Buffett the Market Timer? Part 4: The Berkshire Years 1991-2004

So we continue.  Let's see what he says in 1991:


BRK LTS 1991

     Our outsized gain in book value in 1991 resulted from a phenomenon not apt to be repeated:  a dramatic rise in the price-earnings ratios of Coca-Cola and Gillette.  These two stocks accounted for nearly $1.6 billion of our $2.1 billion growth in net worth last year.  When we loaded up on Coke three years ago, Berkshire's net worth was $3.4 billion; now our Coke stock alone is worth more than that. 

We all know what a home-run KO was, but I still had to go back and read that again about how BRK's KO position is now worth more than the net worth of BRK three years before when they intitially bought KO.

So here's a chart of KO from 1987 to the end of 1991.  While many were waiting for next great depression to come, Buffett was scooping up KO, and not even at value prices.

Here's the large holdings of BRK as of the end of 1991:

                                                        12/31/91
   Shares   Company                                  Cost       Market
   ------   -------                               ----------  ----------
                                                      (000s omitted)
 3,000,000  Capital Cities/ABC, Inc. ............ $  517,500  $1,300,500
46,700,000  The Coca-Cola Company. ..............  1,023,920   3,747,675
 2,495,200  Federal Home Loan Mortgage Corp. ....     77,245     343,090 
 6,850,000  GEICO Corp. .........................     45,713   1,363,150
24,000,000  The Gillette Company ................    600,000   1,347,000
31,247,000  Guinness PLC ........................    264,782     296,755
 1,727,765  The Washington Post Company .........      9,731     336,050
 5,000,000  Wells Fargo & Company                    289,431     290,000

He talks about the difficulty of maintaining their book value growth over time.  And here he makes one of those market forecasts that he does occasionally:

     The third point incorporates two predictions:  Charlie Munger, Berkshire's Vice Chairman and my partner, and I are virtually certain that the return over the next decade from an investment in the S&P index will be far less than that of the past decade, and we are dead certain that the drag exerted by Berkshire's expanding capital base will substantially reduce our historical advantage relative to the index. 

     Making the first prediction goes somewhat against our grain:  We've long felt that the only value of stock forecasters is to make fortune tellers look good.  Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.  However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last.  Our second conclusion - that an increased capital base will act as an anchor on our relative performance - seems incontestable.  The only open question is whether we can drag the anchor along at some tolerable, though slowed, pace. 

So let's take a look at this.  In the decade through 1991, this is what the BRK and the S&P 500 (including dividends) did.  This is from the 2013 annual report:

BRK book value grew +28.4%/year in the 10 years through 1991 versus +17.5%/year for the S&P 500 index.

Now let's see if Buffett's prediction held:

In the next decade after his comment BRK BPS grew +19.4%/year and the S&P 500 index returned +12.9%/year.

So he was exactly right.  The returns over the following decade were lower than the previous ten years.  But again, here's the deal.  Did Buffett lighten up on stocks or sell out to wait for a better opportunity (like many investors did all throughout the late 80's and throughout the 90's)?  Nope.  He managed his expectations, but didn't do anything to exploit his view on the market.

It's hard to believe now, but in much of the 1990's, many people were still shaken by Black Monday and were afraid of getting back into stocks; they thought another crash was around the corner (sound familiar?  Right now feels sort of like the 1990's; people still suffering from (PCSD) Post-Crash (or Crisis)-Stress-Disorder.


BRK LTS 1993
In 1993, Buffett talks about how intrinsic value and market price may not move together in lock step over the short term (but will over the long term).  He mentions how Coke and Gillette stock prices far outpaced their businesses up to 1991, but have lagged in the couple of years to 1993.  But he said:

     Let me add a lesson from history:  Coke went public in 1919 at $40 per share.  By the end of 1920 the market, coldly reevaluating Coke's future prospects, had battered the stock down by more than 50%, to $19.50.  At year-end 1993, that single share, with dividends reinvested, was worth more than $2.1 million.  As Ben Graham said:  "In the short-run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long-run, the market is a weighing machine. 

And about the low amount of activity in the equity porfolio, he says:

     Considering the similarity of this year's list and the last, you may decide your management is hopelessly comatose.  But we continue to think that it is usually foolish to part with an interest in a business that is both understandable and durably wonderful.  Business interests of that kind are simply too hard to replace. 

     Interestingly, corporate managers have no trouble understanding that point when they are focusing on a business they operate:  A parent company that owns a subsidiary with superb long-term economics is not likely to sell that entity regardless of price.  "Why," the CEO would ask, "should I part with my crown jewel?"  Yet that same CEO, will offhandedly - and even impetuously - move from business to business when presented with no more than superficial arguments by his broker for doing so.  The worst of these is perhaps, "You can't go broke taking a profit."  Can you imagine a CEO using this line to urge his board to sell a star subsidiary?  In our view, what makes sense in business also makes sense in stocks:  An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business. 

Here's another great lesson on investing using Coke as an example:

      Earlier I mentioned the financial results that could have been achieved by investing $40 in The Coca-Cola Co. in 1919.  In 1938, more than 50 years after the introduction of Coke, and long after the drink was firmly established as an American icon, Fortune did an excellent story on the company.  In the second paragraph the writer reported:  "Several times every year a weighty and serious investor looks long and with profound respect at Coca-Cola's record, but comes regretfully to the conclusion that he is looking too late.  The specters of saturation and competition rise before him." 

    Yes, competition there was in 1938 and in 1993 as well.  But it's worth noting that in 1938 The Coca-Cola Co. sold 207 million cases of soft drinks (if its gallonage then is converted into the 192-ounce cases used for measurement today) and in 1993 it sold about 10.7 billion cases, a 50-fold increase in physical volume from a company that in 1938 was already dominant in its very major industry.  Nor was the party over in 1938 for an investor:  Though the $40 invested in 1919 in one share had (with dividends reinvested) turned into $3,277 by the end of 1938, a fresh $40 then invested in Coca-Cola stock would have grown to $25,000 by year-end 1993.

     I can't resist one more quote from that 1938 Fortune story:  "It would be hard to name any company comparable in size to Coca-Cola and selling, as Coca-Cola does, an unchanged product that can point to a ten-year record anything like Coca-Cola's."  In the 55 years that have since passed, Coke's product line has broadened somewhat, but it's remarkable how well that description still fits. 

     Charlie and I had decided long ago that in an investment lifetime it's just too hard to make hundreds of smart decisions.  That judgement became ever more compelling as Berkshire's capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically.  Therefore, we adopted a strategy that required our being smart - and not too smart at that - only a very few times.  Indeed, we'll now settle for one good idea a year. (Charlie says it's my turn.)

There's more about investing in the 1993 letter which talks about the benefits of focusing investments rather than diversifying, and what real risk in investing is (and it's not volatility or beta!).


