Is Berkshire Prepared For A Stock Market Crash? (Part II)

In Part I, we shared a series of graphs based upon key financial data from the quarterly statements of Berkshire Hathaway (BRK-A). The objective of the study was to discern what indicators (if any) could be reliably utilized as useful tools regarding Buffett’s asset allocation and evaluation of “relative value” within the markets.

In this part, we are going to review some of the key “mileposts” along the decades-long journey of Buffett’s mastery of the markets. Soon after Buffett took control of BRK-A, he began transforming it from (primarily) a textile-focused company into an insurance-focused company (1967). Through the years, that has proven to be one of the foundational marks of “genius” initiated by Buffett. Can you guess why making insurance companies a central part of his management strategy was such a “capital idea”?

Correct! “Capital” is the key! The insurance company business model is built upon receiving large amounts of premium cash “upfront” – money that (assuming the company’s underwriting is top notch and it is spared (at least for a while) any major losses from a natural disaster (such as tornados)) will serve the function of cash available for investment by the company.  That pool of investable capital is called a “float”. Since the “cost” of these investment funds is similar to having a brokerage “margin account” with a 0% interest rate, a gifted investment manager can secure (over time) exceptional returns.

The bottom line impact of this Buffett strategy is the following: based on the accumulated “float” from Buffett’s base insurance empire (GEICO, General Re, BH Reinsurance, etc.) Buffett was able to invest almost $59 billion of “float” between 1967 and 2008!

Two other basic investment axioms that have guided Buffett include:

1)    The most meaningful measure of BRK-A’s performance during any given year is calculating the annual change between BRK-A book value and comparing that with the annual change in the value of the S&P 500 Index. Putting an “exclamation point” on that performance measure, Buffett has very transparently published a side-by-side comparison of those two measures (at the very front of the annual report) for decades.

2)    Although hardly perfect, the best “formula” through which to discern the relative valuation (attractiveness) of the U.S. equity market is the following:

  1. Total Market Capitalization divided by Gross National Product (GNP)
  2. As a means for making that calculation more manageable, it is understood that the following is acceptable (because the difference between GNP and Gross Domestic Product (GDP) is negligible):

Wilshire 5000 Total Market Capitalization/GDP[1]

With regard to point 2) above, here are two different “looks” at the current equity market valuation:


GRAPH: the graph at the left shows the GDP in green and the Wilshire 5000 Market Cap in orange. Notice that the Market Cap line moved above the GDP line during the “ Bubble” and during the “Mortgage Bubble”! [2]

GRAPH: to the left is a look at the Market Cap/GDP Ratio. Note that the ratio during the “ Bubble” was more out of balance than during the “Mortgage Bubble”.

According to investment expert, John Hussman, this Market Cap/GDP Ratio has “demonstrated a 90% correlation with the subsequent ten-year total return on the S&P 500 Index”.

Some of the better “calls” Buffett has made during the past twenty years includes the following:

1)    He was heavily into stocks in 1995, but weaned himself from those and moved into bonds in 1998.
2)    November of 1999 (with the Dow at 11,000, having appreciated at an average pace of 12.9% since 1981) Buffett made the following public statement: “I’d like to argue that we can’t come even remotely close to that 12.9% (in the months ahead). If you strip out the inflation component from this nominal return, that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”
3)    Between 1999 and 2002, Buffett was very bullish on bonds.
4)    In 2001, he said: “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”
By 2003, Buffett indicated that “value” had shifted from bonds to stocks. Regarding stocks, Buffett poetically offered: “Yesterday’s weeds are today being priced as flowers.”
6)    By 2205, Buffett held his highest ever percentage of cash. He sold his holdings in Disney (DIS), Freddie Mac (FRE) and Travelers.
7)    Demonstrating the power of “holding cash for a rainy day”, when Wall Street was overcome by a “storm” in 2008, Buffett stepped in as a timely financial “savior” – securing sweetheart deals with Dow Chemical (DOW), General Electric (GE), and Wrigley, securing “non-traded securities” with unique features such as oversized dividends and warrants for later purchase of common shares at a contracted price. Over the following few years, that netted Buffett $2.1 billion each year. Separately, he invested a 3% stake in SwissRe in exchange for one-fifth of all property/casualty premiums over the following five years.
8)    By October of 2008 (with blood in the streets) Buffett declared: “Equities will almost certainly outperform cash over the next decade, probably by a substantial degree.”
9)    Just so you know that Buffett is human, he has admitted to missteps along the way – including buying ConocoPhillips Oil (COP) at the peak of oil prices and absorbing an 89% loss from his investment in two Irish banks.
10)   By 2013, Buffett’s investment in bonds is (proportionally) lower than any year since 1995. He refuses to buy any of the “bond du jour” when Apple (AAPL) issued its $17 billion in bonds earlier this year.
11)   In May of this year (contrary to the implication of the headline referred to in Part I), Buffett offered the following commentary and advice during an interview on CNBC (to paraphrase): Stocks are generally selling for reasonable prices. Bond prices are inflated because of the FED’s QE. The average investor should keep enough cash to be comfortable (should the unexpected happen) and invest the rest in equities.

I hope you have enjoyed this detailed look at Warren Buffett. Just as importantly, I trust you have picked up on these “takeaways”:

1)    You can do a lot worse with your equity capital than to invest in either BRK-A or BRK-B.
2)    The Market Cap/GDP Ratio can be an effective valuation tool.
3)    One might benefit from peeking each year at Buffett’s allocation of stocks versus bonds.
You’ll never get the “sweetheart” deals available to Buffett (“size has its privileges”), but having some cash handy during market declines can be quite profitable.

Submitted by Thomas Petty

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