How Buffett Operates Amid Economic Turmoil?

Indian investor Mohnish Pabrai recently published an article on the official website of Pabrai Investment Funds titled "Buffett Succeeds by Doing Nothing," which explains how Buffett's strategy remains calm and wins through it even when the economic environment undergoes significant changes.

We have been authorized to compile and share this with our readers.

Warren Buffett is hailed as one of the best investors of all time.

However, many might be surprised to find that his investment strategy often includes what he calls "sitting on one's hands."

For several years, Berkshire Hathaway did not purchase a single share of stock, even during periods of significant volatility.

Sometimes, doing nothing is the best thing you can do.

Seventeenth-century French scientist Blaise Pascal is remembered for his contributions to pure geometry.

In his 39 years of life, he invented foundational modern devices such as the modern syringe, hydraulic press, and the first digital calculator.

Moreover, he was a profound philosopher.

One of my favorite Pascal quotes is: "All of humanity's problems stem from the inability to sit quietly in a room alone."

Advertisement

I often think that Pascal's words, slightly modified, might be very apt for describing investing: "All the pain of portfolio managers stems from the inability to sit quietly in a room alone."

Why should portfolio managers sit idle?

Why is it beneficial for them?

Let's start with the story of D. E. Shaw & Co.

Founded in 1988, Shaw was composed of some of the brightest mathematicians, computer scientists, and bond trading experts.

Jeff Bezos worked at Shaw before embarking on his Amazon journey.

These individuals discovered that they could make a lot of money by exploiting highly complex bond arbitrage trading algorithms in the bond market for riskless arbitrage.

Shaw was able to profit from minor short-term inefficiencies in the bond market using highly leveraged capital.

The annualized returns were very impressive—and all risk-free!

Shaw set their trading to automatic mode, requiring almost no human adjustment.

They came to work, spending most of their time playing pool or video games, or simply chatting.

Profits per employee at Shaw were astronomical, and everyone was satisfied with this utopian arrangement.

But over time, these eggheads became anxious—they wanted to do something.

They felt that the automatic mode only scratched the surface of trading, and if they delved deeper, they would find more gold.

So they began to adjust the system, trying to improve returns.

(The result was that their returns were not as good as before.)

Long-Term Capital Management (LTCM) also took a similar path.

This fund was once considered the largest and smartest on Wall Street, and no one thought they would fail.

However, when a series of economic events suddenly occurred that did not conform to historical models, LTCM gradually shifted from pure riskless arbitrage to playing high-risk arbitrage games in the stock market.

Although the returns looked tempting, the lack of short-term guaranteed convergence and high-leverage positions ultimately led to LTCM's near-destruction.

Compared to other disciplines, fund management is strange in many ways—effort and intelligence do not necessarily lead to satisfactory results.

As Warren Buffett succinctly pointed out at the 1998 Berkshire Hathaway annual meeting: "We are not paid for action, but for being right.

As for how long we will wait, we will wait indefinitely!"

Buffett and his business partner Charlie Munger are undoubtedly two of the smartest people I have ever met.

However, as we saw with Shaw and LTCM, high intelligence does not necessarily lead to excellent investment outcomes.

After all, among the founders of LTCM were Nobel laureates in Economics.

In the long run, this did not do them much good.

In fact, they were too clever by half.

In an interview with Business Week in 1999, Buffett stated: "Investing success has nothing to do with IQ—once you have ordinary intelligence, what you need is the ability to control impulses."

The events at Shaw and LTCM show that it is difficult for highly intelligent people to sit and contemplate.

The problem is that once you start getting caught up in these intellectual stimuli, you will constantly look for the right answers and then take action—which usually leads to poor outcomes for investors.

By closely observing Buffett and Munger over the years and deeply understanding their psychology through their speeches and writings, I clearly see that, like the people at Shaw and LTCM, these two individuals need a lot of intellectual stimulation every day, like a part of their daily diet.

How do they satisfy this craving for intellectual stimulation without taking impulsive action?

There are several factors worth considering: When Buffett plays bridge (usually 10-20 hours a week), Munger spends most of his time expanding his worldly wisdom and constantly improving his mental model framework.

He is an avid reader, reading engaging books on various subjects, from different ice ages to "National Wealth and Poverty."

He spends a considerable amount of time applying perspectives gained from one research field to others—especially capital allocation.

At the 2002 Wesco annual meeting, Munger admitted that the first few hundred million dollars of Berkshire came from "Geiger counter detection of everything," but the subsequent billions came from simply "waiting for the obvious opportunities" or as Buffett put it, "waiting for the phone to ring."

Buffett still tends to use the Geiger counter on many things.

How does he avoid getting into trouble?

I believe there are three reasons: 1.

If one knows when to run the Geiger counter, then running it can be very effective.

Reflect on the following quote: Until 1974, Buffett had hardly made any public market investments.

In the four years from 1970 to 1974, the P/E ratio of the S&P 500 dropped from 20 to 7.

By 1974, he admitted selling "stocks he had recently bought at three times earnings and bought stocks that were being sold at two times earnings."

Then, from 1984 to 1987, Buffett did not buy any new equity positions for the Berkshire portfolio.

Berkshire Hathaway sat on a pile of cash, but he still did not take action.

In the second half of 1987, Berkshire used that pile of cash to buy more than $1 billion worth of Coca-Cola, exceeding a 5% stake in the company.

He invested 25% of Berkshire Hathaway's book value in a company they did not control!

What were Buffett and Charlie doing from 1970-1973 and 1984-1987?

Both realized that successful investing requires patience and discipline, making large bets during the relatively infrequent periods when the market is undervalued, and "doing other things" during the long periods when the market is fully priced or overpriced.

I'll bet Buffett played bridge a lot more in 1972 than in 1974.

2.

The Geiger counter method works better with smaller, less noticed companies and a range of special situations.

Given their typical smaller size, investing in these companies makes no sense for today's Berkshire Hathaway.

So Buffett usually invests for his personal portfolio.

A good example is his investment in the mortgage REIT Laser Mortgage Management (LMM), where there was a nice spread between liquidation value and stock price.

These types of LMM investments are significant for Buffett's personal portfolio, and more importantly, they consume the intellectual surplus that could lead to less good investment outcomes for Berkshire Hathaway.

Buffett is flexible, moving the Geiger counter away from the stock market and into other inefficient areas when the public market overheats.

These include high-yield bonds (Berkshire bought over $1 billion worth of Finova bonds at a deep discount in 2001), REITs (in 2000, he bought First Industrial Realty for his portfolio when REIT yields were astonishing), or his recent investment adventure in silver.

3.

The relationship between Munger and Buffett is extraordinary.

Both are extremely independent thinkers and prefer to work alone.

When Buffett has an investment idea, after it passes through his filters, he usually tells Munger.

Then Munger applies his broad mental model framework to find flaws in Buffett's ideas and dismisses most of them.

Very few ideas can pass Buffett; it has to be a completely obvious idea to pass through both of their filters.

Buffett and Munger's "do nothing" stands in stark contrast to the daily frenzied buying and selling on the exchange.

This brings me back to a fundamental question: Why do we set portfolio managers as full-time professionals and expect them to "do something smart every day"?

The fund management industry needs to reflect on Pascal's powerful words and how Warren Buffett and Charlie Munger figured out how to sit quietly in a room alone indefinitely.