The Key Insight from Warren Buffett’s Shareholder Letter

While it could have been worse, February was a rough month for the TSP. The C Fund went down 3.6%, the S Fund went down 3.7%, the I Fund went down a solid 5%, and the F Fund went down almost 1%. The G Fund rose a fraction of a percent. As for where that leaves TSP investors, it could be worth checking in on what Warren Buffet is doing: building up his cash position.

Warren Buffett’s Take on the Market

Each February, multi-billionaire investor Warren Buffett releases a shareholder letter for investors of his company about the results of the preceding year, and it’s one of the most widely-read financial documents when it comes out.

From 1965 to 2017, Warren Buffett generated a 19.1% annualized return for investors of his company Berkshire Hathaway, compared to the 9.9% annualized return of the S&P 500 with dividends included. More specifically, the book value of each share increased from $19 to $211,750 during that period.

So, when he shares insights about the market and what his strategy is, it’s worth a read.

The biggest news item from this letter, unsurprisingly, is that Warren Buffett is having trouble finding undervalued investments to buy. His company invests in stocks and bonds, but because it’s so huge, he primarily grows now by buying entire companies. And this is what he had to say about why he didn’t make many major purchases in 2017:

“In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.

That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”

In other words, the market in general is highly-valued.

Over the last several years, Warren Buffett’s company Berkshire Hathaway has been building up its cash position, which now stands at $116 billion:

Source: Bloomberg

Back in 2008 and 2009 when financial markets were falling apart and the S&P 500 was at its low point, Warren Buffett was investing tremendous sums and going on a buying spree, and bailed out Bank of America and Goldman Sachs, which all ended up being incredibly profitable. But as the market recovered and began to get highly valued, Buffett started being more selective with his investments and building up a cash position.

In early 2016, the S&P 500 had a correction and hit a relative low point, which is when Buffett’s cash position dipped because he took advantage of the situation and bought cheap stocks.

In 2017, valuations marched strongly upward, and Buffett mostly focused on building up his cash position for the next time stocks and companies get cheap.

This is of course the exact opposite of what most investors do. They invest more heavily in stocks when stocks are highly-valued (the worst time to buy) and pull away from stocks and stick to cash during periods where stocks are cheap (the best time to buy).

Here is a chart showing cash allocations for the American Association of Individual Investors (AAII):

Source: Chart by The Lyons Share, using data from AAII

As the chart shows, individual investors tend to hoard cash (and thus reduce stock exposure) during market lows, and then reduce their cash during market highs because they’re buying stock.

In fact, members of the AAII report that they have a larger percentage of their portfolios allocated to stocks than any other time in the past 17 years, at 72%. Not since the peak of the Dotcom Bubble have they been so stock-heavy and so cash-light.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.