Warren Buffett’s annual letters are known for his wisdom on investing and many other topics. In the 2018 letter that was published this past weekend, the following six insights stood out:
- “On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period. Over time, however, investment performance converges with business performance. And, as I will next spell out, the record of American business has been extraordinary.”
Many people have learned the wrong lesson – that if you buy good businesses then you will get good long-term returns. The current fashion among a number of value investing practitioners has been shifting away from being disciplined on the price paid for an investment that had been the hallmark of the value investing approach and towards a bold belief that their own ability to foresee the future of wonderful businesses will allow them to minimize the emphasis on the purchase price.
We did not have to wait long for an example of why deemphasizing valuation and focusing primarily on quality is a flawed approach. Warren Buffett himself, in today’s CNBC interview, explained the mistake that he made in purchasing Kraft Heinz (ticker: KHC). It boils down to this: the business is still a good business, but the price paid was too high, leading to a large permanent capital loss.
Buffett walked us through the math. The business is generating $6B in pre-tax profits on tangible capital of $7B. So by any measure, it is still a terrific business and most companies could only dream of such returns on capital. The problem is that Buffett paid a price that implied a $100B premium to the tangible capital invested. So he needs to get a return not on the $7B required to run the business, but on the $107B of capital that he paid. For that the current trajectory of the company’s profitability appears to be insufficient, resulting in what seems likely to be a large permanent loss for the best investor in the world.
You see, it’s not enough to buy a good business. You have to buy it at a price that provides a meaningful margin of safety so that some things can go wrong in the future and you can still get a good investment result. When you pay a fancy price for a good business, that margin of safety is rarely sufficient, as none of us can see the future with perfect clarity, not even Warren Buffett.
- “In recent years, the sensible course for us to follow has been clear: Many stocks have offered far more for our money than we could obtain by purchasing businesses in their entirety. That disparity led us to buy about $43 billion of marketable equities last year, while selling only $19 billion. Charlie and I believe the companies in which we invested offered excellent value, far exceeding that available in takeover transactions.”
Buffett has been on the record as saying that if he were sure that the interest rates on 10-year Treasury bonds were going to stay near their current levels, then it’s a no brainer that the U.S. stock market is a much better investment. That’s not a very interesting statement, as current bond rates are very low by historical standards. Essentially, what Buffett is saying is “Stocks are likely to return more than 3% per year for the next decade.” Not very exciting at all if that is the strongest statement that he can make.
Furthermore, it always pays to watch what someone does, not just what they say. Warren Buffett has gone to great lengths in recent years to avoid saying that the stock market as a whole is expensive. Nonetheless, you can see it in his portfolio. Two things stand out:
- Berkshire Hathaway has ~ $100B in excess liquidity that if Buffett really thought the public markets offered a meaningful opportunity for attractive investment, he would likely deploy a good portion of into buying stocks.
- Among Berkshire’s current holdings there are a number of stocks that Buffett could buy more of if he wanted. There are some where he can’t because he does not want to cross the 10% ownership threshold, such as the large banks. However, a number of large, very liquid stocks in Berkshire’s portfolio are well below that threshold (e.g. Apple). The most likely reason why Buffett doesn’t buy more? He doesn’t like the price enough.
So while Buffett has been much more diplomatic in recent years about saying anything negative about overall stock market valuations than he had been earlier in his career, his actions say all we need to know: he can’t find enough attractively priced opportunities that fit his criteria to deploy Berkshire Hathaway’s available capital despite his considerable effort to do so.
- “Those who regularly preach doom because of government budget deficits (as I regularly did myself for many years) might note that our country’s national debt has increased roughly 400-fold during the last of my 77-year periods. That’s 40,000%! Suppose you had foreseen this increase and panicked at the prospect of runaway deficits and a worthless currency. To “protect” yourself, you might have eschewed stocks and opted instead to buy 314 ounces of gold with your $114.75. And what would that supposed protection have delivered? You would now have an asset worth about $4,200, less than 1% of what would have been realized from a simple unmanaged investment in American business. The magical metal was no match for the American mettle.”
There are always many things to worry about in terms of macro-economic concerns, geo-political troubles and the like. Despite it all, over the long-term U.S. equities have been a much better bet than trying to time the market or than assuming that the engine of U.S. prosperity is no longer running well enough for stocks to provide good returns and leaving the asset class. Assuming that you have an investment strategy and process that make sense to you – stay the course, don’t get swayed by the temptation to be pessimistic or to think that you can do better by trading in and out of the market.
- “We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time. At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal. A Russian- roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside. But that strategy would be madness for Berkshire. Rational people don’t risk what they have and need for what they don’t have and don’t need.”
