Buffettspeak: In productive assets I trust

March 1st, 2012

The wait is over for followers of Warren Buffett’s annual letters. As in the past, this time too he uses the letter to convey his views on investing. He makes interesting observations on three major asset classes — equity, treasury or bonds and gold.

Let us see what he has to say about investing and these three assets classes.

The basic choices for investors and the one we (Berkshire) strongly prefer investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire, we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is foregoing consumption now in order to have the ability to consume more at a later date.

Effectively, Buffett stresses on investing in assets that can, over time, retain and increase purchasing power or provide a good hedge against inflation. He also says the risk of an investment is not measured by beta, but by the reasoned probability that it will cause its owner a loss of purchasing power over his contemplated holding period. He further explains that an investment could fluctuate significantly in price but could still hold its purchasing power. On the other hand, an investment that does not fluctuate in price could be perceived safe, but what if over the period of time one loses purchasing power?

Here is why he emphasises on risk

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth, they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. Even in the US, where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.” For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of US Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points.

Importantly, he explains during this period, the implicit inflation “tax” was more than thrice the explicit income tax that our investor probably thought of as his main burden. In hindsight, we all want our investment to at least beat the rate of inflation and take care of taxes. And if both objectives aren’t achieved, there could be erosion in purchasing power, which could be riskier than what is explained to be safe by way of looking at the beta of an investment. This comes at a time when the world is debating the role of fixed-income securities in the portfolio particularly given perception of risk-free returns.

Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.

But if fixed-income securities aren’t able to retain and increase purchasing power, what about gold, which is making all the news and noise of being the perfect hedge against the inflation? In fact, the advocates of gold as an investment are convinced that it is the only asset class that has retained its purchasing power against the inflation along with having the advantage of money of last resort. In the event of a crisis, gold is supposed to be a better option than equity or buying businesses.

Buffett puts gold in the second category of investments that will never produce anything. Buyers invest in such assets in the hope someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. He compares this phenomena with the buyers of tulips in the 17th century. During this period, which was also known as Tulip Mania, contract prices for bulbs reached significantly high levels and then suddenly collapsed. Studies suggest that at the peak of tulip mania, during the year 1637, bulbs sold for more than 10 times the annual income of a skilled craftsman. It was generally seen to be the first speculative bubble in the history of financial markets.

The major asset in this category (second) is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. As “bandwagon” investors join any party, they create their own truth – for a while. Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

One can always debate about gold and its drivers but this is what the legend has to say. In fact he has made some very interesting calculations, which is worth taking a look.

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all US cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain equilibrium at present prices. A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond. Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

In a nutshell fixed income has the drawbacks of not being able to take care enough of the purchasing power that its owners need. Gold is unproductive and is of practically no use except being marginally used in some of the industrial applications. What about the productive assets such as equity cAan it address both the issues?

Says Buffett: the first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly US obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to non-productive or currency-based assets. Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle.

Buffett is considered to be a firm believer of investing in the productive asset class, which typically means investing in assets which use the capital for the productive purposes and thus grow as productivity goes up. Such assets are also considered to be having the ability to retain and increase the purchasing power of its owner.

The choice is yours — buy and hold the gold for the next ten years in the hope that somebody at the end of the decade will buy it at higher prices. If not with the same money you can start your own business may be making soaps and detergents or invest in Hindustan Unilever, which is the leading player in the segment, because at least there will be somebody using or consuming those products every morning for the years to come.

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Sensex: What’s next?

December 29th, 2011

The anxiety to know where the markets are heading is only increasing while uncertainties abound. While there are many observations and possibilities, the most important question that comes to my mind: what’s in the price? Are Indian stock prices reflecting the worries that we are facing today with regard to what is going on or could possibly go wrong in the global economy, especially given the European crisis and the slowdown in Chinese economy? Most economists say the current global economic environment is extremely uncertain. And if the ongoing crisis manifests completely, the result could be devastating to say the least.

Here is what Marc Faber said when I asked him about his readings of the global economic crisis back in September, “We never really had a recovery in the western world. The stock markets went up because of the money printing and support in 2009. My view is that they can probably muddle through for another two-three years by piling up the fiscal deficit or printing more money. I do not know when it will happen - in 2012 or in 2018 - but the next crisis will be worse than the one in 2008.” Couple this view with that of domestic economists, who believe the homegrown economic issues are yet to play out, and the outlook isn’t bright.

Earnings downgrade cycle
So far from the peak in the month of January 2011, the Sensex has corrected by about 23 per cent. A large part of this has come from the Sensex earnings downgrades of about 10 per cent so far since January this year to currently at about Rs 1,130 per share. The second part comes from the P/E multiple de-rating, which typically happens when investors are expecting less growth and return on equity is expected to be relatively lower. At its peak in January 2011, the Sensex was trading at 16.5 times its one-year forward earnings, which has now dropped to 14 times. Effectively, the P/E de-rating has eroded another 15 per cent from the Sensex value followed by earnings downgrades.

