Market Commentary: Buffett’s Japanese Play Is Genius

There is a reason Buffett is regarded as the greatest investor of all time. He’s got all sorts of tricks up his sleeve that most investors know nothing about. From warrants to riskless arbitrage, the gamut of innovative strategies he employs is as creative as it is extensive.

But his latest play might be among his most imaginative and intelligent yet. To understand it first, you need to know about one of Buffett’s first genius plays that taught him how to capitalize on debt to maximize returns.

Key Points

1. Buffett is a master of using leverage to generate significant returns with very little risk.
2. He learned this technique from his early days of playing the arbitrage game.
3. In his latest play, he is using debt to buy Japanese trading companies that are generating enough cash flow to cover the interest payments.

The “Riskless” Arbitrage

Although Buffett is best known for buying stocks that are undervalued, he made enormous sums of money in his early career playing the arbitrage game. And amazingly, he’s still at it when the time is right to pounce.

Here’s how it works.

Take Microsoft, as a recent example, when it announced its intent to acquire Activision. Immediately upon the news of the deal breaking, shares of Activision soared to a price close to but not quite at the level Microsoft is willing to pay.

Now this is where an arbitrageur steps in.

If the odds of the deal closing successfully is high, buying shares of the acquired company is smart because when the deal is formalized the gap between where the shares sit pre-closing and post-closing is eliminated, and results in pure profit.

This type of play was an old favorite of Buffett’s in the early days and, according to his partner Charlie Munger, he used leverage extensively so his returns on capital were even higher.

What did Buffett learn from this play? Using debt as part of a virtually risk-free play can produce enormous returns.

Let’s now fast forward to how this applies to his “genius” Japanese investment.

The Genius Of The Japan Bet

Warren Buffett’s investment in Japanese trading companies is another brilliant example of how to use leverage to generate significant returns with low risk.

Buffett found a group of companies that were generating enough cash flow to cover the interest payments on the debt he used to invest in them. The key to the genius strategy is in that last sentence. He’s borrowing in yen, and investing in yen. But he’s borrowing at a lower rate than he’s earning in dividends.

This means that the only way he could lose money on this trade is if the Japanese economy falls off a cliff and nosedives. But the odds of that are slim because these companies have global exposure by acting as middlemen primarily in the commodities trade.

Over a multi-decade holding period, Berkshire becomes insensitive to currency volatility, and he will essentially be able to lock in the earnings gains of the companies he owns.

Why is the trade so smart?

• The Japanese trading companies are well-established businesses with a long history of success. They have a deep understanding of the global economy and are well-positioned to benefit from future growth.
• The dividend yields on these stocks are very attractive. This means that Buffett is getting paid to own the companies, which reduces his risk.
• The Japanese government is very supportive of the trading companies, providing them a competitive advantage and makes them less likely to go bankrupt.

The reason Buffett earns his reputation as among the smartest investors of all time is because of a play like this one: It’s low-risk, high-reward, and it has the potential to generate significant returns over the long term.