I suppose it’s time to do a post on the market since I’ve done a lot of activity lately (pretty unusual for me). Fresh off the annual “Woodstock for Capitalists” where 40,000 Berkshire Hathaway shareholders descend into Omaha to hear the latest words from Charlie Munger and Warren Buffett one can’t help but think of our larger investment universe and at least in my case do a thorough portfolio review.
Heading into the weekend I was invested in Berkshire at about 55% of the portfolio with about 12% in short-term bonds and cash, and 33% in Vanguard equity index funds (the S&P500 and the high yield VHDYX equity funds). I was fairly happy with that mix and 2016 was well ahead of the market. During the meeting, Buffett gave ample praise to Vanguard’s John Bogle on his 88th Birthday and acknowledged how much benefit and good Bogle had done for the everyday investor by significantly reducing their fees so that a lot more money flows into their pockets rather than into the pockets of investment advisors. All of this is great for the country.
In that light, I’ve recently heard many “experts” on CNBC say that the market is in a bubble and that some calamitous crash is imminent. Many of them refer to the so-called Schiller CAPE Ratio which shows significant over-valuation by historical standards – comparable to 1999! As I look at my WSJ I see that the price/earnings ratio (PE) of the S&P500 is about 24 for trailing earnings – certainly a lot higher than it’s historical 15. People are fearful of investing new money into the indexes. So what do I think of all of this? Well since you asked here goes!
Best I can tell, the Schiller index has a fatal flaw in that it provides no context for interest rates (I’m open to correction on this score). That said, a stock market with a PE ratio of today’s 24 looks a heck of a lot higher when the 10 year bond is yielding 5% than when it’s yielding 2.5% as it is today or when the 30 year bond is yielding 7% instead of the 3% of today. Risk-free US Government Bonds are your alternative to “risky” stocks and serve as an alternative for investment capital. No wonder then that Buffett said that if bond rates stay this low for an extended period that today’s stock market prices will be a great bargain. I note that Buffett and Schiller say two very different things about the value of stocks today. Will rates stay low for a long time? Ben Bernanke, our ex Fed Chair just said they would. Who knows. Should we sell stocks and put our money in the “safety” of bonds? Are bonds really safe? What if interest rates don’t stay this low? Guess what! It’s bonds (not stocks) that are at nose-bleed levels. The current 10 year bond, if it were a stock, would have a price/earnings ratio of 40. The 30 year bond would have a price/earnings ratio of 33. As longer duration bonds are most sensitive to interest rates if rates rise, it’s the prices of the 10-year bonds and the 30-year bonds that will get slammed. As the very short-term (2-year and lower) bonds are far less sensitive to interest rates their prices would hold up a lot better in the rising rate scenario. Buffett wondered aloud at why anyone would buy long-term bonds at today’s prices. Relatively speaking, “stocks are a far better value.” All I’ll say is that a lot of bond funds are not as safe as a lot of people think – not at today’s prices – and are far more vulnerable than stocks if interest rates were to eventually rise. Bond investors had better pray that Bernanke is right.
All of the above therefore serves to guide our decision-making. Stocks may be high but it’s all relative. Compared to bonds stocks are not in a massive bubble – call them fairly valued. Long-term bond funds are exposed to rising rates and dangerous. Short-term bonds and treasuries are a safer place to park a bond portfolio for portfolio balancing and short-term spending needs but you’re not going to receive much of a dividend and you’re exposed to inflation eroding the value of your money. Hmmmmmmm what to do!!? No wonder why hedge fund managers are flummoxed and complaining that they can’t find anything to buy! Half of them are convinced we’re in a Schiller bubble and afraid to invest. As a group they keep losing to the market index funds. Oh how satisfying to see them and their high fees fail and squirm! Ha Ha Ha Ha! 🙂
Which brings me to my own latest maneuverings. In investing EVERYTHING is relative and we all have alternatives we can examine at any given point in time. At this point in my life I’ve essentially become an index investor. I consider Berkshire Hathaway to be a proxy for an index fund. The company is comprised of many many companies in many different industries. It’s stock portfolio, though concentrated, is a diverse collection. The company is filled with top-flight executive talent. Unlike any index, Berkshire has a “fee” of 0.00% which beats any index fund. So what about now? How does Berkshire compare to my index fund alternatives?
