Raymond James' Jeffrey D. Saut: Warren Buffett's 'Mr. Market'

The following is an investment strategy column by Jeffrey D. Saut, managing director at Raymond James & Associates Inc.

“Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkable accommodating fellow named Mr. Market who is your partner in private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: he doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you. But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up someday in a particularly foolish mood, you are free to either ignore him or take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, 'If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy.'”

. . . Warren Buffett

We revisit Warren Buffet's “Mr. Market” quip this morning because of a few emails I received regarding last week's missive. My emailers were upset with the reference to Berkshire Hathaway's stock performance. To wit:

“Since 1965 the S&P 500's compounded annual gain (including dividends) was ~9.3% for a compounded return of 5,430%. Over that same timeframe Berkshire's annual compounded return was 20.3%, or 434,057%. Consistency was the key to Berkshire's outperformance for over those 44 years the S&P 500 suffered 11 down years, six of which were double-digit declines. Berkshire, however, had only two negative years, neither of which were double-digits. Such risk-adjusted investing has always characterized Warren Buffet for he maintains it isn't his best ideas that gave him his tremendous track record. It was having a smaller number of bad ideas that resulted in a permanent loss of capital.”

Obviously, Warren Buffet doesn't measure himself according to fluctuations in Berkshire's share price. Importantly, he measures himself by growth in book value, which is admittedly less volatile than share price. To be sure, Mr. Market is manic-depressive. “At times he feels euphoric and can see only the favorable factors affecting the business. At other times he is depressed and can see nothing but trouble ahead for both the business and the world.” That manic-depression surfaced in 2008 when Berkshire's shares lost an eye-popping 50% of their value. However, Berkshire's book value declined by a mere 9.6%. Still, that stock price performance brought about catcalls that the “old man” (read: Warren Buffet) had lost his touch. We recall similar cries in the late 1990s when Mr. Buffet was cast as a buffoon, who just didn't “get it,” because he was hoarding cash and shunning Internet stocks. Subsequently, the S&P 500 peaked in the spring of 2000 (@1553) and over the next seven years only gained ~0.008% (to 1565). Meanwhile, the “buffoon” grew his book value by nearly 80% and Berkshire's share price improved by 268%. As Benjamin Graham noted, “In the short run the stock market is a voting machine, but in the long run it is a weighing machine.” Ladies and gentlemen, over the long-term, the fate of every stock is ultimately driven by the operating results of the underlying business. This is determined by BOOK VALUE, EARNINGS, and CASH FLOWS. Accordingly, measuring Berkshire's performance on those metrics makes more sense than measuring on its share price. As the insightful Puru Saxena's writes:

“Over the past 140 years, the return from American stocks has almost mirrored the growth in corporate earnings. During times of high volatility and great economic uncertainty, it pays to remember that stocks represent partial stakes in operating businesses. Therefore, as long as the businesses you own are producing satisfactory results, it is best to ignore the market's temporary appraisal of your holdings. It is worth noting that during secular bull-markets, stocks outperform bonds and cash. Conversely, during secular bear-markets, they produce disappointing returns (like they did in 2008). Fortunately, secular bear-markets do not happen very often and they are always followed by lengthy and powerful bull-markets.”

And that, folks, is the real question. Are we in a new secular bull market, or just a tactical rally within a trading range stock market that we have envisioned since the Dow Theory “sell signal” of September 1999? Regrettably, while we would like to believe it is a new secular “bull market,” we are sticking with the strategy that it is a tactical rally within an ongoing “range bound” stock market. If we are wrong, our accounts should experience good returns. If we are right, said accounts should still achieve decent total returns, on a risk-adjusted basis, given our emphasis on dividend paying stocks. Speaking of dividends, the iShares Trust DJ Select Dividend Index Fund (DVY/$45.36) broke out to a new recovery high last week, as can be seen in the nearby chart. We like dividends and would note that since 1926 dividends have accounted for roughly 44% of the stock market's total return. Dividends also tend to give investors the “margin of safety” Benjamin Graham spoke of in the last chapter of his book “The Intelligent Investor.” This week a number of stocks in Raymond James' universe of stocks will go exdividend. Some of the names we have recommended include: Home Depot (HD); NTELOS (NTLS); Allstate (ALL); Leggett & Platt (LEG); and Family Dollar (FDO). Meanwhile, CenturyTel (CTL) went ex-dividend last Friday and its share price was reduced accordingly. We think that reduction affords an attractive entry point. We also continue to think small capitalization Japanese stocks are in aggregate one of the world's cheapest investments. Selling below book value, and at a price-to-sales ratio of 0.40, we believe the risk/reward ratio is attractive. Hereto, we favor dividends and are using Wisdomtree's Japan Small Cap Dividend Fund (DFJ/$40.73). The call for this week. One year ago we stated that the bottoming process that began in October 2008 was complete and we were “all in.” We won't have that same opportunity this year for we're at the Raymond James 31st Annual Institutional Investors Conference with more than 300 presenting companies and some 700 portfolio managers. Consequently, these will likely be the only strategy comments for the week. Nevertheless, it still appears that the new year's “selling stampede” ended with the “hammer lows” recorded on February 4th and 5th, and, we tilted accounts accordingly. Meanwhile, March, April, and May are seasonally the strongest months of the year for the S&P 500 (SPX/1138.70). Combine that with the fact that the breadth figures have been stronger than the SPX's actual price rise, and that positive 4Q09 earnings and revenue surprises have exceeded 70%, and we see no reason to alter our 1200 – 1250 intermediate-term price target. That said, the SPX has expended a lot of energy, rallying rally back to the 1140 – 1150 overhead resistance zone, so it would not surprise us to see the markets stall for awhile before trending higher. As for the recent spate of softening economic reports, it feels like consumers are merely reacting to a winter that is now legend. Our sense is the stormy February data will abate with Spring. Evidently Warren Buffet thinks so as well given his recent statement, “We got past Pearl Harbor (and) we will win the war. It's going slightly our way.” For more investment strategies by Mr. Saut, go to RaymondJames.com/inv_strat.htm.