FILE PHOTO: Berkshire Hathaway Chairman Warren Buffett walks through the exhibit hall as shareholders gather to hear from the billionaire investor at Berkshire Hathaway Inc’s annual shareholder meeting in Omaha, Nebraska, U.S., May 4, 2019. REUTERS/Scott Morgan/File Photo | Photo Credit: SCOTT MORGAN
Time-tested investing lessons for uncertain times
The current times are uncertain as any that Indian markets have encountered in many decades. While multi-decades-high inflation in the US was threatening to put an end to the party in the markets, geopolitical tensions have complicated things. According to some eminent economists, stagflationary threats are brewing too. Yet another whammy could come from the US Fed as it proceeds with monetary tightening. As the 1970’s stagflation experience indicates, not tightening monetary policy due to commodity shocks (Oil shock of the 1970s) ended up causing a decade-long bitter economic experience.
Why should India worry? Well, when the US sneezes, the world invariably catches cold.
What should investors do under the current circumstances? Warren Buffett’s annual letters to shareholders are worth looking up to. With Buffett releasing his annual investor letter last week, we decided to dig through the troves of investing wisdom that he has shared since the 1970s with shareholders, in Berkshire Hathaway’s annual report. Across these time periods, he has witnessed episodes of stagflation, geopolitical tensions, asset bubbles, changing liquidity paradigms, etc. His investment philosophies thus have been stress-tested and proven to be valuable to use as guide for current uncertain times. Here we summarise five lessons from his communication to his shareholders that have relevance in today’s scenario
#1 Don’t underestimate the impact of inflation on stock prices
“Inflation is transitory’ was the buzzword through most of last year, but it wasn’t. Extended periods of low inflation in developed markets had made investors, analysts and economists complacent in their assessing the risk of extended loose monetary policies. This has left central banks in a tight spot today in the midst of geopolitical tensions. Although this turned out to be excellent fodder for stock markets as their relative attractiveness shot up in a low interest rate regime, the reverse may also play out, ie high interest rates will be negative for stocks.
In his 1982 (annual report for 1981) communication to shareholders, Buffett stresses on the risks of inflation in no uncertain terms – ‘Inflation acts as a gigantic corporate tapeworm. That tapeworm pre-emptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.’
Higher interest rates invariably follow high inflation and he states in his 1986 newsletter that when markets are expensive, he would prefer parking his surplus funds in bonds since when interest rates rise, ‘ it would probably depress common stocks considerably more than medium terms bonds’. He further notes how he would, in that situation, be happy to sell bonds at loss to re-allocate to far better equity values when it happens.
Persistent inflation can completely derail business models that appear great initially and more so in fancy excel models. Many Indian investors themselves endured this pain as the rosy multi-year forecasts built around real-estate, infrastructure and power companies in 2007 and again during2009-10, turned out to be fantasies. Many investments meanwhile became tragedies as inflation and high interest rates made many of the highly leveraged entities in these sectors unviable.
Thus, with recent geopolitical tensions further cementing inflationary threats, and increase in interest rates likely, it may be time for you to assess which stocks in your portfolio would cede their value to the gigantic tapeworm. Highly leveraged companies, those having high commodity inputs, unprofitable new age companies are likely to be more impacted.
#2 Do your investments have ‘margin of safety’?
In his 1991 letter, Buffett refers to a lesson he learnt from the book The Intelligent Investor ‘ Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, ‘Margin of Safety.’ He stresses how forty-two years after reading the book, he still thinks those are the ‘right three words’. He further notes how the failure of investors to heed this simple message has caused them staggering losses. He again reiterates in his letter written in 1993 on how he believes ‘ this margin of safety investment principle to be the corner stone of investment success.’
As he points out above, not factoring for foreseen and unforeseen risks in valuing stocks has been the bane of many investors. Favourable market conditions extrapolated for next ten years sounds great, but is it really practical? While optimistic Sensex, Nifty and individual stock targets were churned out last year, were possibilities of inflation coming in worse than expected, potential for geopolitical tensions, company-specific risks, etc, adequately considered? Stories and estimates for unprofitable new age companies sounded great in PPTs but was there any margin of safety in those stocks when they were priced at 30-50 times revenues? Many of the popular but unprofitable or barely profitable new age companies like Zomato, Paytm, Nykaa and PB Fintech, and Cartrade whose recent IPOs saw good interest are down anywhere between 40 and 70 per cent even before the full-fledged impact of geopolitical tensions on inflation and growth are yet to play out.
Is there margin of safety in IT services companies whose growth for next few years may be modestly better than their growth in recent years, but are trading at 50-100 per cent above historical mean valuations?
