Sunday, March 2, 2014

The Ultimate Contrarian Advice: Don’t Follow Buffett to the Peak


Regular readers of these posts already know that I have been examining the evidence that we are close to going hyperbolic on the way to a high peak. The good news is that we are not there yet. The bad news is that I see the potential extremes that could cause more than a normal decline.

The leader of the band

In the wonderful musical play and movie The Music Man, the promoter/instrument salesman/conductor mesmerized a conservative small town in the Midwest of the United States and convinced it to purchase expensive musical instruments and uniforms. In some ways Warren Buffett could be the Music Man for the next peak, not because of his ukulele playing, but people want to believe and follow him.

The Berkshire Hathaway calendar (BRK)

Each year on the first Saturday of March BRK releases its annual report. As a shareholder and a manager of a fund that owns these shares, and like many others, I read the report online on Saturday to prepare my thinking for Berkshire’s conclave and annual meeting the first Saturday of May in Omaha. (This is always entertaining to see the mix of retail and institutional questions asked of Mr. Buffett and Charlie Munger over five hours.) In reading this year’s letter I was struck by how, in a gentle Midwest almost “aw shucks” approach, Warren Buffett was laying the groundwork again for a big pitch to get others to follow his thinking with their own investments.

What is missing for the run up to the peak?

While every major peak is somewhat different from the others, many of them appear to promise great gains quickly.  In an over-simplification, these peaks are based on the intense belief that great wealth will be bestowed on the investors who believe in the presumed future. These are not value focused investors who believe that they are buying securities at a discount from today’s worth. They are growth investors, and they are not actively buying today.

For my analytical sins I attend many company analyst meetings either in person or electronically. As I commented earlier this week to the CEO of a major financial institution who I have known for more than 20 years, almost all of the analysts’ questions were focused on the last reported quarter with some implications for the current quarter. A great deal of attention was paid to the likely buyback of common stock by the sell-side analysts. There were no questions about “blue-skying” the future (in effect what long-term investors are paying management to produce successfully). Since most of the companies I follow intensively are in the financial services business, their current stock market multiples are low, which indicates the lack of future growth that might command higher valuations. (More on the dangers of small numbers later.)

This is exactly why the Buffett letter is so important. If one analyzes Berkshire Hathaway carefully and adds up its insurance businesses and its financial stock holdings plus its finance companies as well as possibly including its debt dependent railroad and utility operations, one could say that BRK is mostly a financial services investment. Nevertheless, Warren writes in terms of the future including a comment about one hundred years in the future. In last week’s post where I was linking Warren Buffet and George Washington as growth investors, some did not see the connection. George Washington believed in changing the productivity of his assets through technology (the five-sided threshing barn), the distillery (to upgrade his grain growing) and raw land purchases in a number of more western colonies. Buffett is a believer in the increase in productivity, including lowering his operating and financing costs for a number of Berkshire’s operating and security investments. We will see whether his always entertaining annual meeting ignites investors to search for growth.

Applying even relatively modest growth to future earnings would lower the current perception of market price/earnings ratios. Once that happens there may be a renewed search for growth investors. If this happens quickly, we could see such a rapid price advance that chartists would describe the prices as having gone parabolic, which is what happened to the run-ups to other great peaks.

More excitement is needed!

We are currently in a small number world. Often the numbers that are discussed in the financial media are small, usually a few percentage points or smaller. That is not going to drive the animal instincts of the investors who are sitting with too much tied up in cash and fixed income instruments to fear losing out on a great opportunity to make a lot of money. So the numbers have to change. In effect, we will need to breakthrough the expectation boundary. That can happen.

If it happens, what’s the risk?

The risk of large losses from subsequent price declines will be due to not taking to heart the conservative portfolio management principles that Warren Buffett and Charlie Munger have been preaching and following for years. Some of those enjoying what could be a meteoric rise will be wary but will be looking for signals of the top in the wrong places. They will be looking at the companies, political structures and/or the economy.  As Minsky believed, they should be focusing on long periods of stability and quick periods of instability. John Mauldin quotes from a study from a number of years ago by Professor Chichlinisky from Columbia University on endogenous uncertainty which suggests that market declines are ignited by movements within the market itself not caused by outside events. A good trader will spot a sell order that is too big for the market causing the dealers to back away from current prices which in turn will bring in lower prices and more sellers. As we live in a global market, the unexpected seller could come from a small Norwegian fishing village as what happened in the last real estate paper collapse.

Bottom line

The conditions for a major blow off of higher prices are not generally present today. But watch out when brokers start pushing growth and then watch for changes in the market structure.

Please drop me a line and let me know how you see the current market and the future potential for large gains.

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