More Praise for The Warren Buffett Way, First Edition

Omaha World-Herald
asked Travis Pascavis, a Morningstar analyst, about the deal. He
noted that companies like Fruit of the Loom usually sell for
their book value, which in this case would have been $1.4 bil-
lion. So with a bid of $835 million (ultimately, $730 million),
Berkshire would be getting the company for a bargain price.
14

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I n v e s t i n g G u i d e l i n e s : V a l u e Te n e t s
1 3 9
P U T T I N G I T A L L T O G E T H E R
Warren Buffett has said more than once that investing in stocks is really
simple: Find great companies that are run by honest and competent
people and are selling for less than they are intrinsically worth. No
doubt many who have heard and read that remark over the years have
thought to themselves, “Sure, simple if you’re Warren Buffett. Not so
simple for me.”
Both sentiments are true. Finding those great companies takes time
and effort, and that is never easy. But the next step—determining their
real value so you can decide whether the price is right—is a simple mat-
ter of plugging in the right variables. And that is where the investment
tenets described in these chapters will serve you well:
• The business tenets will keep you focused on companies that are
relatively predictable. If you stick to those with a consistent op-
erating history and favorable prospects, producing basically the
same products for the same markets, you will develop a sense of
how they will do in the future. The same is true if you concen-
trate on businesses that you understand; if not, you won’t be able
to interpret the impact of new developments.
• The management tenets will keep you focused on companies that
are well run. Excellent managers can make all the difference in a
company’s future success.
• Together, the business and management tenets will give a good
sense of the company’s future earnings potential.
• The f inancial tenets will reveal the numbers you need to make a
determination of the company’s real value.
• The value tenets will take you through the mathematics neces-
sary to come up with a f inal answer: Based on everything you
have learned, is this a good buy?
The two value tenets are crucial. But don’t worry too much if you
are unable to address the other ten fully. Don’t let yourself become par-
alyzed by too much information. Do the best you can, get started, and
keep moving forward.

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1 4 1
9
Investing in
Fixed-Income Securities
W
arren Buffett is perhaps best known in the investment world
for his decisions in common stocks, and he is famous for his
“buy and hold” positions in companies such as Coca-Cola,
American Express, the Washington Post, and Gillette. His activities are
not, however, limited to stocks. He also buys short-term and long-term
f ixed-income securities, a category that includes cash, bonds, and pre-
ferred stocks. In fact, f ixed-income investing is one of Buffett’s regular
outlets, provided—as always—that there are undervalued opportuni-
ties. He simply seeks out, at any given time, those investments that
provide the highest aftertax return. In recent years, this has included
forays into the debt market, including corporate and government
bonds, convertible bonds, convertible preferred stock, and even high-
yielding junk bonds.
When we look inside these f ixed-income transactions, what we see
looks familiar, for Buffett has displayed the same approach that he takes
with investments in stocks. He looks for margin of safety, commitment,
and low prices ( bargains). He insists on strong and honest management,
good allocation of capital, and a potential for profit. His decisions do
not depend on hot trends or market-timing factors but instead are savvy
investments based on specif ic opportunities where Buffett believes there
are undervalued assets or securities.

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T H E W A R R E N B U F F E T T W AY
This aspect of Buffett’s investing style doesn’t receive a great deal of
attention in the financial press, but it is a critical part of the overall Berk-
shire portfolio. Fixed-income securities represented 20 percent of Berk-
shire’s investment portfolio in 1992; today, 14 years later, that percentage
has grown to about 30 percent.
The reason for adding these fixed-income investments is simple:
They were the best value at the time. Because of the absolute growth of
the Berkshire Hathaway portfolio and the changing investment environ-
ment, including a lack of publicly traded stocks that he finds attractive,
Buffett has often turned to buying entire companies and to acquiring
fixed-income securities. He wrote in his 2003 letter to shareholders that
it was hard to find significantly undervalued stocks, “a difficulty greatly
accentuated by the mushrooming of the funds we must deploy.”
In that same 2003 letter, Buffett explained that Berkshire would
continue the capital allocation practices it had used in the past: “If stocks
become cheaper than entire businesses, then we will buy them aggres-
sively. If selected bonds become attractive, as they did in 2002, we will
again load up on these securities. Under any market or economic condi-
tions we will be happy to buy businesses that meet our standards. And,
for those that do, the bigger, the better. Our capital is underutilized
now. It is a painful condition to be in but not as painful as doing some-
thing stupid. (I speak from experience.)”
1
To some extent, f ixed-income investments will always be necessary
for Berkshire Hathaway’s portfolio because of Berkshire’s concentration
in insurance companies. To fulf ill their obligation to policyholders,
insurance companies must invest some of their assets in f ixed-income
securities. Still, Berkshire holds a signif icantly smaller percentage of
f ixed-income securities in its insurance investment portfolio compared
with other insurance companies.
Generally speaking, Buffett has tended to avoid fixed-income invest-
ments (outside what was needed for the insurance portfolios) whenever
he feared impending inf lation, which would erode the future purchasing
power of money and therefore the value of bonds. Even though interest
rates in the late 1970s and early 1980s approximated the returns of most
businesses, Buffett was not a net purchaser of long-term bonds. There al-
ways existed, in his mind, the possibility of runaway inf lation. In that
kind of environment, common stocks would have lost real value, but

