Warren Buffett’s annual letter to shareholders arrived this past Saturday morning with the anticipated fanfare and has produced its usual industry of commentary. Ever since Berkshire’s 13-F became public (2/17/09), I have been thinking increasingly about whether current economic conditions should alter my investment strategy and return expectations. As we observed yesterday, Graham and Dodd seem to suggest that such changes are unnecessary, if our current holdings were acquired with reasonable expectations and a significant margin of safety. Yet, in Buffett’s letter, he discusses selling some equities (presumably purchased with the requisite margin of safety) in order to purchase fixed income securities:
“On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter &Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”
Of these three equities, I am most familiar with JNJ, a favorite of many value investors (including Prem Watsa and John Hussman). Joe Ponzio at F Wall Street has analyzed JNJ and given it an intrinsic value (using a discounted cash flow analysis) of $83.10. With future cash flows discounted at 15% and a 25% margin of safety, Ponzio would be willing to purchase JNJ below $62.33.
Though personally I find this valuation a bit high, it does show that JNJ has a significant likelihood of returning the investor at least 15% per annum. For Buffett to sell JNJ for his fixed income securities, I would contend that he either sees greater return potential in them, or a greater margin of safety for a similar rate of return. The conclusion then presses upon me—a 15% return in equities may not be sufficient in this market. If that’s true, then perhaps the appropriate strategic response is to increase the discount rate in my DCF evaluations, and/or increase my desired margin of safety.
Of course, we can still find wide moat businesses whose current prices look like bargains even with these heightened standards, but the list is shorter. Ebay makes the new list, but likely not the Washington Post Company.
Lastly, Buffett’s moves have inspired me to look further up the capital structure. In the past decade, corporate bonds rarely looked attractive relative to the projected returns for their equity. Now, however, one can find a few better risk-adjusted returns in the corporate bond market. Tomorrow we’ll look at one potential opportunity by comparing the equity of Sears Holdings with its outstanding bonds.
Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway, eBay, Fairfax Financial Holdings, and debt of Sears Holdings at the time of this writing.