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A Weekend in Omaha 2016

Nobody's seen this movie before
A frothy market and the spectre of negative interest rates continue to confound investors

Rajesh Padmashali

If it is big, expect the Chinese to cash in on it. Sina Finance, which calls itself China’s number one financial website, had a billboard plunked right on the arrival baggage carousel at Omaha’s Eppley Airfield. Surely, you can’t get more in-the-face than that. When you park yourself that prominently, it is almost impossible for those arriving for the 2016 Berkshire Hathaway Annual Meeting to not see you. Evidently, Nasdaq-listed Sina is not only advertising itself to the horde of Chinese coming in to attend the annual jamboree but also to shareholders from all over the world.

There was a time when the world couldn’t have enough of China, now it seems Chinese investors can’t have enough of Warren Buffett. The feeling is mutual as the “Oracle of Omaha”, himself, is accommodative of this in-the-face welcome. As in 2015, this year, too, the Warren and Charlie show was translated into Mandarin. Ever ready with a wisecrack, Buffett remarked at the opening of the meeting, “I’m not sure how sensible all our comments will come out once translated into Mandarin, but I’m not so sure how sensibly they come out initially, sometimes.”

Desperate times
As always, Buffett makes a lot of sense and that is why so many make the pilgrimage every year. What though is not making any sense for most value investors is the current state of the market. They find the market “expensive” and at the same time have no clue as to what the great monetary experiment of central banks around the world will result in. The latest spectre that most investors are trying to come to terms with is the possibility of negative interest rates. In fact, as Aswath Damodaran, professor of finance, Stern School of Business, New York University points out the Japanese and Swiss short-term bonds already have a negative yield and the Eurozone could join them as well. “Negative interest rates are a reflection of central bank insanity. A lot of central bankers have become desperate as their economies are not picking up. It is an indication that they have lost control of the process,” he explains.

While at one end, a DCF guru laments central bank insanity; at the other, Barron’s recently put out a cover story that claimed, “The Market Won’t Crash – Yet”. With a few exceptions, the magazine cover indicator is a constant reminder that when the media starts hyping or gets dogmatic about a trend or a fad, there is a high probability that it has run its course. But on a more practical note, if the current low interest rate continues to stay where it is, then we should see the mother of all bull runs, at least in emerging markets, where there is scope to further cut rates. Or emerging markets should continue to see record inflows. However, for 2016 till date, it is bond funds rather than equity funds that have seen more inflows. That suggests a risk-averse mindset than one firing on all cylinders. While the Federal Reserve does hint at pushing up the funds rate by 25 basis points, investors seem to have priced in the Yellen Put. After a weaker-than-expected May US non-farm payrolls report, the US 10-year yield dropped as much 10 basis points in a single day. 

Now, Buffett has always been of the view that one should focus on individual businesses than obsess over macro but he, too, agrees that, “interest rates act on stock prices like gravity acts on matter”. And right now everybody is obsessed with where interest rates are headed after a prolonged period of suppression.  Though Damodaran disagrees with the current policies of central bankers, he feels that there is an element of fundamentals in negative interest rates and that they aren’t entirely by central bank design. “The only reason that Swiss and Japanese central banks have been able to push rates below zero, is because real growth and inflation have become so low in their economies that the intrinsic rate was close enough to zero to begin with,” he argues.  So, why has non-stop QE by central banks not delivered the goodies that it was expected to? Damodaran thinks that central bankers may have slipped up on attention to detail. “Central bankers have failed to incorporate three problems: that interest rates do not always follow the central bank lead, that risk premiums on equity and debt may increase as rates go down and that exchange rate effects are muted by other central banks acting at the same time,” he points out.

Aswath Damodaran, Finance professor, Stern School of Business, New York UniversityCoping mechanism
How are investors coping with this artificially priced assets market? Well, in a variety of ways. While the majority are taking each FOMC meeting as it comes, there are some who have called for a time-out as they cannot make sense of what is happening in the market. The $1.5-billion Nevsky Fund run by Martin Taylor returned money to clients saying, “Certain features of the current market environment, which we believe might persist for a considerable period of time, are inconsistent with the achievement of our goal of producing satisfactory risk-adjusted absolute returns.”

