Rule-breaking Buffett gets burned

The famed investor violated his own rules this year and has come up on the short end.

Posted by TheStreet Staff Friday, November 12, 2010 10:26:10 AM

By Don Dion, TheStreet

Throughout his wildly successful, decades-long investing tenure, Warren Buffett has offered investors countless nuggets of wisdom that can greatly aid everyday investors in their attempts to navigate any market environment.

So it's no wonder the investor's life and actions have been monitored closely by droves of fans who hang on to his words documented across numerous articles, videos, books and other media.

Abiding by his rulebook has been instrumental in Buffett's ability to create his massive fortune. However, as
we have seen just this year, Buffett doesn't always stick to the points he has laid out.

At the start of 2010, Buffett vigorously expressed his disapproval of the use of share spits and excessive use of company equity to fund M&A activity. When food giant Kraft (KFT) was pushing to purchase U.K. candy maker Cadbury, the Oracle called the share-fueled plan dumb. He reasoned that by issuing new shares the company injects excessive supply into the market and dilutes shareholder power.\

Despite his reservations, in order for the Oracle to fund his $34 billion bid for the remaining shares of Burlington Northern Santa Fe Railroad a handful of months later, he laid out a plan that included a significant share split of Berkshire Hathaway Class B (BRK.B) shares.

While these deviations, as in the Kraft/Burlington Northern episode, are often more peculiar than detrimental, as we saw late last week, breaking a Buffett rule can be costly, even for Buffett.

Perhaps the most criticized example of Buffett's breaking his own rules is his stance on derivatives. In a now-famous letter to his shareholders, the Berkshire Hathaway (BRK.A) chairman took aim at derivatives, labeling them "financial weapons of mass destruction." Given this harsh stance, one would think Buffett and his company have made efforts to steer clear of such complex and risky products.

That assumption, however, would be false. In reality, his firm manages a massive derivatives portfolio valued at more than $60 billion.

Recently, his heavy exposure to these products backfired.

In the third quarter of 2010, Berkshire Hathaway saw profits decline by more than 7%, with poor derivatives bets alone leading to a $700 million quarterly loss.

Interestingly, while derivatives proved detrimental, the traditional stock investments Buffett is far better known for were seen as an element of strength in the Berkshire report.

An uptick in demand stemming from the ongoing economic recovery helped lift Burlington. That helped to offset some of the losses resulting from his derivatives.

As we have seen throughout this year, sometimes the investor has overlooked his own rules, and it has weighed on his company's performance. Still, despite his stumbles, investors can still benefit from abiding by his investing advice and market commentary.

Most of Buffett's success and popularity as an investor have hinged on his ability to pick out and invest in undervalued, easy-to-understand companies that have long-term upside potential. By largely sticking to these criteria, he has been able to build a massive fortune that places him third on the list of the world's wealthiest individuals.