Dennis C. Butler, President
This article first appeared in the December 2, 2008 issue of NYSSA News, published by the New York Society of Security Analysts, Inc. 1.
of all guest columns written by Dennis C. Butler, CFA
The publication of Warren Buffett’s “Buy American. I Am.” was not surprising. Like the “Panic Birds” of Old Wall Street long before him, financial calamities have always prompted Mr. Buffett to action. Also in keeping with past practice, the investment community gave his arguments mixed reviews and, judging by the market response, paid them scant heed.
Almost overlooked in The New York Times piece was a reference to the author’s current holdings: Buffett’s non-Berkshire wealth was in treasury bonds — low yielding, but an ideal place to be when stock prices had fallen 40% since the dawn of 2008. Understanding how Buffett’s portfolio came to be so conservatively and opportunely positioned is a case study in how not merely to survive, but to prosper from, market trauma.
Of all the paradoxes that characterize investing, perhaps the oddest is the periodic need to do poorly in the short-run in order in order to do well in the long-run. In the short-term, the emphasis should be on safety and stability — money funds, treasury bills and such. Short-term thinking involving what should be long-term assets (like stocks) leads quickly to speculation and ultimately disappointment. These are critical distinctions. Successfully handling them requires what we might call the appropriate “investment temperament,” including a willingness to “do poorly” when the market situation demands it.
An extreme example may help. In 1999, the NASDAQ Composite stock index returned 85%. Imagine being tasked to match or beat the index that year (a typical goal for fund managers)! Your options would have been either to buy an index fund or to load up on the most popular technology names of the day. Decline either alternative, and you would “underperform” the NASDAQ index (and for investment professionals, most of the competition). In reality, however, either choice made you a wild-eyed speculator. At the beginning of 1999, NASDAQ stocks were seriously overpriced—and at year-end, absurdly so. Buying those stocks was simply to wager that the market’s momentum would carry the day despite the risk.
True investors recoiled at the idea of taking such a gamble; it would almost certainly undermine the duty to preserve capital. Consequently, they did poorly relative to speculators in 1999, but this refusal to play the performance game — potentially suicidal in the money management and mutual fund worlds — was unavoidable for the true investor, who, by definition, must think beyond the short-term. Indeed, the “underperformance” in 1999 paid off handsomely soon thereafter, as the investor avoided the NASDAQ’s subsequent collapse. Furthermore, those (including Buffett) who made sensible choices during the late-1990s boom years (for which they were then ridiculed) enjoyed sizable gains in the new decade. “Doing poorly” is thus seen as a relative concept having more to do with short-term competitive pressures than real investment considerations. The paradox here is that the poorest investment outcomes result from an unwillingness to “do poorly” in the short-term, relative to others who take undue risks but thereby compromise their long-term advantage.
Investing demands that one be consistent in applying analytical tools and decision-making criteria — or, as Buffett himself put it, that one operate within a “sound intellectual framework.” So conducted, investing is an activity that essentially governs itself, regulated by the natural ebb and flow of investment values. The investor’s work is largely concerned with two things: an asset’s price and its underlying value. During depressed markets, opportunities abound, making it difficult to select among alternatives. In-between times are like Goldilocks’ choice of porridge — neither hot nor cold. Opportunities are fewer, and investment activity slows. Finally, when Wall Street is in the news, with trading heavy and prices high and rising, good investments are rare and investors seldom active.
Wonderful things happen during the latter, frothy periods; the investor reaps the rewards of having built a portfolio on advantageous terms. Security prices rise strongly. Plentiful credit feeds merger and acquisition activity that may liquidate holdings favorably. Solid business conditions and bright prospects lead companies to increase dividends or announce share buybacks. Having fewer opportunities to commit capital, the investor’s cash reserves rise, providing both a cushion for the inevitable downturn to come and firepower to use when buying conditions improve. No market timing or predictions are involved, and rapid turnover of portfolio holdings to capture expected price changes is unnecessary. The cycle is self-regulating. It enriches and protects the investor during unruly periods, and provides the resources for advantageous moves during favorable times — if, that is, principles are consistently applied with a long-term perspective. “Poor” short-term performance is never an issue.
Coming off one of those frothy periods, it is not surprising that an investor such as Buffett would be heavily into cash. Suitable commitments have been difficult to find, and the extent to which risk has been mispriced made risk avoidance the default choice. Now that risk and reward are better balanced, opportunities to use that cash have appeared.
Despite Buffett’s exceptional record, the failure of more investment professionals to emulate his capital allocation methods is regrettable but not surprising. As an individual investor Buffett is not subject to the short-term demands of clients, investment committees, and consultants, and is able to do poorly as conditions dictate, without fear of losing assets, employment, or annual bonus. Indeed, it is for these reasons that the wise individual holds a distinct advantage in investing. “None of the above” is a legitimate choice in the absence of reasonably priced alternatives — and one which individuals are free to make. Few professionals and institutions have the leeway to make the choice to, in effect, sit on their hands for a while.
One exception is Berkshire Hathaway. As evidenced by its huge cash holdings coming into the financial crisis, Buffett manages its investments as a wise individual would. Most institutions cannot count on the genius of a Buffett to manage their operations. Yet adherence to investment principles and being guided by the ebb and flow of investment values could produce good results and turn market disruptions such as we are now experiencing into outstanding opportunities..
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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