How Buffett Played Amazon — Wow, Amazing…

Everyone knows who Warren Buffett is these days. It is hard to stay off the radar when you are one of the richest people in the world and have been for decades.

Today Buffett is still chairman and CEO of Berkshire Hathaway, which has a $400 billion-plus market capitalization and is the fourth-largest company in the United States.

Unlike all of the other large companies, which these days are mainly technology based, this one is built entirely on the investing acumen of one person, the “Oracle of Omaha” himself…

Today Buffett manages within Berkshire an investment portfolio that holds nearly $130 billion in assets. The sheer size of that portfolio is a significant drag on Buffett’s investment performance.

To really understand how great this man is as an investor, you need to revisit what he was able to do in his prime. Back when he was managing a smaller amount of money, before Buffett was a household name…

To do that we need to turn the clock back, way back to 1957. This was when Buffett launched the Buffett Partnership, the investment fund he ran for just over a decade.

The table below shows the performance he put up over this time in comparison with the Dow Jones industrial average.

It is absurdly good. Almost unbelievably so.

Compounding cash at over 30 percent annualized

From 1957–1968 the Buffett Partnership generated annualized returns (before fees) of 31.6%. He beat the Dow Jones by 22.5% per year, which is ridiculous.

If you had given Buffett $10,000 to invest in 1957, he would have turned it into nearly $275,000 at the end of just 12 years. It may be the greatest run of investing the world has ever experienced.

Buffett’s Secret — The Market Is There to Serve You

The thought process behind Buffett’s investing success is amazingly simple.

It is really built on one thing.

The man is an incredibly rational thinker all of the time. He does not let emotion cloud his investment decisions… ever.

Every time Buffett buys or sells, it is because of rational decision-making. That rational disposition is a powerful weapon to use to take advantage of Buffett’s business companion “Mr. Market.”

Who is Mr. Market?

That is who Buffett views the market that he is trading in every day as being. Mr. Market is an individual who comes to Buffett each and every day and offers to buy and sell securities at a specific price.

Buffett describes Mr. Market as being an extremely emotional gentleman.

On certain days he is absolutely euphoric and is willing to pay unusually high prices for certain securities. On other days Mr. Market is extremely depressed and the price he is willing to pay for certain securities is very low.

Mr. Market comes each and every day without fail. You never have to do any business with him unless you want to. That makes him the perfect trading companion.

Most of the time, Buffett says that he ignores Mr. Market because he doesn’t find the prices he is offering for securities interesting. That is when Mr. Market is feeling calm.

It is when Mr. Market starts getting emotional that Buffett pays attention and takes advantage.

When Mr. Market is in a happy mood and is willing to pay very high prices for securities, Buffett is a seller. At those times, Mr. Market is feeling too good and is willing to overpay.

When Mr. Market is depressed and is quoting extremely low prices for securities, Buffett is an eager buyer. Buying when Mr. Market is down in the dumps is how Buffett lays the groundwork for his outperformance.

The Bigger Your Toolbox, the More Markets You Have to Exploit

The beautiful thing about Buffett’s investment approach is that it works on every kind of market.

Every market experiences price swings that are driven by emotion and not rational, analytical thinking. We have seen it in the housing market, the equity market, the currency market and the bond market.

Those emotional price swings are there for us as investors to exploit.

It goes without saying, then, that the more types of markets you are able to invest in, the more opportunity you have to exploit the emotions of Mr. Market.

That is good, because sometimes Mr. Market goes long stretches between times he is feeling depressed and offering up bargain opportunities. It has, for example, been a long time since the U.S. equity markets went through a significant down stretch.

Buffett has always been willing to jump to whatever market is offering opportunities. He has invested in almost every type of market over the course of his career. His first choice has always been the stock market, of course, but he has also bought real estate, a farm, commodities, derivatives, currencies and, yes, our beloved bonds.

In 2001 and 2002 Buffett specifically found Mr. Market offering up terrific opportunities in high-yield bonds.

Here is what he said in the 2002 Berkshire Hathaway annual letter to investors…

Investing in junk bonds and investing in stocks are alike in certain ways: Both activities require us to make a price-value calculation and also to scan hundreds of securities to find the very few that have attractive reward/risk ratios.

Last year we were able to make sensible investments in a few “junk” bonds and loans. Overall, our commitments in this sector sextupled, reaching $8.3 billion by year-end.

He makes it all sound so simple, and to him I suppose it is. Mr. Market became depressed about high-yield bonds, and Buffett was more than happy to take advantage.

In reality, though, this was a big commitment by Buffett to high-yield bonds. The $8.3 billion investment represented just under a quarter of Berkshire’s portfolio at that time.

As you would expect, the investment worked out extremely well for Buffett. High-yield bonds that he purchased in companies such as Amazon for as little as 57 cents on the dollar generated some large capital gains as well as interest income.

Last year Mr. Market provided us with a wonderful opportunity to buy high-yield bonds of certain oil and gas producers. He will give us other opportunities again in the future.

By having exposure to high-yield bonds, we can be like Buffett and expand the markets that we invest in so that we have more chances to exploit Mr. Market.

That is, after all, what he is there for.

Keep looking through the windshield,

Jody Chudley

Jody Chudley
Credit Analyst, Contract Income Alert

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