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March 5, 2018

Buffett on Market Volatility, Risk and More

By Charles Rotblut, CFA, AAII

On my must-read list is Warren Buffett’s annual letter to Berkshire Hathaway (BRK.B) shareholders. Even if you are not a Berkshire shareholder (like I am), the observations on the financial markets and investing are often priceless. This is year was no different. Though Buffett’s comments about acquisitions received the most attention after the latest letter was released last weekend, there were several observations about investing that are worth paying attention to (and even saving).

Possibly the best parts of the letter came from Buffett’s discussion about a 10-year bet. Buffett predicted that the returns of a plain-vanilla S&P 500 index fund would beat those of hedge funds. He won the bet handedly. So I’ll start with the lessons he shared in discussing the bet before moving on to other noteworthy parts of the letter.

The Secret to Dealing With Market Volatility: In putting market fluctuations into perspective, Buffett wrote, “Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals. A willingness to look unimaginative for a sustained period—or even to look foolish—is also essential.”

The Difference Between Risk and Investing: Echoing a point our founder James Cloonan made several times over the years, Buffett told shareholders, “Investing is an activity in which consumption today is forgone in an attempt to allow greater consumption at a later date. ‘Risk’ is the possibility that this objective won’t be attained … As an investor’s investment horizon lengthens, however, a diversified portfolio of U.S. equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.”

Costs Matter: In discussing his 10-year bet that a plain-vanilla index fund could beat an active manager over the long term, Buffett credited his victory, in part, to very high fees charged by the fund-of-funds structure. He quipped, “Performance comes, performance goes. Fees never falter.”

Think Like an Owner, Not a Speculator: Buffett and his partner Charlie Munger view Berkshire’s investments in various companies “as interests in businesses, not as ticker symbols to be bought or sold based on their ‘chart’ patterns, the ‘target’ prices of analysts or the opinions of media pundits.” A few paragraphs later, he added, “Stocks surge and swoon, seemingly untethered to any year-to-year buildup in their underlying value. Over time, however, Ben Graham’s oft-quoted maxim proves true: ‘In the short run, the market is a voting machine; in the long run, however, it becomes a weighing machine.’”

Many Corporate Acquisitions Aren’t Smart: Among the key traits Berkshire looks for in an acquisition is “a sensible purchase price.” (Buffett used italics.) He lamented that this requirement was a big hurdle in Berkshire Hathaway’s attempt to find acquisitions last year because “price seemed almost irrelevant to an army of optimistic purchasers.” While I’ll side-step his racier comments, Buffett criticized CEOs for being “can-do” types, never lacking for forecasts that justify their purchases, being aided by cheap debt and relying on spreadsheets that “never disappoint.” He added that he and Munger “never factor in, nor do we often find, synergies.” (This is not the first time Buffett has criticized so-called synergies forecast by other CEOs to justify mergers and acquisitions.)

As far as what Buffett and Munger look for in a potential acquisition, Buffett explained: “Durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.” He also shared a simple guideline followed by Berkshire: “The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.”

Avoid Relying on Debt (Including Margin): Buffett discussed the use of debt a couple of times. First, in describing Berkshire’s desire not to have to rely on “the kindness of strangers.” Then later in his letter, he warned against investing on margin by writing, “There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”

Be Skeptical of Loss Reserves Reported by Insurers: Buffett estimates the total industry loss from insured claims related to last year’s three hurricanes to be approximately $100 billion. This estimate could be “far off the mark” as initial estimates following mega-catastrophes are often low. The actual losses could also be far in excess of what insurance companies have allocated for. Buffett warned, “Ignorance, wishful thinking or, occasionally, downright fraud can deliver inaccurate figures about an insurer’s financial condition for a very long time.”

The New Tax Law Is Altering Financial Statements: Buffett said $29 billion of Berkshire's $65 billion increase in shareholder equity was due to a one-time, noncash reduction of net-deferred income tax. Berkshire is among many companies to report significant fourth-quarter adjustments related to the Tax Cuts and Jobs Act.

Firms With Unrealized Gains and Losses Could Have More Volatile Earnings Going Forward: A change in accounting (GAAP) rules now requires companies to include the net change in the value of their investments in reported net income. For companies impacted by this rule, their underlying earnings could swing for reasons completely unrelated to their business operations. Buffett believes the rule will create “considerable confusion among shareholders for whom accounting is a foreign language.”

The Week Ahead

Fourth-quarter earnings season will start to wind down. Still, nine S&P 500 member companies are scheduled to report: Autodesk Inc. (ADSK), H&R Block Inc. (HRB), Ross Stores Inc. (ROST) and Target Corp. (TGT) on Tuesday; Brown-Forman Corp. (BF.B), Costco Wholesale Corp. (COST) and Dollar Tree Inc. (DLTR) on Wednesday; and Cooper Companies Inc. (COO) and Kroger Co. (KR) on Thursday.

The week’s first economic report will be the ISM’s February non-manufacturing index, released on Monday. January factory orders will be released on Tuesday. Wednesday will feature the February ADP employment report, January international trade data, the first revision to fourth-quarter productivity and the periodic Beige Book. February jobs data, including the change in unemployment and nonfarm payrolls, will be released on Friday.

Three Federal Reserve officials will make public appearances: New York president William Dudley on Tuesday and Wednesday, Atlanta president Raphael Bostic on Wednesday; and Chicago president Charles Evans on Friday.

About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)  

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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