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Lessons from Warren Buffett - XLI...

Jun 5, 2008

In the previous article, we saw why Warren Buffett would much prefer an environment of lower prices of equities than a higher one. We would now have a look on what the master has to offer in his 1999* letter to shareholders. Taking leaf from history
If gold in the 1970s and the Japanese stock markets in the 1980s was one's ticket to becoming a millionaire, then one wouldn't have gone too wrong investing in tech stocks or to be more specific, the NASDAQ in the 1990s. Not surprisingly then, investors who did not have a single tech stock in their portfolios would have had a high probability of lagging the overall markets. The master's aversion to tech stocks is now legendary and he too was caught at the wrong end of the tech stick. While he did reasonably well in the earlier part of the 90s decade, in the year 1999, the numbers finally caught up with him and he recorded, what he himself termed the worst absolute performance of his tenure. It was not as if Warren Buffett made some big mistakes but some of the businesses that his investment vehicle operated had a disappointing year and the problem got magnified because of the great success stories elsewhere, notably the tech sector.

Tomorrow at 5pm: Get the details of India's #1 defence stock

It is seldom that investors of caliber of Buffett go wrong and when they do, it does provide a lot of fodder for the media. Quite expectedly then, magazines and newspapers pounced on the story and titles like 'Has the Buffett era ended?' or 'What's wrong Mr. Buffett?' were not very uncommon to find. The master however refused to buckle under pressure and maybe followed the dictum of his mentor Benjamin Graham who had once famously said - "You're neither right nor wrong because other people agree with you. You're right because your facts are right and your reasoning is right-and that's the only thing that makes you right. And if your facts and reasoning are right, you don't have to worry about anybody else."

The master had reasoned that tech stocks did not come inside his circle of competence and he had hard time valuing them as he was not aware what such businesses would look like 5 to 10 years down the line. Investors can indeed draw one big lesson from this event. Regardless of the environment and the pressure one has, it always make sense to stick to one's circle of competence. Only those people who are able to do this on a consistent basis can increase their chances of earning attractive returns on their investments on a consistent basis.

And was the master proved right? Indeed! Other investors lapped up tech stocks on the premise that although they did not understand the business fully they would surely find another buyer to whom they will sell. Although this trend did last for a few years, when the bubble burst, it left a lot of financial destruction in its wake. The master surely had the last laugh.

While there have been a lot of theories floating around on the master's aversion to tech stocks, in the letter for the year 1999, he has laid out a few reasons on why he would not consider investing in tech stocks. Let us read the master's own words what he has to say on the issue.

Buffett in his own words
"Our problem - which we can't solve by studying up - is that we have no insights into which participants in the tech field possess a truly durable competitive advantage. Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in which Charlie (Buffett's business partner) and I have no special capital-allocation expertise. For instance, we bring nothing to the table when it comes to evaluating patents, manufacturing processes or geological prospects. So we simply don't get into judgments in those fields."

He further says, "If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries - and seem to have their claims validated by the behavior of the stock market - we neither envy nor emulate them. Instead, we just stick with what we understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for rationality. Fortunately, it's almost certain there will be opportunities from time to time for Berkshire to do well within the circle we've staked out."

* We have skipped Buffett's letter for the year 1998, as we believe it to be a little light on wisdom.

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