The S&A Digest: The wisdom of Warren Buffett

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As of 06/20/2013

The wisdom of Warren Buffett... Can you read financial statements?... Blowback from our GM letter... Even rich people are broke... How NOT to use stop losses...

Below, you'll find Sean Goldsmith's notes from Omaha, where he attended the Berkshire Hathaway annual meeting. (All the quotes are paraphrased.)

Buffett has long said he doesn't use complex math or rigorous modeling when making investment decisions, "If we can't make a decision in five minutes, we can't make one in five months." He told the crowd he's made plenty of investment mistakes, but none were based on due diligence. If he would have performed more research in those situations, he still would have been wrong, but he would have wasted more money and time.

Porter comment: This is a much more valuable concept than most people will ever appreciate. After researching investments professionally for 12 years, I've done significant due diligence on thousands of companies. All of the best situations were clear to me within five minutes. If it's too hard to figure out, it's not a great investment. Investing is one occupation where working too hard will only get you into trouble... Maybe that's why I like it so much...

More on business analysis... "We really like things you don't have to carry to three decimal places. If you have to go to three, you probably don't want to buy it." Then Buffett said, "If I see a 300 or 350 pound man, I may not be able to tell you how much he weighs, but I know he's fat." Buffett likes "financially fat" companies.

If Buffett had to bet his life, he'd bet the dollar would weaken.

Porter comment: Talk about a safe bet...

Charlie Munger, Buffett's long-time partner in Berkshire, is a cynic of few words. His responses at the annual meeting were always short, and often more helpful than Buffett's. Munger said he has learned to filter out bad businesses. During meetings with potential targets, Munger will often stop the presenter in the middle of his opening sentence with "We don't do startups."

One investor asked what Buffett and Munger thought of regional banks. Munger fielded the question: "It's a territory that I think has some promise." Buffett interrupted saying, "That's wildly bullish. I'm gonna go out and buy that stuff as soon as we get out of here."

Buffett told the crowd pharmaceutical stocks will be a safe investment over time, but it's difficult to analyze their pipelines and pick individual winners. He prefers a shotgun approach, buying a pool of pharma stocks and holding them forever.

Buffett doesn't think small investors should buy Berkshire Hathaway stock. He thinks he'll be lucky to grow the business 7% to 10% in the future (versus 22% a year in the past). Due to Berkshire's size, it's difficult to find companies large enough to make a difference in the bottom line. Buffett estimated a company would have to be $50 billion or larger to generate a reasonable return, and outperformance is difficult when investing in a universe that small. Buffett said if a small investor is willing to look at thousands of companies, he'd find more attractive businesses than Berkshire.

Someone asked the question, if Buffett had three sets of financial statements, and knew nothing of the underlying businesses, what would he look for? Buffett said investing that way is impossible, "You should ask yourself do you know enough about the business so the financials can show you what you're looking for. Unless you know the nature of the business, the financials are worthless."

Porter comment: Although I agree with Buffett's sentiment, reading financial statements (income statement, balance sheet, cash flow statement) and understanding them is absolutely critical for investors. How many professional musicians have no idea how to read music? Yet most investors (and most newsletter writers) don't have a clue when it comes to financial statements. This boggles my mind.

As a training exercise with our young analysts, I will often pull up three different companies' financial statements and ask the analyst to describe what's going on in the businesses and if they look like good investments – without telling the analyst the companies' names or even what sector they're in. It's a great exercise to see just how much information you can get from financial statements.

Looking only at the financial statements I can rule out 90% of the stocks I'm considering in any given month. I can tell if the management team is any good, and if it's a business I would consider owning. Whether to buy or not requires more thinking and knowledge – but knowing how to read financial statements saves me a tremendous amount of time, because I can quickly rule out so many companies.

Even the wealthy are stretching to borrow more money. Ian Peck, CEO of Art Capital Group, an art finance firm, reported a 30% increase in lending against artworks since the beginning of 2008. Peck hasn't seen any defaults and said the borrowers are using the cash for non-art investments.

Last week, Jeff Clark told S&A Short Report readers that Motorola's chart was "the best-looking chart in the market right now." But Jeff was the only one bullish on Motorola's prospects. The company's stock was down 50% from its 2007 high. It is trying to break itself into pieces and recently missed earnings estimates. Jeff went long Motorola, and now his readers are sitting on a one-week, 70% gain. Now Jeff is setting up two trades in another unloved sector: oil refiners. To read more about the Short Report and receive Jeff's two oil refiner trades, click here...

New highs: Aracruz Celulose (ARA), Covidien (COV), StatoilHydro (STO).

In the mailbag... A valuable lesson you should have to learn the hard way: don't enter your trailing stops in the market. Plus, a classic response to our most recent letter from the "chairman" of GM. Send your rants. We promise to read them: feedback@stansberryresearch.com.

"I bought several stocks on your recommendations. One was Keyera at around 20 with a stop below that. A few days ago, the stock dropped briefly to 3 – that's right – $3 per share. This took out my stop. Of course there were some shenanigans going on!!! I would like you to round up all your readers that have been similarly hit, and together we can demand from the market maker, the SEC or whoever will listen, that we be put back in the stock with no loss. Because you advised us to buy the stock (and I did buy it after my own due diligence), you have some responsibility here. It would at least give you a lot of brownie points to lead the charge in not allowing this nonsense to occur and get us back our losses." – Paid-up subscriber Phil Kennedy

Dyson comment: I just looked at the chart of this stock's pink sheet listing. You can see the spike down from $20 to $3 and then right back again. The market makers can do crazy things because the pink sheets have no liquidity. That's why we recommend you avoid pink-sheet listings. It's best to buy foreign stocks on the local market through an experienced foreign broker. In our newsletters, we provide contact information for several foreign-stock brokers our readers have found to be reliable.

Porter comment: Never, ever tell your broker your stop-loss points. Keep your trading strategies to yourself. If you tell your broker, he will likely enter your stops as limit orders on electronic trading systems. Then all the market makers have to do is sell a few shares right at your stops. That triggers your limit orders, and presto, you're taken out of the stock at a loss. Yes, it's fraudulent trading. But good luck getting the SEC – or anyone else – to help you.

"I don't like someone on your team pretending to be in charge of GM. thus feeling they have the right to express there personal opinion on a stock. Besides it makes no sence. Every person (really) in charge pretends that their outlook is better – even though it may not be – because the longer the sit in the catbird seat, the more free money they will gain. And when the party is over, they know it first. So port, please tell us more about the convention you are at, (which we are paying for), and stop pretending that you could ever get a seat as CEO of the largest company in this country. We don't like paying to hear what are your daydreams. We want to know what you glean from the warren." – Paid-up subscriber anonymous

"Porter's GM letters are superlative." – Doug Casey

Porter comment: Some subscribers don't understand why I harp on GM. In the last three years alone, the company has added more than $11 billion in additional debt. It lost more than $20 billion in cash from operations – not including any of the noncash charges. It cannot reliably earn enough money selling cars to pay the interest on its bonds. It has been technically bankrupt for at least the last three years – it simply isn't insolvent yet. Any responsible management team would have declared bankruptcy a long time ago and used the court-granted protection from creditors to re-organize the business, renegotiate with the unions, and save something of its shareholders' equity. But GM seems to be in a permanent state of denial. As long as it buys enough advertising, as long as it's generating huge fees for Wall Street, and as long as its union employees continue to vote for the right political leaders, no one will do anything to actually serve the company's owners.

GM is like a huge dead whale that's feeding an entire village of scavengers. It's truly a national shame. I'm disgusted by what I see happening. By writing those satirical letters, I'm hoping to draw a lot of attention to the matter. (GM is also a perfect metaphor for what's wrong with our country in general, where everyone expects to live at the expense of someone else.)

"Listening to the replies to your observations of the Politico's I was bemused by the responses. I am a truckdriver by depression, I mean profession. Want to talk about stupid? I'll let everyone mull that one over. America think. Politics can make you or break you in many ways depending upon which side of the curve you are on. For those so encased in their closed minds slow and stop for a minute... Think, again I say think. The answer should come to you..." – Paid-up subscriber James Schmidt

"If anyone wishes to understand why no politician will dare to attempt to fix the failing social welfare culture we have so dutifully constructed in American over the last 75 years, all one must do is read the hostile attacks directed at you when you merely suggest the current system is immoral. Your opinions obviously have no ability to affect the continued existence of these programs, yet you are vilified by your readers, who, one would like to think, represent a class more informed than the average citizen, for even suggesting that they represent a fraud upon the very populous which defends them so vociferously. How could anyone expect a politician, dependant upon re-election for his only means of support, to undertake such a task? It is far easier to appease the mob by passing out the booty stolen from the producers of society than to explain the ugly truth of our current state of affairs resulting from multiple generations of fiscal irresponsibility. As it so seems for General Motors, it begins to seem for our entire country, that the 'death spiral' is imminent. Shame on you for pointing out the facts." – Paid-up subscriber Ken McGaha

Porter comment: Our founding fathers rightfully feared the devolution of their limited republican government into the kind of unlimited democracy we have today for this very reason... The moment your neighbors discover they can plunder your wealth and restrict your liberties through the ballot box, you have ceased to be a free man.

Regards,

Porter Stansberry

Baltimore, Maryland

May 5, 2008

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