February 27, 2017, 4:30pm EST                                                                                        Invest Alongside Billionaires For $297/Qtr

The big event of the week will be President Trump’s speech to Congress tomorrow.  We know the pro-growth agenda of the Trump administration.  We know the framework is in place to make it happen (with a Republican controlled Congress).  That alone has led to a “clear shift in the environment” as Ray Dalio has called it (head of the biggest hedge fund in the world) – I agree.

But we’re at a point now, with European elections approaching and political risk rising there, and with the reality setting in that execution on fiscal stimulus from Trumponomics won’t be coming quickly, markets are calming down a bit.  As we discussed last week, yields are falling back, following the lead of record level lows set in the German 2-year bund yield (in deeply negative territory).  That dislocation in the German government bond market, as other key market barometers have been pricing in bliss, has come as a warning signal.

Another event of interest: Warren Buffett’s annual letter was released over the weekend, and he was on CNBC for a long interview this morning.

First, I want to revisit his letter from last year:  Last year, in the face of an oil price crash, and a stock market that had opened the year with the worse decline on record, Buffett addressed the fears and uncertainty in markets.  He said the growth trajectory for America has been and will continue to be UP. “America’s economic magic remains alive and well.” 

And the growth trajectory has to do with two key factors: Improvements in productivity and innovation.

On productivity, he said: “America’s population is growing about .8% per year (.5% from births minus deaths and .3% from net migration). Thus 2% of overall growth produces about 1.2% of per capita growth. That may not sound impressive. But in a single generation of, say, 25 years, that rate of growth leads to a gain of 34.4% in real GDP per capita. (Compounding effects produce the excess over the percentage that would result by simply multiplying 25 x 1.2%.) In turn, that 34.4% gain will produce a staggering $19,000 increase in real GDP per capita for the next generation. Were that to be distributed equally, the gain would be $76,000 annually for a family of four. Today’s politicians need not shed tears for tomorrow’s children. All families in my upper middle–class neighborhood regularly enjoy a living standard better than that achieved by John D. Rockefeller Sr. at the time of my birth. Transportation, entertainment, communication or medical services.”

On innovation, he said: “A long–employed worker faces a different equation. When innovation and the market system interact to produce efficiencies, many workers may be rendered unnecessary, their talents obsolete. Some can find decent employment elsewhere; for others, that is not an option. When low–cost competition drove shoe production to Asia, our once–prosperous Dexter operation folded, putting 1,600 employees in a small Maine town out of work. Many were past the point in life at which they could learn another trade. We lost our entire investment, which we could afford, but many workers lost a livelihood they could not replace. The same scenario unfolded in slow–motion at our original New England textile operation, which struggled for 20 years before expiring. Many older workers at our New Bedford plant, as a poignant example, spoke Portuguese and knew little, if any, English. They had no Plan B. The answer in such disruptions is not the restraining or outlawing of actions that increase productivity. Americans would not be living nearly as well as we do if we had mandated that 11 million people should forever be employed in farming. The solution, rather, is a variety of safety nets aimed at providing a decent life for those who are willing to work but find their specific talents judged of small value because of market forces. (I personally favor a reformed and expanded Earned Income Tax Credit that would try to make sure America works for those willing to work.) The price of achieving ever–increasing prosperity for the great majority of Americans should not be penury for the unfortunate.”

And, finally on stocks, he said (my paraphrase): Overtime, with the above growth dynamic in mind, stocks go up. “In America, gains from winning investments have always far more than offset the losses from clunkers. (During the 20th Century, the Dow Jones Industrial Average — an index fund of sorts — soared from 66 to 11,497, with its component companies all the while paying ever–increasing dividends.”

What a difference a year makes.  This time, he releases his letter into a stock market that’s UP 6% on the year already.  And there’s new leadership and policy change underway.

So all of this in the above was written a year ago, what does he think now?
In his letter released over the weekend, Buffett AGAIN addresses the fears and uncertainties in markets

We discussed on Friday the stages of a bull market which slowly moves from the state of broad pessimism, to skepticism to optimism and finally to euphoria, which tends to end the bull market.  But as Paul Tudor Jones says (one of the great macro investors), the “last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic” (i.e. euphoria can last for a while).

