Buffett Gives A Seminar On Risk, Cash, Debt, Discipline And The Future Of Berkshire
Summary
- Buffett's Q&A at Berkshire's virtual annual meeting addressed risk, cash, debt, discipline and Berkshire's future.
- Buffett explained that Berkshire's calculable risks were very manageable but that a large incalculable risk hung over the economy; he suggested that this required a larger cash set aside than previously.
- Berkshire's cash set aside for emergencies has a message for ordinary investors: start with a bucket for cash you need to sustain your lifestyle for the foreseeable future.
- Buffett explained his reasons for dumping the airlines in a way that should focus investors on the true risks for many industries.
- In February, the world changed to a degree which may not have been fully recognized; Buffett showed that he is in the process of learning and changing with it.
"In times of change learners inherit the earth while the learned find themselves beautifully equipped to deal with a world that no longer exists." - Eric Hoffer
Buffett has never been in better form than answering questions at Berkshire's (NYSE:BRK.A)(NYSE:BRK.B) virtual annual meeting on Saturday afternoon. He began with a civics lesson on America's growth into a richer, but also better, nation and detailed its long painful journey to realize the "aspirational" ideals of its founders. He also expressed the view that capitalism was the greatest vehicle for meeting human needs but required supervision, and that Schumpeter's "creative destruction" was necessary but greatly damaged many individuals who deserved some form of rescue.
Sitting an adequate social distance away Greg Abel, the overall manager of Berkshire's non-insurance businesses, commented with the brevity usually supplied by Charlie Munger but also fleshed out answers having to do with operational issues. His command of facts and strategy made him look like a suitable successor when the occasion arises. He will be among the upper 1% of all CEOs.
While answering call-in questions Buffett fully dealt with the inquiries bearing upon his "silence." He was silent during the crash and the rally that has followed because his best judgment was that the future path of the economy was unknowable. That being the case, he had also been silent in terms of actions taken except for the selling of his four airline positions. This sort of silence spoke volumes.
Measuring his words carefully, and declining to speculate on future scenarios, he nevertheless managed to give an outline of his views of the range of business problems presented by the virus and lockdown. In the process he provided a rare gift for his followers - a seminar on risk, cash, debt, discipline and the future of Berkshire Hathaway.
Risk First, Always
As an insurance man, Buffett is an expert in risk - risk that can be quantified, risk that is a matter of broad judgment, and risk that is simply unknowable. He addressed all three. He expressed confidence that the insurance side of Berkshire had priced risk properly in the property and casualty area and that it had very little exposure to business interruption risk, although it would undoubtedly incur meaningful costs of litigation. He alluded particularly to the risk of several mega-cat events in succession.
It was also clear that Buffett had spent some of his "silent" time doing a careful review of risk in all of Berkshire's nearly 100 businesses. He acknowledged that a few small units are at risk of being closed, but in general Berkshire's wholly-owned businesses are in good shape. He also confirmed that Berkshire headquarters had provided its subsidiaries with a modest amount of cash. If you follow Berkshire as I do, you will have anticipated hearing exactly this.
The risks that Buffett considered the most meaningful but unknowable involved worst-case scenarios for the future of the economy. Much of his active inaction arose from this sort of risk. While he felt that Berkshire was in very good shape compared to other businesses, he did note that under the most extreme negative outcomes, the cash hoard of $137 billion (more after the sale of the airlines) would be pressed to be enough. This was perhaps the single most interesting piece of information he provided.
Cash And Its Uses
Buffett has often mentioned that $20 billion of Berkshire's cash and near-cash hoard must be held back for availability in the event of one or more very major mega-cat insurance events. As the current crisis unfolded, I suspected that this number had increased materially as Buffett anticipated possible need for cash to support Berkshire businesses in the event of a very extended and deep business downturn. He confirmed my suspicion.
It has always been my assumption that in his own head Buffett had two numbers for cash - two separate buckets - the cash needed in the event of catastrophes and the cash available for investment opportunities. Though he did not put it exactly that way, it became evident that this is exactly his thinking on cash. I also had strong expectations that the amount of cash needed for defensive purposes had risen sharply during the virus lockdown such that his cash available for investment was not nearly as high as many observers assumed.
