Warren Buffett's bubble cash-out strategy revealed in 38-year-old letter
A letter from the legendary investor written 38 years ago details his view on pension funds
Here is Warren Buffett's pension fund management advice in a nutshell: be patient, buy only a few things, ignore the stock market until it becomes irrationally optimistic, at which point sell.
A recently released 1975 letter from Buffett to Washington Post owner Katharine Graham on the subject offers new insight into how early Buffett was to grasp both the difficulties of pension fund management and the inability of Wall Street to provide adequate solutions.
Perhaps even more valuable is the way the letter throws light on Buffett's approach to value investing. Buffett tries to act not like a typical fund manager but like a company owner thinking about buying another company. The crucial ingredients: patience, to get a good purchase price; courage, to stick with your investment if the business is doing well but the market doesn't agree; and a willingness to sell into a bubble when, as so often happens, one comes along.
First, let's talk about Buffett's letter to Graham. It's a nice little story.
When Amazon.com founder Jeff Bezos bought the Washington Post for US$250 million earlier this month, he bought a lot of problems, but none of them had to do with pension funds. That's in large part because the Post was lucky enough to have Buffett as a board member, investor and adviser for many years, and smart enough to take his advice. The result: a pension fund with US$1.4 billion in obligations and US$2.4 billion in assets.
In 1975, not long after he had joined the board, Buffett sent Katharine Graham, then chairman and CEO, a 19-page private letter, recently published by Fortune magazine, outlining his concerns about pension fund problems and his approach to their solution.
It is well worth reading in its entirety, but in it he lays out exactly how grave, permanent and hard to keep are pension promises and - and this from a money manager - how difficult it is to find someone who can beat the market on your behalf.
"If above-average performance is to be their yardstick, the vast majority of investment managers must fail," Buffett writes.
"Will a few succeed due either to chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance just as would be the case if 1,000 'coin managers' engaged in a coin-flipping contest."
Buffett also points out that, while it may be possible that someone is good at securities selection in a sustainable way, and just about possible that you might be able to select him, that person will almost certainly be flooded with so much money that his ability to beat the market will be swamped.
Interestingly, it seems as if the Post's pension fund may have done well precisely because Buffett was able to pick winning managers. Here's Donald Graham, Katharine's son and successor, speaking in a presentation to investors in 2011:
"Kay Graham describes in personal history how in the late 1970s, Warren sent her an extensive memo about corporate pension funds, urging that we change from our then investors to two investors he recommended, who just knocked it out of the park for the ensuing 35 years."
All right for some, but what do the rest of us do? Having dispensed with index funds, active managers, star managers and bond-only strategies in the letter, Buffett goes on to outline what he says he favours: treating portfolio management decisions like business acquisition decisions.
The keys he cites here are taking a long view and buying not just because a company has good prospects or you think the market will drive its stock up, but because you rate the company highly.
Once you own shares, you need to treat them like a business owner rather than a securities investor. That means concentrating on how the business is doing longer term, rather than obsessing about how the stock market price is moving week to week.
Of course, this is something that Buffett, or Graham, can do but the average fund manager cannot. The average fund manager has to grapple with career risk - the risk that a period of underperformance gets her fired.
As for when to sell, Buffett advises to wait for the market to get frothy, referring to the "periodic tendency of the stock market to experience excesses".
It has been a good 38 years for bubbles since Buffett wrote his letter. To judge by his performance, he has taken full advantage of them.