Lessons from the Sage of Omaha

the jonathan davis column

Mid-March brings with it many old favourites: among them, the first signs of spring, the Cheltenham race meeting, the Budget (after a short interlude when it was moved to the autumn) and - for investment groupies such as myself - the arrival of the "Sage of Omaha's" annual report to shareholders.

When I made my first visit to the annual meeting of Buffett's holding company, Berkshire Hathaway, in 1991, the number of those who turned up could still be counted in their hundreds. The meeting, at which Buffett and his lifelong business partner Charlie Munger sit and talk about the business of investment for hours on end, was still small enough to be held in the local theatre in Omaha, Nebraska, Buffett's home town.

Now, however, as his fame has spread, the attendance has grown exponentially: last year, the turnout had grown to 7,500. Such is his fame that no stock market anywhere in the world is immune from the impact of what he has to say.

Last Monday, Buffett released his latest annual report and accounts for the year just gone. It showed another year of progress, with the company's book value up 34 per cent on the year - not bad in isolation, but "no great triumph", according to Buffett, in a year when the market overall was up 33 per cent.

Having been reported as warning last year that share prices were looking very fully valued, his comment this year that the current level of Wall Street prices could still be justified in valuation terms was enough to spark another round of buying around the world.

All this despite the fact that, by his own admission, Buffett's actions betray a real concern about the riskiness of many stock prices at today's levels.

Buffett's views are as follows. While he professes to having no views about which the market is going to move tomorrow, he does, "try in a very rough way to value it". A year ago, he said that, with the Dow Jones at its then level of 7,070 and the long bond rate at 6.89 per cent, the market did not look overvalued provided that two essential conditions continued to be met.

One was that interest rates at the long end of the scale did not rise; and the second was that American companies continued to earn the "remarkable returns on equity" that they have been achieving in the last few years.

So far, says Buffett, both conditions have held: returns on equity have remained "exceptionally high", the market has bounded on to new records, while interest rates have fallen further, with the long bond rate occasionally dropping below 6 per cent. Buffett himself confirmed the reports which emerged in the autumn that he had been putting money into government bonds, a ploy which can only pay off if interest rates continue to fall. (In the event, so the annual report discloses, the profit on the bonds has been around $600m, on an investment of around $4.0bn).

The trouble is, says Buffett, that finding good value shares in the current climate is difficult even if you make the assumption that his two conditions will continue to hold for a little while longer.

The upshot is that while it may be still be right to buy new shares at today's levels, the height the market has reached has materially eroded the margin of safety that Ben Graham (Buffett's original mentor) identified as the "cornerstone of intelligent investing".

By his own admission, Buffett has been putting a bigger chunk of his money into bonds and what he calls "unconventional commitments". Thus, he has money tied up in forward contracts for oil, and has also been building a position in silver (profit at year-end: $97.4m).

"We are not pleased with our prospects for committing incoming funds," Buffet writes. "It may be some time before we find opportunities that get us truly excited".

Mind you, that last bit can be taken with a pinch of salt. Buffett has been saying the same kind of thing for years now, and each year he manages to conjure some new profitable rabbit out of the hat. When he started buying Coca-Cola 10 years ago, everyone at the time said he had clearly run out of new ideas. His shareholding has since risen more than tenfold to $13.3bn - so much so that Coke alone now accounts for 37 per cent of the world's most successful stock market investor's portfolio.