Understanding Buffett's Silver Play

On 3rd February Warren Buffett's Berkshire Hathaway (BH) reported that it had purchased 129.7 million ounces of silver between July 1997 and January 1998. BH gave its reason for the purchases as "equilibrium between supply and demand was only likely to be established by a somewhat higher price".

Warren Buffett's record indicates that he is, quite simply, the greatest investor of this century. Throughout over four decades of investing he has not had a single down year and has achieved an average compound annual return of around 30%. Due to his reputation as a long term investor, many people have opined that he has purchased silver as part of a long term strategy. However, this conclusion is based on a misconception. Buffett is not a long term investor, he is a smart investor who is not averse to taking a quick profit. To help understand Buffett's motivation for his silver purchase it is worth quickly looking at some of the investments he has made over the past 25 years.

Buffett's best known and most lucrative investments have been long term. Following are some examples :

• In 1973 he bought 10% of the shares in The Washington Post at a time when the Post's assets were valued at $400M, yet the entire market capitalisation of the company was $80M. He still owns these shares, which have appreciated over 20 fold in price.
• In 1983 BH purchased the Nebraska Furniture Mart for $60M (a private company), an investment which remains part of BH's portfolio to this day.
• In 1985 BH bought an 18% stake in Capital Cities for $517M as part of this company's deal to merge with ABC. This investment was held until Capital Cities ABC was acquired by Disney in 1995, realising a $2.5B profit for BH.
• During 1988 and 1989, BH purchased a large stake in Coca Cola, an investment which remains part of BH's portfolio to this day. The Coke shares were purchased at prices ranging from 13 times earnings to 23 times earnings and were considered very expensive by many analysts at the time. However, within 3 years the BH stake in Coke had appreciated in value by 250%.

Buffett has also made many short term investments and trades, some examples of which are :

• In 1977 BH purchased a 3% stake in Capital Cities which was sold for a quick profit after a run-up in the share price.
• During the late 1970s Buffett successfully speculated in share options and copper futures for his own account.
• Throughout the deal mania of the 1980s, Buffett made money as an arbitrageur. For example, in October 1988 he made a quick $64M profit by purchasing RJR Nabisco stock immediately following the announcement of the initial takeover offer by F Ross Johnson.
• In 1985 Buffett took advantage of a hostile takeover offer for General Foods to sell BH's stake for a $332M profit.
• By 1987, due to Buffett's opinion that all shares were over-valued, BH's entire share portfolio was liquidated except for the permanent investments (Washington Post, Capital Cities and GEICO).
• In 1990 BH purchased $440M of RJR Nabisco junk bonds because the market had over-reacted and dramatically under-valued these securities. The bonds were sold a short time later for a $200M profit.

Warren Buffett has made billions of dollars for himself and turned thousands of ordinary investors into millionaires by taking advantage of the fact that markets are not efficient, that is, the market price and the intrinsic (or underlying) value of a stock are seldom equivalent. It is this inherent inefficiency of markets which provides opportunity to the intelligent, principled and strong willed investor.

Buffett purchased silver because he believed that the market price did not reflect the underlying value. He has purchased physical silver most likely to ensure that he is not time constrained regarding his exit from this position. However, those who think that this is necessarily a long term investment are wrong. Buffett's long term investments have exclusively been in great businesses with managers he likes. The silver play is more akin to his foray into RJR Nabisco bonds in 1990 and as soon as his profit objectives have been achieved, or he believes the downside risk has become greater than the upside potential, he will sell.

In the absence of Buffett's purchases, silver would most likely have hit 18 year lows in January 1998 along with gold. However, silver prices have increased steadily over the past 6 months as gold moved lower, with a huge divergence between the prices of the metals occurring in the aftermath of the BH announcement due to panic speculative buying of silver. It is now worth considering what, if anything, Buffett's silver play means for gold.

Gold's greatest attribute is also its biggest problem, at least as far as the price of gold is concerned. The fact that gold is the purest form of money means that there is a large above ground stock of the metal which continues to grow at a small amount each year. Central Banks own a lot of gold and they treat it in much the same way as they treat their US dollar assets, that is, they lend it in order to generate income. (Many people have said that CBs sell gold because it does not produce interest income. The fact is that no money pays interest until it is lent to someone - gold, in this respect, is no different). This large above ground stock means that no individual investor, or group of investors, can affect the supply (and therefore the price) of gold. It is only a sea change in investment demand which will cause a significant change in the price of gold, and such a change only ever occurs in parallel with a change (in the opposite direction) in the demand for fiat currency, particularly US dollars.

To quote Warren Buffett: "You should profit from folly, not participate in it"

Milhouse

9 February 1998

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