Markets are staging something of a comeback, but investors are focused on December 2018 numbers, and are filled with doom and gloom. Yet the smart money is already moving, and since many in the investment community value Warren Buffett, what is he saying and what does Investec Asset Management’s Quality team think?
Warren Buffett (The Sage of Omaha as he’s known to the faithful) is doubtless the most overquoted and misattributed market guru, but his popularity does serve to underline his accuracy and prescience. His latest shareholder letter hasn’t yielded any memorable quotes, but the parallels with what we’re saying and doing bear commenting upon. Common sense is not that common, and hence worth repeating when found.
Is he really that good?
The performance of the Berkshire Hathaway (BRK) share price since inception in 1965 has been remarkable, at 20.5% per annum, versus the S&P 500 Index – with dividends reinvested – at 9.7%. Active management works. The effect of compounding over the long term of this annualised difference is staggering, with BRK delivering 2 472 627% versus 15 019% for the index.1 BRK doesn’t pay a dividend, reflecting the belief that the company can allocate capital better than shareholders can. We hold a similar view: either demonstrate you can add value by reinvesting your earnings at better-than-market rates, or return those earnings to us as dividends so that we can.
Our Investec Global Franchise portfolio is a good case in point, as illustrated in Figure 1. Companies in the portfolio have a return on invested capital of 24.8% (versus the MSCI All Country World Index return of 14.8%), and manage this while growing 26% faster than the market (measured by free cash-flow growth) – yet, the shares are priced close to the market average. Given that over time, share price performance and economic performance converge, this is stock picking at its best, and already reflected in the Investec Global Franchise Fund’s position in the top quartile versus global peers since inception, 10 years, 5 years and 1 year (Figure 2).
Needless to say, we’re not suggesting you sell your unit trusts and buy Berkshire Hathaway. Buying BRK is not the same as buying the Investec Global Franchise Fund, not least because the Fund offers potentially superior diversification compared to owning a single company. To start, there’s the small matter of the BRK share price, currently well in excess of US$300 000 per share. That’s not a typo. Building a diversified portfolio with BRK as a holding, even a large one, would require the kind of balance sheet only the 0.1% of the 1% can muster.
Figure 1: Offshore stocks remain our best investment idea
Past performance is not a reliable indicator of future results, losses may occur. Source: FactSet, Investec Asset Management, 31 December 2018. The portfolio may change significantly over a short period of time. The above reflects the portfolio characteristics reweighted excluding cash and cash equivalents. Based on a pooled vehicle within the strategy and is not available at the composite level. *MSCI All Country World excludes banks from free cash-flow yield calculation, classified in the Banks Industry Group according to GICS. Active Share is a measure of the percentage of stock holdings in a portfolio that differ from the benchmark index. Forward looking measures are not a forecast of the Strategy’s future performance.
Yes, but 2018 was awful and all I want is cash!
BRK’s performance didn’t come in neat, annual, positive chunks, but with startling volatility and some painful drawdowns. As examples, March 1973 to January 1975 saw the share price fall 59%, and in just 25 days during Black October 1987, 37% was wiped off its market capitalisation. Despite not being a tech investor by any stretch of the imagination, the dotcom crash saw BRK losing 49% of its market value between June 1998 and October 2000. In September 2008 to March 2009, 50% disappeared.2 And this is a share held by the average mom and dad, not just by the fabled hard-bitten institutional investor with deep pockets and lots of time! Our Investec Global Franchise Fund’s performance signature is a little different in nature. Last year was one of ‘those difficult years’ that are an inevitable part of being a long-term investor. While no one is happy to see losses, to limit these to half of those suffered by an index investor provides some comfort.
Figure 2: Investec Global Franchise Fund
|1 year||5 years p.a.||10 year p.a.||Since inception p.a.|
|Investec Global Franchise A Acc||-4.5%||5.8%||10.5%||5.8%|
|Msci AC World Nr**||-9.4%||4.3%||9.2%||3.4%|
Past performance is not a reliable indicator of future results, losses may be made. Source: Morningstar, 31.12.18. Performance is net of fees (NAV based, including ongoing charges, excluding initial charges), gross income reinvested, in USD. If the share class currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. *Inception date 10.04.07. The performance is based on the OEIC Investec Global Select Equity Fund from 10.04.07 which then merged into the Luxembourg-domiciled Investec GSF Global Franchise Fund on 04.07.09. **Comparison index: At inception = MSCI World NR; Current Since 01.10.11 = MSCI AC World NR Highest and lowest returns achieved during a Rolling 12 month period since inception: Feb-10: 54.4% and Feb-09: -38.7%. Quartile ranking within GIFS Global Large-Cap Blend Equity sector.
