Discussion in 'Trading' started by Wallace, May 19, 2007.
Buffet trading spreadsheet via aaii.com
this thread title is ironic. Buffet doesn't trade, he buys stocks like a private equity firm, he buys them because of fundamentals and long term financial/cashflow growth, he has no intention of selling a investment.
No need to trade the buffet way when you can just buy an ETF like DDm and make money doing nothing
actually buffett does trade. here's a little article i did with james altucher who studied buffet, publishing the definitive book on buffet's trading tactics, enjoy!
This Week, I spoke with James Altucher who wrote the just-released book, Trade Like Warren Buffett. It's the definitive treatise on the sage's methods, tactics and techniques. The book reveals many little-known facts on Buffett's trading and investing style. This interview will explore the "Buffett trading system" through the eyes of the book's author. Let's get started!
Dave: Thanks for joining me today, James.
James: Dave, once again, I appreciate the opportunity to be here.
Dave: When I first saw the title of your new book, Trade Like Warren Buffett, I was a little surprised. As far as I knew, Warren Buffett is a long-term value investor, not a trader. This is common knowledge shared by everyone I spoke to about this interview. Is this a misconception? Does Warren Buffett actually trade?
James: Warren Buffett has been actively trading and investing now for over fifty years. If you look at all of his transactions during that time, very few are of the "buy and hold forever" variety. Buffett has made his money with merger arbitrage, distressed debt trading, fixed income arbitrage, commodities, trading liquidations, fading severe down moves, etc.
Dave: Sounds like Buffett is actually one of the most experienced traders/ investors living today. Fifty years of experience! Not many of us can make this claim.
James: You are correct. I don't think there are 10 people living today with as much experience as Buffett.
Dave: How exactly did Buffett get his start in the markets?
James: It's a hard question to answer because I don't think there was ever a period in his life when he wasn't in the markets, except maybe when he was five years old. However, he started the Buffett Partnership in 1957 and that ran for 12 years to 1969 when he unwound that and decided to focus on Berkshire Hathaway.
Dave: Was Buffett's hedge fund in the 1960's one of the original "hedge funds"?
James: Absolutely. Guys like Soros, Steinhardt, Julian Robertson and others who brought fame and fortune to the hedge fund world didn't get their start until much later.
Dave: What was the performance of this fund?
James: He returned 29% per year over this time.
Dave: Wow, that is impressive. What tactics did this early hedge fund utilize to make these huge profits?
James: He divided his hedge fund transactions into three categories: Workouts, Generals, and Controls. Workouts were usually merger arbitrage situations, spinoffs, reorganizations, etc. What is usually categorized as "event-driven investing" now. In any given year, more than 50% of the profits of his fund could come from the workouts category. In his 1963 letter to the investors in his hedge fund (not to be confused with the letters he later sent out on behalf of Berkshire Hathaway, which can be found on the Berkshire website) he wrote, when referring to Workouts, "the predictability coupled with a short holding period, produces quite decent annual rates of return." This, in a nutshell, is really his stance on short-term trading. Controls were usually stocks that were trading below their liquidation value that Buffett would go in and buy enough shares so that he would either control the company or be able to have enough influence to force either a partial or full liquidation. Examples in the Control arena include Dempster Mining or Sanborn Map, which I describe in more detail in my book. Generals were usually Controls that got "promoted" into long-term value holdings. The best example, of course, being Berkshire Hathaway, a little textile company he initially bought because it was trading below liquidation value, and which he later transformed into a rollup of insurance companies and other financial institutions like regional banks.
Dave: You mention that the tactic known as "value investing" has changed dramatically since Buffett first started using it. How is value investing different today than it was back then?
James: Well, value investing in the Graham-Dodd sense is somewhat rare today. Graham, and later Buffett, would dig for stocks trading significantly below their liquidation values with the idea that at the very least, you can get your money back by selling off the assets of the company. This gives the investor a significant margin of safety. Today, with the Internet, plus thousands of hedge funds competing for decent plays, it's much harder for any investor to find similar plays that have such a margin of safety. Value investing now is really a conglomeration of all the skill sets that Buffett has sewn together during his 50 years of investing, from arbitrage, to understanding the margin of safety inherent within the transaction.
Dave: Obviously, Buffett is no longer a hedge fund manager. How and why did he make the transition from hedge fundee to insurance companies and asset allocator?
