Every year, investors anxiously await the release of Warren Buffett’s annual letter to see what the “Oracle of Omaha” has to say about the markets, economy, and where he is placing his money.

Before we blindly heed Buffett’s advice we must factor in that he has long been a source of contradiction. As Michael Lebowitz previously penned:

“The general platitudes of market and economic optimism Buffett shares in his CNBC interviews, letters to investors and shareholder meetings often run counter to the actions he has taken in his investment approach.

This year was no different as Buffett wrote in his annual letter to Berkshire Hathaway shareholders:

“If something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments. These elements, coupled with the ‘American Tailwind,’ will make ‘equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions.”

To clarify, Buffett is suggesting that over the coming decades, it will be better to be invested in equities (aka S&P 500 Index) versus Treasury bonds, given that the yield on bonds is so low.

If Buffett thinks stocks will outperform bonds, then why is holding $128 billion in short term bonds?

There is an important distinction to be made if you choose to follow Mr. Buffett’s advice. It is true that stocks will outperform bonds over the long-term given the right starting valuations and a long enough time frame. Currently, using Warren Buffett’s favorite measure of valuations (Market Capitalization to GDP), there is a substantial risk of low returns from stocks over the next decade.

While valuations DO NOT predict market crashes, they are very predictive of future returns on investments from current levels.

Period.

I previously quoted Cliff Asness on this issue in particular:

“Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker.

If today’s Shiller P/E is 30x, and your long-term plan calls for a 10% nominal return on the stock market, you are assuming a best case scenario to play out in a market that is drastically above the average case from these valuations. We can prove that by looking at forward 10-year total returns versus various levels of PE ratios historically.

Importantly, this is likely the reason that Buffett is sitting on $128 billion in historically low yielding bonds. The graph below provides further evidence using his favorite valuation indicator, market cap to GDP.

Not surprisingly, like every other measure of valuation, forward return expectations are substantially lower over the next 10-years as opposed to the past 10-years.

“Price is what you pay, value is what you get.” – Warren Buffett

Do What I Say, Not What I Do

So the question is this:

“If Warren is suggesting you should just invest in the index and hold on, why is he sitting on so much cash?”

The immediate observation is that he is just waiting on a “good deal” to come along. He has been vocal about looking for a new acquisition. However, he hasn’t done so. Why, “valuations”  are sky high.

Unfortunately, “good deals” based on valuations, and market crashes, have typically been highly correlated throughout history. As he said in his letter:

“Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater.”

Or rather, a $1000 investment in 2010 would have grown to nearly $4000 versus just $3500.

Summary

As Michael Lebowitz previously wrote:

“Warren Buffett is without question the modern day icon of American investors. He has become a living legend, and the respect he receives is warranted. He has certainly been a remarkable steward of wealth for himself and his clients.

Where we are challenged with regard to his approach, is the way in which he shirks his responsibilities as a leader. To our knowledge, he is not being overtly dishonest but he certainly has a way of rationalizing what appears to be obvious contradictions. Because of his global following and the weight given to each word he utters, the fact that his actions often do not match the spirit of his words is troubling.”

Warren Buffett did not amass his fortune by following the herd but by leading it.

He is sitting on a $128 Billion in cash for a reason. Buffett is fully aware of the gains he has forgone, yet still continues his ways. Buffet is not dumb!

Before taking his advice to buy an index and hold on, you may want to consider more carefully why he is telling you to “do as I say, not as I do.” 

One of Warren Buffett’s few unsuccessful investments was buying convertible preferred stock of USAir in the late 1980s. For decades after that episode, Buffett would characteristically make fun of himself, while decrying the entire airline industry for its capital requirements and onerous competition.

As he put it in an interview, “If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labor unions and you’ve got commodity pricing. That is not a great recipe for success. I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say:

“My name is Warren and I’m an aeroholic.’ And then they talk me down.”

But Buffett seems to have changed his mind lately, and maybe so should other investors. In a Berkshire Hathaway filing from September 2016, almost three decades after the USAir debacle, three of the four airlines – Delta Air Lines, UnitedContinental, and American Airlines – appeared among the firm’s publicly traded holdings. By the final filing of that year, Southwest, the fourth in what Jonathan Tepper’s The Myth of Capitalism calls an oligopoly that now dominates the industry, appeared on the holdings list. All four have been there ever since, and it’s not because he 88 year-old Buffett has lost his marbles.

