Warren Buffett was interviewed today on CNBC and as always, he provided a great deal of insight into investing. What is so great about Buffett and value investing in general is the consistency of the method used to make money investing. It is about buying fractional shares of a business at material discounts to the intrinsic value. Buffett doesn’t look at charts but instead focuses on the fundamentals of the business. It cannot be said enough that stocks over the short-term can behave in a very manic and scary way. This is 100% to be expected. Over time though, stock prices converge with business value. By buying businesses at a deep discount to intrinsic value, one is able to obtain a large margin of safety.
A few of the points of the interview I really liked were that Buffett believes investors would be much better off if they couldn’t see quotes on a regular basis. Fluctuating prices make people feel like they have to act, whereas if you own a business such as a McDonald’s franchise or a farm, a decline in the stock market doesn’t change anything that you are doing. When markets are screaming higher, many market participants feel that they have to jump in as they don’t want to miss out, despite the fact that prices are obviously going to be more expensive. When stocks decline, many market participants panic and go to cash, despite the fact that the values are much more attractive. I can tell you that this is the most predictable behavioral pattern that I’ve observed throughout my career, personally interacting with thousands of clients. History has proven that those that chase short-term performance tend to post the worst returns, while those that maintain a disciplined value-based approach do the best. These basic principles do not change and never have.
In 2015 for instance, Carl Icahn’s fund was down 18%, and he is down big thus far this year like most long-investors. Did he all of the sudden become a bad investor? Of course not, it is inevitable that there will be periods of underperformance for any strategy including value investing. We are in a market where many stocks and sectors are still expensive, but then there are other areas that offer some of the best value we’ve seen since 2009. This likely will bode poorly for index funds and many mutual funds but should benefit value investors over the next 3-5 year period. Just because “Mr. Market” says Bank of America is worth $12 per share, as opposed to the $17 it was fetching in late 2015, doesn’t make the actual business worth any less. Bank of America actually happens to be one of Buffett’s biggest positions. With a $23 book value and a tangible book value in excess of $15, the company is trading at levels that could only be rationalized if it were going to incur tens of billions of dollars of losses. Capital ratios are the highest that they have ever been and liquidity levels are also unprecedented. Consumer credit is incredibly strong and energy exposure is right around 3%, with most of that being investment grade. Sure interest rates are low but that is nothing new.
Smart investors like Buffett buy more of these stocks when they go down in value as opposed to selling in a panic. In the interview, Buffett says that market participants are always their own worst enemy by acting on emotions instead of facts. There are times when it is necessary to take losses. A perfect example has been energy stocks. Many of these companies were deemed to be cheap last year, based on the value of their assets and the price of the equities. One can look at the acreage and production of an energy company and come up with a sum of the parts or net asset value. Companies like Chesapeake Energy and Apache Corporation looked very attractive based on these metrics. Unfortunately, oil and gas production has stayed stubbornly high and the value of these assets have declined, reducing the intrinsic values of the companies. This fundamental change warrants cheaper share prices than what the stocks were initially purchased at. There is no doubt that anyone that invested in energy stocks betting on a quicker rebound in prices including us, has been very wrong. In the future and perhaps currently, there will once again be great opportunities in the sector, but predicting future commodity prices is an incredibly difficult task and we don’t see the same margins of safety in the industry that we have found elsewhere.
What is great about the financial stocks that we own is that they are so well-financed, that they are buying back their own shares at a huge discount to intrinsic value, which greatly increases intrinsic value per share. Assured Guaranty for instance has bought back over 30% of its common stock outstanding over the last few years, which has added dramatically to intrinsic value per share. Operating book value has risen from the mid $20’s to the mid $40’s over the last few years. While the stock has done adequately over that time frame, intrinsic value has grown dramatically. At some point in the future, the stock price will catch up with intrinsic value. We believe that the likely catalyst will be resolution to the Puerto Rico debt situation. Other companies in the same position of buying back their stocks at huge discounts are Morgan Stanley, Citigroup, AIG and VOYA. Each time they do this, your per share ownership increases. Our investments increased in tangible book value per share over the last year at a far greater rate than what we saw the S&P 500 do, and over time that is what matters, because the stock prices will follow. Over the short-term, many financial stocks have sold off in a panic, but anybody that studies the financials, including the analysts in the industry, sees that business conditions do not warrant current prices. Nobody expects these companies to lose money this year, and dividend increases and stock buybacks are almost a guarantee. Why would we sell these stocks, when the fundamentals instead warrant buying more, and then get into other stocks or sectors, which are much more expensive and are unlikely to produce as good of results? This is what we would do if we invested in many of the overvalued sectors such as Consumer Staples, Utilities, Telecoms, etc.
The key to successful investing is patience. The reality is that many markets including emerging markets, China, and Europe are trading at levels they haven’t seen in many years. This creates tremendous opportunity because the economic fundamentals of the businesses that we own are far better than current prices reflect. We’ll keep following the important fundamental metrics and we will ignore the short-term noise.