The New Warren Buffett Way

From value investor to vulture investor.

On Sunday, Sept. 16, 2001, the night before the stock market was set to reopen following 9/11, Warren Buffett appeared on 60 Minutes to reassure American stockholders. Now was not the time to flee the market, the legendary long-term investor declared. “I won’t be selling anything,” he said. “If prices would fall significantly, there’s some things I might buy. … It’s not a different country economically than it was a week ago.”

Buffett’s plea to sit tight carried particular weight because there has always been a sense among investors that his motives and actions are always purely aligned with those of the most humble holders of common stock. Over the years, the unassuming billionaire has demonstrated a principled consistency and a high regard for his fellow shareholders.  Buffett, who long eschewed options, has never sought to elevate himself above other shareholders in Berkshire Hathaway or in the companies in which he invested, or to profit as they suffer. He pays himself a paltry (by CEO standards) $100,000 salary, and his wealth rises and falls in direct relation to that of Berkshire’s smallest shareholder.

Of course, Buffett, whose assets are intensely concentrated in the publicly traded stock of Berkshire Hathaway, which in turn has significant holdings in insurance, had a lot more to lose from a September 2001 market meltdown than the rest of us. (Read a recent Moneybox about how Buffett’s insurance holdings may have influenced his post-9/11 predictions of more terror attacks.) So, in the charged days after 9/11, he may have had his best interests at heart, rather than ours. In fact, those who followed his advice to sit tight saw their portfolios fall 7 percent on Sept. 17.  And those who followed his advice and bought more as prices fell significantly in the following weeks have suffered further losses. The stock of Berkshire Hathaway, conversely, has risen more than 10 percent since Sept. 17.

What’s most surprising about post-9/11 Buffett is that, while it may not be “a different country economically than it was,” he is certainly acting like it is. As promised, Buffett has been doing some buying in the past 12 months. But he’s not buying stocks in sound, undervalued companies the way he used to, and the way you and I still do. In making several highly publicized investments in struggling public companies, Buffett has departed significantly from his traditional modus operandi—and departed in ways that are potentially hazardous to common shareholders. This classic value investor is behaving more like a vulture investor.

Vulture investors are individuals and institutions that come to the aid of, or prey upon, troubled companies. Smart vultures don’t simply buy common shares in a company that is trending toward bankruptcy. Instead, they’ll lend money at extraordinarily high interest rates, or demand a chunk of equity in return for the loan, or demand to buy stock at a discount to the current market price. Frequently, such transactions cause a dilution of the value of the shares held by existing shareholders and create a situation in which the new investors have better claims on a company’s assets and income than do existing common shareholders.

There’s nothing inherently predatory about vulture investing. It’s one of the iron rules of the marketplace that companies with poor financial prospects wishing to obtain capital simply have to meet more onerous terms than those with sterling balance sheets. But vulture investors, and others who specialize in distressed situations like Carl Icahn, tend to have sharp elbows, which means that common shareholders can get hurt when they move on a company.

In July, Buffett and two other investors bought $500 million in convertible notes from Level 3 Communications, Inc., one of the largest remaining fiber-optics network companies. (Buffett’s share totaled $100 million.) The deal boosted Level 3’s cash position by 50 percent and bolstered its status. But it came at a stiff price. The notes pay 9 percent annual interest, and the holders can convert the notes, at any time, into common stock at $3.41. The stock now trades at $5. 

Buffett’s transaction with the Williams Companies, the established energy concern that got into trouble with misplaced bets on energy trading and telecommunications, is more problematic. Williams staved off bankruptcy in July by striking a $900 million loan deal with Lehman Brothers and a unit of Berkshire Hathaway. But you have to dig deep into Williams’$2 10-Q filing to find the extraordinary terms of the transaction.

The one-year loan carries an interest rate of 19.824 percent. In addition, Williams committed to pay a “deferred set up fee”—a charge that the company must pay if the company assets underlying the loan are sold, or even if they are not—of at least 15 percent of the loan, or $135 million. Add it up, and Williams will be paying nearly 35 percent in interest and charges for a one-year loan.

While beneficial to Buffett’s bottom line, the Williams deal isn’t particularly good for Buffett’s well-tended image. Karl Miller, an energy investor, told that the transaction, on “loan shark” terms, was a “deal with the devil.” Those are probably two epithets that have never been hurled at Saint Warren the Beneficent. And you certainly won’t find any mention of lending money to troubled borrowers at 35 percent per annum in the many books extolling Buffett’s virtues.

Although the stocks of Level 3 and Williams rose after the announcement of Buffett’s investments, neither of these deals represents a vote of confidence in the companies’ stock. In the case of Level 3, Buffett essentially said he’d only be willing to buy the stock at $3.41 a share (a 30 percent discount today)—no matter what price the stock is trading at—and demanded that the company pay him 9 percent a year for the privilege of holding that right. In the case of Williams, Buffett’s move is a vote of no confidence in the stock.

Is Buffett rethinking his style and fundamental investing precepts at the age of 73?  After all, lending to distressed companies is an entirely different prospect than buying stock in sound companies. We may have to wait until his celebrated annual shareholders meeting in Omaha next May to find out.

Perhaps the deals say something more profound about the post-9/11 market than about Buffett. With so many stocks having plummeted, so many companies beset by scandal, so much money fleeing the market, and such a crisis of investor confidence, one might expect that the classic value situations that are Buffett’s hallmark would be everywhere. Buffett should be grabbing an underpriced company every few days. The fact that Buffett, who has oodles of cash to put to work, hasn’t found many—and has instead been nibbling on distressed properties—shows just how overvalued stocks still are.