Buffett rules

On the stage before them sat the famed investor Warren Buffett and his deadpan consigliere Charlie Munger. At 68 and 75, respectively, the duo already bore a passing resemblance to the cantankerous Muppet characters Statler and Waldorf. But as they held court on the business and investment themes of the day, the tone was less heckling and adversarial than reflective. When it came to matters of business, the ‘Woodstock for Capitalists’ was and always has been a mix of the jovial, serious and celebratory.

The topics the pair discussed included a defence of Berkshire’s decision not to buy into highly valued ‘high-tech’ stocks, the hunt for a successor to Buffett, risk, and what a sustainable return on equity was for a business in times of inflation.

“We are perfectly willing to trade away a big payoff, for a certain payoff,” said Buffett, when asked why the company hadn’t joined the vogue for buying red-hot internet firms. “Different people understand different businesses. The important thing is to know which ones you do understand, and when you’re operating in your circle of competence, and the software business is not in my circle of competence.” Two years and one dotcom crash later, that self-awareness had been fully vindicated.

Twenty-three years later, history is repeating itself somewhat. Last weekend, after a three-year pandemic-induced hiatus, Buffett and Munger were back in person in front of their shareholder fanbase, and once again talking about casino-like financial markets, who will lead Berkshire next, risk, and the effect of inflation on equity returns.

The mood was still cheerful, and with good reason. Over the past year, during which another generation of highly valued tech firms saw their share prices slump, Berkshire has outperformed the S&P 500 by 17 per cent on a total return basis.

While rising inflation and interest rates as well as fears of a recession have knocked most stocks, and pushed more than a third of the index’s constituents into bear market territory, Berkshire has resumed its long-term ascent. The conglomerate, which owns $390bn (£311bn)-worth of equities and businesses ranging from insurers to railroads, is among the top fifth of stocks in the blue-chip index over the past year.

Mean reversion for both Berkshire and the broader index has put Buffett back on top. And despite several years of doubts around leadership and deal-making appetite, Berkshire is now ahead of the market on almost any timescale over the past two decades (see chart).

What’s more, with M&A activity across the market slowing down markedly, Buffett is back to the deal-making table. True to his famous aphorism, the Sage of Omaha again appears greedy as fear sets in across markets – after years in which others were greedy and Berkshire at times seemed fearful.

Although the company appears well-poised to deal with current conditions, that doesn’t mean the path ahead is clear.

But for a generation of investors used to endless central bank money-printing and low inflation, what lessons does the seen-it-all king of stock-picking and capital allocation have to offer in 2022? What can we glean from Berkshire’s current investment portfolio and operating model? And are there positive signs for the FTSE 100, many of whose constituents resemble the old-economy companies of which Berkshire has long been a fan? 

Finally, we should ask whether the unheralded engine behind Berkshire’s longevity and success – the US economy – will prove as fertile a hunting ground for Buffett’s successor. As he (surely) nears the end of his illustrious career, how much of his success can be put down to skill, and how much is due to the era in which Buffett was born?  

Buffett’s back

If there was one takeaway from Berkshire’s shareholder meeting this year, it was that the company is once again putting capital to work after several years selling shares and warning of sky-high valuations.

Having swelled to a record $148bn at the end of 2021, the group’s cash pile fell to $106bn by 31 March after it increased and added to its core holdings. Buffett and his team bought $51.1bn-worth of stocks and sold a further $9.7bn in the period, while markedly increasing allocations to US Treasuries, from $32.3bn to $58.7bn. The result was a $58.6bn investing cash outflow, compared to an inflow of $11.2bn in the first quarter of 2021.

This might seem like an instance of buying the dip. Indeed, Berkshire’s first quarter equity purchases peaked on 4 March, just as the S&P 500 entered correction territory for the year. But the increase in government bond buying also suggests Berkshire is using a variety of tools to limit the corrosive effect inflation is having on its dry powder, even as it plans to keep plenty of cash on hand.

After spending $2.3bn on stocks in the first half of the quarter, Berkshire bought $41bn-worth (“in a hurry” according to Buffett) between 21 February and 15 March. “It gave us something to do,” the chairman and CEO quipped in typically understated fashion. Soon after, the group inked the $12bn all-cash purchase of Alleghany, an insurance to toy manufacturing conglomerate which Buffett has long admired.

