Following on from my previous posts, given that equity markets are at post-crisis highs currently, I believe it is a useful exercise to sit back and take stock of what this means for me as I prepare to build a portfolio based on value investing principles. Part of such an exercise should involve a careful study of Warren Buffett’s latest letter to Berkshire Hathaway shareholders, published on 1st March. I note there has been much discussion online recently suggesting that Buffett is no longer a “true” value investor, given the price paid for Heinz. I would argue here that the price Buffett paid for his investment in Heinz constituted value for Buffett, but it does not necessarily follow that HIS price should also represent value for any other investor – it must be recognised that Buffett is in a unique position as an investor, with accordingly unique requirements in terms of preserving investment capital and earning an adequate return. As Dr. Michael Burry once stated “the biggest impediment to investing in the spirit of Buffett is the idea that somehow we can be a 100% imitator of him and see the same success”. Nevertheless, a thorough reading of his latest views on business and investment is useful for all investors, particularly in light of where markets are currently.
Outlined below are some key observations from my reading of the latest Berkshire letter, and the conclusions I have reached from considering these points:
1. The 5 most profitable non-insurance businesses, Berkshire’s “Powerhouse 5” of BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy delivered strong results in 2012, and are expected to deliver higher earnings again in 2013 – “unless the US economy tanks – which we don’t expect” as Buffett states.
Independent Value (IV) observation: these five businesses operate within the railroad, metal tools, specialty chemicals, industrial and energy sectors – all large cyclical, industrial, and capex-heavy businesses. In my view, this suggests that Buffett thinks:
- the US economy will continue to maintain, or improve upon its current positive momentum;
- consequently quality heavy industrial companies represent attractive investments currently; and
- perhaps most significantly, businesses with large capex requirements are good businesses for investment currently;
This third point is highly significant in my view, as it initially appears to jar somewhat with Buffett’s previously perceived preference for businesses with low incremental or growth capex (such as Coca-Cola). Many capex-heavy, industrial companies tend to swallow up investors’ capital while producing modest returns on that capital. Buffett’s “powerhouse” businesses are clearly expected to grow if the US economy continues to improve, but by their nature will always require significant capital investment. From an investment perspective then, what is the appeal of investing in these types of businesses?
Upon reflection, the only logical answer that I can come up is this: interest rates currently remain at all-time lows, as a result of massive, globally co-ordinated QE efforts. The likely result of such extraordinary measures is (eventually) massive inflationary pressure. While no inflationary pressure has occurred as of yet –US inflation averaged 2% throughout 2012 according to the US Bureau of Labor statistics – given the level of stimulus experienced, an inflationary surge is a real possibility. So how does this impact corporate capex spend, and why is this relevant to an investor? Essentially, corporates can invest now in expensive capital equipment at a historically lost cost of funds, before any potential rise in inflation causes the prices of such equipment to rise significantly once inflation again takes hold. As corporate borrowing has never been done on better terms, and with American corporate cash balances at record levels, companies have the means and opportunity now to bolster their operations by investing intelligently in plant machinery, equipment etc., at abnormally advantageous prices. If capex programmes are deferred until the economy begins to re-inflate, capex will be more costly and the cost advantage will have been lost.
I believe that Buffett is indicating that it is only those businesses that have the will to invest significantly in capex now that are attractive for investment. It is these businesses who will be better placed to maintain and grow their market share in future at the expense of competitors who defer capex now due to economic uncertainty. Those businesses that hesitant and sit on cash piles that earn little or no return may find their competitive position weakened while being forced to investment in maintenance capex at comparatively higher costs in future. In my view, Buffett is effectively saying that this failure to recognise such favourable conditions for bolstering competitive position by shunning the current capex opportunity may well prove to be an unintelligent and costly mis-allocation of capital.
The take away for investors? Companies that are spending big on capex now, rather than conserving cash, may well had a competitive advantage over rivals in the medium-term as inflation ramps up. Significant capex spend now means possibly greater free cash flow for business owners in the future.
2. Berkshire’s “Big 4” investments – American Express, Coca-Cola, IBM and Wells Fargo also had a good 2012. Berkshire’s ownership interest in each of these companies increased during 2012, and Buffett indicates that Berkshire’s ownership interest in all four “is likely to increase in the future” as “Over time we expect substantially greater earnings from these four investees.”
