Warren Buffett's Stealthy $8 Billion Junk Bond Trade
- By Rupert Hargreaves
Warren Buffett (Trades, Portfolio) is best known for his equity investments, particularly his long-term core positions such as Coca-Cola (KO), American Express (AXP) and Apple (AAPL).
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He also regularly advocates the benefits of buy and hold investing. He says he likes to buy stocks with the view of holding them "forever" and only invests in companies where he would be happy to hold the stock if the market closed for five or 10 years.
Despite these comments, however, the Oracle of Omaha has also engaged in some short-term trading activity, which generated impressive returns for investors.
Short-term trading
Just after the dot-com bubble burst in the early 2000s, Buffett decided to move quickly to take advantage of the opportunities that had emerged in the junk bond market. In his 2001 letter to shareholders of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), he wrote:
"During 2001, we were somewhat more active than usual in 'junk' bonds. These are not, we should emphasize, suitable investments for the general public, because too often these securities live up to their name."
He goes on to say in the letter this is an area where Berkshire Hathaway has had some success before:
"So far, our 50-year experience in distressed debt has proven rewarding. In our 1984 annual report, we described our purchases of Washington Public Power System bonds when that issuer fell into disrepute. We've also, over the years, stepped into other apparent calamities such as Chrysler Financial, Texaco and RJR Nabisco 3/4 , all of which returned to grace. Still, if we stay active in junk bonds, you can expect us to have losses from time to time."
He then went on to describe one opportunity Berkshire Hathaway was taking advantage of at the time:
" In late 2000, we began purchasing the obligations of Finova Group, a troubled finance company, and that, too, led to our making a major transaction. Finova then had about $11 billion of debt outstanding, of which we purchased 13% at about two-thirds of face value. We expected the company to go into bankruptcy, but believed that liquidation of its assets would produce a payoff for creditors that would be well above our cost. As default loomed in early 2001, we joined forces with Leucadia National (Trades, Portfolio) Corp. to present the company with a prepackaged plan for bankruptcy."
Later, in his 2003 letter to investors, Buffett disclosed that in 2002, Berkshire acquired a sum total of $8 billion in junk bonds very quickly. These bonds almost immediately made a profit for the investment vehicle. By the end of 2003, holdings had reduced to just $1.14 billion.
Should have used a shotgun
In the following years, Buffett admitted he had made a mistake. Rather than buying just $8 billion, he said he wished he had invested another $8 billion to take advantage of all the opportunities that were offered at the time.
According to Bob Goldfarb, one of the founding members of the Sequoia Fund, Buffett later said he probably should have used a "shotgun rather than a rifle" to take advantage of the opportunities in the market (though he also admitted the Oracle of Omaha didn't use these exact words).
Bill Ruane, another founder of the Sequoia Fund, whom Buffett personally picked to manage the money of Buffett Associates Ltd.'s partners when he decided to exit the business, added some more color to the guru's short-term junk bond trade at the firm's 2005 meeting:
"He put about $7 billion or $8 billion to work and he wished he had gone ahead and bought another $7 billion or $8 billion. They were yielding 30%, and he sold them when they were probably yielding 6% or 7% a couple of years later. And he made billions. You know, that would get a lot of attention if it was a stock trade."
Many concentrate on Buffett's most significant investment successes when they are evaluating his past performance. There are, however, many smaller trades he has executed over the years that have made billions for Berkshire shareholders. The early 2000s junk bond trade is just one example.
Disclosure: The author owns shares of Berkshire Hathaway.
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This article first appeared on GuruFocus.
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