Getting up early on Saturday morning to read Berkshire Hathaway’s investor letter written by Warren Buffett was like going back for a refresher course at college in investing. He and I are both disciples of Benjamin Graham, the father of value investing. Invest the time to read his investor letter and earlier letters as well as his rules for acquisitions and investing.
I have been fortunate enough to have had direct communications with him over the years and have given him several recommendations for acquisitions. In fact, I suggested that he buy a large domestic rail system 18 months before he bought Burlington Northern. He turned down the idea, as he was concerned about cyclicality, as he preferred steady growers with well-known brand names. After I inquired why he changed his mind and made his largest acquisition ever in BNI, he simply said that he was flexible and smiled. Today, pipelines and railroad are the two of the largest business units at Berkshire.
While there is so much I took away from this year’s letter, I’d like to draw special attention to the section on book value, intrinsic value and stock prices. Three other areas that stood out to me were investing for the long term (no surprise), not worrying about interim moves, the need to maintain excess liquidity at all times; and finally, the importance of management. He suggests that a good portfolio manager needs real-time experience managing a company to better understand short-term vs. long-term objectives and the creation of value.
It is well known that Warren Buffett feels that active managers such as hedge funds will underperform over time and has recommended that, when he dies, that his estate buys index funds—music to Vanguard founder John Bogle’s ears. The unfortunate reality is that hedge funds have significantly underperformed the markets for the last three, five and 10 years, which covers the sharp decline in stock prices following the financial crisis. I have written several times over the past year that hedge funds as an asset class that has forgotten its mandate to significantly outperform in down markets and perform close to the averages in up markets, therefore outperforming over market cycles. I also mentioned that there is a difference between managers—so don’t generalize. I can state that funds under our leadership have significantly outperformed over 30 years, including 2014 and so far this year. Like Buffett, we control risk by maintaining ample liquidity at all times; we are investors first and foremost on both the long and short side of the market, with an average holding period over 18 months; management is key and we are never more than 95 percent net long even when bullish. Read our blogs over the last year. It’s all there!
Each week we have provided our view of the current economic, financial and political news that influences global investing with an eye to the future. We recently shifted our outlook and became more confident that we were at an inflection point for the global economies and that fears of further economic declines and deflation would dissipate. A change was at hand. Change has been a major theme of ours over the past year. We constantly are looking for both positive and negative changes as it influences our capital allocation; regional and industry emphasis and finally company selection. We are investors and are patient to let events play out over time. For instance, we predicted over two years ago that the United States would significantly increase its oil production, which would change global energy dynamics and lead to OPEC losing its dominance over global pricing. It’s clearly stated in in a piece that I wrote in August 2013. It has been one of our long-term themes. We went short-leveraged energy companies. Another theme has been infrastructure spending. We felt then and even more now that nations around the globe would need to significantly increase infrastructure spending to better compete in a global economy and to create jobs. Add India to that list of countries announcing major spending plans. Read their new budget plans announced a few days ago. We are there and have been for a year now. That is another example of what successful global investing is all about. These are investments, not trades.
So, what has occurred this week and how has that influenced our decision making process?
The United States clearly is the engine at the moment for the global economy and the outlook for the remainder of this year and 2016 remains bright. While fourth quarter GNP was revised downward to 2.2 percent, it became apparent that there would be an acceleration in growth after the winter weakness spurred by the consumer who is, after all, 70 percent of the economy. Declining energy prices and an improving employment outlook will help stimulate spending. Increased business investment will improve, too, as corporations have underspent for years to improve their cash flow, balance sheets, dividends and buybacks. A change is happening, albeit slowly. Remember to look at the margin and follow incremental change whether up as a positive or down as a negative. It’s an easy rule to follow and it works.
Greece’s budget and reform plans were accepted by the EC, so that bullet missed at least for the moment. I believe that the Greek elections were a tipping point in Europe, away from excessive fiscal restraint to somewhat more compassionate policies that are less onerous on the populace. The extent of these adjustments remains to be seen, but changes throughout Europe clearly have begun to stimulate growth so that deflationary fears have abated. As I mentioned last week, there has recently been a sharp improvement in consumer and business confidence in Europe and I believe that the economic turn is at hand, albeit slow, led by Germany for sure.
Germany may talk a tough game regarding strict adherence to budgetary targets, but they are the real beneficiaries of the weak euro. Germany does not want the weaker countries like Greece to back out. There is a reason why Buffett is shopping in Germany. Me too!
China, Japan and India continue to implement policies to stimulate growth. China announced this weekend that its central banks cut rates further in addition to the premier’s call for more fiscal easing. Japan’s government continues to push for more wage increases by corporations to stimulate domestic spending to go with a weaker yen spurring export. Then there is India. The Modi government announced its new budget, including plans for major increases in infrastructure spending for years to come. Some economists now forecast growth over 8 percent for the next few years in India. No wonder GE is investing in India so heavily. Smart!
So where does this leave us?
It remains clear to me that we have reached the inflection point for the global economies and that growth will accelerate as we move into the springtime. There are broad implications for asset allocation, bond yields, currencies and commodities to regional/industry and company emphasis. A key question is how the various markets will react to positive change. How will the markets react to the first move by the Fed to raise the funds rate? Is it good news for the markets or not?
I expect the first reaction to a hike in the Fed funds rate will be negative for the financial markets, but the truth is that it is good news for all in the mid and longer term. There are many headwinds out there to contain the global economies. The most important one is the increase in capital ratios at all financial institutions and secondly the conservative bias that permeates the boardroom and dining room tables at night. Memories of past problems won’t fade fast. It is our long-held belief that the impact of these changes will prolong the impending global economic recovery and that long-term growth will be lower in the future than in the past. Inflation will stay contained, interest rates will rise less than in past recoveries and corporate earnings will surprise on the upside. Not a bad recipe for the stock market.
The key for successful global investing will remain asset allocation and regional/industry and company selection. It is paramount to identify the major global trends out there, whether positive or negative, and then to find through hard research companies adapting to this new global competition with strategies for long-term success. It comes down to management creating long-term value for its investors.
As Buffett would say, “review all the facts, step back, reflect" and …
Invest accordingly!
Bill Ehrman is founder and CIO of Paix et Prospérité Fund (www.prosperitefund.com). He was formerly co-CIO with Byron Wien at Century Capital Associates and was CIO and partner at George Soros’ Quantum Fund.