Excellent long-term returns such as those shown in Figure 2 come with an implicit price that we casually call ‘volatility’ but which we react to most when it manifests as sickening drawdowns. We all understand volatility intellectually, but our emotional reaction to it differs vastly when it’s to the upside compared to the downside. Seasoned investors are able to understand a crisis for what it is, and not make irrational investment decisions – responding appropriately as opposed to having an emotional knee-jerk reaction. Those seasoned investors who have both the financial resources and the resolve to take advantage of market conditions, often act contrary to ‘common wisdom’. Currently, BRK believes that because good businesses and their shares are still not cheap, highly selective stock picking is the only choice. The ‘elephant buys’ that Buffett likes to make are unlikely in the current environment, but when the opportunity comes, the caveat being that this will be created by a substantial crisis, he has both the cash and courage to invest. Clyde Rossouw, Portfolio Manager of the Investec Global Franchise Fund, recently shared that there are still opportunities, and that the level of cash he currently holds in multi-asset portfolios such as the Investec Opportunity Fund is at multi-decade lows, such is his optimism around the prospects for his picks. Given that the worst December for US stocks since the Great Depression has just been followed by the best January in 65 years, bears out the wisdom of buying when everyone else seems to be selling.
“But this time is different.”
We have seen Buffett behave this way before, when everyone else seemed close to capitulating. After 2008, BRK bought stakes in Goldman Sachs and Bank of America and it did not sell down Wells Fargo, a portfolio position that was steadily built since 1990. This clearly illustrates that BRK was unaffected by the market hysteria around financials. If you think that shows commitment to the long term, try American Express, the largest listed investment in the conglomerate. BRK owns nearly 18% of the company and paid US$1.2bn for the stake. It’s currently worth US$14.5bn. Working out an annualised return is beyond the remit of this article, because the first purchase was made in 1964, at around US$35, and that stock split into 108 shares, with each one worth $106 today!3
Low turnover does not mean no turnover; it needs to make investment sense. Our Quality team at Investec Asset Management argues that a long-term active approach with low portfolio turnover to minimise transaction costs has clear benefits to investors. Clyde has pointed out that the portfolio turnover for the Investec Global Franchise Fund is only around 50% from inception to today. This reflects the investment team’s strong conviction about their quality holdings, based on ongoing, diligent analysis – the ability to deliver long-term sustainable returns. This works in our clients’ favour, as patience is scarce, and hence rewarded. Conversely, just because an asset is cheap, does not necessarily mean it’s a buy. A company’s ability to avoid a permanent loss of capital, is as important as its long-term return potential. It’s never different this time – just ask any Bitcoin holder, whose billions converted from US to Zimbabwean dollars disconcertingly quickly.
What will drive Buffett to buy up significant chunks of businesses? Nothing you’ll read about on the front pages of the financial press. He doesn’t mention Trump, China, blockchain, AI, North Korea, gene editing, fake news and troll farms even once in his letter – or anything else that many turn to when explaining the markets’ past performance or outlook. This corresponds to our Quality team’s approach of bottom-up investing.
Instead of trying to forecast the outcome of macro events like Brexit, the team looks at factors such as earnings, cash flows, debt levels and return on invested capital, and whether these metrics are reflected in share prices. Our Quality team is not blind to geopolitics. Recently, Clyde replied to a question on the topic saying, “We know what the key issues are, but it is very difficult to second-guess the next 15 tweets from Trump, for example. We are still dealing with Brexit, which is interesting to think about. But we have found that if you have a one factor system that is based on second-guessing the macro, you are at best in line and probably slightly behind what the market is thinking. Our competitive advantage comes from understanding the businesses we own and how those models are evolving.”
Ultimately what we do is find businesses that have sustainable competitive advantages, high barriers to entry and which are strong cash generators (and which have a history of disciplined capital allocation) – and all this at the right price. This is only possible thanks to a big bench of philosophicallyaligned talent, based in Cape Town, London and New York.
The closing lesson is that while this year’s BRK missive hasn’t delivered anything quotable, Buffett’s consistency of message is remarkable – his focus on underlying business performance unwavering and his optimism undimmed. Similarly, our Quality team has shown great resolve and consistency over the years. As early as 2014, the team warned that returns from SA equities, property, bonds and cash were set to converge lower, with the All Share Index expected to barely beat inflation over the next five years (annualised returns). This wasn’t a message that investors were keen to hear – a message that was often repeated over the ensuing years. As markets seemed set to rise forever, the Quality team looked overly pessimistic. With the markets at more realistic levels, the team remains positive about the prospects for global equities.
All of us as active equity investors are intrinsic optimists, otherwise why commit money today to an uncertain future, unless you have a deep-seated belief that tomorrow will be better than today? We do not believe that this time is different, but instead that human ingenuity and adaptability will serve us as well tomorrow as it did yesterday.
Buffett writes that his very first investment was in 1942, US$114 in common stock. At that point, the US had been part of World War Two for three months, with its participation sparked by the massive losses at Pearl Harbour, the occupation of the Philippines and attacks on three British bases. Buying gold (a whole 3.25 ounces of it) might have seemed more prudent! However, as at 31 January 2019, this investment would have been worth US$4200 while the S&P 500 Index delivered US$606 811, 5288 times the original investment (admittedly, before fees!).1
A quote you can quote
Benjamin Graham said that “in the short run, the market is a voting machine, but in the long run it is a weighing machine”, close to the end of the Great Depression. Right now, the popular vote (as then) is for pessimism and cash, but the popular vote has recently got the world into a lot of trouble as the wisdom of the crowd was proved to be anything but wise. So, don’t follow the crowd and do the popular thing. Instead, weigh your options, and remember that while bears sound clever, bulls make money.