January 14, 1998 |
I first became aware of Warren Buffett in 1986. I was in Boston checking out a business opportunity when a friend of mine in the financial field said to me, "If you are serious about investing, read this!" He then handed me the annual report of Berkshire Hathaway. That night, I went back to my apartment and read the report. I recall feeling as though I'd been struck by lightning. I was new to the business world and didn't really grasp all the concepts put forward by Buffett, but I was beginning to see the light. Since that night, I've re-read the annual reports of Berkshire many times, and each time it has given me some new insight. Like a lot of people, I follow Buffett's investments closely. My objective is not so much to copy the investments he made and profit from them. Instead I am much more interested in understanding the thinking behind his investment moves and hope to apply such thinking in my own investments. In addition I am interested in his investments because my folks own shares in Berkshire (I persuaded them to start buying shares in Berkshire when it was trading at $3,000 per share). In the past month or so, it has been reported in the press that Buffett has bought close to $2 billion worth of long term US Treasury zero coupon bonds. The overall interpretation of Buffett's bond investment by the press is that it is a bet on the US economy slowing down and a resultant decline in interest rates (quite a few economists think a deflation scenario is possible). Some reporters also think it is part of Buffett's asset allocation strategy, signaling a bearishness on equities and bullishness on bonds. I must note that what has been reported in the press is unconfirmed rumors. No one will know whether Buffett really bought bonds until the release of Berkshire's next annual report. However, assuming that Buffett did buy bonds, what is the rationale behind such a move? As a close observer of Buffett for some time, my interpretation of his moves is slightly different from the press. But first some background information on bonds. About Bonds All US Treasury bonds and notes consist of a principal obligation and semiannual coupons for the interest due on the principal. Every six months, the US Treasury pays the holder of a bond an interest payment equal to a percentage of the principal established when the bond was issued. For example, an investor purchasing a 10-year Treasury note with a par value of $20,000 and an interest payment of 10% will receive $1,000 in interest payment every six months for 10 years, plus the $20,000 principal repayment at maturity. There is one problem with the above straight US Treasury bonds. For investors to get a 10% compounded return over the life of a bond, they must be able to reinvest each semi-annual coupon they receive at a 10% rate. If the prevailing interest rate at the time investors receive each semi-annual coupon is lower than 10% - say 6% - then investors will not be able to reinvest the coupons to achieve a 10% compounded return, so there exists a reinvestment risk. Zero Coupon Bonds To partly counter this problem, brokerage firms and the US Treasury (in 1985) began issuing zero coupon bonds. What they did, in essence, was they took the normal straight bonds and "stripped" them of its semi-annual coupons, resulting in separation of the principal amount and semi-annual coupons. Thus a ten year Treasury note with a principal of $20,000 and 10% interest rate is stripped into one principal payment of $20,000 due in ten years and twenty separate semi-annual coupons of $1,000 due in six months, one year, one and a half years, two years, and so on, up to 10 years. Each coupon, once detached, represents a single sum that will be due at a fixed date in the future. The detached semi-annual coupons and principal are then bundled with other coupons and principals of like maturity, and marketed to investors at a discount. The amount of discount from the par value (this is the amount due at maturity) represents the effective interest rate and no coupons are paid (thus the name zero coupon bonds). Investors receive one single payment on maturity of the zero coupon bonds. For example, if present interest rates are at 10% then a twenty-year zero coupon bond will be sold at 14.2% of par value, i.e. a discount of 85.8% from par. This will ensure investors a compounded 10% interest rate if they hold the bond till maturity and thus eliminate the reinvestment risk. The main difference between zero coupon bonds issued by brokerage firms and those issued by the US Treasury is the former are treasury receipts issued by the brokerage firms against the Treasury securities purchased, whereas the latter are direct obligations of the US government and are considered the safer of the two (the US Treasury zero coupon bonds are also known as STRIPS, which stands for Separate Trading of Registered Interest and Principal). Like any financial asset, including stocks, the value of a bond declines when interest rates increase and vice versa. As interest rates increase, the discount rate used in the discounted cash flow valuation of financial assets also increases leading to a lower present value. Zero coupon bonds are more sensitive than straight bonds to interest rate changes and will fluctuate more than straight bonds. Interest rate changes are mostly driven by the state of the economy. In an economic slowdown or deflation, interest rates will fall in order to stimulate the economy. Falling interest rates will boost bond prices. Thus the press' view on Buffett's bond investment is that Buffett is betting that the U.S. economy will slow down, leading to a fall in interest rates which will benefit bond prices. This implies that Buffett is making a "macro" bet on the direction of the US economy and interest rates. I beg to differ as I think Buffett is simply making his investment based on comparative values. His game has never been about making macroeconomic bets. To understand comparative values, one needs to look at equities valuation. Business As A Bond Most big companies, defined as those companies with market value of at least $3 billion or sales of $5 billion, are selling in the market at an average price earnings multiple (p/e multiple) of 35 (before the sharp market correction in late October early November). Coke is selling at a p/e of 36+, Gillette at 37, Hershey Foods at 26.6, and Kellogg at 38, just to name a few. If one thinks of this group of large businesses as a bond (hereafter referred to as Business Bond), then this Business Bond is yielding a return of 2.86% per