Warren Buffet’s strategy, in its simplest form, is buying stocks with equal or less risk than treasury bonds. He bought financial instruments with the amount of risk as bonds, the amount of return achievable with equities, and at prices that over-compensate the actual risk entailed by delivering greater returns.
In Essence, Buffet is a bond investor who does his shopping in the equity market. Sometimes Mr. Market gets confused and sells “equity-bonds” at a discount to Treasuries, because he feels the risk outweighs the potential return. Buffet knows that in the long-run there are select stocks that actually provide much greater returns than bonds with less risk.
How is it possible that a stock could be less risky than bonds? Especially given that the market has always valued equities with a risk premium over bonds? Well, if one finds stocks with a solid historical record of always paying a steady dividend, and increasing payouts with earnings growth, then those stocks can be considered “bond like.” Buffet’s prefers to look at stocks as “equity-bonds.” His goal is to find firms with solid economic moats so that dividend payouts are never a risk of decreasing, much similar to coupon payments Treasuries provide. In this aspect, a stock is very much the same as a bond. Second, Buffet searches for those companies that can increase their dividend at a rate at least equal to inflation + GDP, but ideally, those firms that can grow at even higher pace. This growth ability of dividends provides the equity characteristics of “equity-bonds.” In summary, Buffet likes to find stocks that are no different than bonds in regard to safe, predictable cash flows, yet the equity or “ownership” component allows the investor to share in firms’ success as shareholder payouts increase.
Bonds have fixed cash flow payments. Whether a firm is an average or top performer makes little difference to bondholders. Since the upside potential is limited for bondholders, the amount of risk of their investment is lower due to “first in line” claims on assets over equity holders.
But, if one buys a solid enough business where the possibility of default is so infinitesimal, does it really matter who is at the head of the line ? in a situation that will never occur? If the cash flows are not at risk to neither debt nor equity holders then there should be no need for an equity risk premium. Additionally,bondholders actually face more risk over the long-term than equity holders.
First is inflation risk.
Since interest payments on debt are fixed, higher future inflation eats up bond returns. Yet, for stockholders, companies can increase their dividends to keep pace with inflation. Since inflation stems from companies charging higher prices, then sales and income will be higher resulting in higher dividend payments.
Since interest payments on debt are fixed, higher future inflation eats up bond returns. Yet, for stockholders, companies can increase their dividends to keep pace with inflation. Since inflation stems from companies charging higher prices, then sales and income will be higher resulting in higher dividend payments.
Second is re-investment risk.
If interest rates fall resulting in robust economic growth, bond payments are re-invested at lower current interest rates, whereas public firms can re-invest the dividends internally to capitalize on the favorable growth environment. In sum, debt holders face re-investing at lower return opportunities contrary to equity holders.
If interest rates fall resulting in robust economic growth, bond payments are re-invested at lower current interest rates, whereas public firms can re-invest the dividends internally to capitalize on the favorable growth environment. In sum, debt holders face re-investing at lower return opportunities contrary to equity holders.
Third is interest rate risk inherent in bonds.
This risk increases with maturity. If the economy is robust and interest rates rise due to demand for capital and loanable funds, previously issued bonds lose value. If a bondholder has been receiving a 6% semi-annual coupon and rates move to 8%, then the investor loses out on higher coupon payments currently available in the market since the interest payment is fixed.
This risk increases with maturity. If the economy is robust and interest rates rise due to demand for capital and loanable funds, previously issued bonds lose value. If a bondholder has been receiving a 6% semi-annual coupon and rates move to 8%, then the investor loses out on higher coupon payments currently available in the market since the interest payment is fixed.
Additionally, if the bond is sold before maturity then it would be sold at a discount to face value, hence a loss. On the other hand, robust economic activity benefits firms as revenues and profits grow. This allows the stockholders to participate in economic windfalls by increased dividends.
Over a long time horizon, It is evident that stocks have much less risk than in a comparison of bonds and stocks over a short time horizon. It is also fathomable that a few, select stocks may be less risky than bonds over the long-run. In essence, there should then be a negative equity risk premium since bonds carry more risk relative to Buffet’s “equity-bonds” and additionally provide larger returns.
So what does all this mean? When the market applies risk premiums greater than the actual inherent risk, those stocks are undervalued. The market makes risk adjustments to stocks by taking down the stock price, thus lowering price-earnings multiples to increase required return. When investors perceive lower risk they bid up prices and multiples resulting in lower required rates of return.
Buffet dislikes bull markets. Rising stock prices make him anxious. Buffet only cares about the price paid- NOT the current market price due to his intention of holding the shares forever. He seeks to buy stocks that are solid enough he would never sell thus making current market prices of holdings irrelevant.
Since he only cares about the price he pays, upward markets mean Buffet has to pay more for an “equity-bond” resulting in lower future returns. Falling markets allow Buffet to buy attractive investments at a lower prices which, in itself, adds to the attractiveness. Stock prices fall to increase required returns resulting from higher risk premiums being priced-in by the market. If the long-term risks remain unchanged, then investors are getting higher returns without the additional risk. This is how Buffet views investing.
Warren Buffet was able to capitalize on the mispricing of risk in the market. Especially the price of risk viewed from a long-term vantage point. He bought stocks that traded at multiples much too low for the risks involved and the firm’s future growth prospects. Additionally, the market as a whole traded at a 5% – 6% premium to Treasuries when Buffet started BRK. That premium has fallen to the 3% range today, and will probably fall even further.
Buffet understood that there are stocks that are less risky than bonds when viewed from the long-run approach. He saw much of the time markets assigned too large of risk premiums creating investment opportunities.
Today, it is much more difficult. The market applies higher multiples to stocks that have “equity-bond” characteristics resulting in lower returns. Buffet has demonstrated to the investor class that superior returns can be earned of the long-run with minimal risk. Having become apparent, most Buffet type stocks command a premium making it tougher to attain outsized “Buffet-like” returns.
Many investors have adopted Buffet’s philosophy in hopes of achieving his high returns, eliminating much of the opportunities underpinning the advantages of the Buffet philosophy. Even Buffet himself admitted it has become harder for him to invest with as much “Buffet Savvy”
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