BRK 1994 LTS
1994 was another eventful year in the market with a bond market bubble popping.  Here, Buffett talks about investing again and really gets down to what this series is sort of all about:

     We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.  Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. 

     But, surprise - none of these blockbuster events made the slightest dent in Ben Graham's investment principles.  Nor did they render unsound the negotiated purchases of fine businesses at sensible prices.  Imagine the cost to us, then, if we had let fear of unknowns cause us to defer or alter the deployment of capital.  Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak.  Fear is the foe of the faddist, but friend of the fundamentalist. 

     A different set of major shocks is sure to occur in the next 30 years.  We will neither try to predict these nor profit from them.  If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results. 

Later on he talks about pricing investments and not timing them.

    We purchased National Indemnity in 1967, See's in 1972, Buffalo News in 1977, Nebraska Furniture Mart in 1983, and Scott Fetzer in 1986 because those are the years they became available and because we thought the prices they carried were acceptable.  In each case, we pondered what the business was likely to do, not what the Dow, the Fed, or the economy might do.  If we see this approach as making sense in the purchase of businesses in their entirety, why should we change tack when we are purchasing small pieces of wonderful businesses in the stock market? 

And if he is not going to sell these businesses when market valuations are high, why would he sell any of his permanent stock holdings?   They need to be attractively priced with a margin of safety for purchase, but not necessarily for them to be held.


BRK 1995 LTS
In 1995, Buffett talks about American Express, Capital Cities and Disney (he actually bought shares in the market before the deal closed) and other investments, but here's an interesting story that he tells:

     One more bit of history:  I first became interested in Disney in 1966, when its market valuation was less than $90 million, even though the company had earned around $21 million pre-tax in 1965 and was sitting with more cash than debt.  At Disneyland, the $17 million Pirates of the Caribbean ride would soon open.  Imagine my excitement - a company selling at only five times rides! 

     Duly impressed, Buffett Partnership Ltd. bought a significant amount of Disney stock at a split-adjusted price of 31 cents per share.  That decision may appear brilliant, given that the stock now sells for $66.  But your Chairman was up to the task of nullifying it: In 1967 I sold out at 48 cents per share. 

If he had continued to own Disney from 1966 to 1995, he would have earned 20%/year for 29 years!

BRK LTS 1996
In the 1996 letter, Buffett writes:

     I was recently studying the 1896 report of Coke (and you think that you are behind in your reading!).  At that time Coke, though it was already the leading soft drink, had been around for only a decade.  But its blueprint for the next 100 years was already drawn.  Reporting sales of $148,000 that year, Asa Candler, the company's president, said: "We have not lagged in our efforts to go into all the world teaching that Coca-Cola is the article, par excellence, for the health and good feeling of all people."  Though "health" may have been a reach, I love the fact that Coke still relies on Candler's basic theme today - a century later.  Candler went on to say, just as Roberto could now, "No article of like character has ever so firmly entrenched itself in public favor."  Sales of syrup that year, incidentally, were 116,492 gallons versus about 3.2 billion in 1996.

So don't you wish you can read the 1896 annual report too?  Don't you wish you can show your kids or grandkids for educational purposes?  This is why I mentioned the idea of a Warren Buffett Library of Corporate Annual Reports.

The 1996 letter has a lot of stuff including advice to those who want to invest for themselves.  But since I am only looking for specific views on the market, or his actions at market extremes (in terms of valuation), let's move on.

BRK LTS 1997
The 1997 letter is very interesting for a couple of reasons.  First of all, Buffett for the first time mentions some unconventional investments.  He also mentions selling some stocks to adjust the stock-bond ratio of the portfolio based on expected returns.   Buffett is not known for setting target ratios for that, but I suppose there was some adjustments done there.  This was the late 90's after the 1996, Greenspan "Irrational Exuberance" speech.

Unconventional Commitments

       When we can't find our favorite commitment -- a well-run and sensibly-priced business with fine economics -- we usually opt to put new money into very short-term instruments of the highest quality. Sometimes, however, we venture elsewhere. Obviously we believe that the alternative commitments we make are more likely to result in profit than loss. But we also realize that they do not offer the certainty of profit that exists in a wonderful business secured at an attractive price. Finding that kind of opportunity, we know that we are going to make money -- the only question being when. With alternative investments, we think that we are going to make money. But we also recognize that we will sometimes realize losses, occasionally of substantial size.

       We had three non-traditional positions at year-end. The first was derivative contracts for 14.0 million barrels of oil, that being what was then left of a 45.7 million barrel position we established in 1994-95. Contracts for 31.7 million barrels were settled in 1995-97, and these supplied us with a pre-tax gain of about $61.9 million. Our remaining contracts expire during 1998 and 1999. In these, we had an unrealized gain of $11.6 million at year-end. Accounting rules require that commodity positions be carried at market value. Therefore, both our annual and quarterly financial statements reflect any unrealized gain or loss in these contracts. When we established our contracts, oil for future delivery seemed modestly underpriced. Today, though, we have no opinion as to its attractiveness.

       Our second non-traditional commitment is in silver. Last year, we purchased 111.2 million ounces. Marked to market, that position produced a pre-tax gain of $97.4 million for us in 1997. In a way, this is a return to the past for me: Thirty years ago, I bought silver because I anticipated its demonetization by the U.S. Government. Ever since, I have followed the metal's fundamentals but not owned it. In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand. Inflation expectations, it should be noted, play no part in our calculation of silver's value.

       Finally, our largest non-traditional position at yearend was $4.6 billion, at amortized cost, of long-term zero-coupon obligations of the U.S. Treasury. These securities pay no interest. Instead, they provide their holders a return by way of the discount at which they are purchased, a characteristic that makes their market prices move rapidly when interest rates change. If rates rise, you lose heavily with zeros, and if rates fall, you make outsized gains. Since rates fell in 1997, we ended the year with an unrealized pre-tax gain of $598.8 million in our zeros. Because we carry the securities at market value, that gain is reflected in yearend book value.

       In purchasing zeros, rather than staying with cash-equivalents, we risk looking very foolish: A macro-based commitment such as this never has anything close to a 100% probability of being successful. However, you pay Charlie and me to use our best judgment -- not to avoid embarrassment -- and we will occasionally make an unconventional move when we believe the odds favor it. Try to think kindly of us when we blow one. Along with President Clinton, we will be feeling your pain: The Munger family has more than 90% of its net worth in Berkshire and the Buffetts more than 99%. 

This is certainly a rare move; I don't remember any other commodity investments that he has made like this.  But he does move into areas when there is an opportunity, like junk bonds and writing derivatives puts on global indices.  But this is clearly not a major contributor to the earnings at BRK.

