Monday, May 4, 2009

The Series 65 and Warren Buffett

Many exam candidates believe that what they're learning for the test "has nothing to do with the real world," but if they had sat last Saturday listening to Warren Buffett and Charlie Munger pontificate for some 5 hours, they would be forced to admit how wrong that notion is. The first slide Buffett showed was of a big trade ticket indicating that back when the credit markets truly seized up, Berskhire was able to sell $5 million par value of T-bills for $5 million plus $90 due to a sudden need for traders to post collateral. In other words, the buyer of those T-bills was accepting a negative yield because getting his hands on cash equivalents was that dire. Both Warren and Charlie predicted that we will never see negative yields on government securities again in our lifetimes and both wanted us to know how truly unsual our recent economic turmoil is. Any Series 65/66 candidate struggling to understand the value of modern portfolio theory, beta, standard deviation, etc. would have enjoyed hearing both Warren and Charlie, two of the most successful investors of all time, express their contempt for half of what you're learning under "quantitative methods to evaluate investments." Charlie said that only high-IQ investors fall for the dangerous and false certainty that their equations produce. When a shareholder asked Warren whether discounted cash flow models should use 10 years or should be taken out indefinitely, Buffett basically ridiculed the guy's premise that such certainty could actually exist when trying to buy a business. Warren said something like, "If you need a computer, if you need the difference of a few tenths of a percent--don't do the deal. It should be so apparently obvious to you what the future cash flows are going to be; otherwise, don't buy it." They both talked about the hubris of the high-IQ investors, who consistently lead us to the brink of financial disaster. Warren said, "If you're in the investment business and have an IQ of 180, sell 30 points to somebody else." Charlie said, "Your computer models and calculations can't account for once-in-a-generation occurences. We can't take outsized risks based on some consultant talking about a 2 or a 3-standard deviation event." They both said it doesn't take a genius to run a business or to pick good investments. In fact, Buffett used one of his favorite lines to make the point, which is, "Buy a business so simple it can be run by a fool, because eventually it will be."
In order to explain the crisis caused by financial derivatives, Warren brought up some information tested on the fringes of the Series 65/66. He mentioned that those unregulated, non-standardized markets led to disaster and then mentioned that the Federal Reserve Board still has Reg T, which requires parties to settle generally in 3 business days--the weird derivatives apparently allowed settlements that were very vague and very long-term, allowing the other side of the contract to hem and haw until finally it becomes apparent that the dude, like, can't pay you. He brought up the liquidiation priority of a deadbeat company, how preferred stock is worthless if the company has no equity (like FNMA and FHLMC) but how a company like Goldman Sachs or Wells Fargo actually has all kinds of equity in spite of their financial challenges.
What really struck me had little to do with the exam, or with investing for that matter. What I really noticed was how much fun these two guys in their late 70's are having running arguably the greatest company ever assembled, and how laid back they are about everything. For five hours or so, they just sat there sucking down Coca-Cola and munching on See's candies like they were friggin' vitamins as they casually explained high finance to inferior minds with the humility and folksy charm of two midwestern farmers at the local diner. Do they know what the heck they're doing? Since 1965, the book value of their stock has risen more than 300,000 percent! And it's not because of genius, sophisticated computer models, or ball-busting business tactics. It's because those two geezers in off-the-rack business suits munching on junk food and cracking jokes all day know that being the second or the tenth richest person in the world is nice, but is not to be confused with genius, which has no place in the investment game, anyway.


  1. Great entry.
    I have a question that relates to something you mentioned in your previous entry. Can you explain in detail what the Howey Case is? I know the four elements of the test. What happens if a business passes the test? Is it a good thing? Bad thing?
    I appreciate your help. Thank you.

  2. Thanks, Daniel. It's purely a regulatory concern--if the investment meets the definition of a security, then it is subject to securities fraud statutes, and it may have to be registered. If the investment does not meet the definition of a "security," then the securities regulators have no authority over it. If I hire you as my marketing manager and after 10 years, I give you a 10% profit participation interest, that may not be a "security." Why? Well, you're not a passive investor who hopes to profit "solely through the efforts of others." And, we have a pre-existing relationship. But, if I sell 10% "profit participation notes" to people at the diner next door, those WILL meet the definition of an "investment contract" and, therefore "securities" using the Howey "test." They will need to be registered unless I can find an exemption. And, if I omit material facts, I can be sued for fraud--possibly prosecuted in criminal court.

  3. Thank you for clearing that up.
    I have another question. I hope you don't mind.
    Let's say that I'm not registered. I receive a call from a client saying that he wants to purchase some shares. The client's agent isn't available at the moment. What should I do? Refer to someone who is registered? Let the supervisor know? Since I'm not properly registered, I'm not eligible to take the order, correct?
    Once again, thank you.

  4. Hi, Daniel.

    I like your answer of "let the supervisor know." If you're not registered as an agent or "securities salesperson," it's a bad idea to execute transactions or share commissions without the supervisor's knowledge. Good instincts on compliance here.