Warren Buffett Still Seems More Fearful Than Greedy

Summary

• Berkshire Hathaway has been a net seller of equities and has raised cash since the start of the COVID-19 related shutdowns.
• Investors looking for Berkshire to make opportunistic deals have been disappointed as governments and debt markets stepped in to provide liquidity.
• Berkshire is in capital preservation mode because of the wide range of possible outcomes for public health and the economy.
• Berkshire stock could outperform the S&P if the market has not yet bottomed. If the market is already in recovery, Berkshire could underperform, at least in the near term.

Buffett’s Surprising Conservatism

Source: quora.com

Heading into Berkshire Hathaway’s (NYSE:BRK.A) (NYSE:BRK.B) Q1 2020 earnings release and annual meeting webcast, some investors were eager to see how Warren Buffett would deploy some of the company’s massive cash hoard of nearly $125 billion with which it started the 2020. (Cash figure represents Cash and T-Bills held within the Insurance and Other segment.) Many were surprised to see that this figure was essentially unchanged, once accounting for the $8.6 billion payable for T-Bills purchased but not settled at the end of Q1. Berkshire had about $3.8 billion of free cash flow in the quarter. Most of this was deployed by spending a net $1.8 billion on equity investments and $1.7 billion on buybacks of Berkshire stock. This level of spending was in line with recent quarters and not representative of an environment Buffett would characterize as “raining gold”. The Berkshire stock buybacks were completed by March 10 at average prices above $214 per B share. As prices continued to fall below $200, buybacks did not continue.

The “risk-off” behavior continued in a big way in April as Buffett disclosed that Berkshire Hathaway sold a net additional $6 billion worth of equities. The headlines mention Berkshire throwing in the towel on its airline investments due to pandemic-related changes in the business models that could last for a long time. I estimate the airline sales proceeds at about $4 billion, so there was another $2 billion worth of stocks sold that Buffett did not discuss. We won’t know the details on those sales until August when we see the Form 10-K and 13-F for 2Q.

While these actions caught many Berkshire observers off guard, Buffett provided his reasoning during the Q&A section of the annual meeting. In Buffett’s view, the range of potential outcomes from the pandemic and the resulting economic impacts are still too wide to accurately value investment opportunities. Additionally, Berkshire’s function as a source of liquidity to troubled companies was overtaken by government stimulus and loan programs not seen in the last downturn.

By raising cash in the face of uncertainty, Berkshire Hathaway is following Buffett’s two rules of investing (both of which are “Don’t lose money.”) Both Buffett and Munger have described their current strategy as preserving the capital for those who have a substantial part of their net worth wrapped up in Berkshire. The rest of us, who may already have or are considering a smaller allocation in our portfolios, will need to decide for ourselves if this conservative strategy fits our own market views and investing goals. It is possible the market has not yet bottomed, in which case I would expect Berkshire to outperform an S&P 500 index fund (SPY), although both investments would likely have a negative return, and cash would be the better investment choice. If the market has already bottomed at the end of March, I would expect Berkshire to underperform the S&P due to its conservatism right when it should have been putting cash to work. Nevertheless, as we saw after the last recession, Berkshire may still find great opportunities from months to a couple years after the bottom. In that case, Berkshire would be a long-term hold once management’s confidence is restored.

Insights From The Annual Meeting

I’ll get this out of the way first: Although I agree with it 100%, I am tired of hearing Buffett’s “Bet on America” speech. He has repeated it numerous times over the last 15 years, in annual letters, meetings, and other interviews. It’s like a religious invocation at this point. You know how it goes, but if you are a follower, it provides some degree of comfort. This time, it went on for over an hour and included a slide presentation. Still, the takeaway may lie in the details. Buffett noted the key retracement following the 1929 crash. It just happened to coincide with his gestation period in December 1929 through August 1930. Starting in September that year, the real crash happened, culminating over 80% lower in 1932. This was presented without any analogy to the current environment, but humans being pattern-seeking creatures, many will see similarities to the pandemic crash and retracement that seemingly stalled out at the end of April 2020. Again, Buffett did not say he expects a 1930-32 scenario to play out, but one can understand his conservatism if he sees that as a possibility.

