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Smead Capital Management
Smead Capital Management
Articles (42)  | Author's Website |

Revisiting Buffett’s 1999 Warning: Interest Rates, Orgies and Value

Even Buffett makes mistakes occasionally

We thought it would be helpful to review Warren Buffett (Trades, Portfolio)’s argument in 1999 (1), the last time there were very high expectations attached to technology stocks and the overall level of common stock prices. We will reference Buffett’s quotes by the year he said them. The sections labeled 2017 offer our current observations on the markets and thoughts from respected experts.

“Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set me to talking about the general stock market, a subject I'm usually unwilling to discuss. But I want to make one thing clear going in: Though I will be talking about the level of the market, I will not be predicting its next moves. At Berkshire (NYSE:BRK.B), we focus almost exclusively on the valuations of individual companies. The fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value counts.” – Buffett in 1999

2017

Like Buffett, we recognize that we have no ability to predict market swings and we stick to our “circle of competence.” Buffett recently emphasized on CNBC that if interest rates stay low, investors aren't expecting enough from stocks. Dan Fuss, a 57-year veteran of the bond market and manager of the Loomis Sayles Bond Fund, says, "We are keeping our maturities short for the coming normalizing of interest rates." We find it interesting that Buffett has talked more about one side of the interest rate movement coin rather than the more dangerous rising interest rate side.

“Let's start by defining 'investing.' The definition is simple but often forgotten: Investing is laying out money now to get more money back in the future – more money in real terms after taking inflation into account.

Now, to get some historical perspective, let's look back at the 34 years before this one – and here we are going to see an almost biblical kind of symmetry, in the sense of lean years and fat years – to observe what happened in the stock market. Take, to begin with, the first 17 years of the period, from the end of 1964 through 1981. Here's what took place in that interval:

• DOW JONES INDUSTRIAL AVERAGE Dec. 31, 1964: 874.12, Dec. 31, 1981: 875.00.

Now I'm known as a long-term investor and a patient guy, but that is not my idea of a big move.

To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So, if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates in line.

The increase in equity values since 1981 beats anything you can find in history. This increase even surpasses what you would have realized if you'd bought stocks in 1932, at their Depression bottom – on its lowest day, July 8, 1932, the Dow closed at 41.22 – and held them for 17 years.” Buffett in 1999

2017

We look at 10-year Treasury Bonds with a 2.23% interest rate and stocks trading at high historical levels in relation to earnings, book value and gross domestic product (GDP) wondering if the same case can be made for the next 17 years.

“The second thing bearing on stock prices during this 17 years was after-tax corporate profits, which this chart [we have updated below 2] displays as a percentage of GDP. In effect, what this chart tells you is what portion of the GDP ended up every year with the shareholders of American business.

1894284524.jpg

Corporate profits as a percentage of GDP peaked in 1929, and then they tanked. But from 1951 on, the percentage settled down pretty much to a 4% to 6.5% range.

By 1981, though, the trend was headed toward the bottom of that band, and in 1982 profits tumbled to 3.5%. So at that point investors were looking at two strong negatives: Profits were subpar and interest rates were sky-high.

And as is so typical, investors projected out into the future what they were seeing. That's their unshakeable habit: looking into the rearview mirror instead of through the windshield.”Buffett in 1999

2017

Corporate profits have gone through the roof (see chart above). The chart shows that profits were nearly 10% at the last secular low for interest rates in 1952. It also appears to us that technology companies, which dominate a particular sector of modern life (social media, search, online commerce), are allowed to leverage their dominance in their main business to attack industries and companies without the same proprietary information or clout. More importantly they have caught the investing public’s imagination.

Technology companies are drastically reducing the need for labor in many industries and are causing capital to win at labor’s expense. It looks to us like the Federal Trade Commission (FTC) and the Antitrust Enforcement division of the Department of Justice have taken an eight-year sabbatical on most cases associated with tech stock darlings. Teddy Roosevelt is rolling in his grave as Alphabet (NASDAQ:GOOGL) becomes Standard Oil, Facebook (NASDAQ:FB) becomes AT&T (NYSE:T) and Amazon (NASDAQ:AMZN) becomes the railroads with an overwhelming control over life and business in the U.S.

