Why Buffett Prefers Cash | Financial Times

Good morning. Last week ended with a happy little rally in regional bank stocks. After a weekend of relaxing, deep breathing and walking the dog, let’s hope the market panic has dissipated, leaving investors with nothing to worry about except Wednesday’s looming inflation report. Email us: robert.armstrong@ft.com AND ethan.wu@ft.com.

Warren Buffett and low expected returns

From theft on Saturday:

Warren Buffett’s Berkshire Hathaway sold billions of dollars in stock and invested little money in the US stock market in the first three months of the year, a sign that the famous investor saw unattractive in a volatile market.

According to the quarterly just released by the conglomerate relationship, the company sold $13.3 billion of stock and bought just $2.9 billion. Rather than buy stock, Buffett and his team spent $4.4 billion on buybacks and another $8.2 billion to increase its stake in Pilot, a (formerly) family-owned chain of truck stops.

You can’t read too much into a quarter of buying and selling, and veteran Buffett watchers will know that the big man has complained for years about a lack of places to put money to work on a scale that would make a difference to Berkshire. Still, the fact remains that the company has $150 billion in cash and short-term bonds on hand, enough to buy Goldman Sachs or Lockheed Martin outright and at a large control premium (Warren, this is not a investment advice). The fact that a company awash in cash is a net seller of stocks, even in the wake of the 2022 sell-off, tells you something.

It also plays with recent Comments to the FT by Berkshire VP Charlie Munger:

“It’s become very difficult to have anything like the returns we’ve had in the past,” he said, pointing to higher interest rates and a crowded field of bargain-hunting investors looking for companies with inefficiencies.

Munger talks about low potential returns in terms of higher rates and competition for business. But there’s another way to make the same point, and that’s by aiming high retrospective come back. Even after stocks rallied in 2022, the S&P 500 delivered 10-year compound real returns of nearly 11%. If you go back to 2009, the real annual return is even higher. But one of the most reliable regularities in finance is the tendency for the real return on stocks to return to 6-7 percent over the long run. We’ve earned more than that average over the past decade or so, which makes it likely we’ll earn less in the years to come. To put the same point in a third way: ratings are still high and will go down.

It would appear that Munger and Berkshire recognize this. As Antti Ilmanen of AQR recently wrote paper, we have “borrowed returns from the future” in recent years. It offers this chart of expected returns on stocks and bonds, demonstrating that expected real returns on stocks remain low after 2022.

(Ilmanen understands potential returns simply, in terms of yield: lower current yields imply lower prospective returns. For stocks, this means the earnings yield, or the reciprocal of the cyclically adjusted price/earnings ratio.)

When faced with low potential returns, there are two basic approaches an investor can take: either decrease risk and wait, or increase risk and hope.

Berkshire favors the first option (me too, in my personal investments. I hold a high percentage of cash, albeit a little less than $150 billion). But realists can only pursue this approach to a limited extent. The chart above clarifies how long you can wait for buying opportunities with high potential returns. You must own mostly risk assets, unless you think you can time the market accurately (you can’t). What you can do, for now, is collect cash yields of 4% and hope it doesn’t take a decade for an opportunity to present itself.

The latter approach, which adds risk, is popular with investors piling into private equity and credit, which are now, in most cases, just a way to smuggle more leverage into a portfolio. This may seem rash. But if we are in a world where asset prices are permanently high, perhaps due to demographics and inequality, and rates fall quickly, this will prove to be the best approach.

An interesting question for Berkshire and for all investors is whether taking the cheapest valuations (and therefore the highest potential yields) available in Europe, Japan and emerging markets represents a third option, or simply another way to take the second option and increase the risk. Holding plenty of cash facing expensive US markets and reasonably priced global markets supports the notion that US stocks deserve, and will maintain, their large premium over stocks elsewhere. “Never bet against America,” Buffett said written. If US stocks don’t get cheaper soon, he may not have much of a choice.

China’s side stocks

In January, the explosive potential of China’s reopening of trade had the the big banks are licking their chops. Suppressed demand returning to normal would flank risky assets, which have been valued conservatively. There has been much talk of consumers’ huge savings pool of some 5 percent of China’s nominal GDP. Whatever China’s long-term structural problems, a medium-term recovery seemed like a no-brainer.

A few months later, Chinese stocks staged not so much a bad performance as a forgettable one. If you got into the recovery rally last year, you made money. The CSI 300 index is still up 15% from its October lows (before zero-Covid has started to be canceled). But anyone who has bought Chinese stocks this year is probably on the downside:

Part of the problem is that the economy has fallen short of buoyant expectations. Consumption jogged, didn’t snap, went back. Goldman Sachs estimates that household consumption remained about 8 percent below its pre-pandemic trend in the first quarter. Spending on services has recovered faster than spending on goods, but it also has more ground to recover. Consumption of goods, meanwhile, may have stalled. In April, China’s manufacturing sector fell back into contraction, suggesting what Pantheon Macroeconomics’ Duncan Wrigley calls a “clear divide between the recovering service sector and the declining manufacturing sector.” Adds in a note released today:

A key factor holding back private manufacturing investment is slack and falling prices in many sectors, including autos, steel and solar. The spare capacity is the result of earlier high capital investment, the tepid recovery in domestic demand for manufactured goods and the cooling in export demand since the second half of 2022.

Wrigley thinks the Communist Party of China may try to broaden fiscal stimulus later in the year, despite risks of inflaming China’s housing debt woes; they look like officials unwilling to commit currently.

The mediocre economy comes with mediocre corporate earnings. Goldman calculates that net income of Chinese listed companies grew a measly 1% year-over-year in the first quarter, after declining 6% over the course of 2022. The number of companies that fell short of earnings expectations is surprising : 15% of MSCI China constituents exceeded expectations in the recent quarter while 69% fell short. In the last quarter of 2022, the balance was almost even.

A certain amount of cyclical risk seems obvious. Since January, the MSCI China forward P/E ratio has fallen from 11 to 10. And as this chart from Yardeni Research shows, China now looks inexpensive relative to other emerging markets (which have that hasn’t always been true lately):

However, we wonder if a 10 forward P/E is low enough. The political risks are formidable. US and China are busy retaliatory technological restrictionsand the threat of future Chinese crackdowns on the industry or an invasion of Taiwan cannot be ignored. These alone should make China’s risk assets trade cheap relative to the rest of the world. And with a tepid recovery now also a risk, the reasons to stay away look strong. In all likelihood, some intrepid fund manager will make money investing in China when no one else was willing. But it echoes a classic piece of advice from Buffett: You don’t need to swing with every toss.

A good read

Bryce Elder’s column up theater of resistance.