May 2017
MARKET UPDATE
Woodstock for Capitalists 2017
“Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by
shooting Orville down.” — Warren Buffett writing about airlines in the 2007 letter to shareholders
On Saturday, May 6, 2017, Berkshire Hathaway held
its annual shareholders’ meeting in Omaha,
Nebraska.
Chairman and Chief Executive Officer Warren
Buffett and Vice Chairman Charlie Munger spoke to
a full house of about 40,000 attendees, despite the
meeting being broadcast over the web. They
answered questions from about 9:30 A.M. to 3:30
P.M. PNC Global Chief Investment Strategist Bill
Stone was again among those in attendance. In the
following paragraphs, he reflects on some of what
he believes are the major takeaways from the
meeting.
As usual the meeting started at 8:30 with a
Berkshire Hathaway movie. It was mostly a “best of”
compilation but had a number of clips from HBO’s
Becoming Warren Buffett documentary. As an aside,
I highly recommend the documentary even for those
not as interested in investing as I am, since it
spends significant time on the personal side of Mr.
Buffett.
In my recollection, this was the first meeting since
the financial crisis where there wasn’t a single
question about the economy or fear of recession.
Perhaps we have finally escaped the feeling of
impending doom around every corner.
Politics/Tax Reform
Mr. Buffett spoke about the possibility of a lower
corporate tax rate. For that reason, he said,
Berkshire Hathaway may look to realize more
unrealized losses in its securities portfolio in order
to capture the greater value of those losses under a
higher tax rate this year.
Another question dealt with who would benefit from
a lower corporate tax rate, with Mr. Buffett noting
that in many businesses the benefits will be split
between clients and shareholders. In Berkshire
Hathaway’s utilities business, the lower tax rates
would benefit the customers since Berkshire’s
returns are regulated. The lower tax on unrealized
gains on securities, which total about $90 billion,
would accrue to shareholders.
Technology
Mr. Buffett and Mr. Munger have historically
avoided investments in technology companies and
stated the area was typically outside of their circle
of competence. In some respects, that changed in
2011 when Berkshire started acquiring shares of
International Business Machines Corporation (IBM)
and eventually became IBM’s largest shareholder.
Recently Mr. Buffett disclosed that Berkshire sold
about one-third of its holdings in IBM. He admitted
at the meeting that he “thought IBM would do
better” and that he “could be making two mistakes
on IBM.” This does seem to indicate to us that he
intends to exit the whole position at some point.
The discussion then turned to Berkshire’s other
large technology holding, Apple Inc. (AAPL). Mr.
Buffett noted his belief that these were really two
different types of decisions and that he looks at
Apple as “more of a consumer products business”
using technology.
Mr. Buffett and Mr. Munger both expressed their
admiration for Amazon.com, Inc. (AMZN) and
Google (Google’s parent company is Alphabet
(GOOGL)). Mr. Munger characterized Amazon.com
Chief Executive Officer Jeff Bezos as “a different
species,” with Mr. Buffett adding that he
“underestimated the brilliance of the execution.”
Mr. Buffett also noted than Amazon.com “always
looked expensive.”
Mr. Munger and Mr. Buffett beat themselves up
more for missing their opportunity to invest in
Google. Mr. Buffett noted that Berkshire Hathaway
Woodstock for Capitalists 2017
was an early client of Google and saw the power of
its platform, but just “blew it.”
3G
One topic that came up much more often than I
expected was 3G Capital. Recall that 3G is
Berkshire’s partner in sharing controlling interest
in The Kraft Heinz Company (KHC) and recently
worked together on KHC’s failed bid for Unilever
N.V. (UN).
3G is well known for driving cost savings, including
the reductions in employee count, in their holdings.
In any case, both Mr. Buffett and Mr. Munger spent
quite a bit of time defending their dealings with 3G.
Here is a sampling of a few of their comments:
 Mr. Buffett’s view was that even though
Berkshire does not prefer to engage in this
type of activity directly, it is “pro-social to
think in terms of improving productivity.”
 He also said that 3G focuses to a “terrific
degree on product innovation and
improvement.”
 Mr. Munger went as far as to state plainly: “I
don’t see any moral fault in 3G.”
Airlines
Given the quote I used to start this piece, there was
much interest in Berkshire Hathaway’s change of
heart regarding airlines. Last November, Berkshire
disclosed stakes in American Airlines Group Inc.
(AAL), United Continental (UAL), Delta Airlines, Inc.
(DAL), and Southwest Airlines Co. (LUV). Generally,
it is unusual for Berkshire Hathaway to focus on a
sector rather than one favored holding.
Mr. Buffett did note that one couldn’t pick a tougher
industry, but he did believe that conditions have
improved. He expects airlines to operate at higher
levels of capacity and to avoid some of the irrational
decisions of the past in terms of adding too much
capacity. He pointed to their “quite high returns on
invested capital” and better labor stability. Mr.
Munger added that “railroads were a terrible
business for decades before they got good.”
Investing
In this section, I’ll summarize some different
investing insights from the duo; as usual there were
some good nuggets of advice:
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Asked what he looked for in an investment,
Mr. Buffett said he focuses on looking out
over 5, 10, or 20 years and deciding if the
company’s “competitive advantage would
survive over that period.” Then he considers
the management and lastly the price.
Mr. Munger stated that China might provide
better investment opportunities than the
United States currently, with Chinese stocks
cheaper. He dubbed it a “happier hunting
ground.”
Mr. Buffett noted that the “world has
changed” and companies can now be run
and “huge amounts of market capitalization”
created with very little real tangible assets
(think Google), while the old model required
a large amount of assets (think railroads).
Mr. Buffett said he would likely have “no
utilities” if he was “putting together a
portfolio of stocks now.”
Both Mr. Munger and Mr. Buffett cautioned
against the use of earnings before interest,
depreciation, taxes, and amortization
(EBITDA) when calculating valuations
because depreciation is an expense—and “it
is the worst kind of expense.” Mr. Buffett
said use of the term in valuations was a
“mass delusion to the benefit of Wall
Street.”
When asked about two formulas (market
capitalization to GDP and cyclically adjusted
price-to-earnings ratio), Mr. Buffett said
there is “no simple formula” to determine if
the market is overvalued. He pointed to the
“ultimate formula,” which is discounting the
cash flows to present value, but noted that
knowing what to put into the variables
becomes challenging. He ended with his
view that the most important variable is
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Woodstock for Capitalists 2017
future interest rates. For those not familiar with
discounting cash flows, the lower the interest
rate used, the higher the present value.
Buffett’s comments are consistent with our past
observations that using traditional valuation
metrics relative to history without adjusting for
interest rates is folly.
Other investment ideas can be found in Mr. Buffett’s
recent annual letter (available in its entirety on
www.berkshirehathaway.com).
PNC Investment Strategy
Recommendation
We believe that stocks provide an attractive risk
versus reward for investors with a sufficient
investment holding period and ability to withstand
volatility or the occasional financial mayhem. We
expect the relative performance of stocks to bonds
and cash should remain attractive when viewed
over a reasonable investment period. As we have
noted previously, and we’re confident Mr. Buffett
and Mr. Munger would agree, forecasting the shortterm movement of stocks is a fool’s errand.
Investors should continue to work with their
advisors to select a suitable asset allocation to
provide an appropriate level of assets and cash flow
to help ride out any volatility in the financial
markets while balancing the need to retain and
grow real purchasing power over time to reach
financial goals.
Bill Stone, CFA®, CMT
Global Chief Investment Strategist
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