“Today (1999), if an investor is to achieve juicy profits in the market over 10 years or 17 or 20, one or more of three things must happen. I'll delay talking about the last of them for a bit, but here are the first two:

Interest rates must fall further. If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks. Incidentally, if you think interest rates are going to do that or fall to the 1% that Japan has experienced – you should head for where you can really make a bundle: bond options.”Buffett in 1999

2017

Buffett was correct, and the move to 2% on Treasury bond rates did come close to doubling the Dow Jones Industrial Average. Are we going to 1% long-term interest rates over the next 17 years or is this as good as it gets?

(1) “Corporate profitability in relation to GDP must rise. You know, someone once told me that New York has more lawyers than people. I think that's the same fellow who thinks profits will become larger than GDP. When you begin to expect the growth of a component factor to forever outpace that of the aggregate, you get into certain mathematical problems. In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.”Buffett in 1999

2017

Corporate profits rose substantially since 1999 and rewarded long-duration common stock owners in concert with lower interest rates (quite a rearview mirror). Wise investors like Jeremy Grantham (Trades, Portfolio) have had to wrestle recently with thoughts that a “permanently higher level” of corporate profitability in relation to the overall GDP might exist (It’s different this time).

Buffett mentioned that competition would keep profits down in 1999, but he had no idea that companies the likes of Facebook, Google and Amazon would be allowed to gain national importance the way Standard Oil, AT&T and the railroads did in 1900. Imagine if his Mid-American Energy business was not regulated.

“So where do some reasonable assumptions lead us? Let's say that GDP grows at an average 5% a year – 3% real growth, which is pretty darn good, plus 2% inflation. If GDP grows at 5%, and you don't have some help from interest rates, the aggregate value of equities is not going to grow a whole lot more. Nor can investors expect to score because companies are busy boosting their per-share earnings by buying in their stock. The offset here is that the companies are just about as busy issuing new stock, both through primary offerings and those ever-present stock options.”Buffett in 1999

2017

Buffett's warning is as valid or more valid today than in 1999 before the tech crash! The dilution of existing shareholders at major companies by issuance of stock options and restricted shares should have the same impact on today’s glam tech companies that it did on Microsoft (NASDAQ:MSFT), Intel (NASDAQ:INTC) and Cisco (NASDAQ:CSCO) in the late 1990s. It took 16 years for Microsoft to get even with its 2000 high share price while Intel and Cisco are still far below where they traded in early 2000. Back in 1999, there seemed to be no limit to what the most popular tech companies could accomplish and today, it is safe to say there are no limits being put on the FANG stocks.(2)

“Bear in mind – this is a critical fact often ignored – that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices. You personally might outsmart the next fellow by buying low and selling high. The absolute most that the owners of a business, in aggregate, can get out of it in the end – between now and Judgment Day – is what that business earns over time.”Buffett in 1999

2017

Buffett has been spending a great deal of time praising Jeff Bezos and Amazon who have created astounding returns in the stock market while losing money selling millions of items. It appears that Amazon has become rich by "outsmarting the other fellows." The sum of all reported profits of Amazon in 20 years might add up to $5 billion. Would Buffett pay around $1,000 per share (as of May 30) for Amazon to start with an $8 per share profit in calendar 2017 (Value Line estimate)?

In his book, "A Short History of Financial Euphoria," John Kenneth Galbraith wrote the following: “A further rule is that when a mood of excitement pervades a market or surrounds an investment prospect, when there is a claim of unique opportunity based on special foresight, all sensible people should circle the wagons; it is time for caution.”

Seattle Uber drivers and Joe Kennedy's shoeshine boy are on the same page!

“Let me summarize what I've been saying about the stock market: I think it's very hard to come up with a persuasive case that equities will over the next 17 years perform anything like – anything like – they've performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate – repeat, aggregate – would earn in a world of constant interest rates, 2% inflation and those ever-hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”Buffett in 1999

2017

The argument is better for low returns today because the dividend rate is lower, interest rates are lower, the corporate profits margins are higher and the Standard & Poor's 500 is overweighted again in high price-earnings (P/E) ratio stocks. Also, expensive stocks are the most disconnected to the average stock they've been since 1999.

Expensive stocks extremely expensive1882945678.jpg

“And there's still another major qualification to be considered. If you and I were trading pieces of our business in this room, we could escape transactional costs because there would be no brokers around to take a bite out of every trade we made. But in the real world investors have a habit of wanting to change chairs, or of at least getting advice as to whether they should, and that costs money – big money.

