What I Learned From the Investor Letter Warren Buffett wrote after the Financial Crisis
Insights from the world’s best during pure panic
Let’s go back to 2008 when the Financial Crisis was at its worst. What was one of the greatest investors of our time doing? What was he saying? I think that’s how you really learn who someone is — their actions and words in time of immense pressure.
I found that answer in Warren Buffett’s 2008 letter to investors.
Buffett’s 2008 letter is absolutely incredible. I think everyone should read it. But for those who don’t have time (it’s 25 pages long), I’ve highlighted 35 of the most important things to read. If you want all of my notes in a PDF, sign-up for my newsletter. I’ll email it to you in the next 48 hours. Let’s go and you can read the full letter here:
“In God we trust; all others pay cash.”
During the early 1950s, in small towns across America, this slogan was a friendly way of stores letting their customers know they did not take credit. In 2008, you wanted to be in a position to say this line.
“The U.S. — and much of the world — became trapped in a vicious negative-feedback cycle. Fear led to business contraction, and that in turn led to even greater fear.”
It is paradoxical, but a reality of markets. I think that this feedback cycle is actually under appreciated across markets. I also believe it works both ways. More negativity begets additional negativity. More positivity begets additional positivity. It’s why markets get euphoric, crashes go to ultimate despair, and how momentum works.
“Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21.5% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges.”
This is the one thing that’s made Buffett almost all of his money. If you don’t understand it yet, let me explain using a small anecdote I was once taught: unless a meteor hits or the entire world collapses, America is only going up.
“The real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497.”
The stock market has been the best game in town for over 100 years. Period.
“Charlie and I simply focus on four goals: 1. Maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash. 2. Widening the “moats” around our operating businesses that give them durable competitive advantages. 3. Acquiring and developing new and varied streams of earnings. 4. Expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.”
Write these 4 goals down. Read them again. If you run a business or want to learn anything about how Buffett operates as an owner, it’s all right here.
“Moreover, we are fortunate that Berkshire’s two most important businesses — our insurance and utility groups — produce earnings that are not correlated to those of the general economy. Both businesses delivered outstanding results in 2008 and have excellent prospects.”
People love to glorify Buffett his massive investments from Coca-Cola to Wells Fargo. But the reality is that he owns much more than that and his two most important assets are not correlated to the general economy– a boring insurance and utility company.
“I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.”
It’s the worst kind of mistake. Buffett and his partner Charlie Munger despise this error. What is it? It’s when they hear or see new facts and do nothing with that new information. That’s called an error of omission. When the facts change, you need to change your mind.
“Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
You just read the value investing bible explained in two sentences.
“Our long-avowed goal is to be the “buyer of choice” for businesses — particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin (though we prefer thick and thicker).”
The ethos of Buffett. Or in other words, when he looks to buy companies, he follows this code.
“Most buyers competing against us, however, follow a different path. For them, acquisitions are “merchandise.” Before the ink dries on their purchase contracts, these operators are contemplating “exit strategies.” We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.”
Here’s why Buffett believes his strategy for buying companies and partnering with them will always beat Wall Street and other competitors.
“This past year has retaught clients a crucial principle: A promise is no better than the person or institution making it.”
Don’t get fooled by what the promise is. No matter how good it is. Instead focus on who is making it.
“Ben Franklin once said, “It’s difficult for an empty sack to stand upright.”
Buffett using Ben Franklin to preach about character and good people.
“That certainly looks like a $2,000 cat to me” says the salesman who will receive a $3,000 commission if the loan goes through.”
A hack for life and business: always know the incentives of a salesmen. That will expose their true goal.
“Lenders happily made loans that borrowers couldn’t repay out of their incomes, and borrowers just as happily signed up to meet those payments. Both parties counted on “house-price appreciation” to make this otherwise impossible arrangement work.”
The next time someone asks you to explain the housing crisis, use this paragraph from Buffett.
“Homeowners who have made a meaningful down-payment — derived from savings and not from other borrowing — seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.”
The lesson here: don’t take excessive risk. One way to avoid that is not being tempted by credit.
“Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.”
I guess this is how Buffett would fix the mortgage system so 2008 never happens again. Just something to think about.
“Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.”
The interesting thing here, at least in my opinion, is how most people view their home as a place to make money. But is that the right way to think about a home? The answer to that question might remove risk and speculation from a massive purchase.
“Let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds — virtually all uninsured — were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution… Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.”
First of all, did you know NYC almost went bankrupt in the 1970s? Neither did I. The solution, to avoid bankruptcy, apparently involved a number of parties and people working together. Compare that to a situation were only one person or company would have been responsible. There’s a philosophical argument here in life and markets. I’m not sure where I stand on it but it’s interesting to think about.
“If merely looking up past financial data would tell you what the future holds, the Forbes 400 would consist of librarians.”
The best investments are not going to come from you ability to look into the past.
“Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols.”
When Kobe Bryant suffered his worst career injury, he said knowing exactly what was happening to his body at any given time was what helped him heal so fast. He wanted to study every aspect of the injury, and how the healing worked down to the cell. Likewise, no one should trust an algorithm or equation without knowing just what it means down to each symbol.
“I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.”
Does it get any better than Buffett beating himself up because of poor “timing”? Even the best are prone to regret and make mistakes.