Buffett indirectly confirmed that his two cash buckets had tilted materially toward potential defensive needs in worst-case scenarios. There may have been a hint in his mention that Berkshire was prepared to make a large acquisition up to the area of $50 billion. It's likely that this is the highest amount he feels comfortable in investing at this moment.
This two-bucket view of cash is in fact the way I run my personal financial life, and I think it suggests a helpful approach for many investors. If your ratio between cash and risk assets is 50/50, for instance, but 20% of your cash is mentally assigned to the emergency/defensive bucket, the effective asset allocation of your investable assets is not 50/50 but 62.5% risk assets and 37.5% cash.
There's a more important way to look at this, however, and it is pretty clear to me that it is Buffett's way. You must start with the emergency bucket. As a result, the present crisis does an interesting thing to the way you think about investable cash. I personally started with an upgrade of the family cash bucket to the level that would support our lifestyle for the foreseeable future if every risk asset went to zero. This actually raised total cash to a bit over 60%. If the market collapsed entirely, but left the economic system bruised but intact, I would probably invest half of that - in effect going all in on the total available cash.
Berkshire is Buffett's life, his friends, and his family. The way he now thinks of Berkshire's cash appears to be similar to what I describe above. If it's possible for you to think that way, his actions and lack of action suggest that you should consider the above thinking for your own money.
Better To Be A Debtor Than A Creditor
Buffett spoke of debt in two ways which appear contradictory. In a personal anecdote he told of a friend who had very recently come into a modest sum and sought his advice for investing it. He inquired as to whether she had any credit card debt, and when she said yes he estimated the rate she was paying at 18%. He then told her that the best investment choice was paying off that debt. She wasn't happy with this answer, so he explained that he knew of no way to get that return elsewhere.
From a personal standpoint, debt is poison. As he said at other points in the Q&A it has also become poison to many companies which hadn't foreseen anything like an economic lockdown. The survivors, he implied, would be companies with low debt and adequate cash.
In terms of investment value, however, he took the other view, saying that it is far better to be a debtor than creditor. Rates on debt of any kind are simply inadequate for the various risks. On the other hand, the present moment is a good time to borrow if you anticipate any kind of future need. He put his money where his mouth was, he said, mentioning that Berkshire had taken the opportunity to borrow at the current low rates just in case.
The two sides of his argument fit together perfectly. Both are pieces of valuable advice for ordinary investors.
Buffett Is A Man Of Discipline And Proved It
Buffett proved to be the dog that didn't bark. He bought nothing. The fact that he bought nothing is a powerful indicator. This morning on CNBC before the market open Jim Cramer appeared to be in virtual despair on what Buffett's view implied for the airline industry, several other industries, and the economy as a whole.
The explanation Buffett gave was that he hadn't found anything attractive to buy. This sentence expands in multiple implications. For one thing, as discussed above, the cash available in his investable bucket was smaller than many observers assumed. For that reason, his standard for attractiveness are higher than they might be otherwise. He partially explained why he didn't then do buybacks, saying that although Berkshire traded 30% below a recent buyback price, it was not more attractive at the recent low than it had been at that time. That being the case, with overall risks higher, it made sense to wait.
Imagine, though, what that means when estimating the correct price for the entire market. Has its fair value dropped 30%? The more you think of the damage to the economy the more sense that makes.
The clearest takeaway from Buffett's expressed views was that we had come to the end of an era and entered into a new era in which everything had changed. There is no clarity on the economic path forward. The course of the pandemic is important, but even if the pandemic is defeated in a reasonable period of time, there is still very little visibility on what consumers and businesses will do as the virus ebbs and the lockdown ends.
This point was made most cogently in discussing the sale of his entire position in four airlines, United Continental (UAL), American (AAL), Delta (DAL), and Southwest (LUV). What Buffett did - what most investors find it very hard to do - was face up to the reality of an investment which had been a mistake. To be sure, his premise on the airlines six months ago had been fine, but the new circumstances made it wrong. He cited the famous Keynes quote about changing your mind when the facts change. He bit the bullet and exited the position at a loss.
