Buffett Sees Evidence of Economic Comeback



  • Buffett holds on to losing positions because he made a commitment to sellers to retain those businesses through thick and thin
  • Productive assets deliver an output that retains purchasing power even in times of inflation

Warren Buffett’s letter to Berkshire Hathaway shareholders and annual report were released last weekend. Here’s the link to the annual report (the letter is on page 3), and here are a few of the interesting ideas that I pulled from the letter:

The Board’s job. The primary job of a Board of Directors is to see that the right people are running the business and to be sure that the next generation of leaders is identified and ready to take over tomorrow.

Opportunities in the U.S. Berkshire spent $8.2 billion on property, plant and equipment. This is $2 billion more than they have ever spent in any other year. Approximately 95 percent of this was spent in the U.S. There are investment opportunities in the U.S.

We all make mistakes. Buffett discussed several mistakes – such as buying some bonds issued by Energy Future Holdings. Their prospects were tied to the price of natural gas. He was also wrong last year when he said that the housing recovery would probably start within the year. Housing is in a depression and that’s the major reason why employment has so severely lagged the steady comeback in all other sectors.

Why housing will recover. Today, we are creating more households than housing units. Eventually, these households will actually need homes. Monetary and fiscal policy can help temper recessions, but they neither create households nor eliminate excess housing.

When to repurchase shares. Share repurchases should be favored when two conditions are met:

  1. A company has ample funds to take care of the operational and liquidity needs of its business; and
  2. Its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.

There’s no joy in repurchasing stock at a steep discount because it means that you’re cashing your partners out at too low a price.

Buy good companies and hope the stock goes down (for a while). When purchasing stock, you should hope for two things:

  1. That earnings of the business will increase at a good clip for a long time; and
  2. The stock underperforms in the market for a long time – so that shares can be repurchased (by the company) at a low price (increasing your percentage ownership) or you can purchase more yourself.

Too many investors (including those who will be net buyers in the future) want to see their share price increase immediately. That’s like a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.

Shouldn’t you sell your losers? Buffett holds on to losing positions because he made a commitment to sellers to retain those businesses through thick and thin. If he didn’t live up to his word, it would be hard to buy businesses (at attractive prices) in the future.

Want evidence of the U.S. recovery? You can see the steady and substantial comeback in the U.S. economy since mid-2009 by looking at Berkshire’s earnings. Berkshire owns 54 companies and some of those companies are compilations of many businesses.

Great strategy. “Buy commodities, sell brands” has long been a formula for business success. He cites Coca-Cola and Wrigley as examples.

Don’t feel sorry for everyone who has “lost” their home. Large numbers of people who have “lost” their house through foreclosure have actually realized a profit because they carried out refinancings earlier that gave them cash in excess of their cost. In these cases, the evicted homeowner was the winner and the victim was the lender.

What is investing? Investing is the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power (after taxes have been paid on nominal gains) in the future. It’s the idea of being able to consume more in the future.

What is risk? Risk is not beta. It’s the reasoned probability that the investment will cause its owner a loss of purchasing power over his holding period. So, a non-fluctuating asset (where the price is steady) can be risky – if you don’t keep up with inflation.

What are the three classes of investments?

  1. Fixed income currency based investments (e.g., bonds)
  2. Assets that will never produce anything (e.g., gold)
  3. Productive assets (businesses, farms, real estate)

What’s wrong with category 1: the fixed-income currency based assets? Money-market funds, bonds, mortgages and bank deposits are among the most dangerous of assets – you may not keep up with inflation. Remember that the dollar has fallen 86 percent in value since 1965. It takes $7 to buy what $1 bought in 1965. A tax-free investment would have needed to earn 4.3 percent to retain its purchasing power. For a tax-paying investor (25-percent tax rate), you would have had to earn 5.7 percent to retain purchasing power. Inflation is caused by the printing press. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

Current rates do not come close to offsetting the purchasing-power risk that investors assume. Right now, bonds should come with a warning label. “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk” (quoting Shelby Cullom Davis).

What’s wrong with category 2: assets that never produce anything? The second category of investments includes assets that will never produce anything, but are purchased in the hope that someone else will pay more for them in the future. The gold investor must believe that the ranks of the fearful will grow. This belief has been true in the past decade. Combining an initially sensible thesis with rising prices is what led to the internet bubble and the housing bubble. Skeptical investors succumb to the “proof” delivered by the market. Bubbles inevitably pop.

Today, the world’s gold stock is about 170,000 metric tons. If it were all melded together, it would form a cube of about 68 feet per side (fitting within a baseball infield). At $1,750 per ounce, it would be worth $9.6 trillion.

With the same amount of money ($9.6 trillion), you could buy all U.S. cropland (400 million acres with output of about $200 billion annually) plus 16 Exxon Mobils (the world’s most profitable company, earning more than $40 billion annually) and still have $1 trillion of cash.

In addition, $160 billion of gold is produced annually and this must be absorbed to maintain prices. Years from now, the cropland and Exxon will have produced trillions of dollars of profits. Gold will have produced nothing.

The first two categories enjoy popularity at times of fear. Of course, this is the exact time that you should be allocating capital to risky assets.

Why should we prefer the third category: productive assets? The third category of investments is productive assets. These are businesses, farms or real estate. These assets should have the ability in inflationary times to deliver output that will retain its purchasing-power while requiring a minimum of new capital investment. (Certain regulated businesses don’t meet this test – inflation places heavy capital requirements on them; to earn more, the owners must invest more. But, these businesses are still superior to nonproductive or currency-based assets.)

The third category of investments will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.

McCombs Senior Lecturer Sandy Leeds provides analysis of key market issues on his blog, Leeds on Finance, where this article originally appeared.


The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Sandy Leeds

Distinguished Senior Lecturer, Department of Finance, McCombs School of Business, The University of Texas at Austin

Sandy Leeds, CFA is a Distinguished Senior Lecturer at The University of Texas at Austin. He teaches graduate level classes in the MBA program and...

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