I came across the remark “bears sound clever but bulls make money” in one of the many financial articles that hit my inbox on a daily basis. I thought that it would be an appropriate title for an article to remind investors of the positive returns that are normally generated by equities over an extended period of time despite the intense volatility from one period to the next.
I think it is also timely to publish an article on this topic following the spectacular recovery across international equity markets over the past three months. The S&P 500 index in the US rallied by 13.1 per cent in the first quarter of 2019 (the best quarterly performance since the 2008/2009 global financial crises) following the sharp downturn in the last three months of 2018.
Over recent months, many economists and financial commentators had opined that the international equity market downturn during the final quarter of 2018 was the start of a prolonged bear market which many claimed was long overdue following the very strong increase in global equity prices since the low in March 2009 in the midst of the global financial crisis. Equity markets recovered strongly in the first three months of 2019, principally due to the fact that the US Federal Reserve backtracked on its planned programme of gradual interest rate hikes for 2019 on growing evidence of a global economic slowdown.
Against this background, it is worth assessing the views of some seasoned investors to gauge their thoughts and actions in such periods of extreme volatility.
One of the most well-known investors is Warren Buffett who, at the age of 88, still runs the $500 billion conglomerate Berkshire Hathaway Inc. Many investors across the world await Buffett’s annual letter to the shareholders of the company since the letters invariably provide insights about investing and also some important lessons about financial theory.
The latest letter was published on February 24 and most financial commentators were eager to read his comments about the sharp downturn in the final quarter of 2018 and to gauge whether Buffet took advantage of the decline in share prices to increase holdings of certain positions or acquire initial stakes in other companies.
In the most recent letter, he reminded his fellow shareholders that the “prime goal in the deployment of your capital” is “to buy ably-managed businesses, in whole or part, that possess favourable and durable economic characteristics. We also need to make these purchases at sensible prices”.
Apart from owning some companies in their entirety, Berkshire Hathaway also has an investment portfolio with minority stakes in various publicly traded companies valued at $172.8 billion (as at the end of 2018). The five largest individual holdings within the portfolio are Apple ($40.3 billion), Bank of America ($22.6 billion), Wells Fargo ($20.7), Coca-Cola ($18.9 billion) and American Express ($14.5 billion). Moreover, Berkshire Hathaway has significant control in Kraft Heinz due to its sizeable stake in the company which had a market value of $14 billion as at the end of last year.
In 2018, Berkshire Hathaway reported that it acquired about $43 billion of equities while selling only $19 billion. Buffet stated that the shares which were acquired “offered excellent value, far exceeding that available intakeover transactions”.
The chairman of Berkshire Hathaway also mentioned the strong financial position of his five largest individual stakes which enables these companies to perform share buybacks. He is in favour of such actions and remarked that “we rejoice when management employs some of its earnings to increase Berkshire’s ownership percentage”. Buffett gave an example of the long-term benefit of share buybacks and stated that “notwithstanding Berkshire’s holdings of American Express have remained unchanged over the past eight years, our ownership increased from 12.6 to 17.9 per cent because of repurchases made by the company. Last year, Berkshire’s portion of the $6.9 billion earned by American Express was $1.2 billion, about 96 per cent of the $1.3 billion we paid for our stake in the company. When earnings increase and shares outstanding decrease, owners – over time – usually do well”.
Buffett also highlighted once again what he has invariably stated several times in the past regarding short-term market movements. He stated that he has “no idea as to how stocks will behave next week or next year. Predictions of that sort have never been a part of our activities. Our thinking, rather, is focused on calculating whether a portion of an attractive business is worth more than its market price”.
The letter also highlights once again Buffett’s investment philosophy which ought to be kept in mind when the markets go through intense periods of volatility as seen in recent months. The chairman of Berkshire Hathaway stated that they do not view their sizeable investment portfolio “as a collection of ticker symbols – a financial dalliance [relationship] to be terminated because of downgrades by the Street, expected Federal Reserve actions, possible political developments, forecasts by economists or whatever else might be the subject du jour. What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning about 20 per cent on the net tangible equity capital required to run their businesses.
Over time, however, investment performance converges with business performance
“These companies also earn their profits without employing excessive levels of debt. Returns of that order by large, established and understandable businesses are remarkable under any circumstances. They are truly mind-blowing when compared against the return that many investors have accepted on bonds over the last decade – three per cent or less on 30-year US Treasury bonds, for example. On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period. Over time, however, investment performance converges with business performance”.
Another like-minded value investor published an interesting article in January in which he discussed the sharp downturn in the fourth quarter of 2018 by claiming that investors are fearful by nature, especially after a long period of increasing share prices, and this makes them relatively quick to sell. He referred to economic recessions as short-term events and claimed that investors should never make long-term investment decisions based on short-term fears.
He argued that retail and institutional investors should invest “like business people”. The author stated that “we regard ourselves as businessmen, and businessmen do not sell in downturns, they run their business for the long term”. He also reiterated his belief that “if earnings per share grow, share prices will eventually follow”.
He explained the movements in equity markets by creating a distinction between a ‘signal’ and ‘noise’. The signal from a long-term investor’s portfolio is the companies’ profits. Noise is the daily movement in share prices. The author of this article argued that typical long-term investors should only focus on the signal and not on the daily market movements in the share price.
He then explained the developments in the fourth quarter of 2018 by highlighting that “Mr Market has been in a very bad mood for the last three months and does not want to pay for future profits. On the other hand, if an investment was good three months ago, it’s extremely likely to be equally good now”. This author highlighted that given the downturn in prices during the sharp sell-off in the final quarter of 2018, certain equities can now be acquired at a discount of between 15 and 20 per cent compared to previous price levels. The author also gave an analogy to the property market and questioned whether if some ‘expert’ would pass by your house in which you live comfortably and said it was worth 25 per cent less than two months ago, would you sell and go live in a hotel? Naturally, this would not be well received by the home owner and the sale will not go through. He stated that his investment portfolio is much better than a house since they are “a diversified basket of good businesses that should grow over time”.
These lessons are equally important for Maltese equity investors. As indicated in last week’s article, which tracked some of the movements in the market capitalisation of the larger companies listed on the MSE over a relatively long period of time, share prices reflected a company’s profit trajectory over a number of years. Investors should therefore ignore short-term share price movements which may be even more erratic in a somewhat illiquid market such as Malta’s.
On the other hand, investors should focus on a company’s profitability level and the strategy being adopted by management to grow the level of profits in the future. As we are now in the midst of the period when most annual general meetings take place, investors should wisely use the time dedicated to questions to seek clarity on how their companies are positioning themselves to grow their level of profits which ultimately leads to added shareholder value in the long term.
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