Here is a comment that sounds a little unusual, though.  So if you want to jump up and say "Aha!  Buffett is a market timer after all!", well, do so now.

      We made net sales during the year that amounted to about 5% of our beginning portfolio. In these, we significantly reduced a few of our holdings that are below the $750 million threshold for itemization, and we also modestly trimmed a few of the larger positions that we detail. Some of the sales we made during 1997 were aimed at changing our bond-stock ratio moderately in response to the relative values that we saw in each market, a realignment we have continued in 1998.

But still, this is a minor adjustment in the portfolio.  I've never heard of BRK wanting to maintain any target bond-stock ratio, so maybe the terminology is misleading.

And here is his comment (that he occasionally makes) on the level of the stock market:

       Though we don't attempt to predict the movements of the stock market, we do try, in a very rough way, to value it. At the annual meeting last year, with the Dow at 7,071 and long-term Treasury yields at 6.89%, Charlie and I stated that we did not consider the market overvalued if 1) interest rates remained where they were or fell, and 2) American business continued to earn the remarkable returns on equity that it had recently recorded. So far, interest rates have fallen -- that's one requisite satisfied -- and returns on equity still remain exceptionally high. If they stay there -- and if interest rates hold near recent levels -- there is no reason to think of stocks as generally overvalued. On the other hand, returns on equity are not a sure thing to remain at, or even near, their present levels.

       In the summer of 1979, when equities looked cheap to me, I wrote a Forbes article entitled "You pay a very high price in the stock market for a cheery consensus." At that time skepticism and disappointment prevailed, and my point was that investors should be glad of the fact, since pessimism drives down prices to truly attractive levels. Now, however, we have a very cheery consensus. That does not necessarily mean this is the wrong time to buy stocks: Corporate America is now earning far more money than it was just a few years ago, and in the presence of lower interest rates, every dollar of earnings becomes more valuable. Today's price levels, though, have materially eroded the "margin of safety" that Ben Graham identified as the cornerstone of intelligent investing. 

Despite his "unconventional commitments" and the adjustment of the "stock-bond ratio", BRK's portfolio is pretty much unchanged.  He continues to own the wholly owned businesses and the core holdings in the equity portfolio.


BRK LTS 1998

Investments

         Below we present our common stock investments. Those with a market value of more than $750 million are itemized.

			12/31/98
Shares	Company		Cost*		Market
			(dollars in millions)
50,536,900	American Express Company . . . . . . . . . . . . . . . . . . . .		$1,470		$ 5,180
200,000,000	The Coca-Cola Company . . . . . . . . . . . . . . . . . . . . . .		1,299		13,400
51,202,242	The Walt Disney Company . . . . . . . . . . . . . . . . . . . . .		281		1,536
60,298,000	Freddie Mac . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .		308		3,885
96,000,000	The Gillette Company . . . . . . . . . . . . . . . . . . . . . . . . .		600		4,590
1,727,765	The Washington Post Company . . . . . . . . . . . . . . . . .		11		999
63,595,180	Wells Fargo & Company . . . . . . . . . . . . . . . . . . . . . . .		392		2,540
	Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .		2,683		5,135
	Total Common Stocks . . . . . . . . . . . . . . . . . . . . . . . . .		$ 7,044		$ 37,265
			=====	=====

         * Represents tax-basis cost which, in aggregate, is $1.5 billion less than GAAP cost.

         During the year, we slightly increased our holdings in American Express, one of our three largest commitments, and left the other two unchanged. However, we trimmed or substantially cut many of our smaller positions. Here, I need to make a confession (ugh): The portfolio actions I took in 1998 actually decreased our gain for the year. In particular, my decision to sell McDonald's was a very big mistake. Overall, you would have been better off last year if I had regularly snuck off to the movies during market hours.

The total cost of the equity portfolio in 1997 was $7.2 billion versus $7.0 billion in 1998, so if this is the right way to think about it, the trimming of the stock portfolio wasn't much; more like fine tuning.

         At yearend, we held more than $15 billion in cash equivalents (including high-grade securities due in less than one year). Cash never makes us happy. But it's better to have the money burning a hole in Berkshire's pocket than resting comfortably in someone else's. Charlie and I will continue our search for large equity investments or, better yet, a really major business acquisition that would absorb our liquid assets. Currently, however, we see nothing on the horizon. 

As there are no opportunities, BRK sits on cash. But again, sitting on cash and letting it accumulate is not the same as getting out of stocks because they are fully priced.   They need a discount to intrinsic value and margin of safety to buy stock, but not necessarily to own them (which Buffett said they will do even if they get substantially overvalued, at least for their permanent holdings).

And then he mentions the unconventional commitments he wrote about in the 1997 letter:

         Last year I deviated from my standard practice of not disclosing our investments (other than those we are legally required to report) and told you about three unconventional investments we had made. There were several reasons behind that disclosure. First, questions about our silver position that we had received from regulatory authorities led us to believe that they wished us to publicly acknowledge this investment. Second, our holdings of zero-coupon bonds were so large that we wanted our owners to know of this investment's potential impact on Berkshire's net worth. Third, we simply wanted to alert you to the fact that we sometimes do make unconventional commitments.

 This makes you wonder what else they have done over the years and haven't been disclosed.  But that's OK because most of the wealth at BRK was created by the activities that are disclosed (profit of private businesses, large equity portfolio etc.)


BRK 1999 LTS
So 1999 was a relatively bad year for BRK, with BPS flat versus the 20% gain in the S&P 500 index.  And here he expresses his confidence that they will do moderately better than the index (but not as much as in the past due to size etc.) and reservations about the stock market:

     Our optimism about Berkshire's performance is also tempered by the expectation -- indeed, in our minds, the virtual certainty -- that the S&P will do far less well in the next decade or two than it has done since 1982. A recent article in Fortune expressed my views as to why this is inevitable, and I'm enclosing a copy with this report. 

And here's the discussion about stock price levels (emphasis mine):

     Right now, the prices of the fine businesses we already own are just not that attractive. In other words, we feel much better about the businesses than their stocks. That's why we haven't added to our present holdings. Nevertheless, we haven't yet scaled back our portfolio in a major way: If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter. What really gets our attention, however, is a comfortable business at a comfortable price.

     Our reservations about the prices of securities we own apply also to the general level of equity prices. We have never attempted to forecast what the stock market is going to do in the next month or the next year, and we are not trying to do that now. But, as I point out in the enclosed article, equity investors currently seem wildly optimistic in their expectations about future returns.

     We see the growth in corporate profits as being largely tied to the business done in the country (GDP), and we see GDP growing at a real rate of about 3%. In addition, we have hypothesized 2% inflation. Charlie and I have no particular conviction about the accuracy of 2%. However, it's the market's view: Treasury Inflation-Protected Securities (TIPS) yield about two percentage points less than the standard treasury bond, and if you believe inflation rates are going to be higher than that, you can profit by simply buying TIPS and shorting Governments.

