We wrote this in our last letter, “We believe the pattern of money printing and rising financial assets is not broken. We think within 18 months the markets (and our accounts) will be trying to make new highs. We understand this view is a minority one after a decline of this magnitude. The playbook of the last 12 years is being put to the test. We think it’s still valid.” We wrote that when the S&P 500 was at 2300. Today it is at 3060. We are off to a good start in regaining what we lost in Q1. The market is still very volatile right now. It has big swings daily on every new COVID related development. The gains in the market since the lows are very skewed to a certain sector of the market, which is what we will talk about next.
There are times when the market picks a group of stocks or a style of investing and rewards it with higher stock prices. We have written in past letters about how this market reminds us of the dot-Com bubble of 1999-2000. The chart above shows you visually how that played out. When we wrote in our last letter that the Federal Reserve printing money was going to raise asset prices, we were surprised how quick the markets responded to that money printing. There is usually a lag time of months between when they print the money and you see it in rising asset prices. This time the $3 trillion dollars (it will be more) they printed showed up in stocks in just a few weeks. Most stock indexes bottomed on March 23 rd which was just two weeks after the Fed threw trillions at fixing the economy. Large capitalization tech companies that trade in an ETF called the QQQ were the first stock index to move up. When the Fed was concerned about Y2K in 1999, they also printed a lot of money that ended up in the QQQ at the height of the dot-Com bubble.
The QQQ index includes 100 of the largest domestic and international nonfinancial companies listed on the NASDAQ Stock Market based on market capitalization. Take note: This index does not own any financial or oil stocks. Tech stocks represent 67% of the QQQ. Consumer discretionary and health care represent 23% of the index. Fully 90% of the index is less effected by the economy and COVID than most companies.
When the money printing started in March, gold was the first index to break above its 50-day moving average on March 24 th . It hit a new 8-year high this quarter. The QQQ was the second index to break above its 50-day moving average on April 14 th . The S&P 500 followed 10 days later. What these three indexes have in common is that if you have a lot of money to put to work quickly, you can do it in these groups fast.
It seems clear today that a lot of the “hot” money that was printed by the Fed ended up in the QQQ. As Herbert Stein is famous for saying, “If something cannot go on forever, it will stop.” This was true in 1999 and it will be true this time. As we wrote in our last letter, the end of this move will be when the dollar declines and inflation come back. Until then, it is going to be a party in the QQQ. We own Apple and Tesla. They are now two of our top five stock positions. Apple and Tesla are in the QQQ. When we first bought Apple at 57 in 2013, its phones were viewed as a commodity. The prevailing wisdom back then was their phones were doomed to be wiped out like Blackberry, Nokia and Motorola phones. Apple’s stock had declined that year by over 60% in 2013. Every week some analyst would do a channel check and say, “Sales are terrible; sell the stock.” When we bought Apple however, they had massive earnings to back up their stock price. We thought we could make over 20% a year from the stock if their earnings just stayed flat. Apple was a ridiculously cheap value stock in 2013. Today it has morphed into a growth momentum stock. Apple’s operating income is up 25% since we owned the stock. The price of Apple’s stock is up over 600%. Apple’s stock is not priced to make 20% a year today.
As a comparison to the tech-laden QQQ look at large-cap finance and oil stocks. These groups are not in the QQQ but they are in the S&P 500. The financial index I will use to judge finance stocks is the XLF. Its largest holdings are stocks we have been buying in the last year, Wells Fargo, J.P. Morgan, Berkshire Hathaway and Bank of America. At its peak in May of 2007 the XLF was trading at 31. Today it is trading at 24. In 13 years, the index (not counting dividends) is down 22.5%. The QQQ is up over 400% during that time frame. If you owned a basket of oil stocks during this time frame, you would be down 40% (not counting dividends).
