Last week Tony Finding and Eric Lonergan made their annual ‘pilgrimage’ to Omaha in the US to attend the annual shareholder meeting for Berkshire Hathaway, the investment company run by Warren Buffett. While there they mused on, amongst other things, the attractiveness of US equity today, what low interest rates mean for value investors and whether anyone can display sustained skill in stock picking. In the first of two blog posts, Tony shares his personal take on the experience.
REFLECTIONS FROM OMAHA, NEBRASKA
Beneath the cool grey sky of daybreak one cannot but stand and wonder at what it is that possesses us and thousands of others to queue for hours for the privilege of a front row seat at this most unique event.
Perhaps we are simply fooled by randomness, and identifying skill where there is only luck. However, after seeing first-hand Warren and his dry witted business partner Charlie Munger field a vast array of questions for nearly 6 hours, one is left with a strong impression that the investment success of this organisation is down to factors other than mere luck, although fortune has undoubtedly played a big role, something that these two humble billionaires freely admit.
One appealing attribute of the field of investment management is that experience ought to improve our decision-making. We ourselves feel that this requires a curious mind and a willingness to build human capital and habits indefinitely. Although this is now our sixth visit to this annual event, the observable passion and energy from Charlie (now in his nineties) and Warren, in his eighties, when talking about business and investing remains one of the most inspirational aspects of this trip.
One key takeaway from this year’s meeting was a sense that the S&P 500 index today does not appear as compelling an investment as it has done in recent years with Buffett’s suggestion that the pricing of businesses is now somewhat more attractive in Europe, and Germany in particular.
There has been some recent interest in the level of market capitalisation in the US as a percentage of GDP, a metric that some people call the ‘Buffett indicator.’ S&P 500 market capitalisation as a share of GDP does indeed appear elevated today (see figure 1).
But does this mean that the stock market is expensive? Warren’s answer touches on one of the analytical challenges confronting multi-asset investors today and the need to always question and think deeply rather than simply delegate to some tool or metric, something we wholeheartedly agree with.
As Buffett alluded to in his answer to this question, the correct interpretation of the measure centres on what today’s low interest rates imply about GDP growth and, more importantly, earnings growth going forward. If low interest rates are consistent with reasonable growth in profits, then this ought to make equity markets attractive relative to cash and bonds. It would not be inappropriate then for valuations to be higher than in the past and the measured market capitalisation ratio to rise as a percentage of GDP.
This has already been occurring in sectors of the market where investors, rightly or wrongly, have greater confidence in the earnings growth. This valuation change itself ought not to cause alarm so long as absolute equity valuations remain reasonable as they do today in our view. These underlying interest rate structures today are very different to those pertaining to 1999 (see figure 2) and there ought to be no static valuation rule of equity relative to GDP.
If, on the other hand, the low interest rates are implying weak growth in GDP and earnings as was the case in Japan for much of the last 25 years (see figure 3) then an elevated market capitalisation to GDP could be a real warning sign of poor equity returns ahead.
There are of course many other effects of low interest rates as for example on debt servicing costs and hence profit margins but our analysis of the regime and pricing indicates that absolute equity valuations do not suggest a risk of permanent loss. For multi-asset investors the 6% relative real yield gap between equities and bonds remains attractive in favour of equities in this profit friendly (at least for now) economic regime (see figure 4).
This year’s trip reminds us of the importance of recognising the dangers that arise from an excessive focus on noise and the myopic bias this creates in much contemporary investment management. The chief difficulties in investment are likely to be psychological and we should strive to overcome these. Although the right human temperament can help here, a robust investment philosophy and process leaning heavily toward valuation ought to be a recipe for success in the medium-term. We must recognise the need to look past daily and weekly noise and focus instead on avoiding permanent loss while growing wealth through investing in those asset classes priced to deliver attractive sustainable returns.
Unless the regime changes it is extremely unlikely that anyone can compound investment returns in the future at anything near the 20% per annum rate that Berkshire Hathaway has achieved over the last 50 years. However, visiting Omaha has served to strengthen our beliefs in what can be achieved from a valuation driven investment strategy. Although luck has played a powerful role in the success of Berkshire Hathway, the outcome is also testament to what can be achieved with time and Einstein’s Eighth wonder of the world, compound interest.