     If profits do indeed grow along with GDP, at about a 5% rate, the valuation placed on American business is unlikely to climb by much more than that. Add in something for dividends, and you emerge with returns from equities that are dramatically less than most investors have either experienced in the past or expect in the future. If investor expectations become more realistic -- and they almost certainly will -- the market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated.

     Berkshire will someday have opportunities to deploy major amounts of cash in equity markets -- we are confident of that. But, as the song goes, "Who knows where or when?" Meanwhile, if anyone starts explaining to you what is going on in the truly-manic portions of this "enchanted" market, you might remember still another line of song: "Fools give you reasons, wise men never try."  

Again, he sees the market way too high and expectations way too high and yet he makes very little changes in the equity portfolio.  We can argue that he doesn't own the bubbled up internet and other technology stocks, but we do know that Coke was pretty expensive as was Gillette. He later does regret not selling the more expensive things, though.

Fortune Article 1999
So now let's get to that 1999 article where he warned of a high stock market.  Here's the link if you haven't read it.  It's very good.  You can read it here.

I'm not going to go back and get figures as we all know the market did phenomenally well in every time period up to 1999 (OK, it went up more than 24% per year from the end of 1981 through 1999 including dividends).

Buffett was alarmed that polls showed investors expecting returns of 22% (inexperienced investors) and 12% (experienced investors) over time going forward.

The gist of this article is that this is way too high an expectation.

First he says that valuation won't tell you what the market will do in the short term, but can give you an idea what to expect over the long term:

Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss. But I want to make one thing clear going in: Though I will be talking about the level of the market, I will not be predicting its next moves. At Berkshire we focus almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market. Even then, valuing the market has nothing to do with where it's going to go next week or next month or next year, a line of thought we never get into. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts. So what I am going to be saying--assuming it's correct--will have implications for the long-term results to be realized by American stockholders. 

And in summary after a great explanation, he says:

Let me summarize what I've been saying about the stock market: I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like--anything like--they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate--repeat, aggregate--would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.

 So here's the key point, I think.  He warns people (who are expecting high returns in the stock market) that returns going forward are not going to be as high as they think.  His best guess of returns in the stock market going forward is 6%/year, not too far from long term bond yields at the time, I think.

This is not a warning that a crash is imminent, even though he expects a correction when people's expectations are adjusted down.  Even at the then prices in 1999, he was expecting 6%/year returns.
So this is not really a "get out of stocks now!" warning or anything like that.  It's more of an issue of managing expections (as he would have no idea when the market would decline).  I guess it was a strong warning to get out of the more speculative areas of the market.

But this sort of explains why he wasn't rushing to sell his stocks; he was still expecting 6%/year over time in the stock market.  That's no reason to run to the hills.

It turns out that since 1999 through the end of 2013, the S&P 500 index returned only 3.6%/year.  He did say that returns could just as likely to be less as more.


BRK LTS 2000
He is still lukewarm on the market, but maintains BRK's positions:

     Another negative ¾ which has persisted for several years ¾ is that we see our equity portfolio as only mildly attractive. We own stocks of some excellent businesses, but most of our holdings are fully priced and are unlikely to deliver more than moderate returns in the future. We’re not alone in facing this problem: The long-term prospect for equities in general is far from exciting. 

BRK LTS 2001

     We made few changes in our portfolio during 2001. As a group, our larger holdings have performed poorly in the last few years, some because of disappointing operating results. Charlie and I still like the basic businesses of all the companies we own. But we do not believe Berkshire's equity holdings as a group are undervalued.

     Our restrained enthusiasm for these securities is matched by decidedly lukewarm feelings about the prospects for stocks in general over the next decade or so. I expressed my views about equity returns in a speech I gave at an Allen and Company meeting in July (which was a follow-up to a similar presentation I had made two years earlier) and an edited version of my comments appeared in a December 10^th Fortune article. I'm enclosing a copy of that article. You can also view the Fortune version of my 1999 talk at our website www.berkshirehathaway.com.

     Charlie and I believe that American business will do fine over time but think that today's equity prices presage only moderate returns for investors. The market outperformed business for a very long period, and that phenomenon had to end. A market that no more than parallels business progress, however, is likely to leave many investors disappointed, particularly those relatively new to the game.

     Here's one for those who enjoy an odd coincidence: The Great Bubble ended on March 10, 2000 (though we didn't realize that fact until some months later). On that day, the NASDAQ (recently 1,731) hit its all-time high of 5,132. That same day, Berkshire shares traded at $40,800, their lowest price since mid-1997.

BRK LTS 2002

Here is the 10% pre-tax return benchmark.  We've all heard it at annual meetings and such, but I don't recall seeing this in the annual report (even though I've read all of them before; I didn't remember that).

BRK LTS 2003 

And here he admits a "big mistake" in not selling some large holdings that got way too expensive:

BRK LTS 2004
Buffett still has trouble finding places to invest:

And he discusses why, despite such a strong stock market over the years, many investors don't do too well:

He does say that if people want to really time their participation in equities, that they should buy low and sell high.  But from what I've seen, people do tend to buy low but then sell way too soon as soon as they think the market is fully priced.  So doing that can be difficult too.  When are people greedy, and when are they fearful?

Here is the large equity holdings as of 2004:

And he discusses his long term holdings and contemplates the idea of BRK catching the swings of the pendulum.   But he does still regret not selling things during the Great Bubble.

This isn't really related to our topic, but it's a nice table so I just threw it in here:

Aha, and here again is Buffett playing with the macro:

It is another one of his unconventional commitments, I suppose.  I don't think it was a major factor either way, and I remember he said that he put on these positions at positive carry so he was being paid to carry the position; he wouldn't hold the position if he had to pay to maintain it.  And in fact, I think he did say he unwound it when it was no longer positive carry.

Conclusion for 1991-2004
OK, so again this is getting too long so I will chop it off here and continue hopefully the last segment in 2004-2013.  There is a lot of stuff including the 2006/2007 bubble and then the Great Recession, so reviewing his comments on the markets would be very interesting.

Since he really regrets not selling stuff during the Great Bubble, it will be interesting to see how his actions during the 2006/2007 bubble changed from that experience (or not changed).

Anyway, stay tuned...

Buffett the Market Timer? Part 3: The Berkshire Years 1981-1990

OK, so this was a little longer than I thought, so I will make Part 3 1981-1990.  There's more stuff here than I thought.

Anyway, let's see what Buffett has to say:

BRK LTS 1981
Buffett talks about trying to find whole businesses to buy but sees better opportunities in the stock market:

Currently, we find values most easily obtained through the open-market purchase of fractional positions in companies with excellent business franchises and competent, honest managements.  We never expect to run these companies, but we do expect to profit from them. 

