For those panicking through the recent market turmoil, we find that a revisit to Warren Buffett’s 2008 shareholder letter can provide some solace. The S&P 500 has lost 37% of its value year to date, making it the worst year for the index since Buffett took over Berkshire.
Focus
Acknowledging that nobody can predict the winning and losing years in advance, Buffett stressed that investors have consistent focuses, regardless of market conditions:
“(1) Maintaining Berkshire’s Gibraltar-like financial position, which features huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash;
(2) Widening the “moats” around our operating businesses that give them durable competitive advantages;
(3) Acquiring and developing new and varied streams of earnings;
(4) Expanding and nurturing the cadre of outstanding operating managers who, over the years, have delivered Berkshire exceptional results.”
In our view, a recession can often be an excellent opportunity for market leaders to enhance their competitive positions and fuel the long-term growth gaps against peers. This is especially true for many cyclical businesses.
One classic example of this is Graco (GGG, Financial). The leading fluid handling equipment manufacturer aggressively increased its R&D budget during the last recession while its competitors struggled to make ends meet.
Another good example is Credit Acceptance (CACC, Financial), a subprime auto-financing provider. The company is so disciplined in underwriting loans that it delivered uninterrupted growth in sales and operating income throughout the Global Financial Crisis that helped wipe out much competition. We were not surprised to see the company’s Chief Financial Officer purchase shares twice over the past month.
Low Yield
“Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgment confirmed when they hear commentators proclaim “cash is king,” even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.
Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re-examination of conclusions formed earlier.
Beware the investment activity that produces applause; the great moves are usually greeted by yawns.”
Buffett reflected on the long-term prospect of bonds vs. stocks in a zero-rate environment. The Oracle of Omaha has frequently expressed his bet that stocks are going to outperform. Compared to the 10-year treasury yield of less than 1%, we notice a bunch of high-quality, high-growth businesses yielding more than 3% free cash flow at the moment (for example, 4.1% at Intuit (INTU, Financial), 3.2% at Estee Lauder (EL, Financial) and 3.4% at MasterCard (MA, Financial)).
Investment Risk
“The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probability-weighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm a century from now.)”
Lastly, Buffett elaborated on the under-recognized discrepancy between price volatility and investment risk, which he interprets as the permanent impairment of capital. As a matter of fact, we often consider market turmoil a helpful “friend” for long-term, patient investors, as well as, in some cases, great companies that hope to return capital to owners through share buybacks.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the financial market. We own shares of Berkshire Hathaway, MasterCard, and Credit Acceptance.
Read more here:
- 'Relax' Signs During a Panic Moment
- Edwards Lifesciences: A Leader in an Economically Attractive and Rapidly Growing Niche
- Research and Development: A Twofer to Widen Moat and Fuel Growth
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