Financial markets all over the world have been in a state of turmoil in recent weeks because of the COVID-19 crisis. In uncertain times like these, you may look up to famous investors to emulate their actions. That’s understandable. After all, following authoritative figures can provide a sense of security.
But I’m here to tell you that following famous investors blindly is incredibly dangerous.
Blind faith
A few weeks ago, I recorded a video chat with Reshveen Rajendran. During our conversation, Resh shared the story of his friend’s investment in Occidental Petroleum (NYSE: OXY), an oil & gas company. Resh’s friend had invested in Occidental’s shares at around US$40 each, only to see the share price fall sharply. At the time of recording, Occidental’s share price was around US$16 (it is around US$14 now). Resh’s friend did not know what to do with his/her Occidental investment.
After we finished recording, I had a further discussion with Resh. I thought there could be a really good educational element in the story of his friend’s investment in Occidental.
I found out that the friend’s investment thesis for Occidental was to simply follow Warren Buffett. But here’s the thing: Buffett’s investment in Occidental is radically different from what we as individual investors can participate in.
Buffett’s bet
In August 2019, Buffett invested in Occidental through his investment conglomerate, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B). What Buffett bought was US$10 billion worth of preferred shares in Occidental. He wanted to provide Occidental with capital to finance its planned US$38 billion acquisition of Anadarko Petroleum Corporation, a peer in the oil & gas industry.
Occidental’s preferred shares that Buffett invested in are not publicly-traded. So individual investors like you and I can’t invest in them. The preferred shares come with an 8% annual dividend that Occidental is obliged to pay until they are redeemed; the dividend means that Occidental has to pay Berkshire US$800 million every year (8% of Berkshire’s US$10 billion investment) in perpetuity or until redemption of the preferred shares happen. Occidental has the option to redeem the preferred shares at US$10.5 billion any time after August 2029. In other words, Berkshire is guaranteed to make a return of at least 8% per year from its Occidental preferred shares as long as the oil & gas company does not go bust.
Investing in Occidental’s preferred shares the way that Buffett did is very different from buying Occidental shares in the stock market. The normal Occidental shares we can purchase (technically known as common shares or ordinary shares) don’t come with any dividend-guarantees. Occidental is also not obliged to redeem our shares at a small premium to what we paid. If we buy Occidental shares, how well our investment will do over a multi-year period will depend solely on the business performance of the company. Buffett’s investment in the preferred shares comes with protection that we can’t get with the ordinary shares.
No cover
To the point about protection, consider the following. In March 2020, Occidental slashed the quarterly dividend on its ordinary shares by 86% – from US$0.79 per share to just US$0.11 per share – to save around US$2.2 billion in cash. That was the company’s first dividend reduction in 30 years. Occidental needed to take extreme measures to protect its financial health in the face of a sharp decline in oil prices. Meanwhile, there’s nothing Occidental can do about the 8% dividend on Buffett’s US$10 billion preferred shares investment – Occidental has to continue paying the preferred dividends. To add salt to the wound, Occidental’s US$0.11 per share in quarterly dividend works out to just US$392 million per year, which is less than half of the US$800 million that Buffett’s preferred shares are getting in dividends annually.
Yes, Buffett did buy some ordinary Occidental shares after his August 2019 investment in the oil & gas company’s preferred shares. But the total invested sum in the ordinary shares is tiny (around US$780 million at the end of 2019, or an average share price of US$41.21) compared to his investment in the preferred shares.
We can end up in disaster if we follow Buffett blindly into an investment without understanding his idea’s key traits. Buffett’s reputation and Berkshire’s actual financial clout gives him access to deals that we will never have.
Following authority into disaster
Resh’s story about his friend’s investment in Occidental shares reminded me of something that Morgan Housel once shared. Housel is currently a partner with the venture capital firm Collaborative Fund. Prior to this, he was a writer for The Motley Fool for many years. Here’s what Housel wrote in a 2014 article for the Fool:
“I made my worst investment seven years ago.
The housing market was crumbling, and a smart value investor I idolized began purchasing shares in a small, battered specialty lender. I didn’t know anything about the company, but I followed him anyway, buying shares myself. It became my largest holding — which was unfortunate when the company went bankrupt less than a year later.
Only later did I learn the full story. As part of his investment, the guru I followed also controlled a large portion of the company’s debt and and preferred stock, purchased at special terms that effectively gave him control over its assets when it went out of business. The company’s stock also made up one-fifth the weighting in his portfolio as it did in mine. I lost everything. He made a decent investment.”
Housel also committed the mistake of blindly following a famous investor without fully understanding the real rationale behind the investor’s investments.
In conclusion
It’s understandable if you want to follow the ideas of famous investors. That’s especially so during uncertain times, like the situation we’re in today. But before you do, please note that a blind adherence can be dangerous. Famous investors can invest in financial instruments in the same company that we can’t get access to. Or, their investment motives may be completely different to ours even for the same shares.
It’s always important to know why we’re investing in something. “I’m buying because Buffett or [insert name of famous investor] is buying” is not a valid investment thesis.
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Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
Disclosure: Ser Jing owns shares in Berkshire Hathaway (B Shares).
