Last week saw the official release of a large trove of documents related to the U.S. government’s investigation of the causes of the 2007-09 financial crisis. The documents are a great pool of learning material for investors who would like to gain a deeper understanding of what had transpired before, during, and after the crisis. The financial crisis was a painful time for investors around the world. In Singapore, the Straits Times Index (SGX: ^STI) fell by over 60% from peak-to-trough during that period. Blue chip companies such as United Overseas Bank Ltd (SGX: U11), Singapore Telecommunications Limited (SGX: Z74),…
Last week saw the official release of a large trove of documents related to the U.S. government’s investigation of the causes of the 2007-09 financial crisis. The documents are a great pool of learning material for investors who would like to gain a deeper understanding of what had transpired before, during, and after the crisis.
The financial crisis was a painful time for investors around the world. In Singapore, the Straits Times Index (SGX: ^STI) fell by over 60% from peak-to-trough during that period. Blue chip companies such as United Overseas Bank Ltd (SGX: U11), Singapore Telecommunications Limited (SGX: Z74), and Singapore Press Holdings Limited (SGX: T39) – all stalwarts of Singapore’s business landscape – saw their shares fall by at least 40% from top to bottom.
One of the documents that was released was a 2010 interview that the Financial Crisis Inquiry Commission had with billionaire investor Warren Buffett.
It’s hard to disagree with the statement that Buffett’s one of the best investors in the world today. Since he assumed control of Berkshire Hathaway in 1965, the company’s book value per share (a proxy for its true economic worth) has grown by an astounding compound annual rate of 19.2% as of 2015. And, that had happened largely because of Buffett’s skill in using Berkshire’s funds to invest in the stock market and acquire great businesses.
Buffett’s accomplishments make his views and thoughts about the world of finance well worth learning. The interview with the FCIC is over 103 pages long but it is a wonderful read. I’ve picked out my favourite – and what I think are the most important – parts. They are all Buffett’s exact quotes.
On spotting a great investment:
“And basically, the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.”
On the causes of a bubble:
“[T]he only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise and –- it’s quite interesting how that develops –- originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action.”
More on the causes of a bubble (emphasis mine):
“[W]hat my former boss, Ben Graham, made an observation, 50 or so years ago to me that it really stuck in my mind and now I’ve seen evidence of it.
He said, “You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”
If you have some premise that the moon is made of green cheese or something, it’s ridiculous on its face. If you come out with a premise that common stocks have done better than bonds — and I wrote about this in Fortune article in 2001 — because there was a famous little book in 2001 by Edgar Lawrence Smith –- in 1924 by Edgar Lawrence Smith that made a study of common stocks versus bonds.
And it showed -– he started out with the idea that bonds would over-perform during deflation and common stocks would over-perform during inflation. He went back and studied a whole bunch of periods and, lo and behold, his original hypothesis was wrong. He found that common stock always over-performed. And he started thinking about that and why was that.
Well, it was because there was a retained earnings factor. They sold –- the dividend yield on stocks was the same as the yield on bonds, and on top of it, you had retained earnings. So they over-performed. That became the underlying bulwark for the ‘29 bubble. People thought stocks were starting to be wonderful and they forgot the limitations of the original premise, which was that if stocks were yielding the same as bonds, that they had this going…
…So after a while, the original premise, which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over.”
On detecting danger signs in financial institutions:
“Well, I didn’t know that they weren’t going to be good investments, but I was concerned about the management at both Freddie Mac and Fannie Mae, although our holdings were concentrated in Fannie Mac.
They were trying to – and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort. And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know?
I mean, it isn’t given to man to be able to run a financial institution where different interest-rate scenarios will prevail on all of that so as to produce kind of smooth, regular earnings from a very large base to start with; and so if people are thinking that way, they are going to do things, maybe in accounting – as it turns out to be the case in both Freddie and Fannie – but also in operations that I would regard as unsound.”
On the difference between investing and speculating:
“It’s a tricky definition. You know, it’s like pornography, and that famous quote on that. But I look at it in terms of the intent of the person engaging in the transaction, and an investment operation -– though, it’s not the way Graham defines it in his book, but investment operation in my view is one where you look to the asset itself to determine your decision to lay out some money now to get some more money back later on.
So you look to the apartment house, you look to the stock, you look to the farm, in terms of what that will produce. And you don’t really care whether there is a quote on it at all. You are basically committing some funds now to get more funds later on, through the operation of the asset.
Speculation, I would define as much more focused on the price action of the stock, particularly that you, or the index future, or something of the sort. Because you are not really –you are counting on — for whatever factors, because you think quarterly earnings are going to be up or it’s going to split, or whatever it may be, or increase the dividend — but you are not looking to the asset itself.”
On the dangers of leverage (or using borrowed money):
“Anything that increased leverage significantly tends to make — it can’t even create a crisis, but it would tend to accentuate any crisis that occurs.
I think you that if Lehman had been less leveraged, there would have been less problem in the way of problems. And part of that leverage arose from the use of derivatives, and part of the — part of the dislocation that took place afterwards arose from that.”
More on the dangers of leverage:
“But it gets down to leverage overall. I mean, if you don’t have leverage, you don’t get in trouble. That’s the only way a smart person can go broke, basically. And I’ve always said, “If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it.””
On the dangers of financial derivatives:
“And if I read a 10 K that’s 300 pages long and it describes notional values and all this — not to impugn anybody because probably one of the best managed, really large institutions around — but if I look at JPMorgan, I see two trillion of receivables, two trillion of payables, a trillion seven netted off on each side; of the 300 billion remaining, maybe 200 billion collateralized.
But that’s all fine, but I don’t know what these continuities are going to do to those numbers overnight. If there’s a major nuclear, chemical, or biological terrorist action that really is disruptive of the whole financial system here, who the hell knows what happens to those numbers on both sides or thousands of counterparties around?
So I don’t think it’s — I think it’s virtually unmanageable. It certainly is –- it would be for me.”
On the causes of the housing crisis that brought forth the 2008 financial crisis:
“Well, I think the primary cause was an almost universal belief, among everybody — and I don’t ascribe particular blame to any part of it — whether it’s Congress, media, regulators, homeowners, mortgage bankers, Wall Street — everybody — that houses prices would go up. And you apply that to a $22 trillion asset class, that’s leveraged up, in many cases. And when that goes wrong, you’re going to have all kinds of consequences.
And it’s going to hit not only the people that did the unsound things, but to some extent the people that did the semi sound, and then finally the sound things, even, if it is allowed to gather enough momentum of its own on the downside, the same kind of momentum it had on the upside.
I think contributing to that — or causing the bubble to pop even louder, and maybe even to blow it up some, was improper incentives — systems and leverage. I mean, those — but they will contribute to almost any bubble that you have, you know, whether it’s the Internet or anything else.
The incentive systems during the Internet, you know, were terrible. I mean, you just — you formed a company, and you said, “I’m going to somehow deliver a billion eyeballs,” and somebody says, “Well, that’s $50 apiece,” or something. I mean, you get craziness that goes on there.
Leverage was not as much a factor in a bubble. But I think in this particular bubble, because leverage is so much a part of real estate, that once you loosened up on that, you’ve provided fuel that caused that bubble to get even bigger, and you made the pop even bigger, when it finally did pop.”
Here’s the link for Buffett’s interview again. Go on and take a look. It’d be great – trust me.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway.