Buffett's Subprime Bets

This is one ugly market.

That ugliness shows up in the averages, with the Dow down 4% since mid-October, but it's much worse in individual stocks. Stocks that were considered solid, conservative picks are getting killed.

Citigroup (NYSE: C  ) and Morgan Stanley (NYSE: MS  ) are more than 40% off their 52-week highs. Freddie Mac (NYSE: FRE  ) looks more like Freddie Krueger, slashing investors by more than 50%.

What's a conservative investor to do when confronted with these nightmares? I'd start with a trip to the Oracle, a.k.a. Warren Buffett.

What he says
On one hand, Buffett says that Rule No. 1 is to never lose money. This is a low blow to investors who believed that Citigroup and Freddie Mac were conservative investments. As it turns out, Citigroup and Freddie had significant unknowable elements. That's why, to follow Buffett's advice, you need to know exactly what you're buying and demand a significant margin of safety when buying any stock ... regardless of its reputation.

That would seem to preclude buying shares of these financial stocks today. There are so many unknowns. But then Buffett says of Berkshire Hathaway, his company, "Berkshire buys when the lemmings are heading the other way."

In other words, when everyone else is panicking, that's exactly when you want to be buying. And that would lead us to believe that now is the time to start picking up shares of these financial names.

How he resolves the apparent contradiction
Buffett's best advice, however, may be this:

"It's not risky to buy securities at a fraction of what they're worth."

So, when Buffett says you should try to avoid losing money, he is saying that you should be cautious. Make sure you understand the business with a particular emphasis on understanding what can go wrong. But if you know enough about a business that you can confidently determine its worth, and you're able to buy that business for less than that value, then it isn't really a risky investment even if the stock price drops in the near term.

Buffett's subprime musings
Buffett wasn't taken in by subprime. In his typical common-sense manner, he cut through the obfuscation and noted that securitizing uneconomic mortgages didn't make any sense: "I don't see any way that pooling a bunch of mortgages, changing the ownership, is going to change the viability of the mortgage instrument itself -- whether people can make the payments."

Buffett recognized that it should be impossible to have a profitable business lending money to people who can't pay you back, so he wasn't exposed to most of the subprime mess.

Going forward, Buffett predicted in late October that subprime is likely to cause problems for consumers for six months to two years. Yet while he sees the crisis as a "very big problem" to many in the lending industry, he noted during Berkshire Hathaway's annual meeting that "it's unlikely that [it] triggers anything of a massive nature in the general economy."

So, Buffett recognizes the problem but believes that it probably isn't a huge long-term issue. And that means that it's potentially a buying opportunity.

What he's buying
In fact, Berkshire Hathaway has been buying. For years, Berkshire has been sitting on a huge mound of cash, but it's now starting to deploy that money. Berkshire's purchases have been consistent with Buffett's statements that he doesn't expect a depression. For example, the company bought Burlington Northern Santa Fe (NYSE: BNI  ) -- a cyclical railroad that would definitely be affected by a slowing economy.

Berkshire is also looking for bargains among the lenders. It's been purchasing Wells Fargo (NYSE: WFC  ) and US Bancorp (NYSE: USB  ) , two companies with excellent balance sheets and conservative management. While these firms did do some subprime lending, their balance-sheet strength should take them through this crisis.

However, the Oracle's company is being extremely selective in its purchases and focusing on top-quality businesses. For instance, Buffett said that he "never came close" to buying shares of Countrywide Financial (NYSE: CFC  ) , one of the biggest subprime losers this year. That's Buffett following rule No. 1.

The Foolish bottom line
Buffett clearly believes that this subprime mess is providing the opportunity to purchase quality businesses at cheap prices. You'll do well if you stay alert for the same opportunities.

If you'd like some help spotting the stocks with the greatest potential for high returns, our Inside Value newsletter service can help. We follow Buffett's strategies and recommend only companies trading for a fraction of what they're worth. We're offering a free trial for anyone who's interested in seeing how we plan to profit from this crisis.

Fool contributor Richard Gibbons dreams of one day driving an SIV. He does not own any of the stocks discussed in this article. Berkshire Hathaway is an Inside Value and Stock Advisor pick. US Bancorp is a Motley Fool Income Investor recommendation. The Motley Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy has a hauntingly familiar aroma.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 25, 2008, at 7:09 PM, 9Elle wrote:

    Did the author not know that Buffett/Berkshire Hathaway bought Bank of America at around 50 circa July 2007? Six months later, its writedowns drove down its price to 40. A year later, BAC is trading at about 30. Mr. Buffet was was taken in by subprime like everyone else. Though since Buffett and his army of BH financiers could not see the writing on the wall with institutions like BAC, then maybe this is a comment on how much more regulation banks need.

    Another error: Buffett did comment that "I don't see any way that pooling a bunch of mortgages, changing the ownership, is going to change the viability of the mortgage instrument itself -- whether people can make the payments." But the comment was made only in October 2007, and with reference to the U.S. Treasury proposing an $80 billion fund to help companies with ailing home lending instruments.

    Buffett is good, but he is no messiah. Stop celebrating him as such.

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