Jeremy Siegel, Ph.D. The Future for Investors

Every February Berkshire Hathaway invites a hundred or so Wharton students – MBAs and undergraduates – to visit the firm and listen to “The Oracle of Omaha.”  You could scarcely find a more focused and excited group of students and Buffett, who delights in mentoring his young admirers, does not disappoint them.

Before he was scheduled to meet with the Wharton students, I was privileged to talk with the chief of Berkshire Hathaway. Some advice to those who meet him for the first time: don’t ask him to predict the market– he won’t and he doesn’t need to.  He believes that there are always opportunities to find undervalued stocks and sometimes the entire market is so mispriced that profitable trades await savvy investors.

Threats to Markets

But Buffett did tell me that he thinks that risk premiums are too low and that events like 9-11—or worse – can happen at any time. He said that the probability that a nuclear device could be triggered by a terrorist in Manhattan or in Washington (say, at the Federal Reserve) cannot be ignored and probably is not factored into the market.

I asked Warren whether he would be a buyer if such terrorism struck, and, after a moment of reflection, he said “yes.”  Despite his concern of terrorism, Buffett maintains a long-term bullish view of American equities.

Buffett also thinks the large and growing U.S. trade deficit is a big threat to the markets.  His concerns were one of the reasons he had taken a sizable short position on the dollar several years ago. Although he has since pared his position, he still believes that the U.S. saves too little and consumes too much, paying for these imported goods and services with government debt (which he termed “pieces of paper”) that are future claims on our resources.  He believes this huge deficit is a threat to the dollar and invites future inflation.

This is one of the few issue on which we disagree. I believe many Asian countries want to run trade surpluses and are perfectly happy to continue buying our government bonds.  Certainly the dollar may decline; but the greenback is already cheap when compared against major world currencies on a purchasing power basis.  Betting against the dollar is not a sure thing.

Nevertheless, Warren and I totally agree about the foolishness of preventing cross-border mergers, such as the political opposition to the Chinese oil company, CNOOC’s bid for Unocal last year.  I believe that any actions that discourage the foreign flow of capital have far more serious consequences for our dollar and capital markets than the trade deficit itself.

Buyout Surge

Buffett commented negatively on the recent buyout surge and drew some comparisons with a similar phenomenon in the late 1980s.  He criticized private equity that sweeps down and buys firms, “gussies them up,” (to use his term) by stripping and leveraging their assets and firing employees, and then spits them out to the public at a higher price.

When Buffett buys a firm, he instead maintains a hands-off management style and allows managers to do the good jobs that they were doing.  Although Warren may not pay as much as private equity, he attracts owners who care more about their firm’s reputation and their employees than making a few extra dollars on the sale.  As a result, Berkshire can buy a dollar’s worth of assets for less than one dollar, enhancing Berkshire’s value.

Buffett wouldn’t say that all buyouts are bad for shareholders.  The current craze certainly has not gone as far as the late 1980s, when exotic debt instruments, such as no-cash PIK (paid-in-kind) bonds burst onto the scene.  Indeed part of the reason for today’s buyout surge is that straight debt is very cheap.  Furthermore, there are some firms that should profitably redeploy their assets and may have too much cash on their balance sheets.  Nevertheless, owners who want to sell their company intact have an option if they are willing to accept a deal below top price. A good description of Buffett’s style can be found by reading how he purchased ISCAR, an Israeli tool manufacturer, in the latest annual report.

Long Term Capital Management

One student asked about Berkshire’s role in the Long-Term Capital Management (LTCM) crisis that rocked the financial markets in 1998. It was obvious that Warren wished that he had been able to buy LTCM’s positions when the Fed forced a resolution of the crisis that was crippling the government bond market.

The LTCM crisis was a ready-made example of Warren’s philosophy of buying firms when the economics was right, yet fear ruled the markets.  He noted that “off-the-run” (non-benchmark) government bonds were selling to yield 30 basis points more than the “on-the-run” (benchmark) bonds that were maturing just six months later.  He rightly claimed that this made no sense economically.

LTCM had taken a huge leveraged position in these bonds when the spreads were much smaller, but didn’t have the collateral to hold on to it when the spread widened.  Buffett quoted John Maynard Keynes, who wrote in 1931 that “The market can stay irrational longer than you can stay solvent.” As the spread widened, Keynes’ dictum became devastatingly relevant for LTCM.  But Berkshire, with its huge cash hoard, could withstand the pressure of even more market irrationality before the spread eventually returned to normal.

Unfortunately, Warren was never able to consummate the deal.  He had been invited by Bill Gates to vacation in Alaska when the crisis broke and it was hard to negotiate such a deal on a cell phone.  Eventually the banks holding the collateral made a deal with LTCM and Berkshire didn’t have a chance to top their offer.

Warren is philosophical about the loss of this opportunity, noting it was the most expensive vacation he ever took.  “Bill Gates cost me about $3 billion,” he shrugged.  But that incident certainly has not soured their friendship and didn’t prevent him from giving the Bill and Melinda Gates Foundation the lion’s share of his wealth.

Priorities

One of the students asked Warren whether, despite his many successes, he ever made a mistake.  Buffett said that fortunately most of his mistakes were small, noting his ill-fated purchase of Dexter Shoe in 1993, a buy that was made far more costly when he paid for this money-losing company with Berkshire stock.

But Warren does not stew about past mistakes. He wisely counsels that anything that happens to your finances is secondary to the important things in life – picking a suitable and compatible mate, developing a relationship with your children, and doing something that you enjoy.

After watching Warren interact with all the students, it is easy to see that he is not only the world’s best investor; he is also a consummate mentor. Although the students come to hear Warren Buffett for his financial wisdom, they come away with an appreciation of how financial success fits into a broader perspective on life. Cold and snowy Omaha could not take away from the wealth of ideas and warm feelings that were generated at Berkshire that day.