Newsletter June 21, 2003
Investorsfriend Inc. Newsletter June 21, 2003
More From Warren Buffett
One of the most interesting things that I heard Warren say in Omaha on May 2, was that he would be hard pressed to go through the entire list of the S&P 500 companies and predict which will rise and which will fall in price. As the master investor we might think that he would do a pretty good job at picking the winners and losers.
But his point is that this is not how he does things. Imagine that Warren needed to invest a new equity portfolio of $100 million for a close relative. What he would do is just try to figure out 4 or 5 companies in the S&P 500 that he is sure will offer excellent returns. He would start by ignoring hundreds of companies that are just too unpredictable. He would likely ignore all the mines and minerals and oil and gas as being unpredictable. Many other companies that have had unpredictable earnings would be ignored. Any high-tech company that has no profit but for some reason has a huge market cap would be ignored. He would tend to focus on relatively simple businesses that have a long track record of superior earnings and earnings growth. These companies would tend to operate with little debt. They would have strong competitive advantages such as patents or brand names that protected them from severe completion. Warren would have to think that the management of these companies were trustworthy. These would be companies that Warren was almost certain would be still around and still growing in ten years time.
He would then look at only these companies and try to find a few of them that were undervalued compared to their predictable cash-flow generating capacity. If and only if he found some like these, he would then take and invest all of that money in his top 4 or 5 picks. And if he found no suitable companies then he would not invest in equities at all. He would put the money into short term investments even at 1% and hold his powder dry until the right investments came along.
Berkshire’s annual report revealed that Warren has invested fully 69% of their $28.4 billion stock market investments in just four companies. These are Coca-Cola, American Express, Gillette and Wells Fargo. Actually he invested only $3.7 billion in those 4 companies. But that amount has grown 668% so far.
Meanwhile, the average do-it-yourself investor has a number of mutual funds and if invested in equities generally has their money spread over 15 stocks or more. Now modern portfolio theory says that these investors are right. Warren, the world’s most successful investor thinks this is nonsense and prefers to pile into his best picks, rather than spread his investments out.
If we are going to take Warren’s advice and concentrate our holdings, then we have to be extremely sure about the safety of those few holdings. But in general ignoring Warren’s advice in favor of the academics would be a bit like ignoring golf advice from Tiger Woods in favor of a golf advice book from the United States Golf Association. (The authors would seem like a credible source but they have not won any major championships.)
Warren’s advice in short: Invest only in the best predictable money makers and only when they are bargain priced and forget the rest.
Stocks To Buy Now
With the market having risen rapidly in the last 2 months, I am finding it hard to identify strong buys. But for my paying subscribers I do have a few picks to suggest.
The Incredible Shrinking Interests Rates and Their Impact on the Market
Both long and short term interest rates in the United States continue to drop like a stone, but cannot get much lower.
It is really quite incredible. The 30 year U.S. Government bond yield is 4.2%, the ten year yield is 3.1%, The two year yield is 1.1%, the six month yield is 0.8% annualized!
It appears that the demand to borrow money is much lower than the supply of money available to be invested (loaned out). As a result, big corporations are willing to lend out money to the government at these incredibly low rates. The two year yield of 1.1% appears to be a negative return after inflation is considered.
What Does This Mean For Bond Investors?
The continuing drop in U.S. interest rates in the past year means that long term bond investors of 1 year ago have made unexpected capital gains. Paradoxically, the drop in rate causes higher returns for last year while virtually insuring very low returns going forward. The only way that U.S. government bond investors will earn more than the low yields quoted above is if interest rates fall even closer to zero. If interest rates rise then bond investors will see large capital losses.
What Does This Mean For Stock Investors?
In a sense stocks compete with bonds for investors money. With today’s exceedingly low bond yields, stocks only need to offer a moderate return such as 6% to 8% in order to compete.
This probably explains some of the sharp rise in the market indexes in the last 3 months.
If the return that stock investors falls then stock prices rise, creating one-time gains but causing future returns to be lower.
The historic average P/E on the market has been about 18. If stock market investors require an 8% rate of return then it becomes difficult to justify an average market P/E above about 15. However, if investors require only a 6% rate of return then a P/E of 18 can be justified. The point is that if stock investor’s required return has declined due to much lower interest rates then the justifiable P/E has risen and stock indexes should rise, all else being equal.
What Segments Will Benefit or Be Harmed by Low Interest Rates?
Charlie Munger (Warren Buffett’s partner) said in 2002 “Almost every life insurance company in Japan is in substance insolvent. And the reason they’re insolvent is they agreed to pay about 3% interest on money left with them by policyholders.”
Insurance companies in Japan were certain that they could easily and always earn at least 3% in bonds and so they set prices for life insurance and annuities on that basis. Now, Japanese interest rates are near zero and they cannot earn close to 3% and they are technically insolvent.
Life insurance companies in North America may be facing the same thing. They have likely priced their life insurance and annuity products based on assumptions of much higher interest rates. Who knows what trouble they are in? Their financials are actuarially determined and if interest rates stay low, they could be facing humungous write-offs.
New borrowers benefit from lower interest rates. We may find that newer companies will begin to out-compete older companies. Older companies have locked in much of their debt at high rates. Older companies also face huge pension costs. It may be time to bet on newer companies.
PENSION PLANS IN DEEP TROUBLE
Consider pension plans. We have heard how they have been hurt negative stock market returns. But they have enjoyed capital gains on their bonds as interest rates fell. But with rates near-zero, the capital gains party must end soon. The reality is that pension plans are facing absolutely massive problems. With 10-year U.S. bond returns at 3.1%, they are, frankly, screwed. It is almost inconceivable that they will earn anything close to the 8% returns that most of them are assuming. Even more scary, the lower interest rates will mean that companies have to discount their pension liabilities at a lower discount rate, which sharply increases the value of the liabilities and the amount of the pension deficit.
See my scary article on why pension deficits are set to balloon out of control for many companies.
American Mortgage Refinancing – A Debacle In The Making?
Consider the following scary scenario:
Point 1: The U.S. economy is widely reported to have been kept afloat by mortgage refinancing. I don’t know the figures but in order to have such a large impact on the U.S. economy, consumers must be saving many many billions in interest costs by refinancing. (In the U.S. federal law allows consumers to “get out” of 30 year mortgages by paying a nominal fee.)
Point 2: If consumers are making billions from refinancing then someone on the other side is losing those billions. It is not likely the banks since banks typically hedge these risks by buying financial options.
Point 3: There has been no news to my knowledge about who is losing this money.
Point 4: Some corporations may be sitting on these humongous losses. Maybe they are in derivatives or off-balance sheet, but they must be someplace.
Point 5: When these loses are finally recognized in financial statements some large corporation(s) are most likely going to go down hard. I shudder to think what the ripples from that will look like.