Investor Essentials Daily

How Warren Buffett is tackling the markets in 2021

March 12, 2021

Today, we look at how one of the greatest investors to ever live has performed since the onset of the pandemic.

In his annual letter to his shareholders, Warren Buffett highlighted how low interest rates meant that bond markets were a real risk for the economy, and how his strategy has changed.

In addition to examining the portfolio, we’re including a deeper look into the fund’s largest current holding, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.

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Warren Buffett was recently back in the headlines as Berkshire Hathaway’s (BRK.A) annual letter to its shareholders was released in late February.

In this year’s letter, Buffett highlighted how low interest rates meant bond markets were a risk catalyst for the economy. Investors who rely on bond income may become more aggressive, ultimately increasing the risk within their portfolios.

The letter also revealed Berkshire’s performance in 2020.

Many investors were worried about the firm’s performance, considering how its wide exposure of holdings maps to the economy at large.

Through the pandemic, Berkshire Hathaway can boast its revenues were only down approximately 3.5% in 2020.

Furthermore, the conglomerate’s strategic share buyback initiatives helped drive value in the firm’s undervalued businesses.

Considering the number of investors and market participants who idolize and listen to Buffett, we thought it would be relevant in the current market conditions to take an updated look at Berkshire Hathaway’s portfolio.

This is not the first time we have analyzed Buffett’s portfolio. Our previous article on Berkshire Hathaway can be found here.

Back then, we talked about how investors stuck using GAAP metrics would never be able to spot attractive stock opportunities. Buffett himself says the GAAP earnings don’t represent what is happening in the business.

On Wednesday, March 17th at 7:00pm ET, we are hosting a webinar to discuss how GAAP metrics are still misleading investors, and how to invest going into 2021. If you’re interested in joining us for The Fall of Wall Street: High Alpha in the K-Shaped Recovery, you can register here.

Today, we have updated our analysis through Uniform Accounting to break down the current holdings in the portfolio.


 

In the world of value investing, Ben Graham is the father, and maybe now also the grandfather, of successful value investing. Between Security Analysis in 1934 and Intelligent Investor published in 1949, he laid down the core framework that many of the greatest value investors have used and still build on today.

However, in 1934, while Ben Graham was writing Security Analysis, he was also attempting to get his own Broadway musical produced.

Graham had written Baby Pompadour, a play about a journalist whose writing is influenced by his singer mistress.

It had a semi-successful off-Broadway run, and Graham had gotten Irving Steinman, a producer, to back the production’s Broadway launch.

Steinman just had one condition, his fiancée, who was apparently not a very talented singer or actress, had to be the lead.

The play opened at the Vanderbilt Theater that stood for more than 35 years on West 48th Street. It ran for just one week.

It was a disaster. Critics panned the musical.

One stated:

“Graham had better…find himself a new hobby”

Another wrote:

“The only humor in his [Graham’s] comedy comes during those pathetic moments when the unfortunate actors – who are here spared the humiliation of identification – find themselves with nothing more to do than laugh at their own pitiful jokes”

The musical closed as a failure in short order, and Graham gave up on being a playwright, and instead turned his focus fully towards financial writing, investing, and teaching security analysis.

But while this failure may have been a big let-down for Graham, investors should be forever grateful that he was not successful as a playwright. Instead of dedicating his life to the arts, he dedicated his time to understanding investment research and teaching it to those who would listen.

Ben Graham’s greatest student was, of course, Warren Buffett. Buffett actually received an A+ in Graham’s investing class.

Warren Buffett summarized Graham’s teachings with this one comment:

“The basic ideas of investing are to look at stocks as businesses, use the market’s fluctuations to your advantage, and seek a margin of safety. That’s what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.”

We also should be grateful that Graham didn’t have much success in the theater because if he had, Buffett might never have become the greatest practitioner of value investing.

Buffett studied under Graham shortly after Graham wrote Intelligent Investor. He earned his Master’s degree in Economics from Columbia in 1951. Studying under Ben Graham was a major draw for him in attending Columbia.

After leaving Columbia, Buffett took several stops through the world of finance, including working for Ben Graham’s investment partnership. Then Buffett gained control of Berkshire Hathaway.

Once he obtained control, he started investing the holding company’s money applying Graham’s principles – and produced phenomenal returns.

Over 50 years, Buffett’s Berkshire Hathaway produced an annualized 21.7% return, compared to a 9.8% return for the S&P 500. That’s roughly 12% a year in annualized alpha.

A $1,000 investment in the S&P 500 in 1965 would have been worth $97,000 by 2014. That same $1,000 invested in Berkshire Hathaway would have been worth over $15 million by 2014.

How does Buffett find companies where the market has mis-priced the business, offering a significant margin of safety and value investing opportunity?

One thing is for sure…he is not relying on the as-reported GAAP earnings numbers to conduct his analysis.

Buffett has said quite bluntly time and time again:

“The net earnings figure… it really is not representative of what’s going on in the business at all…”

“The GAAP rules… I’ve warned you about the distortions.”

“The ‘bottom line’ figures are totally capricious. It’s really a shame”

“You should concentrate on the world of companies, not arcane accounting mathematics.”