The point we are trying to make is that investor sentiment for tech is now approaching something of a mania. It is the exact opposite for just about every other sector. The challenge we have managing our accounts is our mania stocks are doing fantastic, performance-wise, and our value stocks are doing awful. The dilemma all portfolio managers face today is do you chase what has been going up that is not cheap on a historical basis, or do you buy value stocks and risk missing the party? Back in 1999 the QQQ mania went on for about two years before it blew up on March 10 th of 2000. We think the key to the reversal of today’s trend is the dollar going down. When the dollar rallied dramatically in 2014, the QQQ’s outperformance went with it. Foreign investors and central banks have also been buying tech stock as well. The central bank of Switzerland has bought 17 million shares of Apple as part of its quantitative easing plan. Central banks would rather own tech stocks than a U.S. treasury bond on their balance sheets. When (some would say IF) inflation returns, the bank of Switzerland will have to sell tech stocks to shrink its balance sheet. This would also occur at a time when most likely the dollar is going lower, which would generate more sales from foreign individuals of U.S. tech stocks.
In 2000 we were accused of pulling the flowers and watering the weeds by not owning the dot- com out- performers. We are prepared to hear that again when we make some changes to your accounts over the next six months. We will buy value over momentum and wait for the party to find us. This almost always means selling what has gone up and looks great on a three-year look back to buy stocks that have not gone up. Does this mean we would sell all of your Apple or Tesla? No. That said, some of our accounts’ tech positions have grown above 10% or 15% of their accounts’ value. There will be some pairing back in those accounts. The money will be rebalanced into other positions or new positions that have been dormant for a while. The risk we have is that we sell some Apple at 350 and it goes to 600. That can happen. The reverse can also happen. We will keep you informed on what we do in our next letter.
Our three largest value stocks are Berkshire Hathaway, CenturyLink and BGC Partners. Their stock performance this year has been poor. Their fundamental performance to date has not been poor. We want to show you a few ways we think about holding them versus owning bonds. The value of CenturyLink’s stock is trading at 10 billion today. They are going to generate $3.2 billion of free cash this year. Last year it was about the same number. By generating that much free cash flow in a year, shareholders will get 33% of their money back in one year. In three years, you will get all of your money back. If you own a 10-year treasury bond today at 0.70% it would take you over 100 years to get your money back. We view a three-year payback in CenturyLink with earnings risk a better bet versus a 100 year payback in a government bond with no earnings risk.
CenturyLink will pay shareholders 33% of that $3.2 billion in free cash flow in dividends. At the end of three years we will receive a third of our investment back. The rest of that money stays inside the company to pay down debt. We view debt repayments as money accruing to the shareholder. We have calculated that it would take you about four years to get your money back on the cash flow BGC will generate and 10 years for Berkshire. When you consider these paybacks versus owning bonds, we are willing to assume the risk of owning stocks.
While the market has driven the value of large-cap tech stocks to new highs, they have punished Berkshire Hathaway’s stock because they are not a tech company. In the traditional sense they are not but let’s explore that a little. The market cap of Berkshires stock today is $433 billion. They have total assets of around $750 billion. Berkshire owns 250,866,566 shares of Apple’s stock. They paid $35,287 billion for it ($140.66 per share). In the last week of June, Apple’s stock was trading at $370 a share. At that price, Berkshires Apples stock was worth $92,820 billion dollars to shareholders. Apple’s stock represents 21.4% of the total value of Berkshires stock. It represents 12.3% of Berkshires total assets. Maybe Berkshire isn’t a tech company, but its largest asset is? Is it fair to label it as a finance company? Let us complicate that question some more.
