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Good morning. Last week ended with a happy little rally in regional bank stocks. After a weekend to relax, breathe deeply and walk the dog, we’re hopeful the market panic will have dissipated, leaving investors nothing to worry about except the looming inflation report on Wednesday. Email us: [email protected] and [email protected].
Warren Buffett and low expected returns
From the FT on Saturday:
Warren Buffett’s Berkshire Hathaway sold billions of dollars worth of stock and invested little money in the US equity market in the first three months of the year, a signal the famed investor saw little appeal in a volatile market.
According to the conglomerate’s just-released quarterly report, the company sold $13.3bn in stocks and bought just $2.9bn worth. Rather than buy equities, Buffett and his team spent $4.4bn on buybacks and another $8.2bn on increasing its stake in Pilot, a (formerly) family-controlled chain of truck stops.
One can’t read too much into one quarter of buying and selling, and veteran Buffett-watchers will know that the great man has been moaning for years about the lack of places to put money to work at a scale that would make a difference to Berkshire. Still, the fact remains that the company has $150bn in cash and shortish-term bonds on hand, enough to buy either Goldman Sachs or Lockheed Martin outright and at a big control premium (Warren, this is not investing advice). That a company awash in cash is a net seller of stocks, even in the wake of the 2022 sell-off, tells you something.
It also chimes with recent comments to the FT from Berkshire vice-chair Charlie Munger:
“It’s gotten very tough to have anything like the returns that were obtained in the past,” he said, pointing to higher interest rates and a crowded field of investors chasing bargains and looking for companies with inefficiencies.
Munger talks about low prospective returns in terms of higher rates and competition for bargains. But there is another way to make the same point, which is by pointing to high retrospective returns. Even after the beating stocks took in 2022, the S&P 500 has delivered 10-year compounded real returns of nearly 11 per cent. If you reach back to 2009, the annual real return is even higher. But one of the most reliable regularities in finance is the tendency of the real return of stocks to revert to 6-7 per cent over the long term. We have over-earned that average over the past decade or so, making it likely that we will under-earn in the years to come. To put the same point a third way: valuations are still high, and will fall.
It would seem that Munger and Berkshire recognise this. As Antti Ilmanen of AQR put it in a recent paper, in recent years we have “borrowed returns from the future.” He offers this chart of expected returns on stocks and bonds, showing that expected real returns on stocks remain low post-2022.
(Ilmanen understands prospective returns simply, in terms of yield: lower current yields imply lower prospective returns. For stocks, this means the earnings yield, or the reciprocal of the cyclically adjusted price/earnings ratio.)
Faced with low prospective returns, there are two basic approaches an investor can take: decrease risk and wait, or increase risk and hope.
Berkshire favours the former option (so do I, in my personal investments. I’m holding a high proportion of cash, though somewhat less than $150bn). But realists can only pursue this approach to a limited degree. The chart above makes clear how long one can wait for opportunities to buy with high prospective returns. You have to own mostly risk assets, unless you think you can time the market precisely (you can’t). What you can do, for now, is collect 4 per cent cash yields and hope it won’t take a decade for an opportunity to arise.
The latter approach, adding risk, is popular with the investors piling into private equity and credit, which are now, in most cases, just a way to smuggle higher leverage into a portfolio. This may sound foolhardy. But if we are in a world of permanently high asset prices — because of demographics and inequality, perhaps — and rates fall soon, this will prove to be the better approach.
An interesting question for Berkshire and for all investors is whether taking the cheaper valuations (and therefore higher prospective returns) available in Europe, Japan and emerging markets represents a third option, or simply another way to take the second option, and add risk. To hold a bundle of cash in the face of expensive US markets and reasonably priced global ones is to endorse the notion that American equities deserve, and will keep, their wide premium to equities elsewhere. “Never bet against America,” Buffett has written. If American stocks don’t get cheaper soon, he may not have much choice.
China’s sideways stocks
Back in January, the explosive potential of the China reopening trade had the big banks licking their chops. Pent-up demand returning to normal would slingshot risk assets, which were conservatively priced. Much was made of the huge stock of consumer savings, equivalent to something like 5 per cent of China’s nominal GDP. Whatever China’s long-term structural problems, a medium-term recovery seemed like an obvious trade.
A few months on, Chinese equities have not so much put in a bad showing as a forgettable one. If you got in on the recovery rally last year, you made money. The CSI 300 index is still up 15 per cent from its October lows (before zero-Covid began being rolled back). But anyone who bought Chinese stocks this year is probably flat to down:
Part of the problem is that the economy has undershot exuberant expectations. Consumption has jogged, not sprinted, back up. Goldman Sachs estimates that in the first quarter household consumption remained about 8 per cent below the pre-pandemic trend. Spending on services has recovered faster than that on goods, but it also has more lost ground to make up. Goods consumption, meanwhile, may be stalling. In April, China’s manufacturing sector fell back into contraction, suggesting what Duncan Wrigley of Pantheon Macroeconomics calls a “stark divide between the rebounding services sector and the flagging manufacturing sector”. He adds in a note out today:
A key factor holding back private manufacturing investment is spare capacity and falling prices in many sectors, including cars, steel and solar. The spare capacity is a result of previous high capex, the tepid domestic demand recovery for manufactured goods and cooling export demand since H2 2022. And the H2 2023 global outlook is darkening, as us banks tighten lending standards and Germany’s factory orders crash.
Wrigley thinks the Chinese Communist party may try to broaden fiscal stimulus later in the year, despite the risks of inflaming China’s property debt problems; officials seem unwilling to commit for now.
The middling economy is matched by middling corporate earnings. Goldman calculates that listed Chinese companies’ net income grew a measly 1 per cent year over year in the first quarter, after shrinking 6 per cent throughout 2022. The number of companies falling short of earnings expectations is striking: 15 per cent of MSCI China constituents beat expectations this past quarter while 69 per cent missed. In the last quarter of 2022, the balance was about even.
Some amount of cyclical risk does look priced in. Since January, MSCI China’s forward p/e ratio has dipped from 11 to 10. And as this chart from Yardeni Research shows, China now looks inexpensive relative to other emerging markets (which has not always been true lately):
Still, we wonder whether a 10 forward p/e is low enough. The political risks are formidable. The US and China are engaged in retaliatory tech restrictions, and the threat of future Chinese crackdowns on industry or a Taiwan invasion can’t be discounted. These alone should make Chinese risk assets trade cheaply relative to the rest of the world. And with a tepid recovery now a risk too, the case for staying away looks strong. In all likelihood, some intrepid fund manager will make money investing in China when no one else was willing. But a classic bit of Buffett advice echoes: you don’t need to swing at every pitch.
One good read
Bryce Elder’s column on endurance theatre.