StreetTalk: The Buffett Way 2006

Regular readers of this column know how I feel about Warren Buffett, often called the Sage of Omaha, NB. I wrote about Buffett last year and, after the mid-point of this year, would like to update you on what Wall Street's finest mind thinks about key investment matters of the day.

Brian O'Connell

The question Buffett gets asked most often is, "What is the secret to your investment success?" It doesn't matter if it's a biotech analyst or a junior high school math student with an online trading program; people want to know how he managed to accumulate $44 billion in investment profits.

Buffett answers this question the same way every time: the secret to investing is that there is no secret. "All there is to investing," he says, "is picking good stocks at good times and staying with them as long as they remain good companies."

Buffett has excelled over the past 40 years at the helm of Berkshire Hathaway, one of the most successful investment companies in the history of Wall Street. The $44 billion company is like a block of granite in an otherwise fragile investment environment. Astute investments in brand-name value plays like Coca-Cola, H&R Block, American Express, and Comcast have fueled Berkshire Hathaway's rise to the top of the global investment pile. Buffett's not much of a life sciences investor; he says he doesn't understand the complexities of the drug manufacturing and approval pipeline. He prefers solid, no-nonsense companies that offer investors the three things that Buffett prizes in his investment picks—steady growth, good management, and no surprises. Buffett's results speak for themselves.

Every May Berkshire shareholders descend on Omaha for the company's annual meeting. Berkshire Hathaway's annual meetings are almost mythical events, with a small army of Berkshire investors—and Buffett zealots—hanging on his every word. Investors began lining up for seats at 4 a.m. to get the best seats at the May 2006 general meeting.

The Berkshire road show is a staple for company investors. Berkshire investors still talk about 2002, when they saw a film of Warren Buffett playing a ukulele and singing, "When the NASDAQ's down, you'll never frown, Berkshire's here to stay."

Attendees were not disappointed this year. Buffett and long-time business partner Charles Munger held court for six hours, taking all questions and explaining why, among other trends, Berkshire Hathaway is looking overseas for value, and why the duo is still bearish on the US dollar.

STILL ALL ABOUT VALUE

When it comes to the Berkshire portfolio, some things never change. At the 2006 shareholder meeting, which drew 24,000 investors to Omaha, Buffett explained how he and Munger evaluate investment opportunities.

He told the audience that the pair rely on three metaphorical boxes: an 'In," an "Out," and a "Too Hard." Anything in the "Too Hard" box is dismissed. The "In"s are evaluated and, if they pass muster, they are pursued and purchased and moved into the "Out" box. "We zero in on things we know, like whether people will be buying more candy in five years," Buffett told the audience. "We don't play big trends. They just don't mean that much. There is too much money to be made year-to-year, rather than waiting for the big trends."

One big trend that I've studied extensively this past year is in commodities, especially gold and silver trading. But Buffett and Munger will have none of it, even if precious metals have posted huge gains in 2006. "We have failed to profit from one of the biggest commodity booms in history and will probably continue to fail in that way," said Munger in Omaha. Buffett agreed, saying that, sooner or later, their patience will pay off. "Being contrarian has no special value over being a trend follower. You are correct because the facts are right. In focusing on business and investment decisions, look for things that are important and knowable."

"[Remember] the market is there to serve us, not instruct us. It just tells us prices. If something is out of line, then you can do something about it—the critical part is how you handle that piece of information; how you play out your hand. Let the market serve you rather than instruct you and you can't miss."

This year, the investment tenets of Buffett and Co.—patience, integrity, and value, were on display in spades. This year Buffett had to deal with an excess of cash, an issue every year, but in 2006, Buffett had about $40 billion in cash on the table.

BUFFETT SHOPS THE GLOBE

Scouring the globe for a place to stash some of that money, Buffett found Iscar, an Israeli toolmaker that Berkshire purchased for $4 billion. Buffett told his audience in Omaha that there was one radical departure involved in the Iscar buy. "It's the first business we've purchased that's based outside the US," Buffett said. "I think we'll look back on this in five or ten years and see this as a very significant event in Berkshire's history."

But it's difficult to go overseas and to find good, inexpensive opportunities to turn Berkshire's unwieldy $130 billion market cap into significant profits for shareholders. Interest rates are still relatively low and don't offer much of a financial payoff for cash investments; the dollar is in decline (and will be for years to come, Buffett said).

Myriad moves by a growing number of hedge fund companies in America toward buying domestic companies make it hard to find good US companies at reasonable prices. Buffett prefers to buy small, publicly traded companies with ample room for growth. Hence, he moved overseas, with Israel as his first stop.

Iscar has its advantages. The company earns most of its cash in non-US dollar currencies, a fact that no doubt pleases the dollar-averse Buffett. With few hedge fund operators looking over his shoulders to outbid Buffett overseas, he was able to buy the company without a nettlesome bidding war and could put $4 billion in cash to work right away.

The Iscar move indicates a trend toward Berkshire buying into companies with solid global operations. Buffett amplified that notion when he bought into equally solid global firms like ConocoPhillips, General Electric, Wells Fargo, and United Parcel Service. Buffett has also purchased a big stake in Tesco PLC, a UK-based retailer. This fuels observations by analysts that Buffett is buying into companies that have great global prospects, hinging on his belief that massive US trade deficits will further weaken the dollar.

BACK TO BASICS?

While Iscar and Tesco represent a notable departure for Buffett and Berkshire, few Buffett followers believe that he's done with US companies. The buzz at the Omaha meeting was that Berkshire had its eyes set on two brand-name US companies: Harley-Davidson, Inc., and Mattel, Inc. Both satisfy Buffett's criteria of having a market value of $5 to $20 billion, according to a review by Bloomberg News.

As his investments in Coca-Cola and American Express attest, Buffett is a big fan of publicly traded US brands. Both Harley-Davidson and Mattel fit the bill nicely. "What he tends to stress is a long product life cycle and how enduring the brand is,'' David Braverman, a vice president at Standard & Poor's Portfolio Advisors in New York, told Bloomberg in May. "By that test, Harley-Davidson and Mattel make the cut.'' Braverman publishes a twice yearly "opportunities report" on companies he thinks Buffett will buy next. Both Harley-Davidson and Mattel are high up on his most recent list. Buffett has already purchased one brand name US company, sports-apparel maker Russell Athletic, for $600 million in cash.

In the annual report, Buffett says companies must have at least $75 million in pretax profit, consistent earnings, "good'' returns on equity, and "little or no debt'' to be considered. Valuations should be between $5 and $20 billion and company stocks must have a price-to-earnings ratio of 15 at a minimum. Companies on the Berkshire "In" list also must demonstrate steady earnings growth of 10% annually.

I see Berkshire continuing to hone in on value companies that possess solid global market prospects and that otherwise fit Buffett's traditional criteria.

Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, 79 Radcliffe Drive, Doylestown, PA 18901, 267.880.3144, fax 267.880.1939, brian.oco@verizon.net