Investing with Success

During periods of stock market volatility, such as we‟re experiencing right now, it has often been the case that investors have rushed for the exit – selling their shares and parking the proceeds in cash until the market starts to rise again. Even then, many investors stay on the sidelines until well after the market rallies.

Our approach is to try to capitalise on the opportunity presented by weak markets to acquire shares in companies that we intend to hold for the long-term. Rather than try and pick the market trough, we focus on the value of companies on a case-by-case basis, looking for solid businesses with share prices that represent good value and which fit into a portfolio designed to give superior long-term, low risk returns. We intend to acquire companies with good prospects for strong earnings and dividend growth, which we believe will translate into higher share prices in the long-term. All investments need growth just to keep up with inflation, especially those designed to take care of one‟s retirement needs.

This approach is neither unique nor unusual – it has been well utilised (and indeed publicised) by one of the most successful US investors ever, Warren Buffett, Chief Executive Officer of Berkshire Hathaway. Buffett and his team have more than doubled the performance of the market (the Standard & Poor‟s 500 Index) over a period of more than 40 years by consistently applying the same investment style and criteria.

In its latest quarterly report (for the three months ended 30 September, 2011), Berkshire Hathaway stated its acquisition strategy neatly and succinctly in a single sentence:

“…Our long-held acquisition strategy is to purchase businesses with consistent earning power, good returns on equity and able and honest management at sensible prices…”

The last two words of this sentence are very important because they are the most likely reason why, as has been widely reported, Berkshire Hathaway spent US$23.9 billion in the third quarter of 2011, acquiring shares in listed companies. This is the most that the company has spent buying stocks in at least 15 years. Mr. Buffett must have thought that there were a number of good companies whose shares were trading at “sensible prices.”

The timing of the Berkshire Hathaway spending spree is particularly educative from an investor‟s perspective, given the fear and apprehension in investment markets.

First of all, let‟s consider the backdrop against which the purchases were made. In the third quarter of calendar 2011, the US faced the risk of defaulting on its sovereign debt (although, of course, it didn‟t); the US had its sovereign debt credit rating downgraded from „AAA‟ (the highest rank)1; a crisis of confidence was starting to grip financial markets in respect of European sovereign indebtedness and there was

1 The same happened to Japan a decade ago, but it‟s borrowing costs are now lower than ever. media frenzy about the prospect of the US slipping back into recession (despite indicators to the contrary).

Despite all of this, Berkshire Hathaway was spending up in the equity markets. In particular, it was snapping up stocks of US industrial companies suggesting that Warren Buffett (and the Berkshire Hathaway team) were seeing value in a range of high quality listed US companies.

Indeed, looking at the chart of S&P 500 10-year rolling returns below, it‟s highly likely that Berkshire Hathaway capitalised on equity market volatility to make its acquisitions at attractive prices.

The chart sets out the ten year return from an investment in the US stock market (S&P 500) at any point in time over the past century. So, for instance, the cumulative ten-year return to around 1960 (the middle of the chart) would have been in excess of 500%. Whereas, the cumulative return over the ten years to the early 1970s) would have been very little, if anything at all.

Now, consider where you would have liked to have started investing. It would appear that, anybody capable of stealing themselves against prevailing sentiment when it was at its worst (Pearl Harbour, the first Oil Shock, the Global Financial Crisis), who focused on the possibility of positive economic growth from that point forward, and who actually invested would have reaped very substantial returns over the subsequent ten years. Conversely, those who sold out were probably rueing their “bad luck” over the course of the next decade.

The red circle on the chart denotes where we are now, and have recently been, in respect of US stock market performance. One might argue that the absolute nadir has been missed and an investor might fret that they‟ve “missed the boat.” Yet, Berkshire Hathaway‟s recent buying spree suggests that this misses the fundamental point – no one successfully and regularly picks market turns and many high quality businesses are still “sensibly” priced. The Australian market, in our view, mirrors this situation.

The current ratio of share prices to earnings (the „price-earnings‟ or „PE‟ ratio) for Australian companies is near a decade low. The prospective price-earnings ratio for the largest Australian industrial companies is currently 13 times versus the average for the last 22 years of closer to 17 times2. Yields are also high – at 4,000, the S&P/ASX All Ordinaries Index would yield 5.5%, before franking credits (it was 4,115 on the 24th of November). Earnings and dividends could suffer a reversal and markets still wouldn‟t look expensive.

Like Berkshire Hathaway, we‟ve recently been a net investor for our client base, buying shares in high quality businesses with good prospects for long-term earnings and dividend growth. We believe that this remains the cornerstone of a successful wealth accumulation strategy.

Gareth Hulbert

25th November, 2011

2 Based on estimates of companies‟ earnings 12 months from now. Source: Afternoon Market Report, 23rd November, 2011; Goldman Sachs Australia.