Further, another thing you need to assess buying stocks in the current context – is there margin of safety if the current geopolitical crisis escalates to even more serious levels?
#3 Wait for the right price
In his letter sent in 1983, Buffett remarks how Pascal’s observation, ‘ It has struck me that all men’s misfortunes spring from the single cause that they are unable to stay quietly in one room,’; is most apt when it comes to investing. He further adds how ‘unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favourable business developments.’
In multiple annual letters he lays out his condition for buying stocks, which are: one , a business he can understand; two, it should have favourable long-term prospects; three, operated by competent and honest people; and four, available at a very attractive price. He highlights how he usually identifies a small number of potential investments meeting requirements one to three, but not requirement four, which prevents him from action.
In today’s world it is hard to stay quiet in one room. You are not free of your smartphone, the brokerage app that you have downloaded and the constant bombardment of market news and stock ideas. Thus even if you resist acting on this information, subconsciously the tendency to act is getting built. These can lead to errors in judgement at some point in time. Developing a temperament to not be impulsive is not easy, but this is what differentiates investing legends from average investors.
Every dip is not necessarily a buying opportunity. Sometimes, change in company or economic fundamentals, geopolitical factors, will merit patience, analysing different range of outcomes and not reacting quickly. In today’s context, is a five per cent dip in the Nifty 50 over the last week actually a buying opportunity when there has been material change in fundamentals of global economy? And these are changes that can make earnings estimates go awry. Are 10-30 per cent corrections in stocks post a 100-500 per cent increase, actually good buying opportunities in uncertain times? These factors need to be assessed.
Buffett’s investing history is loaded with waiting for the right opportunities. For example, one of his most famous share purchases during the Great Recession was that of convertible equity warrants of Goldman Sachs in September 2008. He invested well into bear market territory, after Goldman Sachs share had dipped by around 50 per cent from peak .
One may wonder, what if the opportunity knocked only once? Buffett answers that as well. Invariably, in many annual letters, he makes confession of his errors, but takes comfort from the fact that most of his errors are those of omission and not of commission. With the former case, your principal is largely intact.
If you are still sceptical of waiting, his annual letter sent out in 1986 (1985 annual report) is a worthwhile read, in which he highlights that good opportunities are bound to present themselves again and again. He states, ‘ What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. As this is written, little fear is visible in Wall Street. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely.’
#4 Assess intrinsic value of stocks before you buy
Amongst the most common and repeated words in Buffett’s history of annual letters are ‘Intrinsic Value.’ In his letter written in 1984, he mentions intrinsic value of a business as ‘the measurement that really counts.’. At the same time he also states ‘this is a number that is impossible to pinpoint, but essential to estimate.’
Bufffett defines intrinsic value ‘as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.’
As much as this is hard for investment professionals, this is even harder for people engaged in other professions but are interested in investing on their own. One simple basic way for such investors to start assessing intrinsic value is by identifying the net realisable book value of a company (net cash plus an estimate of remaining consolidated net worth) and adding net present value of expected profits/cash flows for the foreseeable future. Given forecasting is always difficult and inherently risky, investors can also try to assess past growth trends and extrapolate it for the future, subject to adjusting for fundamental changes in business. Alternatively, if this is also difficult, a simpler proxy is to see if earnings growth trends are largely in line with history, if a stock is trading significantly above historical valuation then it likely implies it is trading well above intrinsic value and vice-versa. This, however, needs to be assessed on a case-to-case basis.
In India , over the last decade, more gains in stocks have come from multiple expansion versus earnings growth. This, in the context of moderate earnings growth over the last decade, implies many stocks may have zoomed past intrinsic value. At a broader level, for example, out of the 275 per cent returns that Nifty 50 gave investors in the 10-year period between 2011 and 2021, 170 per cent was from multiple expansion (increase in PE ratio) and current trades. This ideally implies index price has outperformed earnings growth, indicating that the ratio of intrinsic value to price has reduced. The lower this ratio, less the opportunity for investors, and vice-versa.
#5 If you are long-term value investor, be certain you have not become a speculator
In his letter written in 2000, Buffett notes ‘ The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities – that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future, will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.’
Thus if your only reason for holding or buying stocks is because they have always traded at higher valuations levels though their fundamentals may not justify it, you may have crossed the line into speculation. Your speculation might still yield profits as scarcity premium and flight to quality in the Indian context has resulted in some popular stocks trading at expensive or irrational valuation for years. But you need to be cognizant of the fact that structural changes can permanently impair these valuations. For example, paint stocks in India, that have traditionally got valuations far above what can be justified by intrinsic value (the way Buffett would assess it), can see multiple compressions if crude price shock extends for long while at the same growth prospects are impacted due to macro and geopolitical risks.
Published on March 05, 2022