Somehow, a fragmented, intensely competitive industry plagued by unions and underfunded pensions, has become insulated enough from competition that Warren Buffett wants to own the major players. It’s not simply that Buffett now owns an airline. It’s that an investor whose calling card has been finding a company with a durable competitive advantage now owns four major players in an industry that are virtually indistinguishable from each other except for their ability to dominate hubs and routes and seemingly divide the industry among themselves against smaller competitors.

As Robert Kuttner wrote in the New York Times after an overbooking debacle made headlines, “air travel is far from a free market.” That because airlines, once heavily regulated, competed so hard after deregulation that they all went broke. In the 40 years and more than 40 mergers since deregulation in 1978, carriers divided up “fortress hubs,” maximizing pricing power and crushing smaller competition that tried to break into a hub. “An industry that is not naturally competitive went from being a regulated cartel, to a brief period of ruinous competition, and then to an unregulated cartel. . . . [restoring] profitability, but at awful costs both to customer convenience and to economic efficiency as well,” says Kuttner. The solution is regulated competition, according to Kuttner, but the Justice Department now prefers “concentration and collusion” to regulated competition, according to another Times piece.

Airline profitability is also now evident in the numbers. After mostly burning capital from 2004 through 2010, Delta has settled into a remarkably stable mode of posting positive margins and posting respectable returns on assets year-in and year-out.  The same general pattern exists for the other big three in the industry.

If you’re concerned that the Justice Department will start to take a harder look at all the mergers that have occurred over the past 40 years, this investment isn’t for you. If you think the Justice Department will continue to remain asleep at the switch, then the airlines are eminently investable. Profits and returns on assets are not mind-blowing compared to some information technology companies, but they have turned positive for the foreseeable future. Oligopolies and the collusion — even if tacit — that usually occurs within them usually make for a healthy investing situation. It’s probably best to follow Buffett and own the whole group though.

Foreign stock markets have underperformed U.S. stocks this year (if you exclude U.S. small caps). The MSCI ACWI ex-USA Index is down nearly 14% through December 18. But for the month of December, the trend has been changing, with U.S. indices dropping more than foreign indices. And that means it may be time to look at some foreign stocks.

First on the list are German automakers. They are under a lot of pressure from tariffs, slowing sales, which have arguably been boosted by easy credit over the past few years, and perhaps even competition from Tesla, which has brand cachet. Still, Daimler (DMLRY), BMW (BMWYY), Volkswagen (VWAGY), and Porsche (POAHY) look cheap. They all trade at single-digit P/E ratios and P/S ratios of 0.5 or less.

If you’re looking for additional confirmation, the Oakmark International fund (OAKIX) ,run by Morningstar’s International Equity Manager of the Decade in 2009 David Herro, has nearly than 8% of its assets in Daimler and BMW according to its September 30 portfolio. This fund has struggled mightily this year with a nearly 23% loss through December 18, but it has outpaced the MSCI ACWI ex-USA Index for the past 10- and 15-year periods with Herro at the helm for the entire time.

Another stock to consider is Rolls Royce (RYCEY). I don’t mean the auto maker here, which is actually a division of BMW these days, but the jet engine maker. Along with General Electric, Rolls is part of a duopoly in the wide-body commercial engine space. Nobody else makes engines for the largest commercial planes. Pratt and Whitney, for example, makes engines for medium-sized commercial planes. Rolls has had production trouble, and investors have been clamoring for the firm to spinoff or sell other divisions. The American Depository Receipts traded at around $20 per share a decade ago, and are now at around $10 per share. The stock trades at under 1x Price/Sales.

Investors should also check out French pharmaceutical company Sanofi (SAN). It’s the top holding of the Dodge & Cox International Stock fund. The firm markets drugs with an emphasis on oncology, immunology, and cardiovascular disease. It also happens to be one of Berkshire Hathaway’s (BRK.A) publicly traded holdings.

For emerging markets exposure, consider the iShares Emerging Markets Dividend ETF (DVYE). This fund doesn’t look like the typical emerging markets fund because its dividend emphasis leads it to hold stocks from different countries than other funds. For example, the MSCI Emerging Markets Index has 30% exposure to China and another 33% exposure to South Korea, Taiwan, and India. But the dividend ETF has nearly 30% exposure to Taiwan. China clocks in as the fourth highest represented country with its market soaking up less than 10% of the portfolio. One risk of this dividend ETF is that 16% of its assets are in Russia, which makes its shareholders likely partners with Vladimir Putin in those holdings. Nobody ever said emerging markets investing was easy, but at least investors in this fund are getting a 5.65% dividend yield and an average P/E ratio of less than 10 for their trouble.

