A Subtle Investing Tip From Warren Buffett

For those of you who are aware of Warren Buffett’s long-time investment in Coca-Cola, you may know that he has turned a $1 billion investment in the late 1980s/early 1990s into 400,000,000 shares worth over $16 billion today, and that is not included a growing cash dividend that Buffett has received over the past 20+ years, which would make the returns on this investment substantially higher.

If you are a student of the dotcom stock market of the late 1990s, you may be aware of the absurd valuations placed on many companies, including large-cap blue chips that had moved well past their 20% annual growth days. In the case of Coca-Cola, the company traded at over 60x earnings for much of the 1998 calendar year. When a blue-chip stock that has a future earnings per share growth rate of around 10% gets investors willing to pay $60 for each dollar of profit instead of $20, you know you are heading towards trouble (because even if profits grow, you will get whacked by a justified drop in valuation as investors regain their sanity to pay about a third as much for Coca-Cola’s profits after the dotcom bubble as they were willing to pay during it).

Of course, Warren Buffett maintained his position in Coca-Cola stock throughout 1998. But what most people do not know is this: Buffett effectively “sold” some of his Coca-Cola stock by having Berkshire Hathaway purchase General Re in 1998. Check out this passage from Business Week in 1998, because it is one of the more insightful passages about Warren Buffett’s strategy compared to anything else I have read:

 “On June 19, Berkshire Hathaway Inc., Buffett’s investment vehicle, announced its biggest deal ever, buying General Re, America’s largest reinsurer, for about $22 billion in stock. In a bull market, it signals a remarkable redeployment of resources. In essence, Buffett, in buying Gen Re, is reducing his exposure to stocks. And he’s getting Gen Re’s $24.6 billion conservatively managed investment portfolio, which could come in handy in a downdraft. Artfully, Buffett is increasing his defensive posture without selling shares in the public market.

The key is that Berkshire, somewhat atypically, is paying with stock–issuing a stake of about 18% to Gen Re shareholders. And as Buffett has noted, buying with shares isn’t quite buying–it’s trading something you own for something else. For Gen Re, Buffett said at a press conference that he is giving up “an appreciable part” of everything he and other Berkshire shareholders own, including shares of such market highfliers as Coca-Cola Co.

What Buffett, a liquidity buff, may most relish about the deal is, well, all the liquidity it brings. Buffett gets both the low-cost cash generated by a good underwriter and a crack at managing General Re’s investments. Most of that portfolio is parked in municipal bonds and other fixed-income instruments. For now, that’s a hedge against stock market risk.”

Although Buffett held on to his Coca-Cola stake, he effectively sold it by issuing big blocks of Berkshire stock to fund the acquisition of General Re—he acquired a huge bond portfolio (to reduce his overall exposure to stock investments during the bubble) and effectively sold off a bit of everything he owned by diluting Berkshire to issue the stock to cover the transaction.

Obviously, most of us are not in a position to apply Buffett’s strategy to our own lives—most of us reading this are not in the position to buy companies outright with bond portfolios or issue stocks of corporations we control. But just because we cannot take Buffett’s advice literally does not mean that we cannot take “the spirit” of what Buffett is doing and apply it to our own lives.

One of the things you will notice is that Buffett does not reduce the positions in his core holdings (which now include Coca-Cola, American Express, Wells Fargo, and IBM). If they get overvalued, he simply collects the dividends and funnels the cash elsewhere. When the best stocks in your portfolio get overvalued, it can be short-sighted to sell the golden goose that will give you dividends today, dividends next year, and dividends for years after that simply because you can make a buck today. With the best stocks in your portfolio, the only question should be: is the price attractive enough to reinvest the dividends back into this company, or should I send the dividends elsewhere?

The best stocks in your portfolio deserve special treatment. They are above the Benjamin Graham “buy cheap and sell at fair value” approach because they will reliably take care of you for the rest of your life. When you own something like Colgate, Exxon, Johnson & Johnson, or PepsiCo, and you know that they are the kind of companies that will still be pumping out profits when your grandchildren are starting families of their own, why relinquish the ownership rights to something that could take care of you and your heirs for the rest of your time on this earth? Colgate-Palmolive continued to pay its dividends when Germany was streaking across Poland during the Second World War. Life is a whole lot easier when you have an asset like that firmly attached to your side as you go through life.