Friday, May 02, 2008

Inside Buffett's Investor Master Class

This from Smart Investing by Robin Bowerman 2/5/08

Warren Buffett is a multi-billionaire with a powerfully simple way with words.He is also notoriously selective about giving media interviews - largely one suspects because he doesn't have to talk to anyone he doesn't want to.

But there are a couple of events a year where Buffett is happy, even expansive in offering his thoughts on investing and the general state of business. One is his widely read annual chairman's letter to Berkshire Hathaway shareholders while the other amounts to a private tutorial with the world's greatest investor and it probably qualifies for the title of the world's best master class in investing.

Several times a year Buffett invites a group of business students to Berkshire Hathaway's headquarters in Omaha for an intensive day of business and investment education. Recently it was the turn of 150 students from the University of Pennsylvania's Wharton School (where Buffett studied) but unusually, US business magazine Fortune was allowed to sit in to give us an insight into what Warren is thinking and saying about the US economy and market turmoil.

After taking them to lunch at favored local restaurant (Piccolo Pete's in case you are passing through downturn Omaha) the day wraps up with a two-hour question and answer session with Buffett.

One question perhaps captured what most investors would like to ask Buffett should they ever be lucky enough to be in the same room: What advice would you give someone who is not a professional investor? Where should they put their money?

The answer will surprise many although not ardent students of Buffettology: "Well if they're not going to be an active investor - and very few should try to do that - then they should stay with index funds. Any low-cost index fund. And they should buy it over time. They's not going to be able to pick the right price and the right time. What they want to do is avoid the wrong price and wrong stock," Buffett told the Wharton students.

Buffett is something of a paradox - he is arguably the world's most successful active investor yet advises people against following the same approach.

He has consistently argued this point over many years and if you go back to this year's Letter to Berkshire Shareholders he explains his reasoning a little more."Naturally, everyone expects to be above average," Buffett says.

"And those helpers - bless their hearts - will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group - the active investors. But this group will incur high transaction, management, and advisory costs.

"Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group - the "know-nothings" - must win," Buffett says. By "helpers" Buffett means the professional consultants/advisers who have built an industry helping other's invest their money.

Finally, in the Fortune article Buffett offers a typically pragmatic view of what went wrong with the sub-prime mortgage market and the infamous collateralised debt obligations (CDOs).

Buffett says he gets his investing ideas simply by reading. "I read a few prospectuses for residential-mortgage-backed securities - mortgages, thousands of mortgages backing them and then those all tranched into maybe 30 slices.

"You create a CDO by taking one of the lower tranches of that one and 50 others like it. Now if you're going to understand that CDO you've got 50-times-300 pages to read, it's 15,000. If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean it can't be done.

"When you start buying tranches of other instruments nobody knows what the hell they're doing. Its ridiculous," Buffett says.

Which perhaps brings us back to one of Buffett's basic principles: don't invest in things you don't understand.

Simple really.