Dining at Buffett’s Buffet

Warren Buffett is the world’s greatest diversified investor. His wealth of $74.6 billion largely resulted from the growth in the book value of Berkshire Hathaway, which has compounded at a spectacular annual rate of 19.1% since 1965. Although he avoided the cardinal sin of incurring large losses (annual book value declined only twice, -6.2% in 2001 and -9.6% in 2008), the pathway to 19.1% was not linear. Some periods have been fatter than others.

Illustratively, the last 17 years have been comparatively lean. From 2000 through Q1 2017, Berkshire’s book value grew at 9.3%, half of its long-term growth rate, though still more than double the S&P’s total annual return of 3.9%. This period was characterized by extreme valuation headwinds as summarized by the Shiller CAPE (cyclically-adjusted P/E ratio) which averaged 25.5, higher than 19.9, the multiple from 1965–2016. The average CAPE since Shiller first began a series is 16.7 times. Currently, the CAPE’s nosebleed levels around 30—eclipsed  only by 1929 and the waning days of the dot.com bubble in the late 1990s—have made Berkshire’s acquisitions more expensive and absolute bargains in marketable securities rare. 

Seven years into the lean secular cycle that began in 2000, the market had ascended to extreme valuations as the financial economy was on the verge of convulsing. At the May 2007 Berkshire Hathaway shareholders’ meeting in Omaha I probed Warren, hoping to glean whether there was a deeper meaning to his statement in the 2006 annual Chairman’s Letter about the qualifications he sought in a successor: “We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial intermediaries.” Buffett was customarily oblique in answering my question posed in a public setting:

“When I closed the Buffett Partnership, I felt (and wrote to my investors) that the prospective return was about the same for equities and municipal bonds over the next decade, and I was roughly right. It’s not the same today. I’d have 100% of bonds in short-term bonds. Forced to choose between owning the S&P 500 versus 20 year bonds, I’d buy stocks—and it would not be a close decision. We don’t have the faintest idea where the S&P or bonds will be in three years, but over 20 years we’d prefer to own stocks.”

Virtually any market valuation metric (including Buffett’s favorite market-cap-to-GDP ratio) shows valuation risks are notably higher and expected returns lower today than they were in May 2007, yet Warren remained mute on the subject in his 2016 chairman’s letter. Although equities are likely to be the asset class winner 20 years hence, most investor’s time horizons don’t extend out to 2027. Moreover, in these heady times, few investors consider the real possibility of opportunity sets analogous to the 1975–1985 period. We came dangerously close, however, to “an economic convulsion like the 1930s” from 2007–2009, but the Fed bought us extra time. I think it imprudent to wager one’s wealth on there being no consequences for the excesses that have steadily accumulated since. I doubt we will get a pass and move to some new level of nirvana.

In dramatic contrast, Buffett’s heydays from 1975 to 1985 were unconventionally fat. The preceding market environment of the late 1960s had become progressively less attractive, leading Buffett to wind down the 12-year-old Buffett Partnership, Ltd in 1969. Among several apprehensions, he cited mushrooming interest in short-term investment performance engendering a “hyper-reactive pattern of market behavior against which [his] analytical techniques [had] limited value.” Existentially, he worried that the market had become the only game in town and, thus, the antithesis of the kind of environment he found to his liking. It had been “twenty years without an economic convulsion such as that of the ‘30s to create a negative bias toward equities and spawn hundreds of new bargain securities.”

By 1972 the “Nifty 50” craze marked the peak of the manic market phase which was followed by the take-no-prisoners 1973–1974 bear market, the worst since the 1930s. Unlike the deep “V” selloff to which investors had become accustomed, the period from 1973–1985 is better visualized as a hockey stick. With the Shiller CAPE from 1975–1985 averaging 9.5—or one third the average ratio of our current cycle—a “negative bias toward equities” persisted in concert with a relentless water torture of bad news. In addition to the 1974–1975 recession, along with the unprecedented rise in inflation and interest rates into the double-digit stratosphere during Jimmy Carter’s presidency, the period was further scarred by Fed chairman Paul Volcker-induced back-to-back recessions in the early 1980s.

This created a chronically cheap buffet of opportunities at which Buffett dined. The book value of Berkshire Hathaway, a former Buffett Partnership holding, compounded at an astonishing 31% average rate per year from 1975–1985. The significance of that number must not be overlooked. Without it, the 19.1% compounded annual growth rate in Berkshire’s book value from its inception in 1965 through 2016, would have dropped to a less than legendary rate of 15.9%.

Given Buffett’s unique genius, assuming that one could achieve similar returns would be laughable. But even a much more modest performance assumption illustrates how powerful such a period can be to one’s overall returns. Suppose an investor approximated annual returns of 15%—just half of Buffett’s own results—an enterprising investor could double their investment in five years and quadruple in ten. While this scenario requires achieving such returns in the first place, a buffet of unloved bargains will stack the odds in your favor and seems worth the wait.