For the past 15 years, the Nevsky Fund returned an annualised 18.4% compared with the annualised 7.4% delivered by the MSCI Emerging Markets Index and the annualised 3.5% by the MSCI Developed Markets Index. Clearly, Nevksy Capital didn’t down the shutters because of non-performance. In his letter to investors explaining why he was shuttering the fund, Taylor also wrote, “Currently stated Chinese real GDP growth is 7.1% and India’s is 7.4%. Both are substantially overstated. Obfuscation and distortion of data, whether deliberate or inadvertent, makes it increasingly difficult to forecast macro and, hence, micro as well, for an ever growing share of our investment universe.” 

Vitaliy Katsenelson CIO, Investment Management AssociatesWhile Taylor has decided to shut shop, a lot of hedge funds continue to hang in there despite an underwhelming 2015. Hedge fund compensation in relation to their non-performance came under particular criticism from Buffett at this year’s annual meeting. Like every year, before breaking for lunch, Buffett put up a chart which showed that over the past eight years, the Vanguard S&P 500 Index fund was up 65.7% versus five hedge funds that were up 21.9% over the same period. Buffett has bet that over a 10-year period, the unmanaged index would beat these five funds managed by people charging high performance fees. After he had appraised the audience about where his wager against hedge funds stood, Buffett added, “There’s been far, far more money made by people in Wall Street through salesmanship abilities than investment abilities. There are a few people out there who are going to have an outstanding investment record. The people you pay to identify them don’t know how to identify them. They do know how to sell to you.”

But unlike Taylor who could easily wind up his fund, Buffett has a problem of plenty. For quite some years, he has been incessantly looking for opportunities to deploy Berkshire’s massive cash hoard. This problem of plenty means Buffett is now investing much more in capital-intensive businesses compared with his earlier days. “Increasing capital acts as an anchor on returns in many ways. One is it drives us into businesses that are much more capital intensive. We get decent returns on capital, but we don’t get the extraordinary returns on capital that we’ve been able to get in the businesses that are not capital intensive,” he pointed out.  

Those in the value camp, who do not have a problem of plenty, are either sitting on cash or are resorting to the tried and tested. Vitaliy Katsenelson, chief investment officer, Investment Management Associates, says that in their new portfolio accounts, the cash holding is as high as 70% and in the older accounts, it is 30%. His holdings primarily comprise of suppliers entrenched in the corporate space or those that cannot be easily switched, Microsoft, by way of example, or pharma companies. “Central banks have never manipulated the price of money to the extent that they have today. There is no reference point; that is why you have to create a portfolio for this ‘I don’t know’ environment,” he adds. The same goes for Jeff Gramm, founder, Bandera Partners, which has $200 million under management. “We are sitting on $30 million, the most we have had since 2008 as we aren’t finding a lot of compelling ideas. The thought that we might get charged for holding cash is very unsettling,” says Gramm.

On the other end, Mario Gabelli, founder, Gabelli AMC, with $40 billion under management, is among those who are sticking to the script. Gabelli thinks consumer staples companies will continue their good run. “Cereal, water, yogurt companies are terrific plays. If inflation picks up, these companies have pricing power. If inflation doesn’t pick up, they will still grow. They have great cash flow. Even if they don’t grow, they have a lot of cash to buy back stock and pay dividend,” he emphasises.

Mario Gabelli Founder, Gabelli AMCBallooning Activism
Given the low interest rates and the fact that activism does lead to M&A, Gabelli through his funds is resorting to both. “In this low interest rate environment, companies are still likely to look for accretive deals to accelerate their growth and market share. While the Federal Reserve has already raised rates slightly, newly developing economic conditions worldwide are causing speculation as to when the next rate increase will be. Continued low rates with a healthy and active debt market will further perpetuate the M&A trend worldwide,” he opines.

In fact, in the US, activism is now at an all-time high as activist investors work on unlocking value in a bargain-starved market. Because of the explosion of cheap capital, 2015 was the first time in history that the DJIA was up seven years in a row. Gramm, who recently wrote Dear Chairman, a book detailing the rise of shareholder activism, says, “Activism often balloons at the end of a bull market. A lot of hedge fund activism emerged because big institutions, including pension funds, have been quite supportive of it over the last 20 years. Only now do you see the big institutions beginning to question if they let the hedge funds get too powerful.” But given that activism in itself is not a strategy, has it now become an overcrowded trade? Gramm thinks so. “Because there aren’t that many opportunities, you are seeing a lot of situations where there are a bunch of activists on the same stock. So Yahoo or DuPont became what we call hedge fund hotels, where there are just a whole bunch of hedge funds in the same name,” he explains.

