Lessons from Warrn Buffett's latest letter...
WARREN BUFFETT, the world's most famous investor, released the latest letter from his investment vehicle, Berkshire Hathaway, writes John Stepek, editor of MoneyWeek magazine, in its free daily Money Morning email.
What does the ultimate investment guru have to tell us?
Well, put simply – the market's too damn expensive.
Whatever you think of the superficial trappings of Warren Buffett's communication style – the folksy twang, the low-rent salesmanship, the cheeky old chappie off-colour metaphors – his ability to explain a really quite complicated business to normal people is very impressive.
Perhaps more than anything else – including his performance – this communication ability explains why he's the world's most famous investor.
He beings by pointing out that there are four ways in which to "add value" to Berkshire. They can buy new stand-alone companies. They can buy new companies to bolt on to ones he already owns. The companies they already own can become bigger and more profitable. And they can make money from their stock market and bond investments.
In this year's letter, Buffett focuses on new acquisitions. Most of us have a rough idea of what Buffett looks for these days. He's way too big to worry about rooting around in the neglected corners of the microcap market to find deep value bargains.
Even if he could somehow invest in a desirable small cap without shifting the share price dramatically higher in the process, it could never occupy a large enough proportion of his overall portfolio to make any sort of mark worth having. If you have a portfolio of $1bn, then seeing a $1m investment double to $2m is pretty irrelevant.
Instead, Buffett is looking for companies with moats – or "durable competitive strengths", as he phrases it in this year's letter. In other words, he wants a company that can stay ahead of the pack, and earn strong profits without them being competed away by rivals.
That is hard to come by at the best of times. The whole point of capitalism is that when one entrepreneur spots a highly profitable opportunity, a flock of them will descend and nibble away at those tasty profits until only the fittest and most efficient survive. The end result – in theory and often in practice too – is that scarce and valuable resources are put to use in the most efficient manner, and everyone benefits.
As well as a decent moat, Buffett wants to see good quality management, a decent return on capital invested (which usually goes hand in hand with a decent moat), and "opportunities for internal growth at attractive returns" – in other words, the company still has profitable prospects, rather than just having to "buy in" growth in the form of acquisitions.
All of those things are desirable qualities in a business. It's unlikely that most people would debate any of them. You might disagree over which individual companies actually have those qualities – that's what makes a market after all – but few of us would say "no" to a well-run, profitable company with a clear competitive advantage inside its sector.
The question, of course, is how much you would pay for such a company. This is the final key tick box – finding a good company at "a sensible purchase price". It's this little detail that is the one currently giving Buffett the biggest headache.
Indeed, the question of price "proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to any army of optimistic purchasers."
What's behind this? Buffett blames two things. First, there's "the ample availability of extraordinarily cheap debt". Then there are investment banks spurring on chief executives – who don't typically need much encouragement anyway – to do deals. "Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase."
As a result, he hasn't done many big deals this year. But meanwhile, he's happy to sit on his hands and wait for his chance to swoop. Or as he puts it: "The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own."
You might argue that it's easy for Buffett to be sanguine about the lack of opportunities out there. After all, he's already rich. And that's not an unreasonable point. If you have all the money you need, then you can afford to be more risk averse.
Once you've hit your retirement target or any other financial goal, why risk money you have in order to get money you don't need? This is a really important lesson and one to bear in mind in your own financial planning.
However, even if you're not at the stage where you can sit back and put all your money in short-term bonds and cash, you shouldn't ignore Buffett's points. And even if you're a buy-and-hold investor (ie, you're not trying to watch and wait for stocks to get dirt cheap before you buy), then there are some valuable lessons here.
How does Buffett manage to stay patient? Firstly, he accepts that the market gets over-excited at times. Buffett has seen all of this before. In the late 1990s, people were saying he was past it because he wasn't buying tech stocks.
Prior to the credit crunch, it was a similar story. Buffett had run out of ideas. That episode ended with him taking Goldman Sachs to the cleaners when the world's most feared investment bank was forced to come to him, begging bowl in hand, looking for both his money and his reputation.
During booms, it's far too easy to start being plagued by "fear of missing out (FOMO)". You start to doubt your own stance. You start to think that it really is different this time, and that if you don't buy in now, there will never, ever be another opportunity in the future. Buffett's strength is that he can stay calm – he can focus on value, rather than price.
Secondly, and at least as importantly, he avoids using borrowed money. My colleague Dominic Frisby talked about the risks and rewards of leverage the other day in Money Morning. And if you're the sort of person who likes a little trading punt on the side, then as long as it doesn't turn into a problem, then it's your call.
But if we're talking about long-term investing, leveraging up is a no-no. The problem with markets, as Buffett points out, is that no one knows for sure what'll happen next. Even the best assets can take a pummelling in a market storm. When that happens, leveraged players get wiped out.
In effect, using borrowed money compromises your ability to hang on to good assets while everyone else is being forced to bail out of them. Instead, when markets turn, you want to be the person who has enough cash to relieve the desperate leveraged players of their high-quality liquid assets when they come to you hoping to offload them at knock-down prices.