James: Well, we say he is no longer a hedge fund manager but in some sense I disagree. What is a hedge fund? Forget about the word "hedge" for a second since so few hedge funds actually hedge their investments. A hedge fund is really a private partnership where the manager of the fund is taking a percentage of the profits. In the Buffett Partnership, Buffett was paid (quite deservedly) 25% of the profits. In his current situation, Buffett and the shareholders of Berkshire Hathaway, are paid 100% of the profits. An insurance company has remarkably similar characteristics to a hedge fund, except the economics are better. "Investors" put money in (usually every month) in the form of insurance premium and very rarely take money out (only in cases of sickness, death, or whatever other triggers the insurance depends on). The manager of the insurance company gets to allocate the money as he sees fit, and then the insurance company basically keeps all of the profits if the cost of float is zero, something which Buffett has been able to do year after year. I think Buffett realized that the timing was right (the potential downslide of the markets in the â70s) for him to unwind his partnership and move to a vehicle that still allowed him to play asset allocator but gave him better economics.
Dave: I never looked at it that way. There is a strong similarity between insurance companies and hedge funds. Very insightful! Stepping back into Buffett's trading style, what are his seven primary methods?
James: Liquidation/deep value investing, distressed debt, merger arbitrage, PIPEs, closed-end fund arbitrage (similar to his liquidation investing), commodities/currencies (more recently), fixed income arbitrage, demographic investing.
Dave: Which one of these best defines "the Buffett style"?
James: Ultimately, he really only has one style. He looks for situations where there is a predictable payoff and if that payoff does not occur, then he has a "back door." A great example being Arcata, in the â80s. This was a KKR-driven merger arbitrage situation that Buffett bought into. The merger didn't go through, but Buffett also had a "back door" â he was buying in below what his calculations of liquidation value were, and that eventually paid off. In almost every situation, Buffett has a back door to his investment if the initial premise doesn't work.
Dave: The back door escape route seems to be a recurring theme in all of Buffett's trades. He gives himself an out in case his original premise is wrong. This is something that the average trader should take to heart. Moving on here, Buffett is a disciple of Benjamin Graham and Phil Fisher. Most of us know what Benjamin Graham teaches in his famous book "Security Analysis." However, Phil Fisher is largely unknown. What does he advocate?
James: Phil Fisher wrote the investment classic, "Common Stocks and Uncommon Profits." He mostly advocates having a focused portfolio where you can really dig for information on the components of the portfolio. He calls this digging part, "scuttlebutt." His point is that you can only really know a lot about a few things and that too much diversification essentially âdumbs down' your portfolio and reduces your profits. Graham, on the other hand, felt that you couldn't ever really know the full story on a stock so you had to depend on the numbers (the liquidation value) and heavy diversification to diversify away the ones where you were possibly incorrect on your calculation of liquidation value. Both sides are essentially correct and its really a matter of personality, or as Buffett has been able to do, figure out how to combine them.
Dave: That seems contradictory to me. How can one combine Fisher and Graham? They are saying the opposite thing.
James: He really did combine them by taking the best elements of both: the focused part of Fisher's and the "margin of safety" aspect of Graham's.
Dave: Did Buffett personally know Graham or did he just read his book?
James: Buffett studied under Graham at Columbia and then worked for Graham's company for several years. I'm kind of jealous of the sheer consistency throughout all of Buffett's career. The people he worked with at Graham's company in the 1950s became his investment associates and comrades over the next 50 years. To have such a career is a remarkable achievement.
Dave: Let's take several of Buffett's primary investing styles and talk about the main points of each, starting with equities. What are the primary factors Buffet looks at when choosing a stock to purchase?
James: He'll look at demographics, liquidation value, quality of management, consistent return on equity. The most important thing, though, is he constantly asks himself what if his initial premise is wrong and what his possible exit is in that case.
Dave: You mention that Buffett believes that future cash flows are more important than PE ratios when choosing stocks. How can one determine the future cash flow? It seems nearly impossible.
James: It is impossible. This is why, for his personal portfolio (which I talk about in the book) he focuses more on liquidation value of companies. However, for companies like Coca-Cola or Gillette, you can look at larger demographics (3 billion people shave ever day, 2 billion drink soft drinks every day, etc) and determine that even if there is a small blip in earnings that the overall trend is intact. However, this is also why he requires additional margin of safety just in case his views on earnings don't bear out. A great example being Gillette. He didn't simply buy that stock long on the open market. He worked out a private deal with Gillette, a PIPE, whereby he bought convertible debt directly from the company paying an 8.75% coupon. So basically he got paid while waiting for the stock to go up and if the stock never went up he knew that at the end of the duration of the bond he would get paid back in full if he never converted.