It was Berkshire’s first major takeover since 2016, when the group coughed up $37bn to buy aerospace engineer Precision Castparts. Following that deal – which went sour in 2020 and resulted in a $9.8bn impairment – Berkshire spent the intervening years first building a near-$150bn stake in Apple (US:AAPL) and then spending tens of billions of dollars on its own shares. Now, with better options apparently out there – including Apple stock again – buybacks have been curtailed.

That doesn’t mean investing in 2022 is straightforward in Buffett’s eyes.

Having lived and invested through multiple economic cycles, he appears particularly alive to the impacts of inflation. At the gathering in Omaha, he noted that companies aren’t simply affected by higher costs – and the need to raise prices to maintain inflation-adjusted margins – but by the need to boost capital on hand.

“If the dollar were worth one tenth some years hence from now, we have to have ten times the capital investment,” he pointed out. “We’d have forced capital investment to keep the same place.”

Returns on capital, while critical to businesses, also matter a great deal to investors. “Inflation swindles the bond investor, too. It swindles the person who keeps their cash under their mattress. It swindles almost everybody,” said Buffett, while expressing doubt in anyone’s ability to reliably predict the path of inflation.

To Munger, price growth should be seen in existential terms. “It’s the way democracies die,” the 98-year-old told the assembled crowd on Saturday, adding that inflation is a sure-fire route to “ruin your civilisation”, and “the biggest long-run danger apart from nuclear war”.

What would Warren do?

With the stakes for rising, what lessons does Buffett’s current outlook offer investors?

One place to start is with his notion of a “circle of competence”, and the need to identify companies and sectors where your knowledge feels most assured. Given many of today’s companies and management teams have never experienced stagflation or even high inflation, this is a harder task than it appears. But to Buffett, understanding your investment process should be a constant.

“Buffett has areas of the market that he knows very well,” says David Beggs, an investment analyst at Sanford DeLand’s Buffettology fund. “It’s all about improving the predictability of future outcomes, identifying where a business will be in 20 years’ time, and tuning out the sell-side noise.”

Beggs points to a line in Buffett’s most recent letter to shareholders, which encapsulates this sentiment neatly. “We own stocks based upon our expectations about their long-term business performance and not because we view them as vehicles for timely market moves,” he wrote. “Charlie and I are not stock-pickers; we are business-pickers.”

Still, there are a few features of a business which Buffett repeatedly seeks out. Chief among these is a company’s ability to generate cash through the cycle.

This is reflected in both Berkshire’s operating subsidiaries and its largest equity stakes.

The first group includes railroad and utility businesses like BNSF Railway and MidAmerican, which despite their capital intensity possess strong pricing power and so should deliver decent returns if inflation is persistent. Berkshire’s insurance operations, which include GEICO and MedPro Group, should be able to raise prices if the regulatory backdrop is accommodating.

Re-investing unclaimed insurance premiums – known as the ‘float’ – has allowed Berkshire to amass its considerable holdings in the US stock market. Three quarters of this is concentrated in just five companies (see table), each of which appears reasonably well positioned to handle a period of rising rates and sustained inflation. The biggest source of risk here is arguably Apple, whose status as the world’s valuable company owes much to its consistent ability to defend margins with higher prices.

In the first quarter of 2022, Berkshire increased its holdings in its most concentrated bet. But with signs of a US economic slowdown on the way, and costs rising everywhere, the clamour for the company’s products will be rigorously tested in the coming year.

By contrast, Buffett remains a fan of dull, industrial companies trading at modest prices – as demonstrated by his recent acquisition of an 11.5 per cent stake in printer cartridge group Hewlett Packard (US:HPE).

On this score, UK investors in the stodgy domestic blue-chip stocks may have cause for comfort. While the FTSE 100 cannot boast the same exposure to the mighty American consumer as Berkshire, the index’s sizeable weightings to consumer non-cyclicals, energy, materials, insurance and bank stocks mean it more closely resembles the conglomerate than you might expect. Its relative strength against tech-heavy US indices over the past year underlines this.

Another key Buffett lesson is to go with your gut over noisy market trends.

“I think that because he is single-mindedly looking for something in these companies, and because he’s been doing it for such a long time, it becomes an intuition rather than a science,” says David Cicurel, chief executive and founder of Aim-listed scientific instruments business Judges Scientific (JDG) and a long-time Berkshire shareholder.

