The Oracle Speaks

We all wait with great anticipation to read Warren Buffett’s annual investment letter to gain insight into his investment philosophy and views of the current environment.

No one doubts that Charlie Munger and Warren Buffett are the greatest investors of our lifetime compounding the book value of Berkshire Hathaway by19.1% per year over 53 years. Besides all of the operating businesses, Berkshire has over $116 billion in cash and treasury bills, with duration less than 89 days, and an investment portfolio in excess of $170 billion. Most of us focus on their investment moves rather than their operating businesses.

We share many of Buffett’s core beliefs. Some of which are:

  1. “America’s economic soil remains fertile.”
  2. “Equity investors have wind at their backs.”
  3. “Berkshire owns interests in businesses, not as ticker symbols to be bought or sold based in their ‘chart’ patterns.”
  4. “Do not use borrowed money to buy stocks” and “maintain excess liquidity at all times…when major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt.”
  5. “An unsettled mind will not make good decisions.”
  6. “Though markets are generally rational, they occasionally do crazy things. Seizing opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors then need instead is the ability to both disregard mob fears and enthusiasm and to focus on a few simple fundamentals.”
  7. “Often, high-grade bonds in an investment portfolio increase risk.”

Warren went on to discuss the bet that he won that passive management with low fees would beat active management with “high” fees over a reasonable time frame. However, we suggest that you do as Warren does rather than what he says here. In fact, Berkshire is the very pinnacle of active money management. Besides Charlie and himself, he has empowered/employed two managers to actively run over $10 billion each. They receive salaries, perks and incentive fees based on their performance. Sounds like hedge funds managers to us! If they have a down year, don’t you believe that they still get their salaries and benefits? Of course, and all administrative/overhead costs are borne by Berkshire regardless of performance. Not a bad setup.

Paix et Prospérité charges a management fee to pay the expenses of the business; receives an incentive fee after a 5% annual hurdle rate which is in excess of the risk free return on capital; and has a high water mark. We do use leverage but  only to reduce risk. We are never more than 95% net long and maintain excess liquidity at all times. Our performance has far exceeded the S & P since we started the firm several years ago. And our long-term performance over 40+ years in the business is far in excess of all indices too. It all comes down to the right management, which is the first priority for both Warren and us when selecting an investment or an acquisition too.

Warren really did not really focus in this letter on his outlook for the near term environment for investing. He warned many times not to use leverage, maintain excess liquidity and to invest for the long term as the benefits of compounding far exceed any short-term market risks. He also argued that equity investments are preferred over bonds, which he deems risky. Just look at the duration of his bond portfolio, 89 days, to give you a hint of his view on interest rates. It can be gleaned from his fourth quarter report that his operating businesses, which are a cross-section of America, were all improving sequentially from the third quarter with better days expected in 2018. We will be listening tomorrow morning for his 3-hour interview on CNBC. We expect him to be optimistic as usual. So are we!

The stock market’s tug of war between higher inflation/interest rates and higher economic growth/earnings continued last week. In its semi-annual monetary report to Congress last week, the Fed acknowledged that 2018 growth may exceed its prior estimates but that inflationary pressures would lag and that inflation is not likely to hit its 2.0% target until the end of 2019. The Fed continues to view wage pressures as moderate and still expects to raise the funds rate 3 times this year. Several Fed Governors mentioned last week that the new tax policy might encourage higher capital spending that will lead to acceleration in productivity gains later in the year offsetting higher wages. We concur.

We will be tuning in Tuesday to listen to Fed Chairman Powell’s semi annual testimony before the House and then Thursday to hear him before the Senate. We expect him to maintain a balanced view that the Fed will support moderate tightening and unwinding the Fed balance sheet but slow enough to support economic growth but sufficient enough not to permit an overheating economy that lets the inflation genie out of the bottle. He will most likely argue against rising federal deficits and for more financial deregulation. We don’t expect any change in on going Fed policy from the Yellen years. Slow as she goes!

The bottom line is to stay the course. While all companies will benefit from tax reform in 2018, the long-term beneficiaries will be those companies that will benefit from an acceleration of capital spending for new plant/equipment and infrastructure over the next few years. On the other hand, we also own companies that will benefit from a surge in consumer spending abroad rather than production. Trump and his team are serious about a rebalancing foreign trade and an end to dumping.

We continue to emphasize the financials that will benefit from accelerating loan demand and a steepening yield curve; global industrial and capital goods companies that will benefit from accelerating global growth and capital/infrastructure spending; technology at a fair price to growth; industrial commodity stocks as demand growth outstrips supply growth for several more years; domestic steel and aluminum companies who will benefit from accelerating capital spending and an end to dumping from abroad; and special situations where internal changes will add to volume growth, margin expansion and an acceleration in earnings and cash flow gains.

Review all the facts; pause, reflect and consider mindset changes; analyze your asset mix and risk controls; do independent research on each investable idea and…

Invest Accordingly!

Bill Ehrman
Paix et Prospérité LLC

 

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