“During 2008, I spent $244 million for shares of two Irish banks that appeared cheap to me. At yearend we wrote these holdings down to market: $27 million, for an 89% loss. Since then, the two stocks have declined even further. The tennis crowd would call my mistakes “unforced errors.”
I was in this situation once. I had a lot less capital. Like $243.99 million less. But as stocks started to bottom, I went out and bought the National Bank of Greece. There’s something about FOMO that’s make you do dumb things. You look for narratives to catch-up. “This could come back like Bank of America just in Greece!” I like to think Buffett thought the same but with Irish banks.
“We never want to count on the kindness of strangers in order to meet tomorrow’s obligations.”
A common theme throughout Buffett’s letter is his appreciation for his cash position and how much it means now in a time of panic. This line is another example.
“When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”
Never chase or compromise for anything. In stocks and in business.
“When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”
Pay attention here. Seriously. When Buffett wrote this about the “bond bubble” in late 2008, he was just dead wrong. Several years after he wrote this, we got to a point of zero and negative interest rates. The bond bubble only got bigger. Which leads to a quote I recently stumbled across from George Soros, “When I see a bubble forming, I rush in to buy, adding fuel to the fire. That is not irrational.”
“They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.”
The one downfall of cash is growth and inflation. Over time, for the last 100 years, the Dollar has been losing its purchasing power. You need to keep up with inflation.
“Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”
You don’t need to be fancy in markets. In-fact sometimes that is dangerous. It means you are chasing headlines and popularity. I was once told the stock market is the only game in town were being uncool and a loner are the best strategies.
“So indecipherable were Freddie and Fannie (derivatives) that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books.”
The lesson here, at least in my opinion, is don’t count on a third party to do your research. Do it yourself if you really want to take a stake in something.
“When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task.”
I love this line. It reminds me of the old trader adage “cut your losers fast and let your winners run.” When Buffett and Munger don’t like something, they cut it. End of story.
“Improved “transparency” — a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks — won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives.”
I’m not entirely sure what to make of this, but to me it sounds like Buffett was worried about derivatives at the time, and perhaps thinks they still could cause another problem today.
“When I read the pages of “disclosure” in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).”
A common wisdom of Buffett is staying within his circle of competence. Focus on what you know and stay away from what you don’t. Do that for the rest of your life and you’ll be okay.
“Only companies having problems that can infect the entire neighborhood — I won’t mention names — are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mind-boggling screw-ups that are required.”
Some of Buffett’s biggest investments were bailed out or aided by the Government. But still he saw the moral hazard of too big too fail. It’s also only fair to wonder if that simple phrase is still true today.
“To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 — down 10% — on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium — perhaps $100 million to $150 million — that we would be free to invest as we wish. Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future.”
The greatest trade of all-time no one is talking about. I plan on writing another post about this soon. I am floored. You should be too.
“For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. If, however — as an example — all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we would have held the $4.9 billion premium and earned investment income on it.”
Omg this trade is unreal. You just read a continuation of point 33. Everyone should be talking about this.
“The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.”
Buffett sometimes does use formulas. Equally amazing is that Buffett embraces options trading. Points 33–35 all demonstrate that. He is not just a long buy and hold investor. He trades options!
Like many investors, I spend a lot of my time reading and talking about Buffett. He’s a starting point for newbies and he’s a refreshing read for the pros. His 2008 letter, which I just happened to dig back up through curiosity, is easily one of the best investment letters I’ve ever read. The education of it alone is incredible. You are taking a trip through the mind of a great during a moment of financial panic.
Thanks for reading this post. If you enjoyed, subscribe to my email here and I’ll send you a PDF with my annotations and notes. As a bonus, I’ve copied and pasted one final segment from Buffett below. In this segment, which might be fairly complex for some, he walks you through his put option trade and what the math means to him.
“It’s often useful in testing a theory to push it to extremes. So let’s postulate that we sell a 100-year $1 billion put option on the S&P 500 at a strike price of 903 (the index’s level on 12/31/08). Using the implied volatility assumption for long-dated contracts that we do, and combining that with appropriate interest and dividend assumptions, we would find the “proper” Black-Scholes premium for this contract to be $2.5 million. To judge the rationality of that premium, we need to assess whether the S&P will be valued a century from now at less than today. Certainly the dollar will then be worth a small fraction of its present value (at only 2% inflation it will be worth roughly 14¢). So that will be a factor pushing the stated value of the index higher. Far more important, however, is that one hundred years of retained earnings will hugely increase the value of most of the companies in the index. In the 20th Century, the Dow-Jones Industrial Average increased by about 175-fold, mainly because of this retained-earnings factor. Considering everything, I believe the probability of a decline in the index over a one-hundred-year period to be far less than 1%. But let’s use that figure and also assume that the most likely decline — should one occur — is 50%. Under these assumptions, the mathematical expectation of loss on our contract would be $5 million ($1 billion X 1% X 50%). But if we had received our theoretical premium of $2.5 million up front, we would have only had to invest it at 0.7% compounded annually to cover this loss expectancy. Everything earned above that would have been profit. Would you like to borrow money for 100 years at a 0.7% rate? Let’s look at my example from a worst-case standpoint. Remember that 99% of the time we would pay nothing if my assumptions are correct. But even in the worst case among the remaining 1% of possibilities — that is, one assuming a total loss of $1 billion — our borrowing cost would come to only 6.2%. Clearly, either my assumptions are crazy or the formula is inappropriate. The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probability weighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)”