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Warren Buffett, Harley-Davidson and Buying What You Know

When the financial crisis was reaching its peak, Warren Buffett (Trades, Portfolio) made a series of multi-billion dollar investments in a selection of companies that were crying out for capital.


One of these was the investment bank, Goldman Sachs (NYSE:GS). Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) bought $5 billion worth of "perpetual" preferred shares from the bank with an interest rate of 10%, as well as warrants for 43.5 million additional shares.

Berkshire also sent $303 million to Harley-Davidson Inc. (NYSE:HOG) to help the motorcycle maker keep loans available to purchasers and dealers as credit markets sank.

Buffett's Harley

The interest rate on the credit line from Berkshire to Harley-Davidson was 15%. Buffett ultimately made a handsome return on this investment, but he could have generated an even bigger profit by buying the stock. Shares in the company fell to a low of $10 at the height of the market decline.

So, why didn't Buffett buy Harley-Davidson shares? The reason is because he did not understand the business well when he first offered the loan. All he understood was that the company was not going out of business, and a 15% per annum return was highly attractive.

The Oracle of Omaha explained his thoughts on the matter at the 2010 Bershire annual meeting of shareholders:


"I thought I knew, and I think I was right, that, A) Harley-Davidson was not going out of business. And that, B) 15 percent was going to look pretty damned attractive

...

So we could have a very substantial capital gain, a lot of income. I knew enough to lend them money; I didn't know enough to buy the equity. And that's frequently the case. And, you know, we love buying equities, but we love buying the Goldman preferred at 10 percent. Now, let's say Goldman, instead of offering me the 10 percent preferred and warrants had said, "You can have a 12 percent preferred, non-callable," I might have taken that one instead. I mean, the callable -- so there's a tradeoff involved in all these securities.

And obviously, if I think I can make very good money, as we did on Harley-Davidson, with a very simple decision, just a question of, "Are they going to go broke or not?" as opposed to a tougher decision, "Is the motorcycle market going to get diminished significantly? And, you know, are the margins going to get squeezed somewhat?" And all of that. I'll go with a simple decision."



Buffett then handed the conversation over to his right-hand man, Charlie Munger (Trades, Portfolio), who added:


"Well, of course, your one good answer, that you simply didn't know enough to buy the stock but you did know enough to buy the bond, is a very good response.

The other side to that is, after all, we are a fiduciary for a lot of people, including people with permanent injuries and et cetera, et cetera. And to some extent, we are constrained by how aggressively we buy stocks versus something else. And you mix those together, why, you get our investment policy."



Those are the two critical pillars of Buffett's investment strategy displayed in a straightforward quote. The CEO of Berkshire will only buy what he understands, and he understands bonds well, so he is more likely to stick with this asset class than to buy an equity security without understanding the underlying business.

At the same time, Buffett likes simplicity and low risk. He will only buy investments he understands where the potential return is virtually guaranteed. The Harley-Davidson trade is just one example of the type of trade of Buffett has used over the years to get where he is today.

Disclosure: The author owns shares in Berkshire Hathaway

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This article first appeared on GuruFocus.