Warning – Bonds Handle With Care

 

One of my favorite days of each year is the release of the annual letter to shareholders from the legendary Warren Buffet.  This years is no exception.   Below is a link to a PDF File of this years letter.

 

Warren Buffet 2011 Letter

 

Warren offers many nuggets of wisdom in his letter – for example Page 6 on Share Repurchases:

Share Repurchases

Last September, we announced that Berkshire would repurchase its shares at a price of up to 110% of book value. We were in the market for only a few days – buying $67 million of stock – before the price advanced beyond our limit. Nonetheless, the general importance of share repurchases suggests I should focus for a bit on the subject.

Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.

We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value. The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another. (One CEO who always stresses the price/value factor in repurchase decisions is Jamie Dimon at J.P. Morgan; I recommend that you read his annual letter.)

I think Warren’s first law of capital allocation can be applied universally to almost any purchase.

On Page 13 – Warren states that outside of housing, the US Economy looks almost as healthy as where it was before the 2008 recession:

The steady and substantial comeback in the U.S. economy since mid-2009 is clear from the earnings shown at the front of this section. This compilation includes 54 of our companies. But one of these, Marmon, is itself the owner of 140 operations in eleven distinct business sectors. In short, when you look at Berkshire, you are looking across corporate America. So let’s dig a little deeper to gain a greater insight into what has happened in the last few years.

The four housing-related companies in this section (a group that excludes Clayton, which is carried under Finance and Financial Products) had aggregate pre-tax earnings of $227 million in 2009, $362 million in 2010 and $359 million in 2011. If you subtract these earnings from those in the combined statement, you will see that our multiple and diverse non-housing operations earned $1,831 million in 2009, $3,912 million in 2010 and $4,678 million in 2011. About $291 million of the 2011 earnings came from the Lubrizol acquisition. The profile of the remaining 2011 earnings – $4,387 million – illustrates the comeback of much of America from the devastation wrought by the 2008 financial panic. Though housing-related businesses remain in the emergency room, most other businesses have left the hospital with their health fully restored.

Unfortunately,  housing provides the most jobs per industry  and that is being reflected in the current high unemployment rate  – you can’t outsource to another country the building of residential and commercial properties yet.

On Page 17 Warren issues his warning on buying Bonds at Today’s prices:

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments – and indeed, rates in the early 1980s did that job nicely. Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.

Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain – either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital gains on high-grade bonds when rates fall. Though we’ve exploited both opportunities in the past – and may do so again – we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

I share the same viewpoint on Bonds as Warren.   The rates being offered today do not compensate for the purchasing power risk of loss in the future. I was modeling portfolio’s earlier this weekend using a very powerful software application  that allows 1000’s of monte carlo simulations to be ran to project the potential outcomes for each portfolio created over the next 30 years.  What really struck me in creating these models is that the bond performance assumptions that are used to project a portfolio performance for the next 30 years are based on the results of the prior 30 years or so of history.  However, this last 30 years has been the greatest bond bull market in history that has resulted in the lowest yields ever today.  Using the past 30 years bonds performance is not wise in my opinion for projecting results over the next period of time and people who design portfolio’s for their clients should take this into account.

Moving forward from 2012 on, it would be prudent to heed Warren’s warning on Bonds (Jeremy Grantham, another legendary investor likes bonds even less than Warren).  However, Bonds are an essential component for every portfolio, especially a portfolio that is designed to preserve wealth, produce income and reduce volatility.  So what to do?  A couple ideas.

1.  Replace some of the Bond % weightings in your portfolio with high quality, valued price dividend producing securities – better yet an ETF or mutual fund that buys and holds these securities and therefore will provide additional diversification without giving up to much yield.  Companies with true earning power, low debt ratios and a consistent track record of raising dividends are the best candidates.  As with all long term investments, buy these securities during  market corrections which we always get at least one good one each year.

2.  Replace some of the Bond % weightings in your portfolio with Mutual funds that invest in  convertible bonds and convertible stocks – these fund can offer better yields with a partial equity component.   Much research needs to be done on these types of mutual funds because many of these funds are loaded with bank securities and outside of Wells Fargo it is hard for me to say with any certainty that these companies financial statements truly reflect the underlying business conditions.  Still these type of funds yield a little higher rate of return so as with most things in Life – a little hard work in due diligence can yield some superior results.

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