Does Buffett’s Balance Sheet Suggest a Market Top?

Just as children’s literature has provided us with “giants” (Paul Bunyan; the giant from “Jack and the Beanstalk”; etc.) so the investment world provides us with “giants” as well – persons whose names are intoned with a reverence reserved for precious few Wall Street figures.

The identity of the currently “biggest” investment giant is debatable. However, there is no question that Warren Buffett looms large within the pantheon of such giants. He is (practically) universally revered, widely idolized, and perhaps overly analyzed. I offer that last thought as a way of confessing that I probably shouldn’t be adding this article into the oversized bin of “Buffett Analysis”; however, I have been shamelessly bribed to do so (a colleague challenged me to do it — promising a dinner in Dublin with all the Guinness I can drink!).

A recent investment headline questioned: “Warren Buffett Ready for a Stock Market Crash With a Record $49 Billion in Cash?”  That headline is a good example of how Buffett is referred to in the press as a barometer of market direction.  That is quite understandable, given his long-term performance record. However, simplistic headlines often obfuscate the intricacies of how Buffett manages money. Let me try to explain.

First, there is no doubt that Mr. Buffett has a great track record.  Compare the track record of his Berkshire Hathaway stock (BRK-A) vis-à-vis the S&P 500 Index between 1995 and 2013 (note that I use Buffett’s preferred value metric of “Book Value”):

Note the steadily upward movement of Buffett’s stock versus the more cyclical S&P 500! Which would you rather have owned during that period?  During that eighteen-year period, the “Shareholder Equity” of Berkshire Hathaway grew from $16.739 billion to $202.106 billion (per Berkshire’s annual financial statements; the 2013 figure reflects the most recent quarter) – a growth of over $185 billion! That means that Berkshire Hathaway grew at an average annual rate of 14.84%!

The magnitude of this growth illustrates the (relative) meaninglessness of any analysis that utilizes an “absolute” number – such as the headline’s $49 billion.  For example, look at this graph of Berkshire Hathaway “Cash Equivalent” levels through the years:

Can you recognize the fundamental flaw in any analysis that relies upon only “absolute” levels of cash in any given year?  After all, the $44 billion of cash held in March of 2005 dwarfs the $49 billion being held now for the simple reason that shareholder equity in that 2005 quarter was only $86 billion, while the shareholder equity figure today is over $200 billion!

Consequently, a thorough study of Berkshire’s financial statements between 1995 and 2013 makes it obvious that the only analysis of Buffett’s investment genius that makes sense is one that utilizes metrics based on some relative measure. Recognizing that one could make all sorts of choices at this point, I simply chose to use graphs that measure the following:

1)   The percentage of Cash Equivalent vis-à-vis Shareholder Equity;

2)    The absolute level of bonds held in the Berkshire portfolio vis-à-vis stocks held in that portfolio during any given period;

Here is the chart of Berkshire Hathaway cash equivalent levels vis-à-vis shareholder equity during this period:

This chart offers a much more useful snapshot of Buffett’s “big picture view” of the markets during these periods. However, what the chart doesn’t show is a clearly articulated skyrocketing of “cash” just before the “Dot.com” bust and the “Mortgage Crisis”. Those of us who prefer our analytical assumptions to be confirmed within our data experience disappointment when this occurs. But let’s push on to review the interplay of stocks and bonds within the financial statements. The graph below charts the reported amounts of fixed income securities (blue line) and equities (red line) as reported within Berkshire’s financial statements:

This chart provides an interesting view. One can see that (on a relative basis) Buffett’s asset allocation shifted from stocks to bonds between 1998 and 2002, and then between 2007 and 2009, just as we would expect! Given the huge caveat that this analysis is based on a very limited “sample” size (and can therefore only be suggestive, not definitive) – a comparison between the “Cash” chart and the “Bonds/Stocks” chart leads one to think that Buffett’s allocation between bonds and stocks is a more helpful indicator of his market expectations than cash levels on their own.

There is one other chart that I found interesting.  Here is a graph of the relationship between the price of Berkshire Hathaway stock and its book value – a metric to which I am confident Buffett would suggest investors pay particular attention.

It would be interesting to take a reader poll regarding what “message” the above graph holds for each one of you. The data is laid out plainly in the graph, but (as with all graphs) how one interprets the graph often reveals more about that person’s investment philosophy and assumptions than it does about the company itself.  I will simply leave you to your contemplation of these graphs, as well as of that final thought.

NOTE: The author does not own shares of either BRK-A or BRK-B. The graphs were created after the author entered key financial data from seventy-three financial statements into an Excel spreadsheet.  He regrets the time that took, but suggests that such is the most effective way of learning about a company. 

Submitted by Thomas Petty

 

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