New Wall Street dynamics make it harder to pick stocks

Last weekend saw the annual Berkshire Hathaway shareholders’ meeting. Instead of crowds flocking to Omaha, Nebraska, Warren Buffett and Charlie Munger gathered in Los Angeles and talked to investors over the internet.

Buffett is rightly regarded as one of the greatest investors ever. This is not just because of his stellar long-term performance, but because of the extensive knowledge he has built up analysing companies and owning their stocks and businesses outright.

This means that Buffett knows a lot about business and investing and is worth listening to. But he, just like you and me, does not seem to have an information edge. By that I mean he doesn’t possess a crystal ball of the future which allows him to exploit mispriced shares. What we can all do is try to identify good businesses and take a view whether they are attractively priced or not.

Over his investing career, Buffett’s investing edge has been spotting underpriced shares. This was a lot easier to do in the 1950s and 1960s when there were fewer people trying to do it and the magic formulas of Benjamin Graham still worked. 

Today he cannot find an edge through pricing because businesses are very highly priced and in some cases wildly overpriced.

Buffett is what I called an old-fashioned investor with an approach I have a lot of time for. He likes businesses with a competitive edge that produce real profit and cash flows and earn good, and importantly sustainable, returns on money invested. His approach to valuation is refreshingly simple. He looks at yields on his purchase price and wants to see that yield grow. If there is a significant buffer between earnings or cash flow yields above the yield on long-term treasury bonds, then shares of a business may be attractively priced.

2020 should have been a good year for Buffett. He should have been able to pick up good businesses at depressed prices. The printing of money to keep interest rates low and the rise of Special Purpose Acquisition Companies (SPACs) has stopped him doing this.

Shares have been a very crowded trade for some time. It’s very similar to lots of people fishing in a small lake. No one should be surprised that it is difficult to catch any fish.

I have to say that I am very much in agreement with Warren Buffett when he says: “There’s a lot more to picking stocks than figuring out what’s going to be a wonderful industry in the future.”

There are so many stocks that this could apply to, but Tesla fits the bill nicely for me. It is valued at $646bn and is the sixth most valuable business listed on the S&P 500. It makes most of its money by selling regulatory credits to other car manufacturers. 

It has a founder that seeks to enrich himself with generous stock options and who uses shareholders’ money to speculate on bitcoin. Bulls of Tesla talk to the potential for its battery technologies and autonomous driving with projections that are basically guesswork. It seems that the valuation already takes this for granted, and then some, which is concerning  if you believe that valuation matters. In the short run it doesn’t, but ultimately it does.

Tesla could be a great success, but I think it’s difficult to say that a rosy scenario has not been priced in. Investors such as Scottish Mortgage Trust have made a fortune from it, but for me this is not investing but more like intelligent and very fortunate speculation. It could also turn out to be just another car company, albeit with a different engine system, that faces up to the dreadful economics the car industry has endured for most of its mass production history.

But what should we make of the opportunities on stock markets right now? 

As always, it is possible to know three important things about a company:

1. Its current share price or market capitalisation.
2. Its current profits and free cash flows.
3. The general level of interest rates or bond yields.

Everything else is uncertain to varying degrees.