As we mentioned above, Berkshire Hathaway is the largest component of the ETF XLF that tracks finance stocks. When Wall Street talks about Berkshire, it is lumped in with banks and insurance companies. When you look at the chart above you can see that Berkshire has an extremely high correlation with the other finance stocks. Would it shock you to know that last year Berkshire earned $29.25 billion in pretax but only $7.017b of that came from finance? The rest came from Burlington Northern, Mid-American Energy and a host of U.S. manufacturing and retail companies. In 2018 finance was 25.3% of Berkshire’s earnings. In 2017 it was only 8.3% due to some bad reinsurance losses. The powers that be who decide what goes in an index have “cursed” Berkshire by putting them in the finance index. The truth is that Berkshire is so diversified that it really should not be put in any narrow index. How do you have an index that only owns stocks whose market cap is 20% Apple’s stock and generate 75% of their income from non-insurance. Good luck putting that index together. That said, you can see in the chart above how Wall Street trades Berkshire as a finance-only stock.
The last positive we will mention about Berkshire is that it is trading at 1.14 times book value as we type this. If you were to buy Union Pacific today, you would have to pay 7 times book. You can buy Berkshire who owns Burlington Northern at an 83% discount to what you would pay for Union Pacific. If you want to buy a boring old utility stock, you will pay around 2 times book value. You can buy Berkshire’s utilities at a 50% discount. You can buy Sherwin Williams paint stock at 18 times book value on the New York stock exchange. You can buy Benjamin Moore at 1.14 times book. The value is here. How it gets recognized and when has been a struggle for us to predict. At some point Buffett will do what is best for shareholders because he is the largest one. If that means paying out a dividend, buying back stock or making another acquisition he will (or his lieutenants will) do what is best for shareholders. In the meantime, he is considered washed up right after he just made $60 billion in Apple. Go figure.
We get a lot of calls asking us about our views on COVID and its effect on the economy. Please keep in mind that when we researched this subject in the first quarter our conclusion was 100% wrong in how the world’s leaders and markets would react. We did not think the market would drop over 20% and we did not think they would shut down the economy. We did not get that right. That caveat out of the way, here is our current working hypothesis.
Early in the crisis the perceived death rate for those people who got COVID was at 3.4%. That data was supplied by the WHO and China. That death-rate percentage is a horrific number. World leaders used that data to form public policy in March. The 3.4% death-rate decision was made based on the limited data and testing we had at that time worldwide. If that number was even close to right (it was the only one we had at the time), the world had to shut down, and it did. As the world’s testing has improved the death-rate data has been declining dramatically. The death-rate per infection is the most important number to focus on in our opinion. We think Stanford’s John Ioannidis work released in June is the best to look at on this topic. We have included the link below. His paper analyses 23 case studies from across the world. We will post his conclusion below. If his study is statistically accurate (its being reviewed by academics and the CDC now), the odds of another COVID shutdown seem exceptionally low to us based on the data. The risk of us dying from COVID would be higher than the yearly influenza we deal with but not by a catastrophic amount. We can deal with this while still leading normal lives. The death rate that this paper indicates we are experiencing from COVID worldwide is 0.26% and not 3.4%. This is welcome news to the world, and we are rooting he is right. A 0.26% death rate will not shut down the world’s economies. We can handle that rate with social distancing and masks until the vaccines start showing up later this year. Here is a selected paragraph from the paper we have used to summarize its conclusion:
‘’A comparison of COVID-19 to influenza is often attempted, but many are confused by this comparison unless placed in context. Based on the infected-fatality rate (IFR) estimates obtained here, COVID-19 may have infected as of June 7 approximately 200 million people (or more), far more than the ~7 million PCR-documented cases. The global COVID-19 death toll is still evolving, but it is still similar to a typical death toll from seasonal influenza (290,000- 650,000), while “bad” influenza years (e.g. 1957-9 and 1968-70) have been associated with 1-4 million deaths. While COVID-19 is a formidable threat, the fact that its IFR is typically much lower than originally feared, is a welcome piece of evidence. The median of 0.26% found in this analysis is very similar to the estimate recently adopted by CDC for planning purposes.’’
https://www.medrxiv.org/content/10.1101/2020.05.13.20101253v2.full.pdf+html
As always feel free to call us if you have any questions or thoughts.
Sincerely
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR