The unpredictable market: Lessons from Buffett on weathering financial storms

Monday 11 March 2024

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As I prepare for my first trip to Omaha for Berkshire Hathaway’s annual meeting in May, I read Warren Buffett’s latest investor letter with interest and a touch of sadness. I admire him and Charlie for the clarity and tenacity of their investment philosophy and their dedication to creating and sustaining shareholder value.

As he says in his letter, at the meeting in May, Warren will be on stage without Charlie for the first time in decades, marking the end of an exceptional partnership.

These are my key takeaways from his letter.

Invest in high quality businesses

Our goal at Berkshire is simple: We want to own either all or a portion of businesses that enjoy good economics that are fundamental and enduring. Within capitalism, some businesses will flourish for a very long time while others will prove to be sinkholes. It’s harder than you would think to predict who will be the winners and losers. And those who tell you they know the answer are usually either self-delusional or snake-oil salesmen.

Identifying high-quality businesses is not easy, as capitalism is fluid and high returns on invested capital attract capital, just as low returns repel it. As more capital is attracted, the return declines and businesses once coveted by investors revert to a modest return on invested capital. This is the capital cycle and is repeated across all industries from technology to mining.

Buffett’s process seeks to identify businesses that can not only endure through time but also deliver an acceptable return. They earn this return because they enjoy an economic moat. The moat is the structure protecting a business from competition and it can be generated from any number of factors including the quality of product or service, cost, patents or real estate location.

These businesses enjoy “good economics”, even though the winners and losers are hard to predict. The largest positions in Berkshire’s equity portfolio exhibit these moats. Companies like Apple, Coke and American Express have competitive positions that allow their shareholders to receive an attractive return on invested capital over the long haul.

However as capitalism is fluid, investors must be vigilant about their investments, ensuring they assess their moat daily to ensure acceptable returns are protected from the ravages of competition.

The market will always be unpredictable

Occasionally, markets and/or the economy will cause stocks and bonds of some large and fundamentally good businesses to be strikingly mispriced. Indeed, markets can – and will – unpredictably seize up or even vanish as they did for four months in 1914 and for a few days in 2001. If you believe that American investors are now more stable than in the past, think back to September 2008. Speed of communication and the wonders of technology facilitate instant worldwide paralysis, and we have come a long way since smoke signals. Such instant panics won’t happen often – but they will happen.

To be honest, you don’t even need to think back to September 2008. If you are an investor in technology companies, the year of reckoning hit in 2022 when we saw the returns of technology companies decimated, with the Nasdaq falling 35% from November 2021 to December 2022. And while many of those declines were justified, many were not.

The large tech titans Microsoft, Amazon, Alphabet and Meta were crushed under the weight of selling. Twelve months later investors changed their shorthand name from FAANG to the Magnificent Seven and it was off to the races again. While generative AI was the focus of investors during 2023, it is worth remembering that Microsoft made its initial investment in OpenAI (the creator of ChatGPT) in 2019. There is an opportunity in dislocation.

Maintaining an investment process that favours the long term serves to protect against periods of extreme volatility. It is alarming to hear Buffett talk about investment markets now exhibiting far more “casino-like behaviour” than when he was young. The rise of “meme” stocks and algorithmic funds, coupled with short-term expectations, have created an unstable environment that suits investors with a long-term orientation.

The real risk is permanent loss of capital

The real risk with investing is a permanent loss of capital and not share price volatility. Buffett’s investment process has always maintained this tenet, one that is ignored by most practitioners of modern portfolio theory. Modern portfolio theory ties the risk of a company to its share price movement. This theory asserts a business that has halved in price carries greater risk than it did immediately before the decline. However, value investors would argue that acquiring a company for half its former price is materially less risky than it was at a higher price.

To insure against the risk of permanent capital loss, Buffett always invests with a margin of safety. The margin of safety is a buffer between your valuation and the stock price, ensuring that in instances where the share price moves adversely, the investor doesn’t jeopardise their investment capital.

It was a philosophy Buffett learned from his professor at Columbia University, Ben Graham, the founding father of value investing. This principle emphasises the importance of investing with a significant buffer to protect against errors in judgment, bad luck, or market volatility.

Vale Charlie

This year’s letter included a tribute to Warren’s business partner Charlie Munger who passed away in November, just 33 days before his 100th birthday. In this tribute, Buffett acknowledges Charlie’s influence on Berkshire, especially his advice regarding investments. Charlie advocated for Buffett to add “wonderful businesses purchased at fair prices and give up buying fair businesses at wonderful prices”.

Buffett heeded this advice, and the rest is history. Charlie’s influence on Berkshire was immense, the architect may have passed but his legacy will endure.

About the Author
Lachlan Hughes, CFA

Lachlan Hughes, CFA

Chief Investment Officer

Lachlan founded Swell Asset Management in 2014, wanting to create a unique investment offering – a global portfolio with a genuine long term focus. He is the CIO, with responsibility for all investment decisions of the Swell Global Portfolio. Previously he was a Senior Analyst with NovaPort Capital, a boutique fund manager owned by Challenger Limited. Prior to that, Lachlan was a corporate lawyer working with King & Wood Mallesons, The Bank of New York (London), and Allco Finance Group.

Lachlan earned the right to use the CFA designation granted by the CFA Institute in 2010. His professional qualifications include a Bachelor of Commerce (Finance) and a Bachelor of Laws.