And what do they come to? My estimate is that investors in American stocks pay out well over $100 billion a year – say, $130 billion – to move around on those chairs or to buy advice as to whether they should!”Buffett in 1999

2017

At Smead Capital Management, we seek to hold companies for a long time, significantly reducing the frictional costs Buffett is referring to. Now that stocks are at elevated levels compared to history (as they were in 1999) and tech stocks make up nearly 25% of the index if you include Amazon and Netflix (NASDAQ:NFLX) as tech stocks. Buffett is solving the expense problem by heaping praise on the S&P 500 Index and its wholesaler in chief, Jack Bogle. In case you are wondering, index funds were already up and running in 1999.

Together, Bogle and Buffett have created a virtuous circle in tech stocks. Buffett now praises tech stocks, apologizes for not owning them and they go up. The S&P 500 goes up because tech stocks are outperforming. Money pours into the S&P 500 which has the effect of driving up tech stocks in a new virtuous circle. Ironically, long-term historical data shows that the companies with the fastest earnings growth underperform the companies with the worst results over one-year time periods!

“I won't dwell on other glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors: the manufacture of radios and televisions, for example. But I will draw a lesson from these businesses: The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”Buffett in 1999

2017

Standard Oil, AT&T and the railroads had very wide moats before they were broken up or regulated. It is not just us that seem to recognize the risks to the U.S. economy and to the share prices of the most popular technology stocks. Many of the leading business news organizations have recently written about either breaking up or regulating one or more of the FANG stocks. Our favorite writer on the subject is Farhad Manjoo from The New York Times who has dubbed the FANG stocks the “frightful five.” Our question is, are Senator Elizabeth Warren and Senator Chuck Schumer listening?

“Once a price history develops and people hear that their neighbor made a lot of money on something, that impulse takes over, and we're seeing that in commodities and housing. Orgies tend to be wildest toward the end. It's like being Cinderella at the ball. You know that at midnight everything's going to turn back to pumpkins and mice.”Buffett in 1999

2017

At Smead Capital Management, we are very grateful for the wisdom and kind education Buffett has extended to us and other investors. However, even Buffett makes mistakes occasionally. Buffett called Coke (NYSE:KO) and Gillette the "Inevitables" in the late 1990s when he should have sold his holdings. He amassed a position in ConocoPhillips (NYSE:COP) between February 2006 and the summer of 2008 near the 20-year high in oil prices. He traveled to China in September of 2010 at the height of the China, emerging market and commodity hype. He and Munger heaped praise on the guy running BYD when they should have been selling every share. Now, he has entered the FANG-stock orgy, a lot closer to midnight than to 4 p.m., while the S&P 500 Index is at a juncture with lower interest rates and higher profit margins than his warning speech in 1999.

We have already “rounded up the wagons” concerning the rabid mania in glamour tech stocks. As contrarians, we relish expecting higher interest rates and a better economy, which moves the economic spoils away from technology stocks toward household formation, child bearing and more useful endeavors which come with them! Someday in the future, when the great tech companies have stumbled and the crowd is long gone, we will go shopping among those that survive and prosper.

(1) Source: FRED and the US Bureau of Economic Analysis

(2) FANG stocks include Facebook, Amazon, Netflix and Alphabet.

Disclosure:  Smead Capital holds a position in Berkshire.

The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past 12-month period is available upon request.

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About the author:

Smead Capital Management
Bill Smead is the CIO and CEO of Smead Capital Management.

Tony Scherrer is director of research

Cole Smead is managing director

Visit Smead Capital Management's Website


Rating: 4.9/5 (13 votes)

Voters:

Comments

jonmonsea
Jonmonsea premium member - 3 months ago

Great article. Just one thing: "He and Munger heaped praise on the guy running BYD when they should have been selling every share." Why is that? Isn't Buffett up by 5x+ on this investment? Thanks.

consciousinvestor311
Consciousinvestor311 premium member - 3 months ago

BYD is by no means a Buffett stock. Munger was totally sold by Li Lu, and it's mysterious how Munger was so hooked on BYD, very unlike him. He told Elon Musk that he is great but unfortunately in the wrong industry (highly competitive and captial intensive). Apparently Elon Musk did exactly what Munger hoped BYD founder Wang Chuanfu could do -- a combination of Thomas Edison and Henry Ford.