IV observation: these businesses are in the financial, technology and consumer sectors, all markedly differing spaces, but the businesses themselves share similar characteristics – exposure to consumers, service businesses and are not overly capital-intensive in terms of incremental capex (although WFC is impacted by certain regulatory capital requirements). Buffett clearly believes that quality blue-chip names remain attractive as their future prospects remain promising, and has continued to stick with stable names that he understands, with a steady prospective growth profile, rather than chasing high-growth companies that may continue to do well in a rising market.
This would suggest that while Buffett clearly believes that the future corporate outlook is favourable, it is sensible to stick to what one understands as an investor, and not opt for high-growth companies that are swept upwards in prevailing exuberant market conditions.
3. Last year CEOs cried “uncertainty” when faced with capital allocation decisions (despite many of their businesses having enjoyed record levels of both earnings and cash). Berkshire didn’t share these fears, spending a record $9.8 billion on plant and equipment in 2012, about 88% of it in the United States. That’s 19% more than spent in 2011, a previous high. [Munger and Buffett] love investing large sums in worthwhile projects, whatever the pundits are saying. ..Berkshire will almost certainly set still another record for capital expenditures in 2013. Opportunities abound in America.
IV observation: this explicitly reinforces my first observation above; Berkshire incurred significant capex spend in 2012 and will do so gain in 2013, ignoring the widespread economic uncertainty that has paralysed some businesses. As noted above, with interest rates and inflation low at present, the cost of capex is lower now than it is likely to be in the future, so Berkshire is taking full advantage of this by investing in capex while it is CHEAP – replacement costs of plant and equipment will most likely increase in future with inflation. As record profitability corrects with margin mean reversion, capex for companies will become significantly more expensive, reducing free cash-flows. This would result in a double hit of higher replacement costs and lower free cash generation. By taking advantage of temporarily depressed plant and equipment costs, Buffett is ensuring greater intrinsic value for shareholders in future – an efficient use of capital. Given the likely consequences of QE that will follow, the value of cash piles now will wither away with inflation – cash piles now may well become a wasting asset.
4. American business will do fine over time. And stocks will do well just as certainly, since their fate is tied to business performance. Periodic setbacks will occur, yes, but investors and managers are in a game that is heavily stacked in their favour. (The Dow Jones Industrials advanced from 66 to 11,497 in the 20th Century, a staggering 17,320% increase that materialized despite four costly wars, a Great Depression and many recessions. And don’t forget that shareholders received substantial dividends throughout the century as well.) Since the basic game is so favorable, [Buffett and Munger] believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.
IV observation: Buffett believes businesses and corporations will continue to perform in the future, and their common stock will accordingly produce positive returns for investors over the long-term, as they have throughout history. Investors should keep this in mind, rather than paying attention to temporary business fluctuations and financial commentators and analysts’ predictions of the future. When the outlook and opportunities for businesses and investors is so positive (in Buffett’s view), the risk of not investing is significantly greater than the risks that go hand-in-hand with investment. The view that common stock investment is too risky now due to all the economic uncertainty is misguided – there has always been uncertainty, and this creates opportunity for investors.
However, Buffett is not simply suggesting here that all businesses will perform and deliver solid results for investors; as always it is essentially that any investment is predicated on value first and foremost, as the price paid will be the key determinant of future returns. Perhaps the most valuable takeaway for investors here is that the risk of ignoring stocks due to widespread macro-economic uncertainty (and the parking of capital in cash and fixed income securities exclusively) is actually more risky than risk-averse – remember inflation will erode investment capital overtime.
Conclusion: In summary, perhaps the key takeaway for consideration is that despite the near-peak prices awarded to stocks at present, Buffett believes that they remain the most attractive investment proposition. The prevailing macro-economic uncertainty indeed indicates significant investment risk – but not in the sense that many market commentators mean. The risk arising from the uncertain outlook is the risk of not investing in quality businesses now, and succumbing to the herd compulsion for investors to retreat into cash and fixed income. Given the genuine risk of inflation due to the loose monetary policies of central banks, cash and fixed income securities will essentially become wasting assets with poor or non-existent real returns and eventual capital impairment. Buffett is therefore convinced that businesses run by competent managers who recognise this risk of not investing in their own businesses now will prove to be intelligent investments in the future.