There are numerous ways to value Berkshire and some Berkshire nuts will quibble and complain with this method but I think it gets us into the ballpark of value. Berkshire’s A shares are priced at around $245,000 per share (each B share is worth 1/1500th of each A share – call it $163 per B. By owning B’s you just own smaller chunks of the same company). Roughly speaking, Berkshire’s stock and short-term bond portfolio is worth $170,000 per A share. A huge chunk of that figure is in short-term bonds and treasuries. Berkshire’s far flung operating companies (Geico, Dairy Queen, Pampered Chef, BNSF railroad etc) earn about 13,000 per A share. So let’s do some simple math. Market price of $245,000 – $170,000 portfolio = $75,000 left over for the whole company. If what’s left over is producing $13,000 in cash every year that means you’re essentially paying $75,000 for something that earns $13,000. That’s a price/earnings ratio (PE) of 5.77. Say what?! What if we conservatively slap on a more reasonable PE of 10 for that $13,000 in earnings? That’s $130,000. Add $130k to $170k and we get a stock that should be valued at $300,000 per A share and $200 per B share – 22% above today’s prices.
So here’s my thinking. If today’s market is “fairly valued” then Berkshire is certainly “under-valued.” I could invest my money in the S&P500 index which has a PE of 24….. or……… I could invest my money in a company with a PE of 6. What about growth? Well the news there is good as well. The market is growing its earnings at about a 6% per annum rate. Berkshire’s earnings are growing at a rate of about 10%. Safety? Berkshire is sitting on a $90 billion pile of cash – far and away a lot more in percentage terms than the S&P500.
These are the sort of situations that I just absolutely LOVE. I love the probabilities of doing well in Berkshire. I don’t see it as a time to be tepid and my whole life philosophy is to bet big on high probability outcomes. Nothing in life is guaranteed of course but I firmly believe in taking my shots if opportunity presents itself. Here’s what I’m left with after this week’s activity:
Vanguard Equity Index Funds – 14%
Vanguard short-term Bond Fund – 3%
Berkshire Hathaway – 83%
But wait! What if 86 year old Buffett and 93 year old Munger were to leave the scene!!? Oh the horror!! On that score, I don’t think there’s any company in the world which has thought through succession more thoroughly. Berkshire has already lined up high quality, very capable managers to take the place of Buffett and Munger. Enter Todd Combs and Ted Weschler. If you’re counting at home their investment record has beaten both the market and Buffett since they joined Berkshire. The cash won’t disappear. The companies won’t stop earning. The stock portfolio won’t disappear. In the “shock” of the immediate aftermath perhaps the stock would drop 15-20% and people would panic. Boo Hoo. As Buffett has written, all stocks MUST ultimately reach their intrinsic value. It is a law of mathematics. The math pulls the price towards intrinsic value over time. Would a temporary drop of 20% affect my life? Nope! We’ve already been through a 40% drop not that long ago and were buying like crazy. My hands were “trembling with greed.” That’s exactly what I’d do if it happens again.
For those who choose to keep investing in the S&P500 index I happen to think you’ll do just fine. I don’t think your returns going forward will match what they’ve been in the recent past. Your likely return is 4-7% annually counting dividends. That’s a very satisfactory result given the Bond alternative and heck we still have 14% of our portfolio in the index and it’s what I’ve advised my very busy kids to invest in. If you choose Berkshire you absolutely must consider the psychological factors and your own temperament. It ain’t easy to see a massive chunk of your life’s savings suddenly drop 20% while the market is not. One has to be psychologically prepared for just that scenario in owning a large percentage of Berkshire (or any concentrated position). As the saying goes, know thyself.