On April 30, Berkshire Hathaway held its 51st annual shareholder meeting in Omaha, Nebraska. Every year thousands of Berkshire shareholders converge on Omaha to listen to Warren Buffett and Charlie Munger spend several hours answering a wide variety of questions from shareholders, journalists, and stock analysts. Approximately 40,000 individuals attended the meeting this year. It may seem odd to those who are unfamiliar with Berkshire Hathaway that tens of thousands of people would travel to Omaha to hear Berkshire’s 85 year-old-CEO (Buffett) and 92 year-old-Vice Chairman (Munger) answer questions for five and a half hours. However, the duo are widely followed by investors, as Berkshire Hathaway has achieved an absolutely unbelievable long-term performance record. Beginning in 1965 through 2015, Berkshire Hathaway’s stock has increased by approximately 20.8% per year, compounded annually. They are worth listening to!
I had never attended the meeting but was planning on making the trip this year. Unfortunately, due to inclement weather my flight was canceled but I was able to watch the meeting on the internet since it was broadcast live this year for the first time. Although I was disappointed not to be in Omaha, the webcast was great. Buffett and Munger, in addition to their investing prowess, are both known for their wit, wisdom and humility, and they didn’t disappoint.
One of the more interesting questions posed to the pair was about the phenomenon of low and negative interest rates, and if Berkshire paid more for its acquisition of Precision Castparts than it would have if interest rates were higher. The Precision Castparts deal was announced in August of 2015, and Buffett received some criticism at the time that he was paying too high a price. The purchase price of $32 billion represented an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiple of 12 times, which was higher than the 9 times that Buffett paid for his second largest acquisition, Burlington Northern Santa Fe Railway in 2009. In response Buffett said that very cheap money does result in paying a little more for a business and vice-versa. He commented that if rates rise, that will have an enormous impact on asset values. Regarding negative interest rates, Warren said, “This has never happened before. Our advantage is that we know that we don’t understand. If you’re not confused, you haven’t thought about it correctly.”
For me it’s comforting to hear that the world’s greatest investor has a difficult time comprehending negative interest rates, because I don’t understand it either. Unbelievably, according to the Wall Street Journal, there is approximately $9.4 trillion dollars of global debt with negative yields to maturity, which represents nearly a quarter of global fixed income assets. Keep in mind that these bonds actually do have a positive interest rate. It’s just that the current price of the bonds are so high that an investor buying them today would get back less than he or she originally invested, including interest.
Much of this debt is concentrated in Europe, where the European Central Bank (ECB) has set its deposit rate, or the rate paid to banks for storing funds at the ECB, at negative 0.4% to encourage banks to lend money (or purchase sovereign bonds) rather than park it at the central bank. Short-term rates in the U.S., while positive, are microscopic. Facing very low, and in some cases negative, interest rates, investors have been forced into purchasing longer dated bonds that offer prospects for positive returns. For some institutions such as insurance companies and pension funds which must fund very long-term liabilities, purchasing long-term bonds may make sense. However, for most investors, we believe that fixed-rate bonds that don’t mature until far into the future are very risky.
As the length of time until a bond matures increases, the bond’s value becomes much more sensitive to changes in interest rates. The Wall Street Journal recently provided an interesting graphic on its website that calculated the change in price for several different bonds given a change in interest rates. For example, France recently issued a 50-year bond with a coupon rate of 1.75%. That bond is currently priced at $96.98 (relative to a par value of $100) to yield 1.8%. However, if the market interest rate increased by only 1.5%, the price of the bond would fall by 37%. If the market interest rate increased by 3% the price of the bond would fall by 57%. The prospect of risking a loss in excess of 50% in order to earn an interest rate of less than 2% per year on a 50-year bond seems like a bad idea. Why would anyone invest in something with little to no upside but a potentially catastrophic downside? Maybe it’s an appropriate vehicle for a trader who wants to make a bet on short-term changes in interest rates or plans on selling the bond back to the ECB at a higher price, but this is not the game I want to play. I’d settle for earning nothing rather than losing a whole lot.
Like Buffett, I find the current interest rate environment hard to comprehend. I’m sure many investors lament the fact that stock prices for many companies are higher than they’d like to pay. But like Buffett did with Precision Castparts, I’d much prefer investing in a quality business with a decent cash flow yield that will likely grow over time as compared to a long-term, fixed-rate bond, even if that means paying a little bit more because rates are so low.