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I n v e s t i n g i n F i x e d - I n c o m e S e c u r i t i e s
1 4 3
bonds outstanding would have suffered far greater losses. An insurance
company heavily invested in bonds in a hyperinf lationary environment
has the potential to wipe out its portfolio.
Even though thinking of Buffett and bonds in the same sentence may
be a new idea for you, it will come as no surprise that he applies the same
principles as he does in valuing a company or stocks. He is a principle-
based investor who will put his money in a deal where he sees a potential
for profit, and he makes sure that the risk is priced into the deal. Even in
fixed-income transactions, his business owner’s perspective means that
he pays close attention to the issuing company’s management, values, and
performance. This “bond-as-a-business” approach to fixed-income in-
vesting is highly unusual but it has served Buffett well.
B O N D S
Washington Public Power Supply System
Back in 1983, Buffett decided to invest in some bonds of the Washing-
ton Public Power Supply System ( WPPSS). The transaction is a clear
example of Buffett’s thinking in terms of the possible gains from buy-
ing the bonds compared with those if he bought the entire company.
On July 25, 1983, WPPSS (pronounced, with macabre humor,
“Whoops”) announced that it was in default of $2.25 billion in munic-
ipal bonds used to f inance the uncompleted construction of two nuclear
reactors, known as Projects 4 and 5. The state ruled that the local power
authorities were not obligated to pay WPPSS for power they had previ-
ously promised to buy but ultimately did not require. That decision led
to the largest municipal bond default in U.S. history. The size of the
default and the debacle that followed depressed the market for public
power bonds for several years. Investors moved quickly to sell their util-
ity bonds, forcing prices lower and current yields higher.
The cloud over WPPSS Projects 4 and 5 cast a shadow over Projects
1, 2, and 3. But Buffett perceived signif icant differences between the
terms and obligations of Projects 4 and 5 on the one hand and those of
Projects 1, 2, and 3 on the other. The f irst three were operational util-
ities that were also direct obligations of Bonneville Power Administration,

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1 4 4
T H E W A R R E N B U F F E T T W AY
a government agency. However, the problems of Projects 4 and 5 were
so severe that some were predicting they could weaken the credit posi-
tion of Bonneville Power.
Buffett evaluated the risks of owning municipal bonds of WPPSS
Projects 1, 2, and 3. Certainly there was a risk that these bonds could
default and a risk that the interest payments could be suspended for a
prolonged period. Still another factor was the upside ceiling on what
these bonds could ever be worth. Even though he could purchase these
bonds at a discount to their par value, at the time of maturity they
could only be worth one hundred cents on the dollar.
Shortly after Projects 4 and 5 defaulted, Standard & Poor’s suspended
its ratings on Projects 1, 2, and 3. The lowest coupon bonds of Projects 1,
2, and 3 sank to forty cents on the dollar and produced a current yield of
15 to 17 percent tax-free. The highest coupon bonds fell to eighty cents
on the dollar and generated a similar yield. Undismayed, from October
1983 through June the following year, Buffett aggressively purchased
bonds issued by WPPSS for Projects 1, 2, and 3. By the end of June
1984, Berkshire Hathaway owned $139 million of WPPSS Project 1, 2,
and 3 bonds ( both low-coupon and high-coupon) with a face value of
$205 million.
With WPPSS, explains Buffett, Berkshire acquired a $139 million
business that could expect to earn $22.7 million annually after tax (the
cumulative value of WPPSS annual coupons) and would pay those earn-
ings to Berkshire in cash. Buffett points out there were few businesses
available for purchase during this time that were selling at a discount to
book value and earning 16.3 percent after tax on unleveraged capital.
Buffett figured that if he set out to purchase an unleveraged operating
company earning $22.7 million after tax ($45 million pretax), it would
have cost Berkshire between $250 and $300 million—assuming he could
find one. Given a strong business that he understands and likes, Buffett
would have happily paid that amount. But, he points out, Berkshire paid
half that price for WPPSS bonds to realize the same amount of earnings.
Furthermore, Berkshire purchased the business (the bonds) at a 32 per-
cent discount to book value.
Looking back, Buffett admits that the purchase of WPPSS bonds
turned out better than he expected. Indeed, the bonds outperformed
most business acquisitions made in 1983. Buffett has since sold the
WPPSS low-coupon bonds. These bonds, which he purchased at a

