2008: Warren Buffett on the Eve of Crisis

“Banks got into trouble by passing around this toxic Kool-Aid like Jim Jones — and then they drank a couple of gallons themselves.”

Happy Tuesday and welcome to our new subscribers!

I spent the weekend re-reading some old issues of Columbia Business School’s Graham & Doddsville student newsletter. (Press F to pay respects to my social life.)

Written by aspiring money managers and financial analysts at Columbia, this publication pays homage to the school’s rich history of value investing — from the timeless lessons of Benjamin Graham and David Dodd to thought-provoking interviews with some of the best capital allocators plying their trade today.

In 2008, a delegation of Columbia students made the pilgrimage to Omaha to meet with Warren Buffett. (G&D tagged along to jot down all of the relevant details.)

Back in those days, Buffett regularly hosted student groups from around the country — sharing his wisdom and answering questions from the next generation of investors.

As luck would have it, this particular Q&A session occurred right in the midst of one of the most tumultuous periods in American financial history. Just one week after the collapse of Bear Stearns — and with storm clouds beginning to darken over Fannie Mae, Freddie Mac, Lehman Brothers, et al. — these Columbia students (along with another group from Texas A&M) sat down with Buffett at the Omaha Field Club for a frank two-hour discussion on the money game and what might lie ahead…

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BANKING BLUES: When Warren Buffett met with students from Columbia Business School and Texas A&M on March 21, 2008, I imagine the mood was slightly gloomier than usual. Utter financial disaster was still six months or so away, but it’s safe to say that the writing was on the wall by that point.

So Buffett, ever the showman, broke the ice with a joke.

This is a difficult market. Recently, I heard the story of an investment banker who had to tell his wife that there would be no bonus this year.

He said, “We’re going to have to cut back. If you could learn to cook, then we could fire our chef.”

To which she replied, “If you could learn to make love, then we could fire the gardener.”

For close to twenty years, the Berkshire Hathaway CEO had been warning anyone who would listen about the many dangers of derivatives. These opaque, inscrutable contracts — which Buffett likened to “financial weapons of mass destruction” — would wreak immeasurable havoc during the still-unfolding Great Financial Crisis.

But, as G&D pointed out, he “appeared to experience no joy in his recent vindication”.

Derivatives present big opportunities for financial mischief. When we purchased Gen Re, there were 24,000 contracts on the books. One contract went out 100 years.

The CEO should be the head of risk management for any major financial institution. I personally handle all of our derivative contracts. However, it is now obvious to all of us that most banks, insurance companies, and asset managers are not run this way.

Back when we were running Salomon, my partner Charlie [Munger] found a large number of mistakes in one of the derivatives contracts. We paid Arthur Andersen millions of dollars to review the contracts for us — and yet they missed it. These things are designed to fool. They fooled the accountants, but they didn’t fool Charlie.

Buffett then capped off the discussion with probably the best description of the GFC that I’ve ever heard: “Banks got into trouble by passing around this toxic Kool-Aid like Jim Jones — and then they drank a couple of gallons themselves.”

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A TIMELY LESSON ON FOREIGN VALUATION: One student asked Buffett how he evaluates and analyzes international companies for potential investment.

Which, of course, is of particular interest to us today after Berkshire Hathaway increased its stakes in the five sogo shoshas — Mitsubishi, Mitsui, Itochu, Marubeni, and Sumitomo — earlier this month.

To explain his valuation process, Buffett tapped into his roots as pre-teen publisher of the Stable-Boy Selections tip sheet.

At the race track, the first thing you want to do — all things equal — is determine each horse’s chance of winning the race. Then you figure out which has the best odds relative to its chance of winning.

He held up PetroChina as an example. When Buffett first looked over the company’s financial reports, he personally valued the company at around $100 billion. So imagine his surprise when he checked the oil giant’s market cap and saw it selling for just $35 billion. “That got my attention,” he noted wryly.

Even with the risks of investing in China — which Buffett readily admitted — the undervaluation (and resultant margin of safety) was too great to ignore.

Buffett uses the same valuation approach whether a business is located in New York or New Delhi — but “requires an extra measure of undervaluation to compensate for potential unknowns” when it comes to foreign companies.

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HOW I LEARNED TO STOP WORRYING AND LOVE VOLATILITY: It takes a certain mindset and emotional framework to thrive in financial markets. A contrarian streak to search out investments unpopular with the thundering herd, the calm confidence to disregard adverse price actions as mere bumps in the road, and the humility to recognize and correct mistakes as they happen.

For Buffett, problems crept in when he began to manage other people’s money through his limited partnership in the 1950s and 1960s.

I was always comfortable doing things with my own money. That was never a problem. But I was bothered when others bristled at the price action on a stock or investment I had recommended. It was difficult for me.

People would worry if GEICO lost 50% — but I would just buy more.

That ability to tune out the noise, ignore a plummeting stock price, and instead focus on the wonderful underlying business is what separates successful investors from the trailing pack of mediocrities.

Not only did Buffett stand his ground as other GEICO investors panicked and ran for the exits, he actually bought more shares at those depressed prices.

The stock market is there to serve you, not to instruct you. The volatility in a stock is your best friend. I love it when companies’ prices jump up by 100% or down by 50% in the same year. Volatility in stocks is what has made me rich.

“[Stay] detached from the market emotionally,” Buffett continued, “but pay attention to opportunities as they arise.”

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BUFFETT’S SECRET SAUCE: In my opinion, Warren Buffett’s most remarkable skill is purchasing a company for Berkshire Hathaway and then convincing the newly-rich founder or manager to stay on and keep working just as hard as before.

How does he do it?

Well, we’ve all heard Buffett compare Berkshire to his own Sistine Chapel — “I come down to the office, I get on my back, and I start painting” — and he looks for other managers who take the same pride and passion in their own work.

To illustrate the point, Buffett offered up this colorful — and somewhat lurid — analogy. (My apologies to any private equity fans in the audience.)

We don’t do auctions [at Berkshire]. Owners who auction their businesses don’t care about what happens to them. They don’t think of it like a painting.

When you sell your business, you have two options: Sell to Berkshire and it’s like selling your painting to the Metropolitan Museum of Art. We will put up a wing for it.

Otherwise, you can sell to a private equity shop — which is like selling to a porn shop. They will buy the company and they will want to adjust a few things — make the boobs bigger and so forth. It will sit on the shelf for a couple of months and then some guy in a trench coat will come along and buy it from them.

That’s a museum-worthy piece of art right there.