Dave: Merger arbitrage is another one of Buffett's techniques. What is merger arbitrage?
James: Merger arbitrage is the idea that when stock XYZ announces it is getting acquired for $10 it will often trade lower than the purchase price before the deal is consummated. Buying the stock when it is trading lower than the purchase price and then selling the stock to the acquirer when the deal closes is a simple example of merger arbitrage at work. Why would a company trade lower than the purchase price? If people are unsure the deal is going to go through, if it's a hostile deal (making it less likely the deal is going through), if interest rates are high (meaning holding for the spread does not present the risk/reward picture that bonds do), and a variety of other factors. Buffett has often attributed much of the profits from his hedge fund days, and even some of the Berkshire years (like 1989), to arbitrage.
Dave: Does merger arbitrage still work? Do traders still use this tactic?
James: It does. There are public funds out there like The Arbitrage Fund (run by John Orrico, who is interviewed in the book) that have continued to have success with this strategy. However, due to the amount of players in the space, and the quick dissemination of information, its become much more difficult.
Dave: PIPES are another one of Buffett's techniques. The first time I heard this term was when you mentioned it above. Please explain PIPES a little deeper.
James: A PIPE is a private investment in public equity. For instance, if a company needs to raise money quickly and does not want to go to the secondary process they will often sell shares to hedge funds or mutual funds directly at a discount to where there stock is trading.
Dave: Exactly how does Buffet use PIPES?
James: Buffett's investment in Gillette was a great example. Gillette was losing market share to Bic and various hostile takeover guys were circling around like vultures. Gillette approached Buffett as a white knight. He bought a significant piece through a PIPE which was basically convertible debt paying 8.75%, convertible at a slight premium to where the stock was trading then. Buffett saw that Gillette would never have cash flow issues so he would always get his coupon and principal back IN THE WORST CASE, and in the best case he converts and makes a lot of money on the stock, which is what happened. He's played PIPES on over a dozen situations, most of which I outlined in the book.
Dave: This seems to have lots of the "margin of safety" criteria he adheres to. Am I correct? Do PIPES have the safety Buffett craves?
James: PIPES have a huge margin of safety, perhaps more than any other market mechanism. He often gets convertible debt, paying a high interest rate, and convertible into stock at a price he thinks is decent for the company. It's a low-risk situation for him.
Dave: You mention that Buffett's personal portfolio is more in tune with the trades he would have done while running a hedge fund than the behemoth Berkshire-Hathaway. What are several of his current holdings?
James: Since these positions are very small for him we don't always know at any given moment what his precise holdings are, but we do know, based on SEC filings, what his various personal holdings have been outside of the Berkshire Hathaway portfolio. These include stocks such as Laser Mortgage, MGI Properties, Bell Industries, and others.
Dave: I really like the way you delve into 10 seemingly disasters in the US markets, starting with Germany's invasion of Poland and ending with 9.11.2001. Is it after these dramatic occurrences that Buffett makes his best purchases?
James: Not necessarily, but 9/11 is a great example where he was publicly saying if you were a holder of US stocks on 9/10 then you should be on 9/12. We don't know if he was specifically going in the market then but my guess is yes. We do know that after the oil embargo in 1974 he was a heavy buyer.
Dave: It seems to me that this is the best way for the average trader to trade like Buffett. To basically, using history as a guide, buy into the market immediately after a severe pullback. Do you agree with this, why or why not?
James: I think all his techniques are possible. There are many ways right now to trade like Buffett but certainly buying after major disasters has historically proven to be a good time to buy value.
Dave: Thank you for joining me today, James.
James: Thanks again for having me. Buffett is a fascinating topic and I can talk all day about him!
It's interesting how this article not once mentioned that Buffet made a great deal of his money by trading options on his stock holdings that he almost never sells.
Maybe my information is wrong but with the kind of tremendous
stock holdings he has, I can see him making lots of money
trading the options strategies on them.
If you ever wondered why he buys stocks and holds them
seemingly forever (even if the stocks drop in price) then the
use of option strategies on these holdings would explain
why he can afford to hold stocks for so long.
Think about it.
Regarding options, Buffet recently also was cited borrowing out common to other brokers so they can offer it to their clients for short selling. Apparently some hedge fund wanted to short USG back when they were in deeper trouble and Buffet happily borrowed out the stock and collected a few % annually while the stock climbed higher and eventually got it back when the client covered his position at a loss.
I think buffet is very fortunate person. For example the insurance company where money come to him for little reason