(John Coumarianos has positions in DMLRY, BMWYY, VWAGY, RYCEY, OAKIX, and DVYE.)

“I have ways of making money you know nothing about.” – John D. Rockefeller

Contradiction- A situation in which inherent factors, actions, or propositions are inconsistent or contrary to one another- Merriam-Webster’s Dictionary

Investors and the media can’t seem to get enough of Warren Buffett. They hang on his every word as if he was sent from the heavens offering divine words of wisdom. Unfortunately, Buffett is a mere mortal, and like the rest of us, he tends to promote ideals that benefit his self-interests over yours.

The purpose of this article is not to degrade Buffett, as we have a tremendous amount of respect for his success and knowledge. In this article we look at a few recent statements and actions of Buffett’s to highlight some contradictions that lie in their wake. Our conclusion is that it is far better for investors to watch what “The Oracle” does as an investor rather than hang on his words.

This article also serves as a reminder that the most successful investors think and act for themselves. These investors are not easily persuaded to take action from others, even from the best of the best.

Buffett on Stock Buybacks

Warren Buffett has, for a long time stated that corporate stock buybacks should only occur when the following two conditions are met:

“First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated.”

The quote above was from nearly 20 years ago, however based on more recent quotes his thoughts about buybacks remain the same. The following comes from a recent CNBC article:

At the 2016 meeting, Buffett said that buyback plans were getting “a life of their own, and it’s gotten quite common to buy back stock at very high prices that really don’t do the shareholders any good at all.”

“Can you imagine somebody going out and saying, we’re going to buy a business and we don’t care what the price is? You know, we’re going to spend $5 billion this year buying a business, we don’t care what the price is. But that’s what companies do when they don’t attach some kind of a metric to what they’re doing on their buybacks.”

Buffett added: “You will not find a lot of press releases about buybacks that say a word about valuation,” but he clearly believes they should.

Knowing his opinion of buybacks, let’s explore his own firm, Berkshire Hathaway (BRK/A). It turns out BRK/A is now “seriously considering” buying back their own stock. Given their cash and cash equivalent hoard of over $320 billion, such an action would seem to fit right in line with Buffett’s first qualification noted above. Unfortunately, the stock is far from cheap and fails his second test. Currently BRK/A trades at a price to book value of 145% and at a price to earnings of 28 (28 is considered a very high multiple for a company that has consistently grown earnings at a 4% clip over the last 8 years). Altering the firm’s buyback policy would require relaxing or eliminating Buffet’s price-to-book value requirement of “below 120%”.

“When stock can be bought below a business’s value, it is probably the best use of cash.”

The bottom line: Buying back BRK/A at a price to book value of 145% and P/E of 28 is clearly not the “best use of cash”, and the market certainly is not valuing BRK/A at “below intrinsic value.” To counter his contradiction, it would be nice if he either came out and said he has changed his opinion about the optimal factors promoting buybacks, or stated that BRK/A does not have reasonable opportunities to grow earnings and returning cash to shareholders is the best option.

In the end, Buffett is unreliable on this topic, and BRK/A does not make a habit of returning cash to shareholders. In the long history of the firm, they have only conducted a few very small share buybacks and only once issued a dividend of $0.10 in 1967. It seems to us he is feeding the buyback frenzy occurring in the market today and will likely avoid meaningful buybacks in BRK/A.

Buffett on Valuations : Market Cap to GDP

One of the most widely followed equity valuation gauges is what is commonly referred to as the Buffett Indicator. The indicator, Buffett’s self-professed favorite, is the ratio of the total market capitalization to GDP. Currently, as shown below, the indicator stands at 132% and dwarfs all prior experiences except the final throes of the Tech boom in the late 1990’s.

The following section highlighted in orange is from a recent article entitled Would You Rather with Warren Buffett by Eric Cinnamond:

Question to Warren Buffett: “One of the things you look at is the total value of the stock market compared to GDP. If you look at that graph it’s at a high point, the highest it’s been since the tech crash back in the late 90’s. Does that mean we’re overextended? Is it a better time to be fearful rather than greedy?”

