Each year Warren Buffett pens a letter to shareholders, which has become a must-read for investment professionals and individual investors alike. Here, I will highlight some excerpts I found particularly interesting and relevant from this year’s letter (released this morning).
- Market Valuations
- Thoughts On Debt
- Investing Principles
Last year CNBC hosted a #AskWarren segment where people could submit questions to Warren Buffett via Twitter. I did just that and my question was selected and answered by Mr. Buffett on air. I no longer have access to the video, but here’s a screenshot of the Tweet CNBC aired.
Warren Buffett’s answer, in short, was that he was not concerned market valuations were excessive. His view was that low interest rates justified the higher-than-normal valuations. However, it appears he actually was / is concerned about valuations as Berkshire ended 2017 with the highest cash reserves on record with $116 billion. Actions speak louder than words, no? Additionally, in the Letter he wrote:
“In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.”
“That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.” [emphasis mine]
Clearly, Mr. Buffett and his management team have concerns about market valuations.
“The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis, knowing that our taste for overall debt is very low and that to assign a large portion of our debt to any individual business would generally be fallacious (leaving aside certain exceptions, such as debt dedicated to Clayton’s lending portfolio or to the fixed-asset commitments at our regulated utilities). We also never factor in, nor do we often find, synergies.”
“Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need. We held this view 50 years ago when we each ran an investment partnership, funded by a few friends and relatives who trusted us. We also hold it today after a million or so “partners” have joined us at Berkshire.”
“Berkshire, itself, provides some vivid examples of how price randomness in the short term can obscure long-term growth in value. For the last 53 years, the company has built value by reinvesting its earnings and letting compound interest work its magic. Year by year, we have moved forward. Yet Berkshire shares have suffered four truly major dips. Here are the gory details:
“This table offers the strongest argument I can muster against ever using borrowed money to own stocks. There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.” [emphasis mine]
It seems Warren is preparing investors for another significant drawdown, doesn’t it? After all, why else talk about gory declines when everything has been / is so great?
On Investing Principles:
In the Letter, Warren reminds us of Ben Graham’s quote, “In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.”
This essentially means that in the short-term market prices are driven by investors’ inclination to speculate or aversion to risk, which is based on emotions and momentum. However, over more meaningful periods of time, market prices will reflect true value. This is why predicting short-term movements is notoriously difficult and most often a waste of time and money.
“Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date. ‘Risk’ is the possibility that this objective won’t be attained.”
“I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term U.S. bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.“ [emphasis mine]
Mr. Buffett makes two very important points here. The first is that your investment must match your time horizon. To put another way, the asset must match the liability. In practice, this means that if you have a large expense coming up in six months (e.g. down payment on a house) then the money needed for that expense should be left in a vehicle with a very short-term time horizon like a short-term CD, bond, or even just left in cash in the bank. In other words, don’t put short-term cash needs in long-term investments like stocks!
Money not needed for a very long time, on the other hand, can and should be invested in long-term investments like stocks. To keep it simple, just make sure to match the time horizon of the investment with the time horizon of the expense.
The second point he makes is that stocks become less risky than bonds over long timeframes IF the stocks are purchased at a reasonable valuation.
That’s a big “if.” People with high risk tolerances and a bias towards having a lot of stock exposure ignore that last part. They buy stocks no matter what the valuations are because they only consider the expected returns over very long time horizons that may not even be relevant for their situation. For instance, how many investors and advisors have you heard quoting 100-year stock market returns as a justification for their investment approach? Most investors, besides pensions and endowment funds for example, don’t have 100-year time horizons. In fact, many investors will begin withdrawing funds from portfolios within a few years if they’re near retirement or are already withdrawing on portfolios.
This is probably a good place to remind you that market valuations today are higher than they’ve ever been based on the most reliable measures. Investors buying stocks today are not purchasing stocks at sensible multiples as Warren suggests but at / near record-high multiples. This is less of a problem for younger folks with the bulk of their earnings and savings ahead of them, but needs to be seriously considered when constructing portfolios for folks nearing retirement or recently-retired folks.
Remember, Mr. Buffett once said, “Be fearful when others are greedy and greedy when others are fearful.” And now he has the most cash on hand than ever before. I think that tells us a lot.