What has stuck with me after recently attending the Berkshire Hathaway annual meeting in Omaha, Nebraska, is Warren Buffett’s admission that low interest rates led him to pay a premium for Berkshire’s acquisition of jet engine parts manufacturer, Precision Castparts.
Increasing valuations due to low interest rates, rather than growth in economic value, has been the culprit in the S&P500, almost tripling since its low point in March 2009. Murray Stahl of Horizon Kinetics recently illustrated this point using the example of McDonald’s.
“One story: Revenue in those seven years (between 2008 and 2015) rose by less than 1 per cent per year, 7.98 per cent in all; net income by even less. The balance sheet was more dynamic: property and equipment rose 14 per cent, but long-term debt rose by over 135 per cent. Its shareholders’ equity contracted by close to 50 per cent. If you could have been told this story in 2008, would you have purchased the shares? Should we have?
“Another story: The McDonald’s share price appreciated by 90 per cent over the seven years, which is 9.6 per cent annually.
“Explanation: One thing that happened is that McDonald’s PE (price/earnings) ratio expanded from 16.9 times to 24.6 times. That shareholders were willing to pay more for the same earnings accounted for about half of the stock return. Another thing that happened was that interest rates dropped; for 10-year treasuries, from 4.08 per cent at the beginning of 2008 to 2.30 per cent at year-end 2015 (and to 1.77 per cent now). This permitted McDonald’s to finance a massive share repurchase program that would have been unaffordable but for these artificially low rates, which is why its interest expense only rose by 22 per cent, even as its debt ballooned by over six times this amount.”
Why standards matter
Buffett also said if interest rates remain low for many years then there’s plenty of room for the market to increase. But all things being equal, the only way an investor can justify paying increasingly high prices for stocks is to accept lower returns, which is risky.
Fee-paying investors get frustrated when a fund manager holds large amounts of cash, often suggesting to allocate it to existing ideas. Unfortunately this increases the risk of poor stock selection and produces unnecessarily high concentration risk. Dropping your standards in the short term may mean dropping your pants in the long run, as Mark Leonard, president of Canadian-listed company Constellation Software (whose share price has increased around 15-fold over the past decade), recently explained.
‘We observed in early 2015, however, that lowering hurdle rates had historically been far more expensive than we originally thought. We analysed the weighted average expected IRR’s for each of our acquisitions by year, from 1995 to early 2015, and compared them with the prevailing hurdle rate we were using when the acquisitions were made. During that twenty-year period, we made three changes to the hurdle rate, one up, two down. The weighted average expected IRR for each vintage (e.g. all of the acquisitions done in 2004) of acquisitions tended to drop or increase to the newly implemented hurdle rate. Said another way, when we dropped our hurdle rate, it dragged down the expected IRR’s for all the opportunities that we subsequently pursued, not just those at the margin. We try to capture this idea by saying “hurdle rates are magnetic”. It now takes a very brave soul to propose a hurdle rate drop at [Constellation Software].
The key point is that whether you are a CEO or an investor, compromising your investment standards usually means accepting too much risk for inadequate returns.
Big fat pitches
The intelligent approach is to be patient and only invest when you have a margin of safety against bad luck, incorrect analysis or poor decisions. This means holding cash until the fat pitches arrive.
In a world of low returns, too often investors focus on the opportunities available today, rather than thinking of how many wonderful opportunities there will be over the next five to ten years. Giving up those opportunities can be a massive opportunity cost. Remember, it was only a few years ago when bargains were plentiful, as the European economy looked like it was falling apart.
Seth Klarman, one of the world’s most successful investors, put it this way:
“Some argue that holding significant cash is gambling, that being less than fully invested is akin to market timing. But isn’t a yes or no decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can’t or won’t say no forgoes perhaps the most valuable tool available to investors. Charlie Munger, Warren Buffett’s long-time partner, has counseled investors: “Look for more value in terms of discounted future cash flow than you’re paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor. Why should the immediate opportunity set be the only one considered, when tomorrow’s may well be considerably more fertile than today’s?”
While many perceive cash as trash in the current environment, it might be the most undervalued asset right now for what it could buy you in the years to come. I highly recommend reading Klarman’s two-page piece on cash.