The circumstances say quite a bit. It took a little time for the whole situation to sink in, and as a result he did his selling as the market was coming off the lows. This said in part that the rally was not cutting any ice with him. More importantly, he reeled off the problems airlines were going to have going forward under the best of circumstances - largely his strong doubts that airline travel was likely to approach its past level of seat miles flown anytime soon. He noted the impact on Boeing (BA), a great company in his opinion but likely not to have many customers for some time.
If those companies are going to be a disaster for years no matter what happens, you can easily start to tick off a large list of similar companies. Within Berkshire, both Buffett and Greg Abel mentioned Precision Castparts which is doing fine in its military business but taking a major hit in commercial aviation.
The takeaway here: despite his desire for an acquisition, Buffett made a cool assessment and did nothing. When he saw that his position was a mistake, he admitted it and took decisive action. Another point that the headlines this morning didn't want to accept: it wasn't the Fed's action rescuing troubled companies that stopped Buffett from making deals. It was Buffett's judgment that the risks were too great for the possible rewards.
The Future Of Berkshire
Despite an overall tone of uncertainty - I was tempted to type pessimism, but I don't think that quite fits the overall message - Buffett's view of Berkshire's future was generally positive. Yes, his fortress of cash reserve may be pushed to the limit. Yes, some of his smaller businesses may have to go. But Berkshire itself is a survivor and that will mean something as we come out of this.
Buffett believes that over the long run Berkshire will continue to have a solid return on capital. He believes it may or may not beat the S&P 500 but will be competitive. He noted that Berkshire owns a lot of financials and gave an optimistic view of their future. They will have loan problems with energy and consumers but were ready this time with adequate capital and will survive and prosper.
His greatest concern is a cluster of second-order events which could greatly deepen and lengthen the downturn. He has faith in the leaders of Berkshire's various units to deal with the problems presented in their areas, and he had praise for Ajit Jain on the insurance side and Greg Abel on the operating side, one of whom will one day be his successor.
Conclusion
Sometime in February, the world changed. It's arguable as to how radical the change will be, and whether the change will be permanent, but there is no refuting the fact that we have entered a different era. A large number of the investing rules accumulated over a lifetime have had to be modified to a degree. Merely being cheap may not be enough. What Buffett is doing and especially what he is not doing may contain lessons for you and me.
The first goal of every living entity is survival, and the novel coronavirus and attendant lockdown of the economy are separating those entities which prepared with sufficient reserves from those whose preparations were more nominal than real. The fact that survival is the first principle of life and investing is likely to be the major investment rule that has been rediscovered in the course of this crisis.
It's okay to make a few mistakes. It's okay to underperform a benchmark. What's not okay is to put your own or your own company's survival at risk. Older investors have seen and survived many things, but no one has seen anything like this - not even Buffett. As the above Eric Hoffer quote says, succeeding when everything changes is not so much about being learned as about being a learner.
If you think Buffett is being a little slow to pick up the bargains available in the market, you should consider the possibility that he is making sure he understands what the survival qualities are in the new environment and how to be sure apparent bargains are actual bargains. Like the rest of us Buffett has to get up to speed on the New Era. He has to unlearn or modify a few rules, and learn what is likely to work in the future.
Like the rest of us he is starting from a zero base. When the world turned a corner in February it left behind quite a bit of baggage. When Buffett does act, it will have a powerful message about what he has learned. When he waits, that is also an important message. Meanwhile don't hold your breath for a New York Times op-ed saying "Buy American; I Am."
This article was written by
Analyst’s Disclosure: I am/we are long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (179)
www.am1st.com/...
Did you ever end up buying back or replacing the Emerging Market ETF’s that you wrote about and sold around 2 months ago?
I believe you wrote that your intention was to buy them back or replace them with similar ETF’s after 31 days.
Thanks for clarifying
Talk to first responders, stop listening to Dumpty!
seekingalpha.com/...Slightly different to yours. But horses for courses.
Time will tell...always does
On stocks, I would watch Disney. Too many of its businesses, brilliantly run in the past, are going to need some outstanding overall thinking and management to get going again.