Source: Business Insider

Fortunately, Buffett provided some new information and real insights into his thinking during the Q&A period. The aforementioned sale of airline stocks was the first revelation. Buffett expected the pandemic to have a long-lasting impact on the industry. Certainly demand will be lower for an extended time and perhaps permanently if the remote working model catches on. On the financial side, the airlines will have to add debt or issue equity to get through the current period, which will detract from current shareholder returns through interest expense or dilution, even if demand comes back. While Buffett can be commended for acting quickly as the facts changed, it is unfortunate that he put Berkshire in this position to begin with. After getting out of a bad experience with US Air in 1989, Buffett spoke out against investing in airlines for years, right up until he jumped back in in 2016.

Another insight was the shortage of opportunities for Berkshire to be an emergency lender as they did in 2008 with companies like Goldman Sachs (GS) and General Electric (GE). This time, the Fed was quick to provide liquidity at terms Berkshire couldn’t match.

“There was a period right before the Fed acted. We were getting calls. A number of them were able to get money in the public market, frankly at terms that we wouldn't have given them.”

Source: CEO Warren Buffett, 2020 Berkshire Hathaway Annual Meeting

Finally, the inaction on new stock investments or buybacks of Berkshire since the lockdowns started was the final takeaway for me. Buffett apparently sees the pandemic as having impacted Berkshire’s intrinsic value about as much as its market value, stating, “I don't feel that it's far more compelling to buy Berkshire shares now than I did three months or six months or a year ago.” The lack of significant new investments in other equities would suggest Buffett sees similar impairments across the market.

What Berkshire’s Current View Means For Your Portfolio

The lack of risk-taking by Berkshire Hathaway since the pandemic-related shutdowns started indicates that management still sees too wide a range of outcomes to confidently invest a this time. The potential reward for investing in the current downturn exists but so does the potential for large losses if conditions get worse. Buffett saw Berkshire’s current cash balance as not “all that huge when you think about worst-case possibilities”. Additionally, as an insurance company that could be exposed to large catastrophic losses, Buffett noted: “We don't prepare ourselves for a single problem, we prepare ourselves for problems that sometimes create their own momentum.”

With the rule of “Don’t lose money” as Berkshire’s philosophy, Buffett’s actions (and inactions) are perfectly understandable as the steward of the company’s capital. Whether or not that makes Berkshire a good investment at this time is a more complicated topic. Suppose the pandemic and resulting economic impacts take a turn for the worse. In that case, Berkshire did the exact right thing so far to preserve capital. Berkshire would probably do better than the S&P during this larger downturn, but most likely both investments would produce a negative return. So, if you are not a Berkshire shareholder today and have a bearish overall market view, why not emulate Buffett and keep your cash on the sidelines rather than buying Berkshire?

If instead, you have a bullish overall market view, Berkshire’s conservatism over the past few weeks will probably cause it to underperform the S&P as it has for much of the last 10 years. In this scenario, you would be better of owning the index fund or a basket of high-beta stocks to outperform on the way up.

Source: Seeking Alpha BRK.B stock chart page – Note SPY dividends not included, which would widen SPY’s performance gap over BRK.B

However, if you are honest with yourself and admit like most investors (and Buffett) you have no idea which way the market is going in the short term, then Berkshire is still worth holding at this point. If you are bearish and wrong, Berkshire can be a hedge that at least captures some of the market upside. If you are bullish and wrong, Berkshire can be a hedge with its large cash balance and the “opportunity value” thereof.

In such a volatile environment, standard valuation metrics can be an afterthought, but at recent B share price of $177, the price/book value around 1.15 and price/annualized Q1 operating earnings around 18.3 are attractive relative to recent history. The price/book multiple is based on end-Q1 book value and should be even more attractive as the prices of Berkshire’s stock holdings have moved up.

Source: Zacks.com

Conclusion

Berkshire Hathaway’s conservatism in the face of the COVID-19 pandemic and resulting shutdowns has surprised many observers, some pleasantly, others less so. As a steward of Berkshire’s capital, it is understandable that Warren Buffett would be reluctant to invest in risky assets while the range of possible outcomes is still so wide. This makes Berkshire a relatively unattractive choice for investors who currently have either a strong bullish or bearish market view. Berkshire is likely to underperform the market if a bull market has started, and outperform the market (but be worse than cash) if we are still in a bear market.

If, like Buffett, you have a less certain market view, Berkshire can be a useful hedge against your other positions. The opportunity value of Berkshire’s cash should also be considered. Two of Berkshire’s most successful investments since the last recession, BNSF and Bank of America (BAC) came months or years after the market bottomed. Personally, as a long-time shareholder of Berkshire with a general market view of bullish but uncertain, I am continuing to hold.

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.