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I n v e s t i n g i n F i x e d - I n c o m e S e c u r i t i e s
1 4 5
signif icant discount to par value, doubled in price while annually pay-
ing Berkshire a return of 15 to 17 percent tax-free. “Our WPPSS ex-
perience, though pleasant, does nothing to alter our negative opinion
about long-term bonds,” said Buffett. “It only makes us hope that we
run into some other large stigmatized issue, whose troubles have caused
it to be signif icantly misappraised by the market.”
2
RJR Nabisco
Later in the 1980s, a new investment vehicle was introduced to the f i-
nancial markets. The formal name is high-yield bond, but most in-
vestors, then and now, call them junk bonds.
In Buffett’s view, these new high-yield bonds were different from
their predecessor “fallen angels”—Buffett’s term for investment-grade
bonds that, having fallen on bad times, were downgraded by ratings
agencies. The WPPSS bonds were fallen angels. He described the new
high-yield bonds as a bastardized form of the fallen angels and, he said,
were junk before they were issued.
Wall Street’s securities salespeople were able to promote the legiti-
macy of junk bond investing by quoting earlier research that indicated
higher interest rates compensated investors for the risk of default. Buf-
fett argued that earlier default statistics were meaningless since they
were based on a group of bonds that differed signif icantly from the junk
bonds currently being issued. It was illogical, he said, to assume that
junk bonds were identical to the fallen angels. “That was an error sim-
ilar to checking the historical death rate from Kool-Aid before drink-
ing the version served at Jonestown.”
3
As the 1980s unfolded, high-yield bonds became junkier as new of-
ferings f looded the market. “Mountains of junk bonds,” noted Buffett,
“were sold by those who didn’t care to those that didn’t think and there
was no shortage of either.”
4
At the height of this debt mania, Buffett
predicted that certain capital enterprises were guaranteed to fail when it
became apparent that debt-laden companies were struggling to meet
their interest payments. In 1989, Southmark Corporation and Inte-
grated Resources both defaulted on their bonds. Even Campeau Corpo-
ration, a U.S. retailing empire created with junk bonds, announced it
was having difficulty meeting its debt obligations. Then on October 13,
1989, UAL Corporation, the target of a $6.8 billion management-union

