Buffett on Post-Bubble Equity Prices: Berkshire Shareholder Letter Highlights

From Warren Buffett's 2002 Berkshire Hathaway (BRKa) shareholder letter:

We continue to do little in equities. Charlie and I are increasingly comfortable with our holdings in Berkshire's major investees because most of them have increased their earnings while their valuations have decreased. But we are not inclined to add to them. Though these enterprises have good prospects, we don't yet believe their shares are undervalued. 

In our view, the same conclusion fits stocks generally. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge. 

The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns (which translate to 6½-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.

When Buffett wrote that letter (February 21, 2003), the S&P 500 had already fallen from a high of 1,552 to the bottom at 768 then closed out the year at 879.

The day the letter was written the S&P 500 was at 848...just 10% higher than that low of 768.

Generally, you'd expect, after a roughly 50% drop in the market, to get some pretty good values.

Not that time.

Check out the price to earnings ratio of his top 2 holdings as of the date the letter was written:

Coca-Cola (KO) had dropped from the high of nearly $ 89/share to just under $ 39/share (the post-bubble low up to that point). After all that lost market value Coca-Cola's price to earnings ratio was still a pricey 33x (mid-20s on a forward basis).

So a price to earnings ratio of 33x near the bottom of a major bear market.

While certainly not cheap now, consider that Coca-Cola currently has a price to earnings ratio of ~17x after having already rallied 78% off the lows in 2009.

Night and day. Obviously, not all bear markets are created equal when it comes to creating investing opportunities (trading is another story, of course).

Buffett's 2nd largest holding at the time was American Express (AXP). It had a more reasonable, at least in comparison to Coca-Cola at the time, mid-teens price to earnings ratio. Not outrageously expensive but, again, not really cheap for being near the bottom of a major bear market (though the price did go lower the prior year on temporarily depressed earnings ie. not normalized earnings).

Now, compare that multiple to what happened to the stock of American Express in 2009.  Its price fell to just under $ 10/share in March of that year* (it currently sells for over $ 47/share as I write this or nearly 12x current earnings).

American Express should earn $ 4/share this year and, prior to the financial crisis, the company had already comfortably demonstrated it could earn $ 3/share. So, at the time it was selling for something like a 2.5x to 3.3x multiple on an earnings stream that has a high probability of growing nicely forward (AXP generates extremely high return on equity relative to other financials so it doesn't take much incremental capital to create earnings growth).

On a normalized basis $ 3/share was a conservative estimate of Amex's future earning power yet when it was heading toward that $ 10-ish/share price analysts were downgrading the stock.

American Express & the Analyst Upgrade/Downgrade Cycle

An example:

March 12th, 2009: Citi maintains a 'Sell' rating on American Express Co., but lowered their price target lowered from $14 to $9. The firm said sell any strength on deteriorating fundamentals. Link

After Buffett wrote the 2002 letter, stocks would go on to get even more expensive again as stocks rallied over the next 4-5 years leading up to the beginning of the financial crisis. Jeremy Grantham has called that 2003-2007 period "the biggest sucker rally in history". The 2003-2007 so-called "sucker rally" made an already difficult decade even worse if you were an investor looking to buy shares of good businesses selling at a comfortable discount to value.

It's quite a bit different now. Things can no doubt get even cheaper from here but the investing landscape today provides a substantially better possibility of finding a good entry point to own shares of a good business for the long-term.

Adam

Long BRKb, KO, and AXP

*A month or so after it fell below $ 10/share I mentioned AXP as a stock that I like in the Six Stock Portfolio. At that point, it was up from its lowest price (selling at $ 16-18/share) but still very cheap relative to intrinsic value. Since then, AXP is up substantially, of course, as is the porfolio (up ~ 74% compared to 44% for the S&P 500 including dividends...with those gains most of the stocks are tough for me to buy more of at this point). The portfolio, while certainly not stock recommendations (something I never do), it was meant as an example of how returns can be achieved with minimal trading if you buy 5 or 10 good durable businesses you understand at the right price and hold them long-term. I know it flies in the face of some of the more popular approaches to investing these days but that's pretty much the point. All this trading activity is entirely unnecessary and is more likely to make your broker rich. Inevitably one of the stocks will have a bad year or two but the long run results should be fine as long as the economics of each core business franchise remain unimpaired. If something that materially impairs one of these businesses in a permanent way then a change will be in order. Otherwise, my bias is to make no changes and just let the value created by each business compound.
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