Think of the Warren Buffett (Trades, Portfolio) strategy as being comprised of two broad elements: first finding companies with a durable competitive advantage and second, identifying buying opportunities.
As Mary Buffett and David Clark, authors of the 2002 book, “The New Buffettology”, pointed out, “Warren’s buying opportunity is price dictated. Just because he has recognized that a company possesses a durable competitive advantage doesn’t mean he will pay any price for it.”
Understanding how bear and bull markets work is a major element in his perceptions of price.
Bear markets: These depress the prices of all stocks and Buffett sees this as the best time for his kind of buying. Since anxious buyers don’t discriminate between companies with and without durable competitive advantages, the good ones often sell at a deep discount. The authors noted, “It’s easy pickings, so pick the very best.” During bear markets, momentum investors are chased out of the market because of their losses and value-oriented investors come in chasing bargains.
Bull markets: In the transition phase, the Federal Reserve Bank maintains low interest rates (a leftover from the bear market), making it cheaper to finance businesses. As stock prices rise in response, the bear market gives way to a new bull market. Value investors begin turning in excellent returns because prices are rising from their bear market levels; that, in turn, prompts many investors to take money out of low-interest money market funds and invest it in stocks. It also brings back momentum investors who start scoring a few notable returns.
Corrections: No market ever goes straight up; it meanders, making frequent corrections and sometimes produces even panic selling. From Buffett’s perspective, if the bull market hasn’t yet bubbled, then these adjustments offer buying opportunities that he expects will be short-lived. He also knows that most businesses continue to have the same underlying economics during and after corrections. Corporate earnings aren’t changing, just the “perceived specter of doom”.
The authors added a couple of other points about corrections: investors must move quickly and with strong conviction, and a correction will be especially hard for companies experiencing bad news, such as missed earnings. A market panic will amplify bad news. Buffett believes this creates a “perfect selective contrarian buying situation”.
Top of the bull market: As many investors have noted in recent years, bull markets can last for years, with prices continuing to rise and occasionally experiencing corrections or minor panics. This is due, in part, to the interaction between value and momentum investors. When momentum investors get concerned and dump a stock to the extent it falls below its intrinsic value, value investors jump in and buy. As the price of the stock recovers, momentum investors may start buying again.
Earnings stop mattering: During the early and middle stages of a bull market, investment banks price their initial public offerings on net earnings. As the bull begins to wane, however, they stop using earnings as their valuations and turn to metrics based on total sales and revenues. The authors noted at around this time investment banks were pricing IPOs at 20 times total sales and revenues. Venture funds took note in the late 1990s: they funded startups with revenues but no earnings, then went public with them. Since these startups were being valued at 20 times revenues, these sometimes fleeting companies made their venture capital bankers very rich.
Also happening around the top of the bull market: Most fund managers have been “pushed” into a momentum position. That can be temporarily rewarding, with some funds posting returns of 70% or more. It’s bad news, though, for value managers who are now considered stodgy and out of touch. Their clients leave them for momentum managers who can market their aberrant returns—temporarily, at least.
To illustrate the difficulties that value managers face at this stage of the cycle, authors Buffett and Clark tell the story of Charles Clough, the top value manager at Merrill Lynch in 1999; the veteran stock picker realized he could no longer offer rational reasons for buying overvalued stocks. At the same time, the firm’s stockbrokers were bringing in outstanding profits by trading these price-inflated stocks. Clough refused to go along with the brokers and their customers seeking a fast buck, and quit. The authors concluded, “Today his bearish predictions look amazingly prophetic.”
One other element appears as the market tops out: The economy heats up due to price inflation in the stock market, and the Fed raises rates to deal with the inflation that naturally follows. Higher interest rates, along with the pursuit of hot stocks, will push down the stock prices of “stodgier” industries. One such industry in the late 1990s was insurance, which allowed Buffett to pick up Allstate (ALL, Financial) at a steep discount. According to the authors, this means “market bifurcation,” a market divided as the prices of hot stocks go up and the prices of stodgier stocks collapse.
Eventually, the situation reverses as capital moves away from the previous hot stocks and back into the stodgier stocks. As the undervalued stocks start to recover, momentum investors will jump back in, thus pushing those prices even higher. The authors reported that “any company with a durable competitive advantage will eventually recover after a market correction or panic during a bull market. But beware: In a bubble-bursting situation, during which stock prices trade in excess of forty times earnings and then fall to single-digit P/Es, it may take years for them to fully recover.”
After the bubble bursts, the country could first slip into recession and the Fed would respond by lowering interest rates. In a year of so, the economy will begin to recover, helped along by increases in auto and housing sales spurred by lower interest rates. As investors return, they will look for quality stocks that have solid earnings. If lowered interest rates don’t revive the economy, there is likely to be a crash, an event that Buffett dreams of, while everyone else gets very worried.
A final note from the authors: “Warning: Warren Buffett does not buy or sell based on what he thinks the market will do. He is price-motivated. This means that he will only invest when the price of a company makes business sense.” The pricing of companies, the authors added, will be the focus of the second part of “The New Buffettology.”
About
Buffett and Clark are the authors of “The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor.”
(This article is one in a series of chapter-by-chapter reviews. To read more, and reviews of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
