Warren Buffett on Contrarianism

This outcome is made more certain by the dramatically lower interest rates that now exist throughout the world. The investment portfolios of almost all P/C companies – though not those of Berkshire – are heavily concentrated in bonds. As these high-yielding legacy investments mature and are replaced by bonds yielding a pittance, earnings from float will steadily fall. For that reason, and others as well, it’s a good bet that industry results over the next ten years will fall short of those recorded in the past decade, particularly in the case of companies that specialize in reinsurance. Nevertheless, I very much like our own prospects. Berkshire’s unrivaled financial strength allows us far more flexibility in investing than that generally available to P/C companies. The many alternatives available to us are always an advantage; occasionally, they offer us major opportunities. When others are constrained, our choices expand. Moreover, our P/C companies have an excellent underwriting record. Berkshire has now operated at an underwriting profit for 14 consecutive years, our pre-tax gain for the period having totaled $28 billion. That record is no accident: Disciplined risk evaluation is the daily focus of all of our insurance managers, who know that while float is valuable, its benefits can be drowned by poor underwriting results. All insurers give that message lip service. At Berkshire it is a religion, Old Testament style. So how does our float affect intrinsic value?

At the 2009 annual meeting, six months into the recovery from the March 2009 lows, I was asked whether the worst was over. I told the audience that I did not know whether the economy had bottomed, and that I did not need to know. What I knew was that the prices being offered for wonderful American businesses were still attractive, and that the long-run returns from buying wonderful businesses at attractive prices were very high. The market-psychology point I tried to convey was that the investor who waits for the all-clear signal from the economists will miss the move. By the time the economists agree that the recession is over, the market has already moved. The discipline required is to buy when the headlines are still terrifying and the outlook is still unclear, and to hold on through the volatility that always accompanies the early phase of a recovery. That discipline is far harder to apply than to describe. The mistakes-and-learning discussion at the 2009 meeting was, as always, my favourite part. I told the audience that the biggest mistake I had made during the crisis was selling too early. I had bought ConocoPhillips at high prices as oil was crashing, when I should have waited for oil to fall further. I had also bought some Irish bank bonds that turned out to be worth less than I paid, and I had paid too much for a stake in two Irish banks. The lesson I tried to convey was that even the disciplined investor makes mistakes during a crisis, because the speed of the price collapse tempts even the patient buyer to act before the prices have fully adjusted. The correction is to size positions conservatively, to average in over time, and to be honest with oneself about which mistakes were process errors and which were simply bad luck. The contrarianism lesson of 2009 is the one I have tried hardest to teach. The investor who bought during the March 2009 lows, when the headlines were predicting the end of capitalism, made returns of several hundred percent over the next decade. The investor who sold during the March 2009 lows, who panicked and went to cash, has still not recovered the purchasing power he gave up. The difference between the two outcomes is not intelligence; it is temperament. The investor with the temperament to buy when the world is ending, and to hold on through the early volatility, will outperform the investor with the higher IQ who panics at the bottom. That is the single most important lesson I have learned in six decades of investing, and it is the lesson I have repeated most often to the students who visit Omaha each spring. Temperament, more than intelligence, determines the long-run return.

