Recession, Panicking Investors, Stock Market Freefall… What Is Warren Buffett Doing?

October 13th, 2008

Warren Buffett, the chairman of the Omaha-based holding company Berkshire Hathaway, is famous for both his spectacular investment acumen and his common-sense approach to choosing stocks. He also is, according to Forbes Magazine, the richest person in the world, with an estimated fortune of $62 billion. Buffett’s business empire is invested in insurance (GEICO, General Re), jewelry (Borsheim’s), utilities (MidAmerican Energy), and food (Dairy Queen, See’s Candles). The holding company also has non-controlling stakes in Anheuser-Busch, Coca-Cola, and Wells Fargo. It’s not surprising then that some (including yours truly) consider him as the smartest stock picker in history.

That being said, I’ve been watching the economy lately. We’re in a recession. The bursting of the real estate bubble and ensuing financial crisis are taking a heavy toll on businesses in all sectors. Insurance giants have been brought to their knees. Banks have failed or been bought out. Investors have been panicking and selling in droves, causing severe drops in the stock market. Jobs are scarce. Gas prices are still high. In a nutshell, things are pretty grim.

Where am I going with this, you might be asking yourself? Well I recently came across a Warren Buffett quote, taken from one of his letters to shareholders in Berkshire Hathaway’s annual reports. It goes like this (emphasis in bold is ours):

The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

As I read this, three of Warren Buffett’s well-known investing principles came to my mind:

Ignore the stock market. It’s reported that Warren Buffett doesn’t have a stock quote machine in his office. Judging by his company’s performance, he seems to be doing just fine without it. His reasoning is that if you plan on owning shares in an outstanding business for a number of years, what happens in the market on a day-to-day basis is pretty much irrelevant.

Don’t worry about the economy. Stop discussing and debating whether the economy is poised for growth, or tilting toward a recession. Buffett dedicates no time or energy to analyzing the economy.

Buy a business, not a stock. Consider first if the business is easy to understand. Then determine if it has a consistent operating history and favorable long-term prospects. What about its management? Is it rational, candid with shareholders, and able to avoid the herd mentality? Look at the financials, focusing on return on equity, not on earnings per share. Buffett seeks out companies that generate cash in excess of their needs and companies with high profit margins, which reflect not only a strong business but a management with a tenacious spirit for controlling costs. Other financials to look at: retained earnings, estimated cash flows, and the value of a business. Once you have determined the value of a business, the next step is to look at the stock price. Buffett’s rule is to buy the business only when the stock price is at a significant discount to its value. Note that only at this final step does Buffett look at the stock’s price.

Based on this, I could only come to one conclusion. Warren Buffett and other savvy investors are, as of right now, positioning themselves to take advantage of the current fire sale in the stock market. They’re certainly analyzing financial data, looking for sound businesses whose stocks are battered by the current bear market but whose businesses are sound, strong and profitable, making them excellent candidates for strong long-term growth.

Savvy investors don’t follow the herd: they have a game plan. And that’s exactly why they’re successful.