That intuition helps explain why Buffett has been among the most outspoken voices against bitcoin, despite that opposition leading him to be painted as “enemy number one” by cryptocurrency enthusiasts like PayPal founder Peter Thiel. To Buffett, there are no easy wins to be gained from alternative (and supposedly uncorrelated) assets.

“Whether it goes up or down in the next year, or five or 10 years, I don’t know,” he said last week. “But the one thing I’m pretty sure of is that it doesn’t produce anything. It’s got a magic to it and people have attached magics to lots of things.” Even idle speculation wouldn’t tempt the Sage, who says he wouldn’t pay $25 for all the Bitcoin in the world (an amount whose current total market value is roughly equal to Berkshire’s).

Cicurel, says he always feels “very refreshed” when he visits the Berkshire convention. “You see that they have no fashion sense, but they know what’s right, what’s wrong, what’s stupid. They think a lot about what’s good for shareholders; they’re not trying to look good, and he hasn’t got an ego, which is a horrendous thing in investing.”

A dynasty or an era?

Arguably, the British figure who most closely resembles Warren Buffett is the Queen.

Beyond a few biographical markers – each is a nonagenarian who assumed their current leadership role in the 1950s and has at various points been the richest person in their country – plenty of deeper parallels exist.

Because of their long careers, both represent a degree of continuity which few people in history have ever claimed. To this peerlessness, we can add respect. The Queen is admired even by many who oppose the monarchy, while Buffett is feted as a ‘Sage’ or ‘Oracle’ by those who have invested with him, and is a synonym for business, financial and personal success even among non-investors.

But we can go further. Both individuals are deeply bound up with their nations’ respective modern identities. While Elizabeth II’s rein connects a former imperial power to today’s Britain, no-one is more closely associated with America’s historically unprecedented post-war economic growth and wealth accumulation than Buffett.

Like the Queen, Buffett also presides over an institution whose future is hard to imagine without its figurehead. For a start, his successor Greg Abel is unlikely to be granted anything near the same level of autonomy over decision-making.

Some Berkshire investors fear this might increase internal bureaucracy, narrow the group’s access to deals and slow down the pace of action when speed is of the essence. Last week, Buffett described his board’s approach to checks and balance as “if Warren thinks the deal is OK, the deal is OK”.

A more collaborative approach might not be the worst outcome. Berkshire’s standout achievement in recent years – its highly-concentrated conviction bet on Apple – might have been given the Buffett stamp, but it was originally conceived by his investment managers Todd Combs and Ted Weschler.

Still, there’s no denying that Abel – currently head of Berkshire Hathaway Energy and vice chairman of the non-insurance arm – faces an almost impossible task filling Buffett’s shoes. Indeed, Berkshire investors’ greatest hope is that the scale of the comparison will be freeing rather than stifling.

The more important question, perhaps, is whether the future of the US economy will prove as benign as it has been during Buffett’s long career. By his own admission, the horse he has overwhelmingly backed also happened to be the greatest ever economic miracle. For several reasons, including demographics and geopolitics, few believe that the country’s long-term growth can be sustained at the same rates seen over the past half century.

Then again, what are the alternatives? “It’s a great place to do business,” says Beggs, who attended the Omaha meet with his Buffettology fund colleagues. “They’ve got the accounting standards, legal standards, managerial standards, and entrepreneurial spirit which according to Buffett is the goose that lays the golden eggs.”

Beggs believes that politics – specifically the “far left in America, and some of the radical policies that would change the business environment” – is among the greatest threats to long-run equity returns from the US market.

Cicurel also sees reasons for caution. “There’s a question there, of course. If America loses a bit of desire and ability to lead the world, it is possible that the economic miracle of America will also be eroded,” he argues. Ultimately, however, he shares Buffett’s faith in the “US spirit of enterprise”.

Whatever that enterprise produces, the Buffett view of the world sees it as inseparable from a culture of equity ownership.

Whatever happens to Berkshire once its founder departs, there will be America. That will be reflected in whatever money Buffett leaves his wife when he dies: as the trustee of his will has been instructed, the allocation will be 90 per cent in the S&P 500, and 10 per cent in US government bonds.