What if in FY13 the Sensex EPS does not grow at all? Is that a possibility? Let us go back to history. Between FY98 and FY2000, for almost three years, the Sensex EPS remained flat at about Rs 280 levels. Again, very recently, beween FY08 and FY10, the Sensex EPS did not grow much. Let me tell you another interesting story. Last time, when the crisis hit in early 2009, analysts were expecting the Sensex EPS at Rs 1,240 for FY10. However, it actually tuned out to be 33 per cent lower at Rs 834 per share, which is huge and one can think of the difference that could occur between perception and reality when things go wrong. In that context, so far we have only seen 11-12 per cent downgrades in FY13 Sensex earnings.

There aren’t enough signs that we may see a situation like in 2008 and after, but there are enough headwinds in both the global and the domestic economy. The GDP growth has already been lowered and earnings are expected to suffer in the coming months partly as interest rates stay high. Even if we project a scenario of flat growth in FY13, the Sensex EPS could be around Rs 1150 per share.

Worst case
Now with flat growth in EPS what is the worst case for Sensex? If we take the reference of the 2008-09 global financial crisis, which was a classic case where both the global and domestic issues played large roles, the Sensex went down to almost 10 times its one-year forward earnings.

If we apply the same logic the Sensex value works out to nearly 11,300 points (forward Sensex EPS of Rs 1,130*10) or about 30 per cent lower from the current levels. But can the market trade at a P/E multiple of 10? Stock prices do not move only on fundamentals, but also because of sentiment and liquidity, which as we saw in 2008-09 forced markets to trade at lower valuations.

Recently there was a note published by Christopher Wood of CLSA where he said: “At this point, with the RBI hamstrung by stubbornly strong non-food core inflation, a violent sell-off down to the 11,000-12,000 levels on the Sensex, combined with a further depreciation in the rupee to the Rs 60/US$ level, now appears quite possible; most particularly in the context of any potential euroquake.”

Here the last line about the “potential euroquake” is very important, which is precisely what could impact the liquidity and the sentiment. It was not the fundamentals of the Indian economy that led to such huge sell-off in 2009, it was more to do with the sentiment due to the failure of the US banks and Lehman Brothers filing for bankruptcy in September 2008.

Here, the one cautionary statement is that this is an outcome, which is based on many assumptions. After all there is no harm in knowing the risk, whether it will materialise or not is a different issue. It isn’t as if there is no hope for long-term investors. In fact, the best time to invest in equities is when there is lot of pessimism in the market. Which is precisely what Warren Buffett says, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

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Buffettology: More to investing than returns

September 21st, 2011

Most of us want our investments to offer returns similar to the ones generated by the legendary Warren Buffett. To that end we try to learn from his investment style to get superior returns. But the question is, does one have to look at parameters beyond just returns to become wealthy?

Even if one generates returns comparable to Buffet, there is a possibility of one remaining poor or not being able to build enough wealth.

The magic formula

Consider some facts about the Oracle of Omaha. While Buffett was little over 11 year of age, he bought three shares of Cities Service Preferred for himself and while in high school  invested in his father’s business. Buffett filed his tax return at the age of 14. From his early days he tended to save. According to one estimate by the time he finished college, Buffett had accumulated more than $90,000 in savings measured in 2009 dollars.

Nine women or nine months

Buffett has always emphasised on giving time to your investments to grow. Even if one buys the right stock at the right price, the fortunes are made in time.

As Buffett explains in his 1985 annual letter to shareholders,  “No matter how great the talent or effort, some things just take time: you can’t produce a baby in one month by getting nine women pregnant.”

These words explain the power of compounding and the time that it takes before it starts to kick in. Compounding is simple and I know most of us understand the concept very well. However, we need to implement it in its true essence. Hope some these examples should be worth noting.

At 16 per cent annual returns, it takes five years for Rs 100 to become Rs 200. But if one holds the same Rs 200 for another five years it becomes Rs 440.

Differentiating factor

Like early investing, how much one invest is equally important. A Rs 100,000 compounded over the next 10 years with the annual returns of 20 percent would just total little over Rs 6 lakh. However a Rs 10 lakh invested today compounded with the same rate and over longer periods say 30 years would be worth about Rs 24 crore. This is a huge difference. The point I am trying to make is even if we exhibit the best stock picking quality, returns alone may not lead you to the pot of gold.

The widening gap between poor and rich

Here’s another example. Say investor A invests Rs 10 lakh and investor B invests Rs 1 lakh. Today the difference between both investors in absolute terms is Rs 9 lakh. If both of them remain invested and their money grows at a rate of 20 per cent per annum by the end of 30 years, the wealth of A would be Rs 23.7 crore compared to that of B at Rs 2.37 crore. This is a difference of over Rs 21.3 crore as against the current difference of Rs 9 Lakh between investors A and B.

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