And again, in 1981, he talks an awful lot about inflation and how bad it is for equities (emphasis mine):

In past reports we have explained how inflation has caused our apparently satisfactory long-term corporate performance to be illusory as a measure of true investment results for our owners.  We applaud the efforts of Federal Reserve Chairman Volcker and note the currently more moderate increases in various price indices.  Nevertheless, our views regarding long-term inflationary trends are as negative as ever.  Like virginity, a stable price level seems capable of maintenance, but not of restoration.

Despite the overriding importance of inflation in the investment equation, we will not punish you further with another full recital of our views; inflation itself will be punishment enough.  (Copies of previous discussions are available for masochists.) But, because of the unrelenting destruction of currency values, our corporate efforts will continue to do a much better job of filling your wallet than of filling your stomach. 

And yet, as sure as he is that high inflation will continue and it will be bad for stocks/businesses, he continues investing in the stock market.  Much of the country ran the other way into inflation investments like gold.

(What I experienced in the recent crisis is that people who don't want to buy stocks because they are too expensive, or not cheap, won't buy stocks when they are cheap because they will tell you that there is a valid reason why it is cheap and why it may get cheaper!   Of all the people that look at a long term chart of the S&P 500 index and valuations that say that 1982 was a great buying opportunity, I suspect most of them wouldn't have done it if they were there at the time. It was too scary to buy stocks!  But that's a different issue.)

This is interesting because Buffett was wrong about inflation; Volcker did succeed in getting inflation back down.  If he was right and inflation kept going at a high rate, BRK would have still achieved decent returns keeping up with inflation (which as he says would be "illusory").  But if he went into gold (as many did) and was wrong, he would have lost a lot of money (as many did).  So his decision to stay in stocks seems to be a heads I win and make a killing or tails I lose and I give you illusory profits (but at least keep up with inflation).

So in that sense, it seems like a good bet.  He stayed with a position where it didn't matter if he was right or wrong on inflation.  Others made bets (gold) where they had to be right about inflation or else they would end up losing tons of money (and they did).


BRK LTS 1982
After almost a decade of bargain prices, Buffett is already starting to worry about the level of the stock market.  He does say that stock prices were crazy in 1972 (referring to the nifty-fifty) when BRK owned very little stocks compared to 1982.

     Our partial-ownership approach can be continued soundly only as long as portions of attractive businesses can be acquired at attractive prices.  We need a moderately-priced stock market to assist us in this endeavor.  The market, like the Lord, helps those who help themselves.  But, unlike the Lord, the market does not forgive those who know not what they do.  For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments. 

     Should the stock market advance to considerably higher levels, our ability to utilize capital effectively in partial-ownership positions will be reduced or eliminated.  This will happen periodically:  just ten years ago, at the height of the two-tier market mania (with high-return-on-equity businesses bid to the sky by institutional investors), Berkshire's insurance subsidiaries owned only $18 million in market value of equities, excluding their interest in Blue Chip Stamps.  At the time, such equity holdings amounted to about 15% of our insurance company investments versus the present 80%. There were as many good businesses around in 1972 as in 1982, but the prices the stock market placed upon those businesses in 1972 looked absurd.  While high stock prices in the future would make our performance look good temporarily, they would hurt our long-term business prospects rather than help them.  We currently are seeing early traces of this problem. 

He says equities is 80% of total insurance company investments, but I don't know what percentage it would be versus the net worth of the insurance company.  At 80%, it's possible that some of the float itself was invested in equities too, but I can't confirm that without a BRK 1982 balance sheet.


BRK LTS 1985
1985 was a great year for BRK and Buffett says this kind of return won't be repeated; neither the one year nor the twenty year returns (emphasis mine):

     Our gain in net worth during the year was $613.6 million, or 48.2%.  It is fitting that the visit of Halley's Comet coincided with this percentage gain: neither will be seen again in my lifetime.  Our gain in per-share book value over the last twenty-one years years (that is, since present management took over) has been from $19.46 to $1632.71, or 23.2% compounded annually, another percentage that will not be repeated. 

     Two factors make anything approaching this rate of gain unachievable in the future.  One factor probably transitory - is a stock market that offers very little opportunity compared to the markets that prevailed throughout much of the 1964-1984 period.  Today we cannot find significantly-undervalued equities to purchase for our insurance company portfolios.  The current situation is 180 degrees removed from that existing about a decade ago, when the only question was which bargain to choose. 

     This change in the market also has negative implications for our present portfolio.  In our 1974 annual report I could say: "We consider several of our major holdings to have great potential for significantly increased values in future years."  I can't say that now.  It's true that our insurance companies currently hold major positions in companies with exceptional underlying economics and outstanding managements, just as they did in 1974.  But current market prices generously appraise these attributes, whereas they were ignored in 1974.  Today's valuations mean that our insurance companies have no chance for future portfolio gains on the scale of those achieved in the past. 

And here's another interesting point.  Buffett no longer sees equities as cheap but what is notable is that he is not selling stocks.  He doesn't say stocks are fully valued and then just sell out and go to cash (or buy puts or other hedges).

This veers a little bit off topic again but I thought it is an interesting comment.  We often hear arguments that it is harder now to make money in markets because there are so many hedge funds and other professional market participants picking over the market that things aren't often mispriced anymore. This may be true in some areas (merger arbitrage, for example) but Joel Greenblatt once said that despite all the MBA's / professional money managers out there, we still had the 1999/2000 bubble and collapse so how much more efficient is the market these days?

Buffett made this comment in the 1985 letter:

     You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets.  They are not:  stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued. 

     Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do:  An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news.  "You've qualified for residence", said St. Peter, "but, as you can see, the compound reserved for oil men is packed.  There's no way to squeeze you in."  After thinking a moment, the prospector asked if he might say just four words to the present occupants.  That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, "Oil discovered in hell."  Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions.  Impressed, St. Peter invited the prospector to move in and make himself comfortable.  The prospector paused.  "No," he said, "I think I'll go along with the rest of the boys.  There might be some truth to that rumor after all."

First, a correction.  In Part 2 of this series, I mentioned that Buffett bought Washington Post (WPC) in 1972, but the 1985 letter says that he bought all the WPC shares in mid-1973.  Anyway, here is a comment on WPC.  This is one of the first times he starts to talk about holding stuff 'forever', I think.

     Our Capital Cities purchase, described in the next section, required me to leave the WPC Board early in 1986.  But we intend to hold indefinitely whatever WPC stock FCC rules allow us to.  We expect WPC's business values to grow at a reasonable rate, and we know that management is both able and shareholder-oriented.  However, the market now values the company at over $1.8 billion, and there is no way that the value can progress from that level at a rate anywhere close to the rate possible when the company valuation was only $100 million.  Because market prices have also been bid up for our other holdings, we face the same vastly-reduced potential throughout our portfolio. 