Eric Cinnamond (EC): What a great question, I thought. I couldn’t wait for his answer. Let him have it Warren! It’s your favorite valuation metric flashing red – tell everyone how expensive stocks have become! I was very excited to hear his response.  Buffett replied,

Warren Buffett (WB): “I’m buying stocks.”

EC: But in 1999 when this valuation was actually less than today he said this…

WB: “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.”

Our take: Stocks are far from cheap. Based on Buffett’s preferred valuation model and historical data, as depicted in the scatter graph below, return expectations for the next ten years are as likely to be negative as they were for the ten-year period following the late ‘90’s. To read more about this graph click on the following link –Allocating on Blind Faith.

The article provides a glimpse of the value added in our new service RIA Pro.

The more compelling question for Mr. Buffett is not whether or not he generally likes stocks but which stocks he likes. As a value investor, he ardently discriminates on price within the context of which companies operate with unique pricing power. This characteristic, more than any other, best defines Buffett’s investment preferences. He routinely speaks about the competitive “moat” that he likes for his companies to have. Understanding what he means by that is important. The following quote captures the essence:

“If you’ve got a good enough business, if you have a monopoly newspaper or if you have a network television station, your idiot nephew could run it.”

Keyword: Monopoly. That is how a company retains pricing power. The empire of the perceived champion of American capitalism and free markets is built on monopolistic companies. Yes, I think we can add that to the list of contradictions.

Buffett on Bullish Market Prospects

The following recent quotes are from a CNBC interview of Mr. Buffett on June 7, 2018 about bullish market prospects:

• “The decision on the stock market should be made independent of the current business outlook. When you should buy stocks is when you think you’re getting a lot for your money not necessarily when you think business is going to be good next year. The time to buy stocks in America generally has been always with a few exceptions because the long-term outlook is exceptionally good and I don’t think you should buy stocks based on what you think the next 6 months or year is going to bring.”

• “I like buying stocks. I’m a net buyer.”

• “I’m no good at predicting out 2 or 3 or 5-years from now although I will say this, there’s no question in my mind that America’s going to be far ahead of where we are now, 10, 20 and 30-years from now.”

If the economic outlook is so constructive, and you can afford and are willing to hold investments for long periods, why does BRK/A hold so much dry powder as shown below?

A growing war chest of over $300 billion in cash certainly appears to be inconsistent with his stated outlook.

Buffett’s True Concerns

The general platitudes of market and economic optimism Buffett shares in his CNBC interviews, letters to investors and shareholder meetings often run counter to the actions he has taken in his investment approach. Not only does he seek out companies with monopolistic characteristics and pricing advantages, he seems to be increasingly positioning to protect against imprudent central bank policies that have fueled this bull market.

His purchase of Burlington Northern Santa Fe (BNSF) railroad is an acquisition of hard assets. Control of BNSF affords a multitude of other benefits in the form of rights of way and adjacent mining rights, and it allows him to move other energy resources he has been steadily accumulating as well.

Four of his top ten holdings are financial services companies such as Wells Fargo (WFC), Bank of America (BAC), and American Express (AXP). Additionally, he is also known to hold large offshore assets in Asia and elsewhere which generate non-dollar profits that can be held tax-free.

The common theme behind these holdings, besides the fact that they each have their monopolistic “moat”, is that they serve as a firebreak against an uncontrolled outbreak of inflation. If monetary policy sparked serious inflation, the hard assets he owns would skyrocket in value, and the off-shore holdings in foreign currencies would be well protected. As for the financial institutions, inflation would effectively minimize the costs of their outstanding debt, while their assets rise in value. Further, their net interest margin on new business would likely increase significantly. All of that would leave BRK/A and Buffett in a position of strength, allowing them to easily buy out bankrupt competitors from investors at pennies on the dollar.

Summary

Warren Buffett is without question the modern day icon of American investors. He has become a living legend, and the respect he receives is warranted. He has certainly been a remarkable steward of wealth for himself and his clients. Where we are challenged with regard to his approach, is the way in which he shirks his responsibilities as a leader. To our knowledge, he is not being overtly dishonest but he certainly has a way of rationalizing what appears to be obvious contradictions. Because of his global following and the weight given to each word he utters, the fact that his actions often do not match the spirit of his words is troubling.

Reflecting back on the opening quote from John D. Rockefeller, Buffett has ways of making money that we know nothing about, and he seems intent on obscuring his words to make sure we don’t figure it out. Putting that aside, Warren Buffett did not amass his fortune by following the herd but by leading it.