Warren Buffett recently turned 93 years old and has been such a gift to those of us in the investment industry. I am a huge fan of the straightforward way he approaches investing with a focus on intrinsic value and free cash flow, which he calls owner’s income.
But this concept is something so many of us have forgotten because central bankers’ ultra-low interest rates and easing policies since 2008 have allowed what would normally be uneconomic businesses to receive low-cost funding. Things are changing, however, and we think now couldn’t be a better time for a return to the basics.
Buffett does a great job of explaining this in a lecture he once gave at the University of Georgia. To summarize, intrinsic value is the number you would get if you could predict all the cash that a business or investment would give you between now and judgment day discounted at the proper rate — for example, 10-year Treasuries. The only reason for laying out money now on an investment is to get more money later. That is what investing is all about.
Therefore, in order to know whether to buy something now is to have confidence in how much cash you will get, and the timing of when you will get it. As the saying goes, a bird in the hand is worth two in the bush, but just how sure are you that there are even two in the bush and, if there are, when you can get them out.
More specifically, if interest rates are 10 per cent, you must get the birds out in seven years to equal one in the hand. If rates fall to three per cent, you must get the birds out in 20 years to equal one in the hand for it to make sense.
So many miss this idea, but it is imperative in understanding the market. Ten-year Treasuries were as high as eight per cent in 1995, but have been on a steady decline, more so since the United States Federal Reserve started quantitative easing post-2008. The 10-year T-bill then fell to the 0.7 per cent lows in 2020 from approximately five per cent.
With rates being so low, the Fed made it viable to own excessively long-duration bonds and stocks. Even taking the two per cent average over the past decade, this means you would be comfortable investing if you got those two birds out within a whopping 36 years.
Is it surprising that many were willing to pay monstrous multiples for high-growth tech companies with impossible-to-predict cash flows? The same thing happened prior to the 2000 tech bubble, when Buffett said we soon found out there were not any birds in the bush at all. All it took was for rates to rise to 6.5 per cent from 4.5 per cent for the emperor to see he had no clothes on. Even rates falling thereafter couldn’t undo the damage that was already done.
Fast forward to today and you have the exact same situation playing out with companies such as Nvidia Corp. trading at more than double what the entire global semiconductor industry will earn in revenue in 2023 and nearly double what it will get in 2024, according to financial pundit Samantha LaDuc.
After you let that sink in, consider that rates on the 10-year T-bill have gone up to 4.1 per cent from 0.7 per cent in 2020. Now ask yourself: Are there two birds in that bush and when can you get them out?
This is why we like boring companies that have dividends of five or six per cent, complemented by protective moats that help ensure the timing and amounts of future cash flows. Wrap around an option overlay on top of this, boosting cash flows to eight to 10 per cent, and suddenly you get two birds in seven years instead of 18 if rates remain at current levels.
The same thinking can be applied to structured notes. For example, there are notes called contingent monthlies that pay out a similar yield if the underlying index does not fall below 20 to 50 per cent and stays there. On judgment day, five to seven years out, you also get all your money back if the index doesn’t fall below those downside barriers. As you can see, this offers a lot of confidence and predictability of there being two birds and that you can get them out in seven years or less.
Interest rates would have to double from here to offer a comparable profile to these investments. However, this would be disastrous if you held long-dated bonds, so why position your portfolio to depend on the direction of interest rates or speculate on who will win in sectors such as artificial intelligence.
Buffett has something to say about that as well. Automakers once transformed the entire U.S. economy and there were once more than 2,000 of them. By the 1930s, only three survived on the Dow Jones, and not one of those three are making cars today. Owner’s earnings and intrinsic value: Can it really be that simple? It has worked for Buffett for decades, so why will it not for you?
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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