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1 4 6
T H E W A R R E N B U F F E T T W AY
led buyout that was to be financed with high-yield bonds, announced
that it was unable to obtain financing. Arbitrageurs sold their UAL com-
mon stock position, and the Dow Jones Industrial Average dropped 190
points in one day.
The disappointment over the UAL deal, coupled with the losses in
Southmark and Integrated Resources, led many investors to question
the value of high-yield bonds. Portfolio managers began dumping
their junk bond positions. Without any buyers, the price for high-
yield bonds plummeted. After beginning the year with outstanding
gains, Merrill Lynch’s index of high-yield bonds returned a paltry 4.2
percent compared with the 14.2 percent returns of investment-grade
bonds. By the end of 1989, junk bonds were deeply out of favor with
the market.
A year earlier, Kohlberg Kravis & Roberts had succeeded in pur-
chasing RJR Nabisco for $25 billion f inanced principally with bank
debt and junk bonds. Although RJR Nabisco was meeting its f inancial
obligations, when the junk bond market unraveled, RJR bonds de-
clined along with other junk bonds. In 1989 and 1990, during the junk
bond bear market, Buffett began purchasing RJR bonds.
Most junk bonds continued to look unattractive during this time, but
Buffett figured RJR Nabisco was unjustly punished. The company’s sta-
ble products were generating enough cash f low to cover its debt pay-
ments. Additionally, RJR Nabisco had been successful in selling portions
of its business at very attractive prices, thereby reducing its debt-to-
equity ratio. Buffett analyzed the risks of investing in RJR and concluded
that the company’s credit was higher than perceived by other investors
who were selling their bonds. RJR bonds were yielding 14.4 percent (a
businesslike return), and the depressed price offered the potential for cap-
ital gains.
So, between 1989 and 1990, Buffett acquired $440 million in dis-
counted RJR bonds. In the spring of 1991, RJR Nabisco announced it
was retiring most of its junk bonds by redeeming them at face value. The
RJR bonds rose 34 percent, producing a $150 million capital gain for
Berkshire Hathaway.
Level 3 Communications
In 2002, Buffett bought up large bundles of other high-yield corporate
bonds, increasing his holdings in these securities sixfold to $8.3 billion.

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I n v e s t i n g i n F i x e d - I n c o m e S e c u r i t i e s
1 4 7
Of the total, 65 percent were in the energy industry and about $7 bil-
lion were bought through Berkshire insurance companies.
Describing his thinking in the 2002 letter to shareholders, Buffett
wrote, “The Berkshire management does not believe the credit risks as-
sociated with the issuers of these instruments has correspondingly de-
clined.” And this comes from a man who does not take unaccounted-for
(read: unpriced) risks. To that point, he added, “Charlie and I detest tak-
ing even small risks unless we feel we are being adequately compensated
for doing so. About as far as we will go down that path is to occasionally
eat cottage cheese a day after the expiration date on the carton.”
5
In addition to pricing his risk, he also typically bought the securi-
ties at far less than what they were worth, even at distressed prices, and
waited until the asset value was realized.
What is particularly intriguing about these bond purchases is that, in
all likelihood, Buffett would not have bought equity in many of these
companies. By the end of 2003, however, his high-yield investments paid
off to the tune of about $1.3 billion, while net income for the company
that year was a total of $8.3 billion. As the high-yield market skyrock-
eted, some of the bonds were called or sold. Buffett’s comment at the
time was simply, “Yesterday’s weeds are being priced as today’s f lowers.”
In July 2002, three companies invested a total of $500 million in
Broomf ield, Colorado-based Level 3 Communications’ ten-year con-
vertible bonds, with a coupon of 9 percent and a conversion price of
$3.41, to help the company make acquisitions and to enhance the com-
pany’s capital position. The three were Berkshire Hathaway ($100 mil-
lion), Legg Mason ($100 million) and Longleaf Partners ($300 million).
Technology-intensive companies are not Buffett’s normal acquisition
fare; he candidly admits he does not know of a way to properly value
technology companies. This was an expensive deal for Level 3 but it gave
them the cash and credibility when they needed it. For his part, Buffett
obtained a lucrative (9 percent) investment with an equity position. At
the time, Buffett was quoted as saying that investors should expect 7 to 8
percent returns from the stock market annually, so at 9 percent, he was
ahead of the game.
There is another aspect to this story that is typical of Buffett—a
strong component of managerial integrity and personal relationships.
Level 3 Communications was a spin-off from an Omaha-based con-
struction company, Peter Kiewit Sons; Buffett’s friend Walter Scott Jr.,
is both chairman emeritus of Kiewit and chairman of Level 3. Often

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T H E W A R R E N B U F F E T T W AY
called Omaha’s f irst citizen, Scott was the driving force behind the
city’s zoo, its art museum, the engineering institute, and the Nebraska
Game and Parks Foundation. Scott and Buffett have close personal and
professional connections: Scott sits on Berkshire’s board, and the two
men are only f loors away from each other at Kiewit Plaza.
Even though Buffett knew Scott well and held him in high regard,
he wanted the investment to be fair and transparent, with no question
that the relationship between the two men unduly inf luenced the deal.
So Buffett suggested that O. Mason Hawkins, chairman and chief ex-
ecutive of Southeastern Asset Management, which advises Longleaf