A surviving investor is always learning beyond what is obvious from platform presentations and gaining additional insights from past experiences. As almost all the investing world knows, there is a five-hour question and answer session at the annual Berkshire Hathaway meeting, which this year probably had an additional 10,000 attendees participating, including many well-known value investors.
If one was paying attention, one could hear the clash of the quantitative/accounting approach written about by Warren Buffett’s patron saint, Ben Graham, and a more real-world focus on the nature of businesses and focus on people as advocated by Charlie Munger, a proud graduate of Caltech. The clash can be summed up in prior bank mortgage policies of “Pretend and Extend” vs. prediction of meaningful change.
The investment quants believe the future is captured by extended past published earnings reports projected into the future based on today’s prices. The genius of the Berkshire Hathaway approach, particularly the approach to acquisitions, is to focus on likely significant future changes. At this year’s meeting there was a focus on its two regulated activities, the railroad group and the utility group. Part of the attraction of these two large and growing investments is that they are major cash users rather than cash generators.
What Buffett and Munger (the 83-year-young and 90-year-young leaders) are betting on is that the concerns about climate change will not dampen the world’s thirst for liquid energy. Advancements in the production of oil and natural gas have led to dramatic changes in quantity and processes. The railroad now has nine long tanker trains that can deliver petroleum twice as fast as a pipeline, and it has ordered 5,000 new tanker cars and is looking at the possibility of using liquid natural gas to fuel its locomotives.
On the utility side, this week Berkshire Hathaway purchased oil transmission pipelines in Alberta, Canada. In addition, it recently purchased a chemical process that would speed the transmission rate within pipelines. The company is hedging its bets by being one of the largest tax-benefited suppliers of solar and wind power.
Clearly, the favorite mathematical measure that the quants use (extrapolation to determine future valuations) is likely to significantly understate the future value of these operations for Berkshire Hathaway. In this particular case, the predictive method is much more growth-oriented than the mathematical models. It is this very specific focus on growth that is the key to future general stock market performance.
“Just not yet”
One of the leading theorists studying the market is Jeremy Grantham, who has a generally good but somewhat spotty record as a portfolio manager. Grantham believes that the current bull market will have to rise to an S&P 500 level of 2250 from the current level of approximately 1880. Jeremy believes this will happen within the current presidential cycle. He is generally viewed in the investment community as a bear. I find it a bit ironic that while he is possibly correct about a future peak, his timing may be too long-term.
My studies of past peaks have uncovered many similarities with the current structure of the bond and stock markets, with the exception of the final parabolic advance. I believe we may be near the launching point of the final spike. We need wide-scale public participation to get breakthrough acceleration.
Typically, before a major peak there is a period of almost exhausting enthusiasm that translates into parabolic price rises. Whether a potential 19% rise from the current level qualifies as a parabolic rise is questionable after more than 30% gains in 2013 and more than a double in the five year recovery. If we look at the potential rate of ascent, however, a net 1% per day over a trading month might just qualify for the kind of blow-off that characterizes many peaks. If we don’t get such a move, I would agree with Jeremy for now: We are not yet at peak. But the increase of volume being generated by the more publicly oriented discount brokerage firms that we own in our financial services private fund is something to watch as an enthusiasm indicator.
Further declines in the quality of bank services
All sectors don’t peak at the same time. The weekend in Omaha perhaps should be called the “Reunion of Value Investors.” Many of the well-known value investors were there. We met with and examined portfolios that, like Berkshire’s and my own, have substantial positions in financial securities. In most cases, they are in bank shares. We also see this high commitment to banks in the portfolios of many international stock portfolios, particularly if the portfolio managers were trained in Europe.
My concern is that on a longer term basis many banks increasingly rely on administrative services and investing for others as a source of earnings power. In a somewhat misguided rule change, regulators have reduced the potential for capturing yield spreads and at the same time required more isolated capital. Thus, the historic ways banks have to make money have been materially curtailed. As a natural outcome of these pressures on bank profitability, banks have been cutting their personnel rosters, particularly trust banks that have less highly profitable loan opportunities.
Until I started to refocus on secondary sources of bank earnings power, I forgot one of my reactions as a young bank trainee at a trust bank. One of my tasks was to remove checks and letters from envelopes addressed to an insurance company’s drop box. It was at that time that I recognized that, among other things, banks were giant paper processors. They remain paper/data mills as they process clearing and settlements, making transactions in securities, currencies, and structured loans. Years ago, the banks had armies of clerks and support people to carry out these activities efficiently and safely. In the intervening years much, but not all, of the work was automated.
I fear that because of the combination of the elimination of some competition and the probable narrowing of the profitability of foreign exchange and structured loans utilizing LIBOR and related indices, some major banks have been forced to cut administrative and investment staffs. While some of these people may indeed have been excess, I am predicting future bank services clients will be disappointed and their reliance on past experience will be similar to an analyst using extrapolation as a principal decision tool. We predict there is a good chance that the quality of bank services is likely to decline. Don’t say that you weren’t warned.