Warren Buffett's Market Alarm: Why His $350 Billion Cash Pile Speaks Volumes

by Cole and William Smead, Smead Capital Management

In an interview back in 2014, Warren Buffett argued that the stock market spends most of its time at reasonable prices, which he chose to call “reasonableness.” He said back then that there had been five instances in his investment career when the market wasn’t reasonable. Since he has been piling up massive cash in his company ($350 billion) and his favorite stock market measuring tool is sending warning signals, we believe it would be helpful to dig into his thoughts and the history of the U.S. stock market.

Buffett’s teacher was Ben Graham, and most of Graham’s and Buffett’s work was on individual companies. Graham liked to say that in the short run, the stock market is a voting machine, and in the long run, it is a weighing machine. Buffett’s main indicator for overall stock prices is comparing the stock market to the Gross Domestic Product of the U.S. as seen below:

Buffett has every reason to be concerned with the prevailing level of stock prices from a historical perspective. However, most investors think we’re crazy to be concerned because of the advent of what Charlie Munger called “the legitimate development,” which is Artificial Intelligence (AI). Munger called this current era the biggest financial euphoria episode of his career, because of the “totality of it!” He pointed out that each euphoria era has had a legitimate development, like radio in 1929, semiconductors in 1970, and the internet in 1999.

There is another big factor that is affecting the stock market’s “reasonableness” today. Munger’s originally wise preoccupation with wide moat/high-quality companies has been adopted universally among portfolio managers in this euphoria episode and reinforced by the capitalization weighting of stocks in the mega-popular S&P 500 Index. Many of our shareholders who practice asset allocation tell us that they would get fired if they reduced their exposure to the S&P 500 Index.

What that means for investors is that 70% of the stocks in the S&P 500 Index are caught in this euphoria (with inflated price-to-earnings ratios). In comparison, in 1999, about 40% of the stocks were connected to mania and 60% weren’t. When the mania broke in early 2000, the part of the stock market that was maniacal was obliterated. The 35% of the capital that didn’t get obliterated made it out of the “unreasonable” stocks and stayed in common stocks. Much of that capital flowed into the neglected and valuable stocks that hadn’t participated in the euphoria.

How will things go this time when 70% of the stocks are priced richly compared to history? Our portfolio traded in late December at 13-times earnings versus 22.75-times on the S&P 500 Index, with dramatically more favorable numbers on price-to-book, price-to-sales, price-to-cash flow, dividend yield, cash-flow growth and book value growth. We are ready to be weighed in the long run because we aren’t getting the votes at the moment.

Back in 2012, our portfolio traded at 12-times profits versus 14-times for the S&P 500 Index. The spread allowed us to compete very favorably with the S&P 500 Index in an era that has left stock pickers and value people in either a graveyard or in the dump. When the weighing machine kicks into gear and the stock market reestablishes “reasonableness,” we like our position in the marketplace.

Fear Stock Market Failure,

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The information contained herein represents the opinion of Smead Capital Management and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

Smead Capital Management, Inc.(“SCM”) is an SEC registered investment adviser with its principal place of business in the State of Arizona. SCM and its representatives are in compliance with the current registration and notice filing requirements imposed upon registered investment advisers by those states in which SCM maintains clients. SCM may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Registered investment adviser does not imply a certain level of skill or training.

This newsletter contains general information that is not suitable for everyone. Any information contained in this newsletter represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. SCM cannot assess, verify or guarantee the suitability of any particular investment to any particular situation and the reader of this newsletter bears complete responsibility for its own investment research and should seek the advice of a qualified investment professional that provides individualized advice prior to making any investment decisions. All opinions expressed and information and data provided therein are subject to change without notice. SCM, its officers, directors, employees and/or affiliates, may have positions in, and may, from time-to-time make purchases or sales of the securities discussed or mentioned in the publications.

This Newsletter and others are available at smeadcap.com

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