Risk is very hard to judge, either prospectively or after the fact. Let’s say you see an investment manager who put up a great rate of return over many years. How do you assess the risk that they took to get there? It’s not easy to say if, to use Buffett’s analogy, they happened to play the Russian-roulette game and avoided a bad outcome by sheer luck, or if they were truly skilled and never exposed their capital to the risk of a large permanent capital loss.
One relevant view on risk is to think about the alternative paths that the world could take and what they would mean for your investment outcome. Risk management then becomes trading off some of the extra upside from the particularly good paths that the world can take for your investments in order to makes sure that you don’t lose your shirt if things go differently than you expect them to.
Buffett is right to be extra cautious with financial leverage, as you never know when some unforeseen event comes along and causes those who levered up to reach for that extra unit of profit to get wiped out. Most of the time that won’t happen, and that prudence will look like a drag on results in hindsight. However, you will be really glad that you didn’t overreach if and when the capital markets do go into their periodic period of tailspin when financing is very hard, if not impossible, to come by.
- “Over the years, Charlie and I have seen all sorts of bad corporate behavior, both accounting and operational, induced by the desire of management to meet Wall Street expectations. What starts as an ‘innocent’ fudge in order to not disappoint ‘the Street’ – say, trade-loading at quarter-end, turning a blind eye to rising insurance losses, or drawing down a ‘cookie-jar’ reserve – can become the first step toward full-fledged fraud. Playing with the numbers “just this once” may well be the CEO’s intent; it’s seldom the end result. And if it’s okay for the boss to cheat a little, it’s easy for subordinates to rationalize similar behavior.”
In my almost two decades of professional investing, I have been shocked how much CEOs of public companies pander to the short-term expectations of so-called “investors.” Many of these companies aren’t reliant on coming to the capital markets for extra financing on a regular basis. Why then can’t these CEOs simply ignore those Wall Street analysts and investors who are focused purely on the short-term?
Part of the answer is about incentives. The rest is about our basic human desire to be liked and the validation most of us feel when what we are doing meets with the approval of others. The CEOs that I respect the most choose the long-term investors as the group for which they work. They don’t indulge sell-side analysts who ask for intra-month business trends on quarterly calls. What possible relevance could those have to long-term business owners? They don’t set guidance that then forces them to deviate from the behavior that is best for the long-term. They simply manage the business as if they owned all of it and were going to measure the outcome many years from now.
- “It is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down… For continuing shareholders, the advantage is obvious: If the market prices a departing partner’s interest at, say, 90¢ on the dollar, continuing shareholders reap an increase in per-share intrinsic value with every repurchase by the company. Obviously, repurchases should be price-sensitive: Blindly buying an overpriced stock is value-destructive, a fact lost on many promotional or ever-optimistic CEOs.”
I have been appalled with how poorly many CEOs and boards of major public companies allocate capital, especially with respect to share repurchases. It seems so simple to do it right, as Buffett outlines above, but behaviorally it is difficult. Why? Many CEOs are not natural capital allocators and got to their jobs through other skills. Also, when the stock is the most undervalued it is frequently the hardest to act as current market conditions or short-term business trends are unlikely to be favorable.
So what happens? Boards freeze up and choose to act “conservatively” and do nothing when the business whose shares they were buying back at $100 now trade for $60 with little change to the long-term fundamental outlook. Sorry, that’s not being conservative, that is just being conventional and being afraid to do the rational thing.
The overall record of U.S. companies with respect to share buybacks is abysmal: companies in the aggregate consistently buy when their stock is expensive and rarely buy much, if at all, when it is cheap. Consider these two statements that I have heard recently from company managements as to why they are not buying back stock that appears to be undervalued:
- “Well, we bought it back at a higher price last year and the stock still went down, so we decided the buyback wasn’t working and stopped it.” Really? If you are going to use short-term price movements as the metric for whether a buyback made sense, then you are really mis-understanding the logic of how it is supposed to work.
- “Studies have shown that buybacks don’t expand the valuation multiples so we are not buying back our stock even though we think it is undervalued.” I am not sure which studies the person referred to, but that is not the relevant criteria either. You should be buying back stock if 1) it increases the intrinsic value per share, 2) it is a better allocation of capital than other opportunities and 3) if doing so does not expose the company to undue risk because of financial leverage
Studying the writings of Warren Buffett can greatly improve your understanding of business and investing. There are many insights to be found in Berkshire Hathaway’s annual letters and in Buffett’s interviews over the years. Just remember that he doesn’t say everything there is to say (nor should he), and that there are times when he likely holds back on saying something because doing so would not be beneficial to him or to Berkshire Hathaway. So don’t just study what he says – combine that with studying his actions over time to get a fuller picture of how he implements his investment process.
If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.
Disclaimer: The above is my personal opinion, and does not constitute investment advice.
