Warren Buffett is a risk-taker.
There, I said it. Sounds sacrilegious? Read on.
A lot of people think that Buffett’s modus operandi is simply to buy stocks at a discount, i.e. buy low, sell high. However, he doesn’t go on to explain why the stocks he buys sell at a discount to begin with. If you peel back his words a little, you’ll see that what he means when he says “buy low, sell high” is very different from what most people are thinking.
As a rule, the market is efficient enough. By that, I mean that while the stock market isn’t perfectly efficient, it is still efficient enough to rule out most opportunities for would-be investors. Try searching for a “value” stock in today’s market, for example, and you’d be hard pressed to find anything worth buying. So finding bargains in an efficient market entails taking on some risk, risk which subsequently has driven a stock’s price down.
How does Buffett do it? How does he identify when to enter a stock at its low, while seemingly everyone else misses it?
You see, Warren Buffett is a risk-taker, plain and simple. Nearly all of his cornerstone investments has involved taking on some kind of risk that others weren’t comfortable taking. And it is by diving headfirst into risks that others are running away from, that he always gets the market timing right.
In other words, the reason why he is able to buy low, is because he is willing to take risks that others are not. Therefore, even in an efficient market, he is still able to buy low, because the market has priced in that risk which others are running away from. Makes sense?
In many of his major investments, he was simply willing to take risks that others were perhaps less willing to. (i.e. to buy when the stock price is low)
Let’s get a few examples, shall we? In his Coca-Cola investment, Buffett famously bought 7% of the company in 1987, citing the strong potential of co*ke to sell its soda to the growing global market. But why didn’t others see the same thing he saw? Well, what is missing from the story as it is commonly told is that when Buffett made his purchase, Coca-Cola was a very different company. Unlike the streamlined Coca-Cola focusing on selling exclusively soda that we know today, the company then was a conglomerate with many diverse sets of businesses, including at one point owning a news company and Columbia Pictures (the movie production company). It was these businesses that were faltering at that time, dragging both profits and the stock price down, and keeping most stockholders away. Buffett was simply willing to take the risk that management, in the form of Robert Goizueta (who Buffett knew well), would streamline the failing quasi-businesses of the conglomerate and focus on the growth potential of the soda business, and buy while other investors were selling (i.e. sending the stock price down).
Still not convinced? Consider Buffett’s purchase of GEICO in the 1970’s, which turned out to be a phenomenal investment for Buffett in the end. Most people are aware that Buffett made his entry into GEICO when the company was reeling from losses, due to a series of missteps made by previous management. It was only with the hiring of Jack Byrnes as CEO, that Buffett was willing to invest in GEICO at purportedly $2 a share.
Of course, we all know how that story turned out. GEICO has become enormously successful and has since become a cornerstone of Berkshire Hathaway. Yet how many people were willing to invest in the GEICO of the1970’s, when the company was almost bankrupt? The company had then seriously underestimated its liabilities for insurance payouts as a result of a protracted price war in selling insurance premiums, and the company was facing the very serious threat of bankruptcy. Even with Jack Byrne at the helm, GEICO’s recovery was no sure thing. For the stock to be selling at $2 a share then (in contrast to $55 a share 20 years later when Berkshire acquired the rest of GEICO), the market must have had some serious doubts about whether the company would survive. Buffett had to have some serious guts to be jumping into an investment which everyone else was doubting, and which could have ended up worth a fat zero. Here once again, it shows that he is a risk-taker when it counts.
Another example of Buffett’s affinity with risk is the story of how he bought into American Express during the Salad Oil scandal in 1963. Buffett famously bought 5% of the company during its death throes; in this case, the company was the victim of fraud – it had mistook a warehouse full of barrels of seawater for which it was taking as collateral for barrels of salad oil that was supposedly worth over $150 million at the time. American Express’s CEO at the time committed to making good the losses despite there being no legal obligation to do so, and the stock price promptly dropped 50%.
The story goes that Buffett made some checks of his own and realized that the salad oil scandal didn’t affect how well its traveler’s cheques were selling. On the strength of that fact, Buffett made his investment. Yet how many of us would have done the same? At the time, the scandal was supposedly to have cost American Express nearly half its enterprise value in losses, and the market rightfully saw it as a path to bankruptcy. Would we have been as steel-minded as Buffett in buying the shares while seemingly everyone else was selling them off? It’s here again that we see Buffett’s healthy appetite for risk.
One more example of Buffett being a risk-taker was his entry into Wells Fargo in 1989 and 1990. At the time, investors were flocking away from the bank due to the Californian real estate crisis which threatened to undermine the bank’s reserves. Again, in this case there was talk of potential bankruptcy despite the bank’s solid stature, such was the severity of the real estate crisis. But Buffett didn’t shy away from the risk; his contrarian style only shined more when he bought a nearly 10% ownership of the bank, at 5x earnings. As it turned out, it was a fabulous investment, with the investment returning more than 7x the performance of the S&P since Buffett entered it.
A more recent example of Buffett’s risk-taking is his purchase of Goldman Sachs stock in the depths of the 2008 financial crisis. Again, it’s easy to say with hindsight that it turned out to be a wonderful investment. But why weren’t investors buying in droves (but selling instead) when the share price was at its low? Most people would by now have forgotten the fear that gripped the markets when Buffett was buying – he was absolutely taking risks which others weren’t comfortable with at the time. Again, in this case there was talk about Goldman Sachs potentially going into bankruptcy (Lehman Brothers had just collapsed) around the time Buffett made his purchase. Buffett’s affinity for risk-taking once again turned out to be enormously profitable for him.
Of course, not all of Buffett’s investments were risky at the outset. Some were just genuinely good investments bought at a wonderful price, such as See’s Candies, Nebraska Furniture Mart, and Illinois National Bank & Trust Company. But when the going gets tough, we see clearly that Buffett doesn’t shy away from risk, instead possessing nerves of steel and plunging in when others are heading for the exit.
So what can we take home from all this? That Buffett was a risk-taker to the extreme, and that we too should plunge into risky situations with reckless abandon? Not necessarily. While Buffett’s risky investments were inherently risky, they all shared one similarity: having a margin of safety. He doesn’t enter risky investments simply because they are risky – for one can easily find thousands upon thousands of such types of companies everyday. He enters risky investments where there is a mispricing of risk – where the risk is measured and bearable, and where the risk of loss has been finely observed under a microscope and deemed acceptable to bear.
In other words, look for risky situations where the risk has been overestimated, and is being reflected in the share price as such. The market tends to throw the baby out with the bathwater, and many times good investments are those where the risk of something has been wildly taken out of context and the share price reflects more risk than inherently exists. But the point I’m trying to make is that one should make risk a focus, rather than return, and try to identify mispricings in risk rather than mispricings in return.
One thing I would like to impress on readers is not to shy away from risky investments! For in an efficient market like ours, there is no attractive share price without some degree of risk. The key is to identify whether the risk is acceptable or not. Every once in awhile, there’s an investment where the share price has cratered due to a certain risk materializing, but which hits all the right notes in all other respects. When such an investment shows itself, do some due diligence to see whether the risk is acceptable to bear. But don’t shy away from risky investments simply because of risk! As Buffett has shows us, it sometimes pays to take some risk in our investing career.
