Following Buffett’s bargains

Global markets might be crashing, but veteran investor Warren Buffett isn’t worried – he’s already snapping up bargains. JAMES THOMSON looks at how Buffett has profited from the the last two big sharemarket crashes and examines his latest moves.

By James Thomson

Global markets might be crashing, but veteran investor Warren Buffett isn’t worried – he’s already snapping up bargains. 

We look at how Buffett has profited from the the last two big sharemarket crashes and examine his latest moves.

When the great Warren Buffett waded into the market last month to buy big stakes in investment bank Goldman Sachs and conglomerate GE, many saw it as a sign that the market had finally reached the bottom.

Those predictions turned out to be wide of the mark. Since the start of October, shares in Buffett’s investment vehicle Berkshire Hathaway have slumped 17.6%, which is actually a little worse than the 17% fall in the Dow Jones Industrial Average. The value of Buffett’s stake in Berkshire Hathaway – he owns around a third of the company’s Class A shares – has fallen from $U63 billion to around $US53 billion.

But Berkshire Hathaway shareholders aren’t likely to be complaining too loudly. In the last five years, Berkshire Hathaway’s Class A shares have risen 45%, while the Dow has slumped 8%.

So while Buffett’s GE and Goldman Sachs purchases may not have instantly turned global markets around, investors around the world will be watching his every move closely over the coming months. And with good reason – Buffett’s ability to find bargains among the rubble of a market crash is extraordinary.

At the Berkshire Hathaway shareholders meeting in 1986, Buffett lamented his ability to find bargains. “There’s nothing we could see buying even if it went down 10%,” he told investors. By the next year, the market had crashed 30%; and Buffett started buying.

Actually, his buying started just before the crash of October 1987, when Berkshire came to the rescue of struggling investment bank Salomon by buying $US700 million worth of convertible shares. It wasn’t an easy deal and it took almost a decade for Buffett to make big money, after Salomon was embroiled was in a bond trading scandal and Buffett ended up running the company for a few years. But eventually it paid off. In 1997, when Salomon was sold to Travelers for $US9 billion, Buffet’s $US700 million investment was worth $US1.7 billion.

Another preferred share deal Buffett did in 1989 was the purchase of an 11% stake in shaving products giant Gillette for around $US600 million. That company was purchased by Proctor & Gamble in 2005; Berkshire Hathaway’s original stake (it has since bought more P&G shares) is currently worth just under $US6 billion.

Buffet’s other biggest post-crash purchase was large stake in Coca-Cola. In 1988, he spent $US1 billion buying 6.2% of the company; at the time, it represented 35% of Berkshire’s entire common-stock portfolio. In the last 20 years, the value of Coca-Cola’s stock has increased 12-fold from around $US3.45 (adjusted for share splits) to around $US44. No wonder Coca-Cola remains the biggest stock in Berkshire’s portfolio.

The next big sharemarket crash occurred in early 2000, when the dot-com bubble burst spectacularly. Buffett had copped a criticism from some analysts in the years before the crash, claiming he had missed the boat. But Buffett believed the extraordinary returns technology stocks were delivering had blinded many investors.

“After a heady experience of that kind,” he said, “normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities… will eventually bring on pumpkins and mice.

“The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them.”

So instead of sinking money into shares, Buffett went on a private business buying spree in 2000, acquiring a string of decidedly old-economy companies including Cort Business Services, which rents furniture to businesses; US Liability, an insurance company; boot and bricks maker Justin Industries; carpeting manufacturer Shaw Industries; Benjamin Moore Paint; and Johns Manville, an insulation and roofing-products maker.

Judging the success of these private businesses is not as easy as calculating the difference between a few share prices, but Berkshire Hathaway’s 2007 annual report shows revenue from its manufacturing, services and retailing operations increased from $US48 billion in 2005 to $US59 billion in 2007, with profit climbing from $US1.6 billion to $US2.4 billion – not a bad for traditionally low-growth sectors operating in a low-growth economy.

Buffett’s new Goldman Sachs and GE deals are rightly seen as masterful pieces of bargain hunting in the current crash.

The Goldman deal is particularly brilliant. For Berkshire’s initial $US5 billion investment, Buffett has negotiated a 10% annual dividend, paying out a healthy $US500 million a year. In addition, Berkshire Hathaway received warrants to buy $US5 billion in Goldman Sachs common shares at a strike price of $US115 that can be exercised at any time over the next five years.

That means Berkshire can buy the shares at $US115. If Goldman managed to get back to $US165 – the price on 1 September – then the potential profit from his warrants would soar to some $US2.1 billion.

But these are only two most recent deals. For the past 18 months, Buffett has been on a buying spree. In 2007 Berkshire Hathaway bought a whopping $US19.1 billion worth of stocks, including Kraft Foods, Wells Fargo and Johnson & Johnson.

In March this year, Berkshire spent $US4.5 billion on diversified manufacturing and services company, Marmon Holdings. In April, Buffett supplied Mars with $US6.5 billion to help the candy company acquire Wrigley. In July, Berkshire put $US3 billion into Dow Chemical’s $US15.4 billion takeover of Rohm & Haas and also bought shares in NRG Energy, industrial products company Ingersoll-Rand and French drugmaker Sanofi-Aventis.

Buffett explained his buying spree this way: “It’s nice to have a lot of money, but you know, you don’t want to keep it around forever. I prefer buying things. Otherwise, it’s a little like saving sex for your old age.”

What’s particularly interesting about Buffett’s buying spree is that with the exception of the Goldman and GE deals, most of these purchases were made well before shares prices really crashed in late September and early October.

There are two possible theories here:

• Did Buffett get the timing of his buying spree wrong and fail to pick the bottom? Is the great man fallible?
• Or was Buffett convinced he was buying bargains as early as 2007? In which case, could the buying spree be read as a sign that Buffett is reasonably optimistic markets can rebound after this period of instability?

Time will tell, but few will be willing to bet against Buffett coming out on top.