In October 2008, with the world's financial system apparently collapsing, I wrote an op-ed for the New York Times titled Buy American. I Am. The headline was not a slogan; it was a description of what I was actually doing with my personal account. I was buying American stocks. The rule that guided me was simple, and I had learned it from Graham decades earlier: be fearful when others are greedy, and be greedy when others are fearful. In the autumn of 2008, fear was at a level I had rarely seen. The S&P 500 had fallen by more than forty percent from its peak, and most observers believed the decline was only beginning. My view was the opposite: the panic had made wonderful businesses available at prices that, in normal times, would have been unthinkable. The pessimism was so thick that even strong, well-capitalised companies were being dumped at distress prices. What I wrote in the op-ed, and what I still believe, is that the long-term outlook for American business was not as bad as the prices implied. The simple rule is that stocks, over time, will outperform cash, because businesses earn a return on capital and cash earns nothing after inflation. During a panic, the market prices stocks as if cash is the only safe asset, and that pricing is almost always wrong. I did not claim to know where the bottom would be. I have never known where the bottom will be, and I never will. What I claimed was that buying a slice of America's future at a marked-down price was the rational bet, made repeatedly over many months, and that the long-run outcome would reward the investor who was willing to look foolish in the short run while he was buying what others were panic-selling. The market-psychology lesson is the most important one. Most investors, when they see the market fall, conclude that the world is ending and they sell at the worst possible moment. The few who hold on are, paradoxically, often the ones who never look at their statements during the panic. The investor who buys when the headlines are terrifying, and who refuses to sell when his neighbours are panicking, has an enormous long-run advantage over the investor who waits for clarity. Clarity, I wrote in 2008, is what kills long-run returns, because by the time the outlook is clear, the prices have already moved. The patience lesson is the simplest one in investing and the hardest to apply: do nothing when the market is calm, do nothing when the market is euphoric, but buy aggressively when the market is in a panic. That is what I was doing in October 2008.

At the Berkshire annual meeting in May 2008, the financial crisis was already underway but had not yet reached its climax. I told the audience that the credit cycle had turned, that the easy money that had fuelled the housing bubble was gone, and that the unwind would take years rather than months. The mistakes that had been made during the boom were the standard ones: lenders had underwritten loans on the assumption that house prices would keep rising, ratings agencies had stamped triple-A on bonds whose underlying collateral was suspect, and investors had bought those bonds on the assumption that the ratings agencies knew what they were doing. The cycle had taught me, once again, that credit is a pendulum. It swings from abundant to scarce with a violence that surprises everyone who had grown comfortable during the easy phase. The investor who survives the swing is the one who has positioned his balance sheet for the scarce phase before it arrives. The contrarianism angle was the one that mattered most. I told the meeting that the worst time to sell a stock was during the panic phase of a credit cycle, and the best time to buy was during the same panic. Most investors, however, do the opposite: they buy during the easy phase because prices are rising, and they sell during the scarce phase because prices are falling. The investor who can invert that pattern, who can buy when the headlines are terrifying and refuse to sell when his neighbours are panicking, has an enormous long-run advantage. I had been buying throughout the crisis, both for Berkshire and for my personal account. The reason was simple: the prices being offered for wonderful businesses were absurdly low, and the long-run returns from buying wonderful businesses at low prices are very high. The discipline required was patience, and the resource required was a balance sheet strong enough to absorb short-term paper losses without being forced to sell. The credit-cycles lesson I have repeated most often is that the pendulum always swings back. The credit cycle does not end in scarcity; it ends in abundance, when lenders, having forgotten the losses of the previous scarcity, begin lending freely again to borrowers who cannot repay. The investor who recognises this pattern, and who positions his portfolio for the next phase of the cycle rather than for the current phase, has an enormous advantage over the investor who assumes the current phase will continue forever. The 2008 crisis was, in this sense, no different from the 1990 savings-and-loan crisis, the 1998 Long-Term Capital Management crisis, or the 2000 dot-com unwind. The names of the assets change; the underlying psychology does not. The investor who memorises that single observation, and who acts on it with patience and a strong balance sheet, will outperform the elaborate risk-management models of the largest banks in nearly every cycle.

We do know that it would be a huge mistake to bet that evolving atmospheric changes are benign in their implications for insurers. Don’t think, however, that we have lost our taste for risk. We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk. We are not willing, though, to take on even very small exposures at prices that don’t reflect our evaluation of loss probabilities. Appropriate prices don’t guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses. Rates have recently fallen because a flood of capital has entered the super-cat field. We have therefore sharply reduced our wind exposures. Our behavior here parallels that which we employ in financial markets: Be fearful when others are greedy, and be greedy when others are fearful. Lloyd’s, Equitas and Retroactive Reinsurance Last year – we are getting now to Equitas – Berkshire agreed to enter into a huge retroactive reinsurance contract, a policy that protects an insurer against losses that have already happened, but whose cost is not yet known. I’ll give you details of the agreement shortly. But let’s first take a journey through insurance history, following the route that led to our deal. Our tale begins around 1688, when Edward Lloyd opened a small coffee house in London.