Jeff Gramm Founder, Bandera PartnersCoincidentally, among the questions at this year’s annual meeting, there was one which sought to know the “corporate defenses in place to prevent activists from trying to break up Berkshire Hathaway in the future”. Buffett’s reply was rational and tactical. He said he worried about it less now, given the size Berkshire had grown to. “As long as it’s willing to buy back the stock close to intrinsic value, there should not be a large discount to intrinsic value, so there would be no advantage to breaking up Berkshire. There would be money lost by breaking it up.” And then the finesse, “In my own case, because the way my stock will be distributed after I die; it’s very likely that my estate for some years would be by far the largest shareholder of Berkshire in terms of votes.”

While what Buffett said was matter of fact, companies have also wizened up in dealing with activists.  Instead of blocking off the activist, they now move rapidly to execute the bare minimum to pacify them.  “Companies have learnt that if an activist shows up, the best way to defend is to co-opt their arguments. So, if an activist says you need to cut costs, de-grow the board and buyback shares and I want a place on the board, they say “Ok, we are buying back shares and plan to cut costs.” Then they go to the shareholders and say, 'We did everything that they demanded. So vote for us'. That works.” Buffett is familiar with this and more given that he was an activist himself in the 1950s and early 1960s.
Endgame
Clearly, Buffett has a rational opinion on almost everything that is posed to him but the one thing that is not clear to him or even Charlie is how negative interest rates will affect asset prices. “We have been with a low interest rate situation for a long time and longer than I would have anticipated. If interest rates continue at this rate for a long time, that will have an enormous effect on asset value,” he said. To which Charlie quipped, “If you are not confused by negative interest rates, you did not think about it correctly.”

Those assembled there did have a good laugh at that moment, but one legendary investor who is far from amused is Stanley Druckenmiller, chairman, Duquesne Family Office. At the recent Sohn Conference in New York, he lambasted the Fed for spoon-feeding the market and being obsessed with preventing a 20% drop in the S&P 500. He is critical of where the cheap money is going, “While the debt in the 1990’s financed the construction of the internet, most of the debt today has been used for financial engineering, not productive investments. Last year, buybacks and M&A were $2 trillion. All R&D and office equipment spending was $1.8 trillion.”

Stanley Druckenmiller Chairman, Duquesne Family OfficeBut despite the Fed’s mollycoddling, many hedge funds were hit by the fall in commodities and related stocks last year. Much of the blame for this carnage is being pinned on faltering Chinese demand. It’s like the in-laws never complain about all the affection or the goodies that you send their way but if they are left out of something important or get overlooked, then you are being “mean”. China today finds itself in that unenviable position. When it was performing on steroids and spreading the love, everybody kept singing its praises and now that its growth has stalled, it is being looked upon as a spoilsport.

Druckenmiller believes that the world has lost a major growth engine in the China slowdown and the pain there is still to play out. “Since 2012 the Chinese banking sector has allowed credit to grow by the amount of the entire Brazilian GDP per year! Incredibly, all this credit growth has been accompanied by a fall in nominal GDP growth from 15% to 5%. This is an extremely toxic cocktail for companies that have borrowed at 10% expecting 15% sales growth. A large part of this growth is just credit flowing to otherwise insolvent borrowers,” he cautions.

Given that there are no permanent enemies in business, this seems transient. But for now, China is everybody’s favourite whipping boy. Even Damodaran, who says his biggest concern is “that a big emerging market (China) will take the rest of the world down with it.” Investors have a temporary distraction in Brexit but they should be back to blaming their old flame for all things wrong with the market.

What then does the current uncertainty portend? “The bedrock of financial practice, built on extrapolating from past data and assuming mean reversion in all things financial, may be shaky, and we have to reevaluate them for the economies that we operate in today,” remarks a composed Damodaran.

Druckenmiller is far less charitable and summed up his presentation at the 2016 Sohn New York Investment Conference on a dire note, “Higher valuations, three more years of unproductive corporate behavior, limits to further easing and excessive borrowing from the future suggest that the bull market is exhausting itself. While policymakers have no end game, markets do.”

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