In the past I’ve printed excerpts from speeches of Alan Greenspan and given my critical interpretations of them. Today I want to look at something a little different, and much more insightful than the scared crow. This weekend Warren Buffett sent out a letter to the shareholders of Berkshire Hathaway in which he made a lot of comments about the state of the stock market and investing. It is a must read for anyone who invests or speculates in the stock market. You can read the entire letter at
berkshirehathaway.com
Warren Buffett’s company has outperformed the S&P 500 during almost every year of its existence and posted a gain last year while most mutual funds and investors got caught up in the bubble. I expect his value investing approach to continue to outperform the market in the years to come. If you want a long term investment you may want to check out his company.
What he has to say is worth 1000 hours of watching CNBC. Below I have put some excerpts from his letter in quotes, My own comments follow:
"Another negative ¾ which has persisted for several years ¾ is that we see our equity portfolio as only mildly attractive. We own stocks of some excellent businesses, but most of our holdings are fully priced and are unlikely to deliver more than moderate returns in the future. We’re not alone in facing this problem: The long-term prospect for equities in general is far from exciting. "
Buffett is negative on the entire stock market and does not currently see it as an attractive place for investment. Unlike most fund managers he is not afraid to state the obvious.
"Finally, there is the negative that recurs annually: Charlie Munger, Berkshire’s Vice Chairman and my partner, and I are a year older than when we last reported to you. Mitigating this adverse development is the indisputable fact that the age of your top managers is increasing at a considerably lower rate ¾ percentage-wise ¾ than is the case at almost all other major corporations. Better yet, this differential will widen in the future."
And he has a sense of humor...
"Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush ¾ and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota ¾ nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe."
In other words recent advances in technology have not changed the basic rules of investment. Balance sheets are still important. Earnings still matter. This is what I was trying to hammer home to you this weekend. When the steam engine was invented a bubble in railroad stocks eventually occured. The mass production of the automobile and other inventions in the 1920s made people think that they were in a "new economy," just like some nuts still think now. The Internet no more changed the rules of investing than previous "new eras" did. Those bubbles popped and so did this one. It was inevitable. By conventional valuations the stock market is still way overvalued and interest rate cuts cannot change that.
"Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component ¾ usually a plus, sometimes a minus ¾ in the value equation."
This is an important comment and deserves a careful reading. What Buffett is saying is that low P/E’s and high EPS growth rates MEAN NOTHING. To really know what a company is growing at and is worth you need to do a detailed study of the balance sheet. Earnings Per Share and growth rates can be cooked up by manipulating the numbers so real investors cannot rely on them, but 99% of investors do - including mutual fund managers.
"At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.
Now, speculation ¾ in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it ¾ is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?"
By Buffett’s definition I engage primarily in stock speculation. Anyone who doesn’t focus on real fundamentals is in his book. The goal of technical analysis is to determine the emotions swirling around the market and figure out where the crowd is going. By his definition that is speculation.
"The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities ¾ that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future ¾ will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands."
Almost everyone went mad in the bubble and few knew when to get out. People are too greedy to sell, because they are afraid to miss out on any gains and refuse to take a loss - even if they know what they are investing in is worthless. The more extreme prices deviate from reality the more reckless they get.
"Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else, piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them."
Good description of 1999.
"What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the "business model" for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen."
This is the second key point to be taken from this. What we saw in the stock market bubble was a total fraud that took wealth away from people and transferred it to Wall Street brokerage houses, founders of bubble companies, and stock manipulators. The Internet stocks and the 1999 IPO market were not designed to create long lasting companies or investments, but to rip off the gullible public and the average investor. You can tell your broker next time you see him that Warren Buffett thinks that the Nasdaq is a scam. He’s right. The bubble was nothing but a legal ponzi scheme.
"But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street ¾ a community in which quality control is not prized ¾ will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest."
The analysts and CNBC talking heads will sell any stock to you to make a buck. Abby Cohen and Mary Meeker will tell you the stock market is going up while their firms unload into the buying frenzy that they create. Henry Blodgett was not making a mistake when he told you that Pricline and Amazon were good companies. He was lying and laughing all of the way to the bank. The more dire the need for Wall Street firms to sell, or the more worthless the company, the bigger the lies. As the bull market peaked the lies got more and more ridiculous.
"We applaud the work that Arthur Levitt, Jr., until recently Chairman of the SEC, has done in cracking down on the corporate practice of "selective disclosure" that had spread like cancer in recent years. Indeed, it had become virtually standard practice for major corporations to "guide" analysts or large holders to earnings expectations that were intended either to be on the nose or a tiny bit below what the company truly expected to earn. Through the selectively dispersed hints, winks and nods that companies engaged in, speculatively-minded institutions and advisors were given an information edge over investment-oriented individuals. This was corrupt behavior, unfortunately embraced by both Wall Street and corporate America."
"The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to "make the numbers." These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more "heroic." These can turn fudging into fraud. (More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)"
This system of Wall Street lies and fraud has corrupted the behavior of CEOs. You can ask Lucent about what Buffett is talking about. Or Amazon and perhaps you’ll have to add Oracle to the list. CEOs play accounting games to make it look like their companies are growing faster than they really are or that they are growing at all. Widespread deception has spread and it is hard for the investor to determine what is real and what is not. Read the excerpts again without my comments or go and read the entire piece. Pretty powerful stuff. If you own semiconductor companies you might want to examine the balance sheet and save yourself some money.
A lot of people poo-pooed Warren Buffett in 1999 because he missed out on the tech boom. When this epic market meltdown is over he will still be standing and the nuts will be gone. George Gilder and Michael Murphy will disappear, but Bill O’Neill, George Soros, and Warren Buffett will always be here. |