annum (divide 1 by the average multiple of 35). The only reason investors will buy the Business Bond with a yield of 2.8%, when risk free US long bonds are yielding around 6.3% - 6.5%, is they expect the interest payments of the Business Bond to increase in the future, i.e. earnings growth. Indeed, if companies can reinvest their earnings to grow at 15% per annum indefinitely, then the Business Bond will theoretically have an infinite worth. When you have the earnings growth rate exceeding the discount rate, then mathematically you have an infinite number and no price is too high to pay for the Business Bond (equities). Can businesses really grow their earnings indefinitely at 15% per annum? On August 8, Coke announced that its third quarter earnings will only slightly exceed last year's results. A slew of large companies such as Gillette, Motorola, Kodak, and Polaroid, issued similar earnings warning statements. If the earnings of these businesses fail to grow at a sufficient rate or, God forbids, decline in the future, then this means the Business Bond is grossly overvalued at present. Comparative Values I believe that if Buffett did indeed buy zero coupon bonds, his main motivation is that the zeros offer him the "best/cheapest value" on a discounted cash flow basis compared to all the alternative investments available. The press reported that Buffett bought the zeros at a range that gave him a yield of 6.5% - 7%. Assuming Buffett's yield on his zeros is 7%, which investment would you rather put your money into - risk free US zero coupons yielding 7% or a Business Bond yielding 2.8% with unassured growth prospects? Thus I believe this is a case of comparative values and not some macroeconomic bet. A 7% compounded return (assuming interest rates stay the same) is not the most attractive return for Buffett. However, it is probably the best value he could obtain in the present environment of the financial markets. Possible Scenarios In evaluating bonds, one has to take into consideration the future purchasing power of money. If interest rates stay the same, then Buffett will achieve a yield between 6.5% - 7% on his bond investment. In the meantime, a couple of things can happen to the Business Bond. The price of the Business Bond may go sideways for many years, giving investors minimal returns as the intrinsic value of the underlying business strives to catch up with its overvalued market price. Another possibility is the market price of the Business Bond will correct sharply to fall more in line with its intrinsic value. Another scenario is, if the economy overheats and the Fed raises interest rates to contain inflation, the Business Bond will experience a double whammy - its already overvalued market price has to adjust down to reflect both the increased interest rates and declining earnings growth. Buffett's zero coupons will also decline in market value if interest rates increase, but probably on a far smaller scale than the Business Bond. In addition, if Buffett holds onto the zeros, he will only suffer a reduction in returns. The zero coupons he owns will continue to appreciate in value (the discount from the par value will shrink as the bond approaches maturity) over time. The risk of a large loss on principal is small unless interest rates increase very substantially and stay there for many years. On the other hand, if the economy slows or enters into deflation, then the earnings of the Business Bond will fall and there will be a sharp decline in its market price. If the Fed then lowers interest rates to stimulate the faltering economy, this may help to cushion some of the reduction in value of the Business Bond. Buffett's zero coupons, however, will appreciate in market price sharply (caused by the decrease in interest rates) giving him an even better return than 7%. I have no idea which of the above scenarios will happen and I seriously doubt that Buffett spends much time thinking about the economy. Whichever the case, Buffett's downside is very limited while he has already locked in a decent comparative return in a pricey market. In addition, he has good upside potential if the economy slows down or enters into deflation. With a limited downside, Buffett has the time and option to compare values. If at some point in time he deems the value offered by stocks to be superior to the zeros, he has the option to redeploy his funds into equities. I have a feeling that there will come a time when most investors become highly discouraged in equities and seek refuge in bonds. To quote Buffett, "The secret to success on Wall St. is to be fearful when everyone is greedy and to be greedy when everyone is fearful." Thus I believe comparative values led Buffett into investing in bonds. The purchasing power of money - inflation and interest rates - is a consideration in evaluating the bonds but this is secondary to comparing values. To say that Buffett bought bonds because he is betting on the economy slowing down and interest rates falling is putting the cart before the horse. One last thing : there is also a lot of focus by the press on whether Buffett sold his stock portfolio to buy the zero coupon bonds. Indeed the financial logic is compelling enough. However, I personally doubt if Buffett has unloaded a significant portion of Berkshire's estimated $33 billion stock portfolio. To put things in perspective, as of 6/30/97, Berkshire Hathaway had over $1 billion in cash and cash equivalents. Additionally, its insurance operations generate substantial float for Buffett to invest. So Buffett could easily find $2 billion to invest in zero coupons without liquidating much of Berkshire's stock portfolio. Buffett may have trimmed his stock portfolio, but I doubt if he has sold it down substantially. It is likely that with regard to his core holdings, such as Coke, Washington Post, and Gillette, he is content to accept that their market prices are momentarily ahead of their intrinsic value and may face a possible decline. Moreover, it is not easy to move a $33 billion portfolio without causing some significant disruptions in the market prices of the stocks he owns. So would I follow the legendary master's move into bonds? Not necessarily. Buffett works with $33 billion, and therefore his universe of opportunities is limited to the really big companies. The amount of money I work with is minuscule, which gives me a far larger field to choose from. That in mind, I believe there are still available limited opportunities in the equities area that will give me a better return than long-term US government bonds. |