In stock markets, the slow softening of equities continues amid buoyant inflation. In this post, we’ll briefly discuss China's economic recovery and then take a look at the latest inflation data for Europe. Finally, I’ll share a few words of wisdom from Buffett's recent investor letter.
To start things off, here's a great graph from Macrobond, which sums up well the Fed's dilemma in the economy. The graph shows what different parts of the economy, such as financial conditions, consumer credit or industry, say about its health. While the inverted yield curve and the OECD's leading indicators scream red, financial conditions, consumer credit and employment are in favor of a strong economy. So much for trying to figure out the direction of the economy and when the interest rate hikes will go overboard.
China's economy bounces back from the COVID hole
The Chinese economy is bouncing back from the COVID hole more strongly than expected, according to the latest official purchasing managers' data. The opening up of the economy is also spilling over into the economies of neighboring countries such as Thailand and Vietnam. Both manufacturing and non-manufacturing indices showed an economic recovery in February compared with January.
The private Caixing PMI, which focuses on smaller companies, also showed a pick-up in the economy.
The world dry bulk index, oddly named the Baltic Dry Index, has also been sailing strongly upwards, supporting expectations of a pick-up in Chinese exports.
At the beginning of the year, for example, I presented Goldman Sachs' consensus expectations for a sharper economic comeback in China, once the sudden opening is behind us. China's economy is expected to grow by more than 5% this year, but the long-term growth picture is clouded by deteriorating demographics in the form of an aging population. At the same time, digesting the country's real estate bubble is a big question mark and the deepening back-and-forth with the US isn’t really encouraging in the longer term. However, the real estate sector showed small signs of life as property developers saw positive annual growth for the first time in a year and a half.
Eurozone inflation accelerates
There has been less encouraging inflation data from the eurozone throughout the week. Preliminary inflation figures for February in France, Spain and Germany all came in above expectations. The same story continued in eurozone inflation data published today.
Harmonized inflation jumped to an annual rate of 9.3% in Germany and accelerated in the other two. Inflation has become a persistent guest in the economy, a headache for the ECB and others.
The interest rate on the German ten-year bond has already risen to 2.7%. This is certainly an odd situation for equities. In principle, as the risk-free rate rises, the expected return on equities should increase if nothing else changes. If the risk premium for equities, i.e., the required additional return on top of the risk-free interest rate, is 7.5% (PWC's estimate for Finnish equities), the required return for the stock market as a whole would now be around 10%. That means that an average company that isn’t growing, or its growth isn’t creating value, would have a P/E ratio of around 10. If interest rates were zero and the risk premium the same, the corresponding P/E for a static firm would be around 13.3x. With this simple illustration, I just want to make the point that rising interest rates should lower the valuation of companies, unless earnings growth accelerates accordingly, which it doesn't seem to do.
This somewhat confusing but not messy graph shows the forward-looking P/E ratio of Nasdaq Helsinki and, on an inverted scale, the German 10-year bond rate. This shows quite clearly how the stock market's valuation crashed at the same time as the 10-year interest rate rose sharply, i.e., fell in the graph. In recent weeks, equity valuations have recovered slightly further, despite the deterioration in the interest rate and inflation picture. Of course, with a better-than-expected economy, earnings growth may look more certain, justifying the increased valuation. And yes, the current P/E ratio of just under 14 is modest compared to the pre-pandemic level of around 16, but then interest rates were low. If the strong inflation doesn’t subside, I wouldn’t be surprised to see a headwind for the average stock valuation in the future.
Words of wisdom from Warren Buffett
Last Saturday, Warren Buffett, the world's most successful investor in absolute terms, published his annual investor letter. During his 58 years as CEO so far, Berkshire's stock has returned around 20% per year, or a total of 3,800,000%. During the same period, the S&P 500 index has returned 9.9% per year with dividends reinvested, i.e., “only” 25,000%. So in practice, one dollar given to Buffett in 1964 would be 38,000 dollars today, whereas invested in the S&P 500 it would only be 240 dollars.
The 92-year-old Buffett's letters have become shorter in recent years and contain fewer and fewer new perspectives. Understandably, after almost a century of investing, perhaps not many new insights can be gleaned. Yet, there is always a timeless wisdom and experience that I want to share with you, my esteemed reader.
While in many sectors skills become obsolete and irrelevant, in investing they tend to accumulate.
Basic fundamentals, such as the need for a company to generate cash flow or not to overpay for shares, don’t change, even though the world, technology and the business environment are constantly changing. And the psychology of the investor, the interplay of greed and fear, will not change either.
And those old guys really know how to keep up with the times. Warren Buffett's bromance Charlie Munger lured Berkshire to what is now the world's largest electric car company in 2008, China's BYD. Berkshire's initial investment of $230 million rose to $10 billion at best.
Buffett points out that Berkshire's excellent performance over the years is based on a dozen really good investment decisions.
Note: Berkshire essentially buys companies into 100% ownership where they continue as autonomous entities, although there is more media hype about Buffett's equity investments, such as Apple. In Berkshire, the different companies operate independently, but the allocation of capital is mainly concentrated in Buffett's own hands. As long as money flows to the headquarters, the parent company doesn’t interfere in the work of the daughters. So, the Berkshire model is very well decentralized, putting this buzzword into good use.
This observation by Buffett is interesting: Berkshire has made thousands of different investments over the decades, but a few crucial super successful bets such as the 20-fold billion-dollar investments in Coca-Cola and American Express have ultimately made the difference. Over the decades, holding these winners in your portfolio cancels out the effects of numerous mediocre or bad investments.
According to Buffett himself, he isn't a stock picker, he just invests in business. He has said in the past that he is a better entrepreneur because he is also an investor, and he is a better investor because he is also an entrepreneur. Berkshire is a passive shareholder in listed companies such as Bank of America, Apple, and Coca-Cola, which it doesn’t fully own. I think many retail investors would benefit from a similar attitude of not buying just stonks but businesses, even if the sums were smaller. There would be less useless hustling and speculation.
Buffett writes that in a competitive economic system, few companies can create an extraordinary amount of value over a long period of time. Most companies eventually fall into irrelevance, and even among the many companies currently owned by Berkshire, few are exceptionally good. But over time, the cumulative returns of those rare few have driven home the big profits. This observation has influenced my investing activity a lot. Of course, I always try to find the needle in the haystack, the next ten-bagger, but in practice I accept the fact that eventually portfolio returns are likely to be driven by one or a few successes and the rest of the investments are nothing much to write home about. As long as you don't concentrate the portfolio in rotten eggs and keep diversification in mind.
The main recipe for success is time. Not the timing, but the time on the market. The longer you can hang around in the stock market, the more tangible the end result will be. Patience and discipline will eventually pay off handsomely, of which Warren Buffett is a prime example.
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