BYD has little intrinsic value. It earns no cash and still gives people some hopes after more than a decade of manufacturing their EV. It's share price was sustained by its being listed in both mainland China and HK, where it can get very cheaping financing by abitraging the price differenes between the two markets (a unique Chinese A/H share phenomenon). Munger was very wrong on BYD, and he knows it now and has been well informed with the process of BYD. He complained that BYD's lack of progress was a result of local government self protection (which is partially true). Now given what Tesla is doing and the overall EV market, there is little hope for BYD to go beyond China's mid-tier market with little brand premium and value.

Bufett was never convinced about BYD, it was really because Munger and David Sokol (who was convinced and impressed with the labor-intensive manufacturing process) strongly advised him to buy BYD. The mistake was also apparent to him after a few years, but Buffett was relunctant to sell it because of Berkshire's holding-forever tradition and a good relationship established with Wang on personal level, who also demonstrated certain integrity that Buffett really likes.

Apparently the author understands about the BYD's true value, thinks the party time is over for the Halloween, and mice and pumpkin will come for the overhyped tech stocks in general (this part I tends to disagree).

stephenbaker
Stephenbaker - 3 months ago    Report SPAM

On what basis do the authors believe that interest rates will "normalize" and corporate profits fall anytime soon? Buffett's recent comments and actions seem to assume otherwise.

dgavrile
Dgavrile - 3 months ago    Report SPAM

Regarding BYD, one must provide facts / data - fundamental analysis to sustain pesimistic position, otherwise it's just emotion and pre judments about personalities. Besides this, BYD has some growth ahead on e-public transportation (buses and city railways) were there are strong entry barriers. I am positive also on TESLA althought the value may be a bit gonflated. In general I am positive about EV market. Regarding tech hype I do not know much and I cannot generalise, but I beleive that some streams such as robotics& AI, cybersecurity and semiconductors (especially SW design) is going to thrive in the allready present ioT.

mvpfx
Mvpfx premium member - 3 months ago

I generally agree with sentiments expressed here. The interest rate issue is difficult to call. I think antitrust actions will return after the next hard times. cheers

Seattle Ethan
Seattle Ethan - 1 month ago    Report SPAM

Very interesting conversations. I gave 5 stars.

The bet on BYD is probably not over. Remember $5 per gallon price at the gas station? Munger's lollapalooza theory on EV and the importance of battery technology in the future sort of depended on high fuel costs and bad pollutions in China. Munger couldnt have known fracking technology improvement would bring down the price of oil and natural gas. Munger is wrong for now but I'm not sure in 15 to 20 years. The emerging market is adding a lot of cars on the road and the current production capacity per day is only a few million barrels higher than the daily consumption. We are also using up easier sources of fuel, but in 20 years, those eaiser sources will have gone dry - probably. Also assuming fracking technology will hit a limit, which who the heck knows.

Tesla has battery giga factory. BYD started out as a battery company, so the directions seem the same. If Tesla battery succeeds, maybe BYD battery business can too. BYD could make it cheaper - probably. Tesla hasn't made any money, though I love its cars, yet. BYD has made money in various divisions, including auto. I'm not sure about recently. EV hasn't taken off yet and the last time I checked BYD still had impressive battery technologies (but it's been awhile since I checked). It has massive patents too. If EVs take off, BYD could get some batteries business if it continues to develop techonlogies. Munger has recent years hinted BYD has a tough road but that they paid a price for BYD shares that was close to nothing. He also said that about IBM, which sadly didn't work out.

Coke is another interesting conversation. I want to ask Buffett if he would have sold KO at 50 times earnings in 1998 or whenever if tax wasn't a factor. Is tax the reason he held on or did he think KO could reach $1 trillion like the Munger essasy on How to make a $1 trillion company. He got out of Proctor and Gamble in a tax efficient way, why not get out of KO in a tax efficient way?

Also, can we call KO investment a failure since Berkshire is getting $560 million in annual dividends on $1.3 billion invesment in 1988? I dream of making a mistake like this.

Conoco was a mistake, but he made billions from PetroChina so his batting avg is still good, I would say.

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