As I saw Warren Buffett’s “One Year Later” interview with CNBC, there were two things that really struck me.
Buffett mentions that Barclays wanted to buy Lehman before the collapse, but they needed Buffett to insure the transaction, without which the British government wouldn’t let them proceed. Buffett states that the transaction they were describing was quite complex, and he couldn’t understand it over the telephone. He asked them to send a fax with the details, and tell them how much premium they were willing to pay, and the limit they wanted.
The two things that strike me about this:
- Buffett doesn’t hesitate at all to state he didn’t understand the transaction.
- He was looking for simple parameters to evaluate the decision. He needed them to send him the premium they were willing to pay, and the limit. It couldn’t have been broken down into simpler elements.
These are seemingly simple things, but practicing them is hard sometimes. For instance, it took me several hours to understand how a 130 / 30 ETF works, and to this day, I don’t completely understand how contango affects oil ETFs. But, it is really hard for me to accept that I can’t understand things like an oil stock ETF easily. When I don’t accept this fact, there are chances that I get into stocks, mutual funds or ETFs that I don’t fully understand, and then later repent.
In fact the exact thing happened with a lot of investors who tried to use leveraged ETFs for hedging, but found out — that the short term nature of such ETFs make them useless for hedging in the long run.
When you look at some of the more complex ETFs and other structured products – the devil lies in the details. You may easily understand what leverage means, but it may not be so easy to understand how a particular fund is using it. That may well turn out to be the difference between the right and wrong decision.
The lesson for me in this is that a lot of financial products are complex in their structures, and if I don’t understand how they work, I should stay away from them.
The second point is also quite interesting because there are so many things like free cash flow, PEG Ratio, and other such things you can analyze – that it is easy to miss the forest for the trees.
If you buy a mutual fund, it must be made of stocks, future contracts, bonds or commodities. If it is made of future contracts, then what is the underlying? When will the underlying go up or down?
This line of reasoning should ultimately take you towards one or two fundamental things that will decide whether the asset will be profitable or not. Following this line of reasoning and being cognizant of these factors helps better understand the circumstances in which the asset will be profitable, and cut the clutter and noise that surrounds investing.
I have always been a fan of the simplicity and clarity of Buffet’s ideas and his letters to shareholders are a great way to start learning more about them. These were two great lessons learnt from watching a short interview and reflecting on what he said.