Of course the obvious question is, why wouldn't he sell some of this stuff if he didn't see a lot of potential?  Over the years, Buffett has responded to similar questions by asking where else he would put the capital.  He wouldn't want to sell out and hold cash (well, cash back then earned more then in recent years).  He often said that he would have to sell, pay taxes on that and then find something that is just as good, qualitatively, at a better price (to offset the tax paid on realized gains).  That is hard to do.

So just because something becomes fully priced for Buffett is not an automatic reason to sell.

And here's a comment on Buffett doing some risk arbitrage (now called merger arbitrage):

     You will notice that we had a significant holding in Beatrice Companies at year-end.  This is a short-term arbitrage holding - in effect, a parking place for money (though not a totally safe one, since deals sometimes fall through and create substantial losses).  We sometimes enter the arbitrage field when we have more money than ideas, but only to participate in announced mergers and sales.  We would be a lot happier if the funds currently employed on this short-term basis found a long-term home.  At the moment, however, prospects are bleak. 

This is also interesting.  Notice that he says "prospects are bleak" to deploy capital in the market.  And yet he still owns a bunch of stocks.  Just because prices are not attractive enough to buy is not a reason to sell, and just because something is good enough to own is not a reason to buy.  I know that's a little confusing.  People always ask why Buffett doesn't just buy more Coke or whatever other stocks he happily owns.

He wants to buy when things are cheap, but is happy to own at full value and even when it is overvalued as long as the business is doing well.  We will see more comments about that later.

So, just because there aren't any bargains in the market is not a reason to go to cash.   Just because there isn't much to buy is not a reason that you shouldn't own stocks.

BRK LTS 1986
This lack of opportunities in the stock market continues:

     Meanwhile, we had no new ideas in the marketable equities field, an area in which once, only a few years ago, we could readily employ large sums in outstanding businesses at very reasonable prices.  So our main capital allocation moves in 1986 were to pay off debt and stockpile funds.  Neither is a fate worse than death, but they do not inspire us to do handsprings either.  If Charlie and I were to draw blanks for a few years in our capital-allocation endeavors, Berkshire's rate of growth would slow significantly.

And an extended comment on the markets:

     During 1986, our insurance companies purchased about $700 million of tax-exempt bonds, most having a maturity of 8 to 12 years.  You might think that this commitment indicates a considerable enthusiasm for such bonds.  Unfortunately, that's not so: at best, the bonds are mediocre investments.  They simply seemed the least objectionable alternative at the time we bought them, and still seem so.  (Currently liking neither stocks nor bonds, I find myself the polar opposite of Mae West as she declared: "I like only two kinds of men - foreign and domestic.")

     We must, of necessity, hold marketable securities in our insurance companies and, as money comes in, we have only five directions to go: (1) long-term common stock investments; (2) long-term fixed-income securities; (3) medium-term fixed-income securities; (4) short-term cash equivalents; and (5) short-term arbitrage commitments. 

     Common stocks, of course, are the most fun.  When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs.  But we currently find no equities that come close to meeting our tests.  This statement in no way translates into a stock market prediction: we have no idea - and never had had - whether the market is going to go up, down, or sideways in the near- or intermediate term future. 

     What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community.  The timing of these epidemics will be unpredictable.  And the market aberrations produced by them will be equally unpredictable, both as to duration and degree.  Therefore, we never try to anticipate the arrival or departure of either disease.  Our goal is more modest:  we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. 

     As this is written, little fear is visible on Wall Street.  Instead, euphoria prevails - and why not?  What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves?  Unfortunately, however, stocks can't outperform businesses indefinitely. 

Again, it's important to note that some people with a similar view as Buffett would sell stuff and go to cash, but Buffett doesn't.  He doesn't buy stocks with new cash coming in, but he is not rushing to sell stocks in anticipation of a sell-off to buy back cheaper either.  Nor is he putting his private businesses on the block.  Just because times are not good to buy stocks doesn't mean that it's a bad idea to own stocks.

And here he starts to talk more about stocks as businesses:

     We should note that we expect to keep permanently our three primary holdings, Capital Cities/ABC, Inc., GEICO Corporation, and The Washington Post.  Even if these securities were to appear significantly overpriced, we would not anticipate selling them, just as we would not sell See's or Buffalo Evening News if someone were to offer us a price far above what we believe those businesses are worth. 

     This attitude may seem old-fashioned in a corporate world in which activity has become the order of the say.  The modern manager refers to his "portfolio" of businesses - meaning that all of them are candidates for "restructuring" whenever such a move is dictated by Wall Street preferences, operating conditions or a new corporate "concept."  (Restructuring is defined narrowly, however: it extends only to dumping offending businesses, not to dumping the officers and directors who bought the businesses in the first place. "Hate the sin but love the sinner" is a theology as popular with the Fortune 500 as it is with the Salvation Army.)

     Investment managers are even more hyper-kinetic:  their behavior during the trading hours makes whirling dervishes appear sedated by comparison.  Indeed, the term "institutional investor" is becoming one of those self-contradictions called an oxymoron, comparable to "jumbo shrimp", "lady mudwrestler: and "inexpensive lawyer."

     Despite the enthusiasm for activity that has swept business and financial America, we will stick with out 'til-death-do-us-part policy.  It's the only one with which Charlie and I are comfortable, it produces decent results, and it lets our managers and those of our investees run their businesses free of distractions. 

So this explains why Buffett didn't sell Coke at 40-50x earnings in 1999.  I'm not saying that he shouldn't have sold it (didn't he later make a comment regretting it?).


BRK LTS 1987
And a letter from an interesting year:

Marketable Securities - Permanent Holdings

     Whenever Charlie and I buy common stocks for Berkshire's insurance companies (leaving aside arbitrage purchases, discussed later) we approach the transaction as if we were buying into private business.  We look at the economic prospects of the business, the people in charge of running it, and the price me must pay.  We do not have in mind any time or price for sale.  Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate.  When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts. 

     Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities.  But by no means is it essential:  a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book of Fechheimer.  Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total. 

He talks a lot about Benjamin Graham and Mr. Market and then (emphasis mine):

     We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time.  (Of Wall Street maxims the most foolish may be "You can't go broke taking a profit.")  We are quite content to hold any security indefinitely, so long as prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business. 

     However, our insurance companies own three marketable common stocks that we would not sell even though they became far overpriced in the market.  In effect, we view these investments exactly like our successful controlled businesses - a permanent part of Berkshire rather than merchandise to be disposed of once Mr. Market offers us a sufficiently high price.  To that, I will add one qualifier:  These stocks are held by our insurance companies and we would, if absolutely necessary, sell portions of our holdings to pay extraordinary insurance losses.  We intend, however, to manage our affairs so that sales are never required.