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful. Sector Results As managers, Charlie and I want to give our owners the financial information and commentary we would wish to receive if our roles were reversed. To do this with both clarity and reasonable brevity becomes more difficult as Berkshire’s scope widens.

The most common cause of low prices is pessimism - some times pervasive, some times 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. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do." * * * * * * * * * * * * Our other major portfolio change last year was large additions to our holdings of RJR Nabisco bonds, securities that we first bought in late 1989. At yearend 1990 we had $440 million invested in these securities, an amount that approximated market value. (As I write this, however, their market value has risen by more than $150 million.) Just as buying into the banking business is unusual for us, so is the purchase of below-investment-grade bonds. But opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare. Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly.

We follow a price-based-on-exposure, not-on-competition policy because it makes sense for our shareholders. But we're happy to report that it is also pro-social. This policy means that we are always available, given prices that we believe are adequate, to write huge volumes of almost any type of property- casualty insurance. Many other insurers follow an in-and-out approach. When they are "out" - because of mounting losses, capital inadequacy, or whatever - we are available. Of course, when others are panting to do business we are also available - but at such times we often find ourselves priced above the market. In effect, we supply insurance buyers and brokers with a large reservoir of standby capacity.

What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

In May 1984, at Columbia Business School, I gave a speech called The Superinvestors of Graham-and-Doddsville in honour of the fiftieth anniversary of Graham and Dodd's Security Analysis. The speech was a defence of value investing against the academic claim that the market was efficient and that no investor could, in aggregate, outperform. The argument I made was that a group of investors, all of whom had been trained in the same value-investing tradition, and none of whom had access to non-public information, had produced long-run records that, taken together, were extremely unlikely to have occurred by chance. The group included Walter Schloss, Tom Knapp, Bill Ruane, Charlie Munger, Stan Perlmeter, and Rick Guerin. Each had compounded capital at rates well above the market over periods of one to two decades, and each had done so with portfolios that bore very little resemblance to the market index. The market-psychology point was that the value tradition gave each of them a temperamental advantage that the efficient-market hypothesis could not model. The contrarianism angle was the most important part. Each of the superinvestors had, at one time or another, held substantial cash because the prices being offered for the businesses they understood did not meet their standards. None of them had felt pressure to be fully invested at all times, and none of them had felt pressure to mimic the holdings of the index. The market-psychology point I tried to convey was that the discipline of refusing to buy when the prices were not attractive, and of holding cash while waiting for attractive prices, was the single most important differentiator between the value tradition and the index tradition. The value investor, by waiting for his pitch, had a long-run advantage over the index investor, who was forced to be fully invested at all times, regardless of the prices being offered. The moat that protected the value investor's returns was a temperamental moat, not a business moat. The moats lesson I tried to add to Graham's framework was that the businesses the superinvestors owned were, in many cases, businesses with durable competitive advantages. Charlie Munger had been the most articulate advocate of the shift from cigar-butt investing toward wonderful-businesses-with-moats investing. The shift had produced, in Charlie's record, returns even higher than those of the other superinvestors, and the reason was that the wonderful businesses had compounded their earnings at higher rates than the cigar butts, and the compounding had, over decades, dwarfed the entry-price advantage. The market-psychology lesson was that the investor who recognised both the temperamental advantage and the moats advantage, who combined the patience to wait for his pitch with the judgment to recognise a wonderful business, had the best of both worlds. That single insight, applied over a working life, had produced the long-run records of the superinvestors, and it was the lesson I most wanted to convey to the students who had gathered at Columbia that spring.