunately not that small. During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”

“On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter & Gamble and ConocoPhillips)”.

“However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits”.

“The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today’s could have been obtained on good-grade municipal or corporate bonds even while risk-free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms. When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary”.

“Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time”.

“Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns”.

This is the kind of warning that any investor tempted to go into cash or government bonds at today’s prices should take seriously. Sure, bond yields could well go lower, and those who bet on that outcome stand a chance of looking wise for at least a week or two. But as with any kind of bubble, you will only come out ahead if you are content to operate on the basis of the Greater Fool theory.

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