Legends of Our Time

Warren Buffett and Charlie Munger are widely considered the best investors of our time. We always look forward to their year-end letter and annual meetings. This year’s annual meeting, usually a love fest held in Omaha attended by thousands of shareowners, was instead streamed on the internet without anyone present. Charlie stayed home in California as he did not want to fly for obvious reasons.
The company’s first quarter results reported before the meeting earlier in the day was an eye-opener as Berkshire took a $70 billion charge for investment and derivative contract losses. The other surprise was that the company did not use its huge cash hoard to buy stocks during a quarter when the markets declined 30%. Were Buffett and Munger uncharacteristically bearish? Then, we learned that Berkshire continued selling in April including the total elimination of their huge airline holdings. What was happening?
Buffett talked about how our country has successfully navigated through national disasters, including wars, and how our markets continued to march upward over time. But, he also mentioned that the move higher could take time, just as it did after the Great Depression. 
It is our impression that the markets did not really understand why Buffett and Munger continued to build cash reserves during the quarter and through April. The fact is that Berkshire is a conglomerate made up mostly of economically sensitive companies that are being severely hurt by the drop in demand due to the virus.  Buffett and Munger violated one of their major core beliefs. Do you remember they were drinking Coca-Cola, eating hamburgers, and donuts talking about the virtues of owning great consumer companies with stable growth, earnings and cash flow? Well, now over 75% of Berkshire includes an aerospace supplier, a railroad, utilities, energy, chemicals, distributors/suppliers, retailing, real estate brokers, housing, and much more. Yes, insurance is the largest piece of Berkshire but that is that is now only 25% of the company. Besides liking the insurance business, they love the float which gives them the firepower to buy stocks.
The simple truth is that the dynamic duo needs to husband their cash today to provide the needed liquidity for their operating businesses in this environment. Even strong public companies are taking down their lines of credit, raising debt, and selling equity to boost their liquidity, but Berkshire can use their Fort Knox balance sheet to do the same for their 100%-owned businesses and they have. The bottom line is the market has not read them correctly. Berkshire has not added to their stock portfolio as they wanted more and more cash to support their 100%-owned economically-sensitive businesses not knowing when demand would recover to make them self-sufficient once again!
Remember that earnings yield is one of their cherished valuation metrics which Buffett used when commenting on his sale of the airlines. He mentioned that if they buy 10% of a public company as he did in four airlines, they consider 10% of the earnings theirs, which justifies the carrying cost of the ownership. Since the future of airlines is in question, they doubted whether these companies will earn anything, and they will have to leverage their balance sheets to stay alive. This sounds like many of Berkshire’s 100% owned businesses which they cannot easily sell. Even Charlie admitted that many of their 100%-owned companies may go bankrupt.
The story of what is happening to Berkshire is a microcosm of what we see happening in many parts of our economy. While we are growing more confident that we will have a therapeutic soon, more testing and a vaccine within 18 months, we do not see any semblance to normal until 2022 after we are all vaccinated. Yes, we believe that the economy will improve as we slowly open, but we doubt that many companies will be very profitable until their utilization rates rise above 75% which may not be for a year. And we do not see earnings rising to new highs until sometime in 2022 when and if we can return to a normal environment. We still expect a Phase 4 and 5 until we make it to the other side plus some sort of an infrastructure program to stimulate demand.
We remain convinced that the shape of our economic recovery will be an elongated U unless there is a huge increase in testing, a great therapeutic and a vaccine is found.  We continue to focus on the winners in this environment as it will take a long time for many sectors of our economy such as leisure, hospitality, airlines, and retail to return to historic earnings levels. Many of the changes in mindsets, both individual and corporate, support more technology spending whereas heretofore it may have been put off to another day.
While the pundits warned us to “sell in May,” growth in the virus has peaked, states are slowly opening, and our economy has troughed. The question is what the market is worth today with a 12 to 18-month time frame. While we are not sure, we are confident that all the liquidity created by the monetary authorities and governments will push investors further out on the risk curve. In addition, there is a huge amount of money on the sidelines in cash, cash equivalents, and bonds that will move to equities over time. Our bottom line is that the wind is to our back owning high quality equities with strong fundaments and financials. The key to outperformance will be stock selection.
We remain concentrated in the winners in the new normal. Those companies whose business models are built around the internet and others are also beneficiaries of growth in the cloud, data centers and 5 G. In addition, we have added companies that will benefit from states opening permitting people to go outside of one’s home. Finally, we have also added some financials as we expect the yield curve to steepen as the government issues more and more debt combined with a recovering economy. Interest rates are just too low today.  Continue to avoid any company in need of government money as demand for their services/products have fallen off the cliff resulting in virtually no operating cash flow. And listen to as many earnings calls as possible to gain insight into what is happening economically here and abroad. Until demand for their services/products increase meaningfully, there is very little that can be done except reducing operating losses. Notwithstanding, many of these companies are improving their operating leverage once business improves meaningfully.
We do not own any bonds, are flat the dollar, and do not own private equity companies.
Let’s keep our fingers crossed that we all maintain social distancing, wear masks and gloves, and wash our hands frequently so that this over sooner rather than later.
Our weekly investment meeting will be held on Monday May 11th at 8:30 am EST. You can join the webinar by typing https://zoom.us/j/9179217852 into your browser or dialing +14086380968 or +16465588656.
Remember to review all the facts; pause, reflect and consider mindset shifts; turn off your cable news; do independent research and …
Invest Accordingly!
Bill Ehrman
Paix et Prospérité LLC

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