      A determination to have and to hold, which Charlie and I share, obviously involves a mixture of personal and financial considerations.  To some, our stand may seem highly eccentric.  (Charlie and I have long followed David Ogilvy's (this is misspelled as Oglivy in the letter at the Berkshire Hathaway website and book!)  advice:  "Develop your eccentricities while you are young.  That way, when you get old, people won't think you're going ga-ga.")  Certainly, in the transaction-fixated Wall Street of recent years, our posture must seem odd:  To many in that arena, both companies and stocks are seen only as raw material for trades. 

     Our attitude, however, fits our personalities and the way we want to live our lives.  Churchill once said, "You shape your houses and then they shape you."  We know the manner in which we wish to be shaped.   For that reason, we would rather achieve a return of X while associating with people whom  we strongly like and admire than realize 110% of X by exchanging these relationships for uninteresting or unpleasant ones.  And we will never find people we like and admire more than some of the main participants at the three companies - our permanent holdings - shown below: 

No. of Shares                                          Cost       Market
-------------                                       ----------  ----------
                                                        (000s omitted) 
  3,000,000    Capital Cities/ABC, Inc. ...........  $517,500   $1,035,000 
  6,850,000    GEICO Corporation ..................    45,713      756,925 
  1,727,765    The Washington Post Company ........     9,731      323,092 

...and here is a comment that applies equally well today.  Back in 1987 they had insider trading scandals, portfolio insurance and other derivatives that caused market volatility etc.

    Many commentators, however, have drawn an incorrect conclusion upon observing recent events:  They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys.  This conclusion is dead wrong:  Such markets are ideal for any investor - small or large - so long as he sticks to his investment knitting.  Volatility caused many money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves.  He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times. 

And for the first time since the early 1970's, it looks like Buffett is finally 'out' of the stock market: 

      At Berkshire, we have found little to do in stocks during the past few years.  During the break in October, a few stocks fell to prices that interested us, but we were unable to make meaningful purchases before they rebounded.  At year-end 1987 we had no major common stock investments (that is, over $50 million) other than those we consider permanent or arbitrage holdings.  However, Mr. Market will offer us opportunities - you can be sure of that - and, when he does, we will be willing and able to participate. 

But wait a second.  BRK has no major common stock investments other than the permanent three.  Plus he still owns the wholly owned businesses, which to him are the same as permanent stock holdings. 

So he dumped all of his other stocks, so it does look like he ran for the hills.  But if you look back at the equity portfolio, the permanent three was already 76% of total stock holdings in 1985 and 93% in 1986.  This became 100% in 1987 (excluding arbitrage holdings as there is no total table for 1987 in the report like the other years).  So his selling out of stocks doesn't account for very much; it's a minor adjustment to the portfolio; not a big liquidation and run to cash from stocks by any means.  

And here's a sort of macro view of Buffett's that does keep him away from long-term bonds: 

     We continue to have an aversion to long-term bonds (and may be making a serious mistake by not disliking medium-term bonds as well).  Bonds are no better than the currency in which they are denominated, and nothing we have seen in the past year - or past decade - makes us enthusiastic about the long-term future of U.S. currency. 

He goes on to explain the problem with trade deficits and the other problems we had in the 80's.  So he is very aware of all the things that the bears were touting as reasons to get out of the market, short the market, buy gold and run for the hills.  Even in the recent crisis, otherwise sane people were confused as to why Buffett doesn't see what is so obvious; that the world is about to end. 

And how many of the gloom and doomers of the 80's have a good track record since then (either in fund performance or accuracy of predictions?).  OK, some hedge funds have done well since then with macro, but very few, I think.

So again, like his call on inflation in the 1970's, he makes a good macro call on the dollar.  But by sticking to his "investment knitting", it doesn't really matter much if he is right or wrong on the call.  His investment success is not dependent on his making the right call on interest rates or the dollar.  This is one of the key things to learn from this exercise. 

And here's an interesting section on the beginning of Buffett's nightmare to come.  Economically, I think, this worked out OK. But what unfolded later was not ideal to put it mildly.  But I bring this up because it gives us an example of how he comes to certain investment decisions: 

     By far our largest - and most publicized - investment in 1987 was a $700 million purchase of Salomon Inc 9% preferred stock.  This preferred is convertible after three years into Salomon common stock at $38 per share and, if not converted, will be redeemed ratably over five years beginning October 31, 1995.  From most standpoints, this commitment fits into the medium-term fixed-income securities category.  In addition, we have an interesting conversion possibility. 

      We, of course, have no special insights regarding the direction or future profitability of investment banking.  By their nature, the economics of this industry are far less predictable than those of most other industries in which we have major commitments.  This unpredictability is one of the reasons why our participation is in the form of a convertible preferred.   

     What we do have a strong feeling about is the ability and integrity of John Gutfreund, CEO of Salomon Inc.  Charlie and I like, admire and trust John.  We first got to know him in 1976 when he played a key role in GEICO's escape from near-bankruptcy.  Several times since, we have seen John steer clients away from transactions that would have been unwise, but that the client clearly wanted to make - even though his advice provided no fee to Salomon and acquiescence would have delivered a large fee.  Such service-above-self behavior is far from automatic in Wall Street. 

So it is interesting that despite the mania he saw in the stock market, he was willing to buy preferreds of an investment bank that would obviously be hurt in a bear market.   Despite bubble conditions, he said that they have "no special insights regarding the direction or future profitability of investment banking", and bought the preferreds on the character / integrity of the CEO, John Gutfreund, and the structure of the preferred.  

Market timers might say that this is a bad deal; the market is going to crash, the dollar is plunging, and investment banks are going to go bust.  Or something like that.  We hear that every time (and once in a while it happens, like in 2008!). 

BRK LTS 1988

And in 1988, it looks like he starts to buy stocks again.  Remember that 1988 was not necessarily a bear market low or anything like that.  Many at the time wanted to wait for the stock market to get back to 7-8x p/e ratio (just like it did in 1982) before buying stocks again.  In fact, that's what I heard in 2009 too.  People said that the market won't bottom out until the p/e ratio gets to 7x because that's what happened in 1932, 1974 and 1982. 

Lucky for BRK shareholders, Buffett doesn't look at things that way: 

     In 1988 we made major purchases of Federal Home Loan Mortgage Pfd. (Freddie Mac) and Coca Cola.  We expect to hold these securities for a long time.  In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.  We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint.  Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.  Our holdings of Freddie Mac are the maximum allowed by law, and are extensively described by Charlie in his letter. 

