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Buffett's three commandments - Eureka Report article

Buffett's three commandments

By Scott Francis
October 28, 2009

PORTFOLIO POINT: Heeding the Gospel according to Warren would have helped investors avoid crippling losses.

Twelve months ago the Sage of Omaha, Warren Buffett, proclaimed: "Buy American . I am." It was call for investors to use the prevailing atmosphere of fear around stockmarkets as an opportunity to invest in shares (see In defence of the king).

The market's surge since then has only served to enhance the Sage's reputation although, to be fair, Buffett did say he was buying American shares with no certainty of short-term gains, rather for the likelihood of attractive long-term returns.

Let's face it, few people were advocating share ownership 12 months ago, so it is worth looking to see what the World's Greatest Investor has been saying recently. Asked recently for the three most important investment rules, he nominated:

  • Always know what the other guy is making.
  • If it seems too good to be true, it probably is.
  • Stay away from leverage. No one ever goes broke that doesn't owe money.

Sadly, much wealth has been destroyed for many people during the past two years; the collapses of mortgage schemes such as Westpoint and MFS Premium Income Fund, margin lending firms like Tricom, the collapse of Storm Financial and the immense problems at Timbercorp and Great Southern Plantations have cost people much money.

The reality is that sticking to Buffett's rules would have helped investors avoid the worst of these disasters.

Always know what the other guy is making

Storm Financial, Westpoint and the agricultural investment schemes of Great Southern Plantations and Timbercorp will be long seen as high-water mark for atrocities committed by the financial planning industry.

All of these schemes paid massive fees to financial planners. Protests by Storm Financial founder Emmanuel Cassimatis that he was an industry leader in reform of the fee structure were not borne out by any examination of what Storm Financial was doing. Storm would encourage people who were often at a stage of life where borrowing was not appropriate to borrow against their houses, double-gear using a margin loan and then throw that money into the sharemarket.

The fees ran to 6% upfront and about 0.7% a year as a trailing commission. A pensioner with a $400,000 home, for example, might be persuaded to mortgage it to the tune of $300,000 and invest in shares, and use a margin loan for another $400,000 to take the portfolio value up to $700,000. Storm would then skim a 6% upfront fee - an eye-watering $42,000 upfront and $4900 a year ongoing.

The point of what Warren Buffett was saying? If people fully understood how much the Storm Financial advisers were making from their recommendations, perhaps they may have examined the advice more closely; was it in their own or Storm's best interest that they borrowed so exuberantly? Sadly, the answer now is clear.

Great Southern Plantations, Timbercorp and the failed mezzanine finance schemes such as Westpoint had the reputation for paying advisors and accountants upfront commissions of 10% or more. Had investors realised how much their advisers stood to gain they might have examined their recommendations more critically.

If it seems too good to be true, it probably is

A 10-12% fixed interest return "secured" by property when the prevailing cash rate is about 6% - what a great way to invest!

However, the apparent simplicity of these schemes hid a level of underlying risk that is now well known. Westpoint and Fincorp have collapsed, while the MFS Premium Income Fund and City Pacific are struggling along with frustrated investors having to wait and see what eventuates.

All these schemes seemed to be risk-free opportunities to earn 4% better than the cash rate.

As Buffett reminds us, there is no such thing as a risk-free return paying 4% above the cash rate; so if it seems too good to be true, it probably is.

Stay away from leverage. Nobody ever goes broke that doesn't owe money

Those worst hit by these failed investment schemes are the ones who borrowed. For example, Storm Financial clients who borrowed heavily - which was the basis of the Storm model - have ended up with debts far beyond the value of their assets.

It was those investors who borrowed to invest in Westpoint, Timbercorp and Great Southern Plantation who now have debts and assets of dubious or no value.

It is one thing to invest $50,000 in Westpoint and lose the money. It is another to borrow another $200,000 against your house, invest that in Westpoint, and lose both your $50,000 stake and your house as well.

Buffett's point is simple: if you own an asset outright, the worse that you can happen is that you lose your money. If you have borrowed money to invest in an asset you can end up owing money if the investment fails.

Buffett's ‘Buy American' campaign was an attempt to take advantage of the atmosphere of fear and buy shares. His more recent observations would have helped investors navigate the loss of wealth that has come with some of the biggest failures of investments and strategies in recent history.