Buffett has regularly railed against issues with as-reported accounting metrics. He’s mocked the changes with net income causing Berkshire’s earnings to swing quarter to quarter in ways that completely misrepresent the company’s performance.

Buffett is not alone in recognizing that as-reported earnings numbers and other financial statement data are terribly problematic and misleading. He is certainly one of the more outspoken on the issue.

If the earnings number is not reliable, then neither is the as-reported earnings growth number. That makes the P/E, price to earnings ratio, just as useless.

Graham mentions the importance of a company’s “earning power” over a hundred times in his books. Unfortunately, as-reported earnings is a poor metric for examining a firm’s earning power.

So, any examination of Buffett’s portfolio, or your portfolio, using as-reported data would be a complete waste of time. It might be worse than that. Using as-reported financial data could cause you to make some very bad decisions… buying businesses that you shouldn’t, and selling businesses that you ought to have held.

That’s why Uniform Accounting and Uniform Financial Analytics are so powerful. Financial data that reflect the real economic performance and valuation of firms are necessary for great value investing. They unlock and reveal insights about the world of companies that arcane accounting – the existing accounting – hides and misleads.

Berkshire’s internal analysis unsurprisingly lines up directly with analysis using cleaned-up, consistent financial metrics calculated with Uniform Accounting.

We’ve conducted a portfolio audit of Berkshire’s top holdings, based on its most recent 13-F, to see Buffett’s investments in 2021.

On an as-reported basis, many of these companies are poor performers with returns at 10% or below, with the average as-reported return on assets (ROA) right around 9%.

In reality, the average company in the index displays an impressive average Uniform ROA of 39%.

Once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earnings power, we can see the underlying strength of the portfolio.

Once the distortions from as-reported accounting are removed, we can see VeriSign (VRSN) does not have a return of 20%, but a sizable ROA of 224%.

Similarly, Mastercard’s (MA) ROA is really 53%, not at 16%. While as-reported metrics are portraying the company as a slightly above-average business, Uniform Accounting shows the company’s truly robust profitability.

The list goes on from there, for names ranging from Moody’s (MCO) and Visa (V), to AbbVie (ABBV) and Coca-Cola (KO).

Now, let us see how these firms’ returns can strengthen over time through EPS growth.

This chart shows three interesting data points:

  1. The 2-year Uniform EPS growth represents what Uniform earnings growth is forecast to be over the next two years. The EPS number used is the value of when we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework.
  2. The market expected Uniform EPS growth is what the market thinks Uniform earnings growth is going to be for the next two years. Here, we show by how much the company needs to grow Uniform earnings in the next 2 years to justify the current stock price of the company. If you’ve been reading our daily analyses and reports for a while, you’ll be familiar with the term embedded expectations. This is the market’s embedded expectations for Uniform earnings growth.
  3. The Uniform EPS growth spread is the spread between how much the company’s Uniform earnings could grow if the Uniform earnings estimates are right, and what the market expects Uniform earnings growth to be.

The average company in the U.S. is forecast to have 5% annual Uniform Accounting earnings growth over the next 2 years. In comparison, these top stocks are forecasted by analysts for 6% Uniform earnings growth.

On average, the market is pricing these companies to grow earnings by 8% a year. Analyst’s are forecasting higher expectations, which may mean the market is leaving some upside on the table.

One example of a company with high growth potential is Charter Communications (CHTR). Even though the market expects Charter Communications to grow earnings by 9%, analysts project the firm to grow by 42%.

AbbVie (ABBV) is another example. While analysts forecast AbbVie to grow by 24% over the next two years, the market expects the firm to see a 7% shrinkage over the same period.

That being said, there are many companies forecast to have earnings growth less than market expectations. For these companies, like Visa (V), Amazon (AMZN), and Mastercard (MA), the market has growth expectations in excess of analysts’ predictions.

Ultimately, once we make uniform accounting adjustments, we can see that Berkshire is investing in high quality businesses, forecasted to grow in excess of market expectations.

SUMMARY and Apple Inc. Tearsheet

As Berkshire Hathaway’s largest individual stock holding, we’re highlighting Apple Inc.’s tearsheet today.

As our Uniform Accounting tearsheet for Apple Inc. (AAPL:USA) highlights its Uniform P/E trades at 24.1x, which is around the corporate average valuation of 25.2x, but above its own historical valuation of 19.7x.

Average P/Es require average EPS growth to sustain them. In the case of Apple, the company has recently shown a 10% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Apple’s Wall Street analyst-driven forecasts are 35% EPS growth in 2021, followed by a 1% EPS shrinkage in 2022.

Based on current stock market valuations, we can back into the required earnings growth rate that would justify Apple’s $121 stock price. These are often referred to as market embedded expectations.

Apple is currently being valued as if Uniform earnings were to grow 9% annually over the next three years. What Wall Street analysts expect for Apple’s earnings growth is above what the current stock market valuation requires in 2021, but below that requirement in 2022.

Furthermore, the company’s earning power is 7x the corporate average. Also, cash flows and cash on hand are more than thrice its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals a low credit and dividend risk.

To conclude, Apple’s Uniform earnings growth is above its peer averages, and their valuations are also traded above its average peers.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research