Warren Buffett: Investing in volatile times
With the 10-year US touching 3.24%, we have revisited a Buffett interview from earlier this year, discussing the impact of rising rates, as well as offering a timely reminder to stick to fundamentals during volatile times. Read on for the transcript with video.
Is it investing or gambling?
Becky: In terms of the return of volatility? Is it something to be worried about? What's causing it?
Warren Buffett: Well if you own stocks like you'd own a farm, or apartment or house, you don't get a quote on those every day or every week. You look at the business. The value of American business depends on how much it delivers in cash to its owners between now and judgement day. And I don't think it changes 10% in the two month period if you're looking at it as a business. Now, anything can happen in markets. Markets don't have to open tomorrow. You can have extraordinary events. So, I think to some extent you can get some of the instruments that people don't understand very well that have a lot of firepower in them.
Becky: Like the volatility index and things that are tied to that?
Warren Buffett: Yeah. They're gambling, they're not investing. Nobody's investing when they buy some supercharged index on, you know, on how the VIX does or something like that. It's an unnecessary instrument. Wall Street will create instruments that the public will buy, and you can just count on that. They’ve been doing that since they met under the buttonwood tree in 1792 or whatever what it was on the exchange. If I'm going to buy a half interest in the McDonald's stand and you're going to run it for a McDonald's franchise, you're going to run it. I look to the business to determine whether I made a good investment and I'm concerned about whether we have new competition out and so forth.
But it's the business I look at. When you're just looking at the price of something, you're not investing. For example, with Bitcoin or some cryptocurrency, you're not looking to the asset itself to produce anything. If you buy an apartment house, you're looking at how the apartment house does, you buy a farm, you're looking at how the farm does. If you buy a whole business, you're looking at how the business does. If you buy a part of a business, why shouldn't you look at how the business is going to do?
People get charmed by lots of action and the fact that things are liquid and all of that, and it has repercussions back into the market when you get something like, an ETN arrangement supercharged on the VIX, where you can lose 90% of your money in one day. I mean that really doesn't belong with the word investment. It’s just, it's a gambling form of activity.
How much does a 3% bond yield matter when ROE is 15%?
Becky: Part of the reason that you've been so bullish on equities, for many years at this point, is the interest rate environment. You've looked at interest rates and said "Interest rates are gravity on stock prices, and when interest rates are so low, stock prices inevitably are going to climb.
There's been this really weird thing that's been happening in the markets where all of a sudden good news from a good jobs report made people start to worry that interest rates were going to climb and that the Fed was going to raise rates more than anticipated. People got really nervous around that and you can still see it every time we get up on the 10-year treasury bond back towards 3%. It gives investors, or at least traders I should say, some concerns about what's happening. How do you kind of look at that?
Warren Buffett: If you buy a 30-year government bond you get a whole bunch of coupons attached. The coupon says 3% or whatever it may say, and you know that's what you're going to get between now and 30 years from now and then they're going to give you the money back. What is a stock? A stock is the same sort of thing, it has a bunch of coupons, except they just haven't printed the numbers on them yet. It’s your job as an investor to print those numbers on. If those numbers say 10% (most American businesses earn over 10% on tangible equity), that bond is worth a hell of a lot more money than a bond that pays 3% on it.
But if that government bond goes to 10%, it changes the value of this “equity bond” that in effect you're buying. When you buy an interest in General Motors or Berkshire Hathaway, you are buying something that over time is going to return cash to you. Maybe a long time in terms of Berkshire but it'll be bigger numbers. And those are the coupons and it's up to you, your job as an investor to decide what you think those coupons will be, 'cause that's what you're buying. And you're buying the discounted value of it. So the higher the yardstick goes, and the yardstick is government bonds, the less attractive these other bonds look.
And that's just fundamental economics. So in 1982 or 3, when the long government bond got to 15%, a company that was earning 15% on equity, would be no more than the book value under those circumstances. You could buy a 30-year strip of bonds and guarantee yourself 15% a year, and a business that earned 12% was a sub-par business then. But a business that earns 12% when the government bond is 3% is one hell of a business now and that's why they sell for very fancy prices.
Becky: Right, is there an inflexion point that way, 'cause people think oh my gosh, we've gone from 2.4% to 2.9% and that's a big difference.
Warren Buffett: That isn't much. I’ve watched the treasury yield go from 3 to 15% too. 2.4 to 2.9% is nothing if you're comparing it with businesses that earn 12% on equity and reinvest. And the S&P, you can just look at the figures for decades has earned on tangible equities a lot more than that. And it translates into more higher prices, and it should.
Becky: Is there a tipping point along the way? Or do interest rates cause a gradual decline for equities?
Warren Buffett: Nobody knows. But it's gravity. I mean, if you told me interest rates were going to be 15% next year on bonds, there's a lot of equities I wouldn't want to own now and I would buy a lot of government bonds at 15 and I kind of wish I had in 1982, but I didn't.
Becky: What if I told you that the long bond was going to trade at 4.5 to 5% next year.
Warren Buffett: It makes a difference. But it's been idiotic to own long bonds during the last few years. And big public pension funds and all that, they sat there, and they own bonds. Now they may have bought them on a 4 or 5% basis, but if they go to a 3% basis, they're selling way above par. People do some very silly things.
The reward and the risk
Becky: I mean you lay this out in the annual report, but a lot of investors are told, retail investors are told, that they should have a certain percent of their portfolio in bonds. Maybe they're told 60-40, maybe they're told 70-30 stocks to bonds. That's something that you should do and that's the safe way of doing it. What are they missing?
Warren Buffett: Some people should not own stocks at all because they just get too upset with price fluctuations. If you're going to do dumb things because your stock goes down, you shouldn't own a stock at all.
Becky: What are dumb things? Selling a stock because it goes down?
Warren Buffett: Yeah, selling a stock because it goes down. If you buy your house at $20,000 and somebody comes along the next day and says "I'll pay you $15,000", you don't sell it because the quotes $15,000, you'd look at the house or whatever it may be. But some people are not actually emotionally or psychologically fit to own stocks. But I think more of them would be if you get educated on what you're really buying which is part of a business. And the longer you hold stocks, the less risky they become.
Whereas the longer the maturity of a bond, the riskier it becomes.
Becky: Do you feel like that's a message that is getting through to people? It's one that you repeat again and again, and I always feel, like I was watching a lot of the Olympics and I felt like what they do in the Olympics is so easy. These guys sailing through the air and doing massive spins on the ice and turns. And then I read your annual letter and I think, oh it's really easy to invest. And then I walk away and realise it's not that easy.
Warren Buffett: It's not easy psychologically for many people. But I've been teaching since I was 21, you know my first class on investments and I had a class last week with 11 schools, 220 students, and some of them get it and some of them don't. But people would rather gamble, I mean the idea that you can double your money in six months, it's why people go to the races, why they go to Vegas, you know, whatever it may be. They even know the odds are against them and they still do it. I mean it's a strong instinct to want to get rich fast, and I don't know how to do it.