The fact that Buffett is still addressing concerns about valuations and the future of the American economy, is more evidence that we’re far from euphoria (bubble-like territory that some like to often talk about) and were probably more like the area between skepticism to optimism.

About Valuation:  As we’ve discussed many times here my daily Pro Perspectives piece, when rates are low, historically, valuations run higher than normal (a P/E of 20 or better).  At a ten year yielding at 2.4% and fed funds at 75 basis points (well below the long run average) the forward P/E on the S&P is just 17.8x.  That’s still cheap, relative to the alternative of owning bonds.  That incentivizes money to continue to flow into stocks. And if we apply a 20 P/E earnings estimates for the next twelve months, we get about 12% higher on the S&P 500.

Now, let’s hear from the legend himself on the topic:  Buffett said this morning, “We’re not in bubble territory, if interest rates were 7% or 8% then these prices would look exceptionally high, but you measure everything against interest rates, measured against interest rates, stocks are on the cheap side compared to historic valuations.

By the way, on that “valuation note” for stocks, as you may recall I made the case early this month for why Apple (the largest component of the S&P 500) was cheap (Is Apple A Double From Here?).  What does Buffett think?  Buffett disclosed that he’s doubled his position in Apple since the beginning of the year. It’s now his second largest position at $17 billion.  He thinks Apple will be the first trillion dollar company.  Full disclosure:  We own Apple in our Billionaire’s Portfolio along with Buffett and his fellow billionaire investor David Einhorn.  We’re up 30% since adding it in March of last year.

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This past week we’ve talked about the recent public disclosures made about the investments of some of the world’s best investors.

The biggest news was Warren Buffett’s new $1 billion plus stake in Apple.

Apple’s stock price peaked in April of last year (following a 65% rolling 12-month return).  Much of that run up was driven by activist efforts of Carl Icahn.  Icahn influenced sentiment in the stock, but also influenced value creation for shareholders by pressuring Apple management to buy back stock.

But since peaking last April (2015), Apple shares had lost nearly 34% as of earlier this month.  Icahn dumped his stake and made it public in late April.

And then we find this past week that Buffett is now long (he’s in).

So should you follow Buffett?  Is it the bottom for Apple?  And what makes Apple a classic Buffett stock?

First, Buffett has compounded money at 19.2% annualized over a 50 year period. That’s made him the second wealthiest man in the world.

Buffett loves to buy low.  He has a long and successful record of buying when everyone else is selling.  Buffett purchased his Apple stake last quarter when Apple was near its 52-week low.

But he famously stays away from technology.  Why Apple?  For Buffett, Apple is a global, dominant brand.  That trumps sector.  He loves brand name companies with a loyal customer base, and there is probably no company on the planet with a more loyal customer base then Apple.  Plus, one could argue that Apple is a consumer services company (with 700 million credit cards on file, charging customers for movies, songs, apps …).

Generally Buffett pays less than 12 times earnings for a company. Of course there are exceptions, but Apple fits this criterion perfectly with a P/E of 10.

Buffett loves companies that have a high return-on-invested-capital (ROIC) and low debt. Apple has an ROIC of 28%, extremely high. Companies with a high ROIC usually have a “wide moat” or a competitive advantage over the rest of the world. That gives them pricing power to drive wide margins.

Apple really is the classic Buffett stock. And now that Buffett has put his stamp of approval on Apple, we believe the stock has bottomed, especially since it’s so cheap compared to the overall stock market.  And he’s not the only billionaire value investor who loves Apple. Billionaire hedge fund manager David Einhorn also loves Apple.  He increased his Apple stake last quarter to 15% of his entire hedge fund, almost $900 million dollars worth.

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Buffett’s famed annual letter is due to be released this weekend. With that, today we want to talk a bit about his record, his philosophy on markets and successful investing and the high conviction stocks that he has in his $130 billion plus Berkshire Hathaway stock portfolio.

First, only one living investor has a length of track record that can compare to Buffett’s. That’s fellow billionaire Carl Icahn. Icahn actually has a better record than Buffett, and it spans a little longer. But he gets a fraction of the attention of the man they call the Oracle of Omaha. (more…)