How Not to Invest

THE DOW INDUSTRIALS ROSE more than 120 points to their highest level in more than six years as traders weighed nonfarm payrolls data and Warren Buffett’s next move.

—Wall Street Journal Online

That was the explanation for Friday’s market rally on the WSJ online edition during the late afternoon.

The Journal may have been right about the reasoning behind the rally, but buying stocks based on Warren Buffett’s purported acquisition plans is a heck of a lousy way to invest.

While Buffett did indeed make a “move”—announced yesterday at his shareholder’s meeting—it was not what those traders were looking for. Instead of a nice, big, juicy, all-cash deal at a huge premium for one of those thirty Dow Jones Industrial companies, Berkshire Hathaway announced it is taking an 80% stake in an Israeli metalworking company.

Worse, for those traders at least, Buffett told the faithful at his shareholder meeting that he remains bearish on the U.S. Dollar and is more interested in making new investments outside the U.S. as opposed to in.

Meaning that a $15 billion acquisition, which Buffett also disclosed he is working on and appears to be the anticipated deal everybody was front-running on Friday, is certainly not likely to be any one of the 30 components of the Dow Jones Industrial Average that was bought in anticipation of Buffett’s “move,” nor even a NASDAQ-listed company.

In any event, the notion of buying stocks because Warren Buffett is looking to make a large acquisition is one of the least appealing reasons to invest that I can fathom, although buying a stock that might appeal to Warren Buffett–say, for its high return on equity, business “moat,” excess cash flow and simple operating model–is certainly one of the best. Those Friday traders might want to consider that Buffett recently sold a large market “put” with a reported maximum notional exposure of $14 billion—meaning that if the indices covered by the put contracts fall to zero in the next 15 to 20 years, Berkshire would lose $14 billion.

While it might look on the surface that Buffett’s huge sale of market puts with a 15 to 20-year time horizon represents a positive bet on the trend in equity prices—after all, he loses money only if the market goes down—it is actually a brilliant way to accomplish what Buffett most fervently wishes for: the ability use Berkshire’s $40 billion cash hoard to buy stocks at drastically reduced prices.

If the market goes up, the puts Buffett has sold expire worthless, and he’s had the use of that cash for many years, at no cost to Berkshire.

If, on the other hand, the market collapses, Berkshire will be “put” a large basket of stocks at dramatically lower prices, and Buffett will have put his cash hoard to work at the kind of prices he has been waiting patiently for.

Either way, Buffett wins in a big way.

Which is more than you can say for most of the traders speculating on whatever Warren Buffett might announce at his weekend shareholder meeting.

Jeff Matthews I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.