StreetTalk: Investing The Buffett Way

It's summer and the living is easy if you don't mind heat, insects, and thunderstorms. The biopharm indexes are listless, because August and September are notorious for inactivity in the various life sciences stock market indexes. Earnings announcements taper off and life sciences companies keep their gunpowder dry by holding off new announcements until after Labor Day. As of mid-July, the American Biotech Index (Symbol: BTK) has leveled off at the tail end of a year of unbridled growth. If history is any indication, the autumn months will see another rise from the 550 or so levels we're now seeing in the BTK.

Brian O'Connell

So let's chart a different course with this month's edition of StreetTalk. I've been reading up on Wall Street legend Warren Buffett lately and his story – especially his views on investing – is worth telling in an otherwise quiet stock trading period. As investors, we can learn a great deal about true stock-picking. So pull up a chair while I tell the tale of the Sage of Omaha.

A MONEY TREE GROWS IN OMAHA

Warren Buffett's story is quintessentially American. He is by most counts the second richest man in America (the wealthiest is Bill Gates) with a fortune estimated by Forbes Magazine at more than $44 billion. He is the only US billionaire to have made his money entirely through investing, and today, along with Alan Greenspan and Paul Volcker, the current and former chairmen of the Federal Reserve, he is arguably the most respected voice of financial America.

His natural habitat is not Wall Street or Washington, but the unpretentious midwest heartlands. To investors across the globe Buffett is also known as the Sage of Omaha. This title derives from the pleasant, but largely unremarkable, Nebraska city on the banks of the Missouri River where he was born and raised, where he made his fortune, and where he lives to this day, in the same gray stucco house he bought for $31,500 in 1956.

Buffett is the best-known Nebraskan on earth, a gray-haired, no-nonsense Man of the Heartland who has been triumphantly and repeatedly vindicated by financial market events. He is not so much a financial institution as a national institution, and has become the object of a cult that attracts 14,000 or so people to Omaha every May for Berkshire Hathaway's annual meeting. Buffett himself has called the occasion the "Woodstock of Capitalism." Some people buy a Berkshire Hathaway share just to attend. This is not as small a matter as it sounds, for old-fashioned Warren has never been one for fancy devices such as stock splits, and a single share of Berkshire Hathaway stock can cost over $80,000.

Buffett's investment strategy is an interesting one. And learning it is a useful exercise for any investor — in the biopharmaceutical market or elsewhere. Let me elaborate. Buffett is careful and cautious, and he places a huge premium on solid, well-run companies (more on that in a moment) that produce steady profits and good shareholder value.

But it wasn't so long ago that the so-called "experts" on Wall Street were laughing at Warren Buffett, mocking his cautious, carefully measured methodology of investing. To the self-proclaimed gurus, Buffett's take on things seemed out of tune. They said the rules of the game had changed, and he just didn't get it. "Warren Buffett should say, 'I'm sorry,'" fumed Harry Newton, publisher of Technology Investor Magazine, in early 2000. "How did he miss the silicon, wireless, DSL, cable, and biotech revolutions?" That was when AOL stock rose six-fold, and Amazon.com rocketed by 1,000 percent in a year, while shares in Berkshire Hathaway, the investment company Buffett built from virtually pennies, climbed — only 11 percent.

But the Buffett Way won out in the end, as the dot-com bubble exploded, leaving millions of Americans with huge holes in their investment portfolios and more than a few "experts" with egg on their faces. Right now, these experts would kill for 11 percent investment returns. But wise old Warren ("a life long technophobe" as he confesses on the Berkshire Hathaway website) stuck with boring blue chips like Gillette, Coca-Cola, and American Express, saying he couldn't understand these newfangled companies.

What did Buffett know that the dot-com geniuses didn't? Buffett and his partner, Charles Munger, began looking closely at dot-com company valuation sheets and came away convinced there was more folly than fortune in all those celebrated "new economy" companies. Instead, they returned to the grounds they had tilled before and knew so well — value stocks. They invested in companies like Procter & Gamble that made products people actually used.

It is hardly necessary to point out that this was during the age of irrational exuberance, when the Nasdaq was flying and Berkshire's stock was flopping. While the experts considered Buffett's fixation on value (and values too) old hat, the Sage proved them all wrong. But now Berkshire Hathaway is an old hat that lots of people would like to try on to see if it fits, just like Cinderella's glass slipper.

DIGGING UP CIGAR BUTTS

One of Buffett's mentors was the great Benjamin Graham, the author of The Intelligent Investor (Harper & Row, NY, 1973). Graham's strategy was to search for what he called "cigar butt" companies, no longer of interest to the market and thus undervalued, but which still had a few puffs of life in them. In 1962 Buffett found one — a runned-down Massachusetts textile concern called Berkshire Hathaway. He poured its modest cash flow and profits into other businesses, notably insurance.

It was a stroke of genius. Insurance companies intrinsically may not be hugely profitable, but they have a "float," up-front premium payments from policyholders from which claims are only settled later. The cash pile grew during the early 1970s Wall Street bear market. Buffett used the money to buy stakes in other companies at bargain prices, and the Berkshire Hathaway phenomenon was born.

But the Buffett way isn't only about unearthing value. He's a big believer in corporate leadership, too. To truly understand what Warren Buffett looks for when making his decisions about where to invest his money, first look at the CEOs of the Berkshire family of companies.

The heads of the 37 subsidiaries share similar personality traits. Buffett says he seeks three character traits: integrity, energy, and intelligence, in that order. He also has written that "if a CEO doesn't have the first trait, the other two will kill you and the business."

Buffett also insists that the CEOs of the companies in his portfolio run their companies as they did before he acquired them. He asks only that they follow his management philosophy, which Robert Hagstrom, senior vice president at the Baltimore financial services firm Legg Mason and author of The Essential Buffett (John Wiley and Sons, NY, 2001) and The Warren Buffett Way (Wiley, 1994), sums up as "acting rationally about capital allocation, being candid at all times, and resisting the lemming tendency of companies to imitate one another for no good reason."

In the end, Buffett's investment philosophy is also attractively simple. He believes that investors should be buying a business, not simply a stock. Buffett's annual report is nothing if not readable — quite famously so — and is perhaps the best window into the way Buffett's mind works.

His 2003 annual report contained what is probably as clear a one-paragraph summary of Buffett's investment philosophy as can ever be stated: "Whenever we buy common stocks...we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts — not as market analysts, not as macroeconomic analysts, and not even as security analysts."

This is a good lesson for investors looking to make some money in biopharm stocks. Many times, success is not the result of the hot trend or the big patent breakthrough. More often, it is the quality of the people who are running the companies and the quality of the ideas they bring to the table. After that, it is hanging onto the company stock for dear life. Because, as Buffett has proven time and again, once you latch onto a winner, ride it for all it's worth.

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