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Warren Buffetts Letter and the Magic Formula, 2009

Warren Buffett is a legend in the investing world. The chairman of Berkshire Hathaway (BRK-B), he has amassed a fortune of over $60 billion dollars, using his company as a vehicle for investing in stocks, fixed income instruments, and buying entire businesses. As of the last list, he was the 2nd richest man in the world according to the Forbes 400. Berkshire has evolved from a textile mill in the northeast into a huge conglomerate, with operations ranging from car insurance (GEICO) to underwear (Fruit of the Loom) to paint (Benjamin Moore). Moreover, some of Warren's stock investments, such as his positions in Moody's (MCO), Coca-Cola (KO), and Gillette (now Proctor & Gamble PG) are textbook examples of buying quality at bargain prices. Berkshire's performance has been remarkable - since 1965, the company has grown book value at an annualized 20.3%, vs. the S&P 500's 8.9% annual gain, outperforming the market in 39 of those 44 years.

So it is with baited breath that value investors await his annual letter to shareholders. These have been Warren's principal method of passing his wisdom along to the general public, on everything from how he chooses stocks to his outlook on the near future. Entire books have been written from the content in his letters - for example, The Essays of Warren Buffett is an organized compilation of the wisdom from these letters. Let's take a look at a few points from his 2009 letter to shareholders and see what nuggets we can apply to investing the Magic Formula way.

Keep Investing in Down Markets

2008 was a terrible year for all stock investors, and Buffett was not immune. Berkshire's net worth per share fell about 9.6%, compared to a 37% drop in the S&P 500, and a 26% drop in the earliest MFI screen MagicDiligence has available. In the letter, Warren offers two pieces of advice for investors in markets like this, one "do" and one "don't". Neither of these should surprise any Buffett fans, but nevertheless they reinforce the right way to invest.

First, the "don't". Warren again re-iterates that selling out, swearing off stocks, and holding cash is a terrible investing policy. He points out the smugness of those holding cash as stocks continued to decline late into the year and early this year. While that smugness may feel good for a few months, in the long term cash destroys value. The worst course of action in a down market is to sell and hold cash, especially if the purpose is to swear off the market entirely. In fact, for those with excess cash, 2008 presented a very rare buying opportunity for patient investors.

Second, the "do". Warren mentions that Berkshire is always a buyer of businesses and securities. Poor market conditions present the chance to buy value for very cheap prices. He adds a "Buffettism": When investing, pessimism is your friend, euphoria the enemy.. MagicDiligence certainly agrees.

Despite a record downturn in the S&P last year, Buffett's investing style remains the same - the time to buy is when stocks are cheap, not when everyone else is buying.

Tough Times Separate the Wheat from the Chaff

I've pointed to "best-in-industry", "baby with the bathwater" stocks as typically excellent investments when a certain sector is out of favor. The Magic Formula is very good at pointing out the industries that are out of favor with investors, as usually several stocks in any particular sector show up at the same time. In tough times, the best and most financially strong companies widen their market share over struggling competitors. Two very visible Magic Formula examples in 2008 were Bed Bath and Beyond (BBBY), whose main competitor Linens N' Things bit the dust, and Best Buy (BBY), whose sworn enemy Circuit City also went the way of the dodo, leaving gobs of market share for the taking. Buffett backs up this viewpoint with experience. Speaking of Berkshire's retailing, manufacturing, and service businesses, Warren points out how these businesses improved competitive position because financial strength allowed them to make "tuck-in" acquisitions on the cheap while competitors were treading water or sinking.

Even Buffett Makes Investing Mistakes

Mistakes are a part of stock investing. The future is difficult to predict, and as Buffett likes to say, "if investing was as simple as looking at past trends, the Forbes 400 would be filled with librarians". There are mistakes in our Top Buy portfolio, though few. Buffett too makes mistakes, owns up to them, learns from them, and moves on. Two he pointed out for 2008 were investments in ConocoPhillips (COP) stock at the height of the oil price boom, and investments in two Irish banks (presumably Allied Irish (AIB ) and Bank of Ireland (IRE)) before they fell 90% apiece. This also shows the difficulty of picking the right price for commodity stocks, as well as the difficulty in valuing bank stocks.

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