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The Value King is Dead

May 4, 2016


I come to praise Warren Buffett, not to bury him. But keep a shovel handy just in case. The iconic value investor presided over his annual "Woodstock for geeks", otherwise known as Berkshire Hathaway's annual meeting. What did we learn?

The company only released preliminary results for the first quarter. Let's ignore those and talk about return on capital. That's been the secret to Buffett's success all these many years. You buy companies that generate wads of cash with very low capital requirements. Think of Coca-Cola or, more recently, the insurance business.

Berkshire's balance sheet shows $71 billion in cash and short-term investments (securities that could be converted into cash quickly). Buffett said he'd be happy to deal (buy other companies) at the right price. He'd even be happy to buy Berkshire's own shares back, at the right price. But the price is not right, and Berkshire's size is part of the problem.

Jeffrey Miller at Eight Bridges Capital Management summed the problem up neatly in a note to clients excerpted in Barron's. It's exactly the same point Tim Price made in early April in The Price Report when he dipped his toe into small-cap value stocks here in the UK. You may not have $71 billion in pocket change like Warren Buffett. But you have an advantage as an investor - you can buy small things. He can't. Miller explains (emphasis added is mine):

The most interesting part was when he was asked why Berkshire had changed from investing in companies with high returns on capital and no-or-low capital requirements to those that require massive amounts of capital, like railroads and pipelines. His answer: because Berkshire is too big now to invest in those great low-capital businesses (even though they are superior to what he is buying recently and are what created the track record of which so many are envious). My takeaway: smaller is better in asset management, because it opens up many more opportunities that are unavailable to investors that grow too large - like Berkshire Hathaway. Buffett hesitated before he answered, because the answer revealed an uncomfortable truth - that Berkshire is no longer able to maximize returns for its shareholders, but Buffett is unwilling to return the capital to them to go and find other investments.

Buffett's more recent purchases - railroads and pipelines - are certainly tangible assets. But they don't generate the kind of high returns on capital as, say, insurance. You couldn't blame Buffett for not buying anything... if there wasn't anything good to buy. But if it's a matter of being too big for its own good, then surely this is good news for individual investors.

Plus, value stocks haven't been this cheap relative to growth stocks since 1999. This could be an important secular turning point in markets.

By "secular" I mean long term. Tech - via the decline and fall of Apple - is giving up leadership of the market. Gold - pricing in low rates for much longer - surges. The leadership of the market passes from easy credit surfing "asset gatherers" (a Tim Price term) to asset managers - investors who know how to value a business and, thus, what the right price to pay is.

Please Note: This article was first published in Capital & Conflict on May 03, 2016.

Dan Denning studied literature and history, moving to Agora Financial in Baltimore fresh out of college. Working alongside Bill Bonner and Addison Wiggin, he became managing editor of Strategic Investments. He then moved via Paris and London to Australia, publishing a book - The Bull Hunter - along the way, and opened Agora's successful office Down Under. He returned to London in 2015 and became the publisher of Fleet Street Publications' financial newsletters.

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