Bookworm: Lessons from Buffett’s behaviour in a long bear market
Equity indices don’t often fall for several years in a row. Here is what Buffett did last time it happened.
Welcome to the Bookworm, my fortnightly column that draws useful insights from investing books and shareholders written by great investors.
Each Bookworm insight falls under one of three core principles that I think underpin sound investing:
- Own high quality assets
- Foster a long-term mindset
- Prioritise process over emotion
Today’s insight falls under the long-term mindset piece of that puzzle. The source material is Warren Buffett’s letters to Berkshire Hathaway shareholders in Berkshire’s 2000, 2001 and 2002 annual reports.
Why 2000-2002?
This was the last time the US’s S&P 500 index fell for more than one calendar year in a row. It is also the only time it has ‘achieved’ a three-peat of negative calendar year returns since World War Two.
Many investors today (myself included) have not experienced a grinding bear market of this nature. This also rings true in Australia. The ASX All Ordinaries has not fallen for consecutive calendar years since 1981-1982 and has only done so on four occasions since 1900.
That is not to say there haven’t been big sell-offs. 2009 was a bloodbath and March 2020 was bonkers. By and large, though, most weak periods for equities in recent times (as measured by index returns) have been followed by a fast and sustained recovery. Hence ‘buy the dip’ becoming quasi-religion.
Grinding bear markets do occur from time to time, though. And you could argue that they become more likely after periods of strangely high equity valuations. Like the dot-com boom before the 2000-2003 bust. Or – devil’s advocate – the zero interest rate, quality bubble, Covid stimulus and ‘AI boom’ era.
As a result, I thought it might be interesting to see how the world’s most famous investor operated during a time of sustained losses for the S&P 500.
How did Buffett invest in the bear market?
For context, the S&P 500 returned -9.1% in 2000, -11.9% in 2001 and -22.1% in 2002. It’s also important to note that tech and non-tech stocks often had a very different experience of this era and the dot-com boom that preceded it.
Tech (and especially internet) stocks boomed until the peak in March 2000 and grew to an ever bigger portion of the S&P 500. Their subsequent crash and continued slide dragged down the index’s return. Many (but not all) non-tech stocks rose far less pre-crash and fared better in 2000-2003.
In his review of 2000, Buffett mentions selling Fannie Mae and Freddie Mac and buying “15% ownership positions in several medium-sized companies”. This included Berkshire’s stake in the credit ratings agency Moody’s, which Berkshire still owns. This investment has done incredibly well for them.
Those purchases were pretty much as exciting as it got, though. Look at the cost-basis of Berkshire’s equity portfolio between 1999 and 2002 below. The cost-basis ended 2002 less than $1 billion ahead of where it ended 1999. This is peanuts compared to Berkshire’s $60 billion-plus book value in 2000.
Figure 1: Cost basis of Berkshire’s equity portfolio, 1999-2002. Source: Berkshire Hathaway
Below are Berkshire’s equity holdings with more than $750 million in market value by the end of 1999 and 2002. As you can see, most of the key positions are as they were. Even down to the number of shares owned (Amex split 3-1 in 2000, explaining the rise in shares held by Berkshire).
The only change brought about by trading alone was the sale of Freddie Mac. And, as I covered earlier, Moody’s was an initially very small position that grew into a much larger one.
Figure 2: Berkshire’s holdings worth over $750 million at end 1999. Source: Berkshire Hathaway
Figure 3: Berkshire’s holdings worth over $750 million at end 2002. Source: Berkshire Hathaway
Meanwhile, take a look at what happened to Berkshire’s pile of cash and cash equivalents over the same period of time. It almost tripled in size, suggesting that Buffett was waiting for better opportunities.
Figure 4: Berkshire’s cash and equivalents balances 1999-2002. Source: Berkshire Hathaway
Why didn’t Buffett plough in?
It is fair to say that Buffett was not gorging himself on shares during the 2000-2002 bear market. His commentary during this time – especially in the 2001 and 2002 letters – shows why.
Here is a sampler of the 2001 letter:
“Charlie and I believe that American business will do fine over time but think that today’s equity prices presage only moderate returns for investors. The market outperformed business for a very long period, and that phenomenon had to end.”
And here are his (potentially even stronger) words from the 2002 letter:
“Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble.”
Two early takeaways, then, are 1) Starting valuations as a key component of the return you can expect from an investment and 2) An asset isn’t automatically ‘cheap’ because it has fallen in value recently.
Even after a 50% peak-to-trough fall in the S&P 500, Buffett wasn’t finding stocks of the quality he desired at prices good enough to justify a major commitment. That included his two biggest positions, Coke and Amex, which had experienced roughly 25% and 35% haircuts in value.
Buffett’s comments in 2002 continued:
“We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns, we will sit on the sidelines.”
Having a long-term mindset, then, isn’t just about buying-and-holding things. It is also about exercising patience and waiting for ‘no-brainer’ investments to present themselves.
If your time horizon is several years, you don’t need to find something to buy today, this month, or even this year. This is a trap I fall into sometimes.
Perhaps I should get more comfortable with the fact that 1) building a bigger cash position and 2) waiting for truly exceptional opportunities still counts as ‘doing something’ for future me.
Something people forget about Buffett
Warren Buffett is almost certainly the most famous investor of all time. But people often see him purely as a stock picker. This is not the case. He is a CEO and allocator of capital – a role that sometimes happens to involve stock market purchases.
By contrast to his relatively muted activity in the stock market from 2000-2002, Buffett was very active in his preferred arena of buying private companies. He also made a lot of opportunistic purchases of corporate debt (a feat he would repeat following the GFC).
I think it’s important to remember Buffett’s ‘bigger picture’ - that is, Berkshire’s universe of investment opportunities beyond stocks – when you consume content fawning over changes to the company’s equity portfolio.
A prime example here is the so-called ’40% plus position’ in Apple before it was trimmed – often used as evidence to bet big in the first place and let winners run to the moon. Sure, it might have reached a 40% plus weighting in Berkshire’s US share portfolio. But it was not a 40% position for Berkshire as a whole.
If my calculations are right, the Apple stake peaked at something like 30% of Berkshire’s book value – a number that fully values public holdings like Apple but likely undervalues many of Berkshire’s longer-held private investments. Yes, Apple grew into a very big position. But it wasn’t that big.
When it comes to trying to mimic the approach or buy/sell decisions of great investors, context is everything. And as outsiders, we need to accept that we will rarely have all of that context. That goes for this article too.
Closing thoughts
The crux of this article wasn’t that Buffett ignored stocks completely during the S&P 500 index’s slide from 2000-2003. That would be inaccurate. Berkshire made some important buys during the period, from the Moody’s purchase mentioned earlier to a very successful investment in Petro China.
What I am saying is that Buffett didn’t go in all guns blazing. The $499m outlay for Moody’s shares, for example, represented less than 1.5% of Berkshire’s equity portfolio at the time, let alone the company’s total book value.
And Buffett definitely didn’t feel like he ‘needed’ to act because equity markets or some of his holdings had fallen. Keep this in mind next time the market drops 5% and you’re bombarded with pictures of Buffett and quotes of his, such as “buy when there’s blood in the streets” and “when it’s raining gold bring a bucket, not a thimble”.
As we’ve seen today, “buying the dip” for the sake of it isn’t very Buffett-like at all.
