A Q1 Letter to Clients: Why Warren Buffett is Bullish on Stocks

Two things worth noting about first quarter performance:

1. Driven by a strong start in January, the US stock market was up over 10% in the first quarter, leading a rise in equities globally. One word of caution: Last year the market was up by 13% in the first three months before giving back almost all of those gains in the second quarter, in large measure due to concerns about Europe.
2. On the topic of Europe, in spite of recent headlines about the bank crisis in Cyprus and continuing issues in Greece, the European market was up by 7% (in local currency) in the first three months of 2013. While Cyprus and Greece got the headlines, the large bulk of Europe’s economic performance will continue to be driven by the larger countries.

Here’s how first quarter performance looked:

Returns to month end, all in local currency, including dividends

Warren Buffett’s view: Stocks still offer value

Warren Buffett is generally considered the greatest investor of all time. In the 47 years from when he began running Berkshire Hathaway in 1966 to the end of 2012, the overall U.S. stock market (including dividends) has returned an average of 9.4% annually. That means that $1,000 invested in the US market in 1966 was worth just over $74,000 at the end of 2012. During that same time, the book value of Berkshire Hathaway increased by almost 20% per year, twice the U.S. market. The result : That same $1,000 invested in Berkshire Hathaway’s book value would have grown to over $5 million.

That’s why Warren Buffett’s advice is worth heeding. And that’s also why his annual letter to investors is awaited each year with such anticipation. Some of the key messages in this year’s letter:

1. Invest in “wonderful” businesses

   Buffett is known for saying that he’d rather buy “a wonderful business at a fair price than a fair business at a wonderful price.” He’s written in depth about the competitive insulation that makes for a great business. (In another well-known turn of phrase, he’s said that he wants to buy businesses “so wonderful that an idiot could run them, because some day an idiot will.”

   In this year’s letter, Buffett touched on Berkshire Hathaway’s investment in the “big four” of American Express (of which he owns just under 14%), Coca-Cola, IBM and Wells Fargo, in which he has holdings of between 6% and 9%. In all four cases, he increased his stake in 2012; he quotes the Mae West line that “too much of a good thing is wonderful.”

1. Look past today’s uncertainty

   Buffett addressed the uncertainty that preoccupies many members of the media and which has dampened the willingness of American business to invest. He pointed out that uncertainty has been a constant in the United States since 1776; the only variable is whether people ignore the uncertainty (which typically happens in boom times) or fixate on it.

   Buffett expressed confidence in the resiliency of American business, just as he did in his famous New York Times article in the fall of 2008 titled “ Buy American I Am”; that appeared close to the throes of the uncertainty in the aftermath of the global financial crisis.

2. Stay in the game

   In this year’s letter, Buffett addressed the temptation to, in his words “ try to dance in and out (of the stock market) based upon the turn of tarot cards, the prediction of so-called experts or the ebb and flow of business activity.”

   He went on to say that since the long-term outcome of investing in stocks is so overwhelmingly favorable “ the risks of being out of the game are huge compared to the risks of being in it.”

In an interview that followed the release of his letter, Buffett reiterated his view that given that at some point interest rates will inevitably rise, stocks of quality businesses continue to offer good value relative to bonds, even in the face of the run-up in equity prices since last summer. He also repeated his skepticism about owning bonds, saying that today “ the dumbest investment is a government bond. ”

Click here to read Warren Buffett’s letter to investors.

And click here to watch a nine-minute excerpt of the television interview that followed the release of his letter.

What this means for your portfolio

In my email at the end of last year, I outlined some guiding principles in my approach to building client portfolios, three of which I repeat here. I’d be pleased to discuss these guidelines at our next meeting.

1. Time to rebalance: Adhering to your plan

   In light of stock valuations and the risk in bonds, early last year we recommended that clients increase equity weights to the upper end of their range. Given strong stock performance since the mid-point of last year, that has worked out well and we continue to advise that clients hold their maximum equity weight.

   But strong performance by stocks means that some clients are above the top of their equity allocation. In those cases, we have been recommending reducing equity weighting to bring portfolios back within their guidelines. Regardless of what happens to markets in the short term, barring a significant change in your circumstances, you should stick to your investment parameters.

2. Diversifying portfolios

   When building equity portfolios, I’ve always advocated broad diversification outside the United States. This helped my clients through most of the decade after 2000.

   Going forward, I have no idea whether the U.S. market will do better or worse than global markets, but I do know that we represent fewer than half of investing opportunities around the world. The rapid economic growth in markets like China, India and Brazil is creating opportunities. For those reasons, I continue to recommend geographic diversification of stock portfolios.

3. Focus on dividends and cash flow

   The final principle relates to the role of cash flow from investments. Amid the uncertainty surrounding economic growth and equity returns, I continue to place priority on the cash yield from investments. While the headlines talked about US markets hitting new highs in March, investors who reinvested their dividends saw their account values exceed the 2007 peak significantly earlier.

   Dividends on stocks in selective sectors continue to make these stocks attractive. When it comes to equities, we do have to be increasingly discerning, however. In some traditional high-dividend sectors, stocks that pay steady income are expensive by historical standards and show signs of stretched valuations.

I hope you found this overview helpful. Should you have questions about anything in this note or about any other issue, please feel free to give me or one of the members of my team a call.

And as always, thank you for the opportunity to serve as your financial advisor.

conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written and video commentaries, go to www.clientinsights.ca. Use A555A for the rep and dealer code to register for website access.

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