The case for cash + Some thoughts on Warren Buffett's letter

As many of you know by now, the DJIA topped 21,000 for the first time ever with Trump’s latest speech to the Congress resonating strongly with the market. The speech offered slogans, few detail, yet the market keeps charging ahead. Strange world, isn’t it? Naysayers have stayed on the sidelines waiting for a correction to come, yet they are getting left behind in the dust.

Source: Google images

There’s a theory going around that there’s just too much cash lying around waiting to be deployed, so people are just looking for reasons to buy. True or not, such mentality effectively pushes investors towards owning assets at virtually any price, which is surely nonsensical. 

What’s wrong with cash anyway? True, it generally has a zero expected real return. But at least there is a near certainty around that expected return, which sometimes is more attractive than the highly uncertain expected real returns on offer when alternatives are overvalued. It is beginning to feel like one of those times.

There are some pointers that I wish to share from Warren Buffett’s latest shareholder letter, which I finished reading a couple of days ago. There are many valid points that he made, but let's take a look at the top three for me:

(Admittedly, this is the first of his shareholder letters that I’ve read in detail. As I look to improve my knowledge as an investor, I plan to read all of the rest soon because it is truly as insightful as it has been said to be.)

1. “Of course, a business with terrific economics can be a bad investment if it is bought at too high a price.”

Reiterates what I just mentioned above. I know there is a lot of literature on this. Everyone wants to buy low and sell high, but it’s easier said than done. I’ve had my fair share of pitfalls too. Two things that I learnt I should have: (1) Discipline - stop that itchy finger! (2) Cash. Lots of it. Cash has one important endowment which is too frequently unrecognised: a hidden optionality derived from its relative stability. In other words, the holder of cash has an effective option to purchase more volatile assets if and when they become cheap. 

Speaking of cash, OCBC 360 is facing new changes (again) effective 1 April. Seems like the bank wants to further increase the deposit base and shift more into the revenue-generating products. Read Ezhuat's post about it here.

2. “Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings.”

Eeeks, I really do hate it when I see the word “adjusted”. Because then I have to find out what has been adjusted, why they were adjusted, and more often than not there is not enough information (especially for private companies). Coincidentally, I had been reading through the prospectus of an F&B company earlier in the week and was quite disturbed (more like irritated) when I realised that the section on financials is littered with the word “adjusted”.

Look at this:

Whut? Had a headache immediately.

“Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.”

Hear, hear! Look at these adjustments to EBITDA of the same company:

Ok to be fair, the company had just made an acquisition, hence the acquisition costs and restructuring and integration costs etc. BUT that’s precisely the company’s entire business strategy. For growth, it acquires underperforming units from its competitors and refurbishes, converts, and integrates them into its own brands. They have such costs constantly, every single year, so obviously earnings should fully reflect them. The same goes for every acquisitive company, including Berkshire:

“Berkshire, I would say, has been restructuring from the first day we took over in 1965. Owning only a northern textile business then gave us no other choice. And today a fair amount of restructuring occurs every year at Berkshire... We have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power. If there were to be some truly major expenses in a single year, I would, of course, mention it in my commentary... But, to tell owners year after year, “Don’t count this,” when management is simply making business adjustments that are necessary, is misleading. And too many analysts and journalists fall for this baloney."

3. “At Berkshire, we never count on synergies when we acquire companies.”

This comment appears to be made in passing as Warren Buffett talked about one of his favourite businesses. It struck a chord with me, because I have a case in point regarding promised synergies.

There is this food retail company in some part of the world which, a few years ago, acquired a food retail company in a neighbouring country, touting massive synergies from cost rationalisations and whatnots. Investors lapped it up, provided generous financing, and patiently waited for the magic to happen. Fast forward to now, the touted synergies still have not been realised, business is deteriorating at the acquired company because of intense competition, the acquirer is spending more than ever on the acquired in order to compete, debt load is massive with upcoming maturities, and worst of all the management has problematic communication which leaves investors second-guessing.

The market, of course, has gotten impatient and the company is now being punished. Bond prices came down probably about 30 points or so within a month.

Would love to write more, perhaps on how Warren Buffett humbly admits his misjudgments, how he gives his stamp of approval for low cost index funds, or how there seem to be subtle allusions to Trump (maybe I read too much into it), but I shall leave you with this:

“Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks. No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.” 

Good luck in the markets!

Cheers

Yolohuat