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Weekend Reading: Price Is What You Pay

Written by Lance Roberts | Jul, 20, 2018

Yesterday, I discussed the failure of tax cuts to “trickle down” as they have primarily been used for corporate share repurchases. As I was digging into the data, Doug Kass emailed me a quick note:

“Berkshire Hathaway, likely under the weight of an enormous cash horde and more scarce alternative investment opportunities, has announced that it is loosening the terms of its buyback policy. It is also a signpost that the company has matured and will only duplicate GDP-like growth.”

While the announcement set the shares of Berkshire (BRK/A) (BRK/B) surging higher yesterday, there is a much more important message that investors should be heeding.

We recently delved into the performance of Berkshire as it has become the 10th-largest company in the world in terms of revenues. To wit:

“The graph below highlights this concern. It shows that 90-day rolling correlation of price changes in BRK/A and the S&P 500 are statistically similar. In the market crash of 2008/09 BRK/A’s price was cut in half, similar to the S&P 500. Based on correlations we suspect a similar relationship will hold true for the next big market drawdown.”

Both the sheer size of Berkshire, and the chart above, confirm Doug’s comment that Berkshire is likely to only generate rates of growth equivalent to GDP going forward.

So what’s the message that Mr. Buffett is sending? Simple:

“Price is what you pay, value is what you get.”

Investing is about maximizing the return on invested dollars by buying something that is undervalued and selling it when it is overvalued. This is the point missed by those who promote “buy and hold” investing which is the same as “buy at any price.” 

Corporations are, in many ways, held hostage by Wall Street and short term investors. An earnings miss can be disastrous to a companies stock price which can have severe consequences to stock option compensated executives and employees, shareholders and even bondholders. So, with pressure on companies to deploy excess cash, what are the options considering the “beat the estimate” game that must be played.

  • Hire Workers? Employees are a high cost and have a direct impact on profitability. Companies hire as needed to meet excess demand. Demand has remained stable and increased at the rate of population growth which is also the rate of employment increases: (Read this)
  • Invest To Produce More Products? Investments in future growth are accompanied by a negative short-term impact to profitability. Further, with rates rising the cost of borrowing for CapEx adds to the negative impact on current earnings.
  • Mergers & Acquisitions? Using cash to acquire revenue can be accretive to bottom line profitability. However, with stock price valuations elevated the costs to acquire revenue in many cases is becoming less attractive and often not immediately accretive.
  • Share Repurchases? While share repurchases do not increase top-line revenue growth or bottom line profitability, it does make it APPEAR the company is more profitable when they report earnings on a per share basis. The illusion of an immediate increase in profitability supports asset prices in the short-term despite potentially decreasing fundamental value.

From an investment standpoint, share repurchases by companies are a message that companies simply have no better options available with which to grow earnings and protect shareholder value.

So, back to Mr. Buffett who has been sitting on over $100 Billion in cash and T-bills over the last few quarters. With a dearth of value in the market, there have been few opportunities for a legendary value investor to deploy capital in a manner that will generate an attractive future rate of return. However, sitting on cash, in a low interest rate environment, is also not conducive as the purchasing parity power of cash is eroded by inflation.

So, what does the “World’s Greatest Value Investor” do when there is no better use for cash – buy back shares of your own company, of course.

The message from Buffett is quite clear – there is little value left in the market today otherwise he would be allocating his cash hoard very differently.

While many suggest that individuals should just “buy and hold” investments regardless of what the market does, Mr. Buffett’s actions reinforce the view that buying assets at current valuations is likely to have a disappointing outcome. 

Does this mean you should never invest? Of course, not.

But as Mr. Buffett himself has stated:

“Be fearful when others are greedy. Be greedy when others are fearful.” 

Just something to think about as you catch up on your weekend reading list.


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Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter and Linked-In

2018/07/20
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