And this is a cue for us to go and get Charlie's letter and read it.  I don't know if I've ever read his 1988 letter.

Here's the BRK equity portfolio as of 1988: 

   Shares   Company                                    Cost       Market
   ------   -------                                 ----------  ----------
                                                        (000s omitted) 
 3,000,000  Capital Cities/ABC, Inc. ..............  $517,500   $1,086,750
14,172,500  The Coca-Cola Company .................   592,540      632,448
 2,400,000  Federal Home Loan Mortgage 
               Corporation Preferred* .............    71,729      121,200
 6,850,000  GEICO Corporation .....................    45,713      849,400
 1,727,765  The Washington Post Company ...........     9,731      364,126

*Although  nominally a preferred stock, this security is 
 financially equivalent to a common stock.

And he still doesn't like long-term bonds: 

     We have not lost our aversion to long-term bonds.  We will become enthused about such securities only when we become enthused about the prospects for long-term stability in the purchasing power of money.  And that kind of stability isn't in the cards:  Both society and elected officials simply have too many higher-ranking priorities that confict with purchasing-power stability. 

So he still doesn't like the dollar, but notice that he doesn't rush into gold, emerging markets or other non-dollar assets like some of the people who yell and scream to get out of U.S. dollar assets (and curiously, they are only on TV when the market is down more than 100 points!).  He isn't looking for investments that do well in inflationary times, or when the dollar weakens.  He is not looking to hedge his equity portfolio or business holdings despite his negative views on bonds and the dollar. 

For those interested in special situations investing, there is an extensive discussion of arbitrage (and merger arbitrage) in the 1988 letter.

BRK LTS 1989

Here's the table of BRK's large stock holdings in 1989: 

                                                             12/31/89
  Shares    Company                                      Cost       Market
  ------    -------                                   ----------  ----------
                                                          (000s omitted)
 3,000,000  Capital Cities/ABC, Inc. ................ $  517,500  $1,692,375
23,350,000  The Coca-Cola Co. .......................  1,023,920   1,803,787
 2,400,000  Federal Home Loan Mortgage Corp. ........     71,729     161,100
 6,850,000  GEICO Corp. .............................     45,713   1,044,625
 1,727,765  The Washington Post Company .............      9,731     486,366

He talks about how long it took him to buy Coca-Cola (having first had a Coke back in 1935 or 1936, and having made a business out of selling Coke in the neighborhood), and what he likes about it.

And then he talks about the valuation of his holdings (his italics, my underline):

     As I mentioned earlier, the year-end prices of our major investees were much higher relative to their intrinsic value than theretofore.  While those prices may not yet cause nosebleeds, they are clearly vulnerable to a general market decline.  A drop in their prices would not disturb us at all - it might in fact work to our eventual benefit - but it would cause at least a one-year reduction in Berkshire's net worth.  We think such a reduction is almost certain in at least one of the next three years.  Indeed, it would take only about a 10% year-to-year decline in the aggregate value of our portfolio investments to send Berkshire's net worth down. 

And note again that despite prices of his holdings being much higher than their intrinsic value, he doesn't sell.  Instead, he prepares himself and BRK shareholders for the eventual decline in price levels and a possible decline in BRK's net worth.   BRK's long term performance would be very different if he sold his holdings, even if he sold them at a level that is much higher than intrinsic value.

He thinks it is almost certain that there will be a drop in BRK's net worth in at last one of the next three years.

Just for reference, here's the BPS growth for BRK over the next few years after this:

1989:  +44.4%
1990:  +7.4%
1991:  +39.6%
1992:  +20.3%
1993:  +14.3%
1994:  +13.9%
1995:  +43.1%
1996:  +31.8%
1997:  +34.1%
1998:  +48.3%

And he didn't have a negative BPS change until the year 2001. So much for predicting the market/stock prices, even using valid valuation techniques.  BRK shareholders are lucky that he didn't sell out to avoid this possible drop in BPS and try to get back in later.  I was pretty active in the business in these years, and I think in every single year, people said that the market was overvalued and had many great, valid reasons why owning stocks were a bad idea.  A bear market was 'imminent' in every one of these years.   Food for thought.


LTS BRK 1990
Here's the table of holdings from the 1990 report (only the largest holdings):

                                                                 12/31/90
  Shares    Company                                  Cost         Market 
  ------    -------                               ----------    ----------
                                                       (000s omitted)
 3,000,000  Capital Cities/ABC, Inc. ............ $  517,500    $1,377,375
46,700,000  The Coca-Cola Co. ...................  1,023,920     2,171,550
 2,400,000  Federal Home Loan Mortgage Corp. ....     71,729       117,000 
 6,850,000  GEICO Corp. .........................     45,713     1,110,556
 1,727,765  The Washington Post Company .........      9,731       342,097
 5,000,000  Wells Fargo & Company ...............    289,431       289,375

In 1990, he talks a lot about the Wells Fargo purchase, so I'll cut and paste a bunch about that here since it is relevant now too as Buffett has been buying a lot of WFC recently too.   

      Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.

      The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

      Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.

      With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no genius," he said. "I'm smart in spots - but I stay around those spots.")

      Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.

      Wells Fargo is big - it has $56 billion in assets - and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price, would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.

      Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

      None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.

      A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.

      Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices.) Similarly, at the Buffalo News we would cheer lower prices for newsprint - even though it would mean marking down the value of the large inventory of newsprint we always keep on hand - because we know we are going to be perpetually buying the product.

      Identical reasoning guides our thinking about Berkshire's investments. We will be buying businesses - or small parts of businesses, called stocks - year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.

      The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

      None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." 

Conclusion for 1981 - 1990
So this is longer than I thought it would be, so I will have to cut it here for now.   This is very interesting because we see markets get very high and bubbly in 1986-1987 and yet Buffett hangs on to most of his stocks.  He did sell the stock that weren't 'permanent', but since he is so focused, other stocks were not that big so the increasing market valuation didn't really seem to cause a major asset reallocation out of stocks into something else.

And it is interesting that he said that he won't sell his permanent holdings even if they get substantially overvalued.

And we see the consequence of that in the late 1980's and early 1990's.  He seemed so sure that BRK's BPS will go down in one of the next three years in the 1989 letter.  He wasn't timing the market from a conventional point of view, but rather 'pricing' the market and noting the discrepancy between intrinsic value and market price.  And still, he proved to be wrong.

Again, like his comments about bonds, inflation and the dollar, he made sort of a prediction, but his performance wasn't dependent on that prediction coming true.  If he had sold some stocks to 'lighten up' so that he can get back in at a lower price later, he would have hurt his own performance by being wrong.

There is a difference between noting something and managing your expectation and trying to exploit that insight and trying to profit from it.

Hopefully, Part 4 will be able to fit the years 1991 - 2013.  But a lot happened in those years so who knows.