In his 2011 Letter to Shareholders, Berkshire Hathaway (NYSE: BRK-A, BRK-B) Chairman Warren Buffett puts investments into three major categories. His comments about each category defy conventional wisdom.
The first category is what he calls currency-based investments. This category includes bonds and bank deposits. Most Australians have money in bank accounts or term deposits offered by major banking institutions such as Commonwealth Bank (ASX: CBA). These investments are considered safe, but, to quote Buffett, "In truth they are among the most dangerous of assets." He continues:
"Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation."
The second category is speculative assets, namely, assets one buys with the hope of selling them to someone else for a higher price. The most obvious example of this kind of investment is physical gold, but gold mining companies such as Newcrest (ASX: NCM) are exposed to the same risk. Speculative assets don't produce anything useful.
Stock prices for certain companies can easily become inflated by speculative buyers. These investors are prone to lose a lot of money. As Buffett says,
"Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the "proof" delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop."
Buffett's favourite kind of investment falls into the third category, productive assets. Investors can buy a share of a productive asset when they buy shares in a company that owns such an asset. Productive assets, says Buffett, "will prove to be the runaway winner among the three [categories] we've examined."
Buffett further divides productive assets into two subcategories. First, there are assets that require little additional capital. For example, the right use Coca-Cola brands (itself an asset) gives Coca-Cola Amatil (ASX: CCL) significant pricing power. This allows it to maintain strong margins.
The second subcategory is productive assets that require significant capital injections. For example, TPG Telecom (ASX: TPG) owns extensive telecommunications networks, but continues to build and acquire more infrastructure, in order to maximise profits from the existing network. Such companies can be good investments where it is unlikely the asset will be duplicated.
Foolish takeaway
Buffett's best three investments are a different kind of 'asset'. Numbers one and two were wedding rings and the third was his family home. Although not everyone would call these purchases investments, the point Buffett makes is that some things are more important than financial returns. Money is a means to an end, not the end itself.
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Motley Fool contributor Claude Walker has an indirect interest in TPG Telecom through a managed fund. Find him on Twitter @claudedwalker.
