Investing

High Yield Investing: Bend It Like Buffett

Co-produced with Trapping Value

It is easy to pass judgement with perfect 20:20 hindsight. We saw that in the recent extreme market volatility as everyone had pangs of selling too soon or buying too early. We also saw a lot of flak being dished out at the greatest investor of all time, Warren Buffett. He was “coached” by investors as he booked losses on Airlines.

Buffett confirmed that he had sold all of his stakes in the four largest U.S. airlines: His positions in United (UAL), American (AAL) , Southwest (LUV) and Delta Air Lines (DAL) were cumulatively worth north of $4 billion.

“The world has changed for airlines,” Buffett said, noting that the industry has been “really hurt by a forced shutdown” due to the coronavirus.

Buffett said Berkshire originally invested between $7 billion and $8 billion for large stakes in the major airlines, but the company didn’t get anywhere near that in return for its investment.

“It turned out I was wrong,” the Oracle of Omaha said, adding that he’d made an “understandable mistake” given the unforeseen downturn in the industry. I don’t know that three, four years from now people will fly as many passenger miles as they did last year,” Buffett warned. “You’ve got too many planes.”

Source: Forbes

While the sale itself was unremarkable, Buffett caught heat as the same airline stocks rebounded strongly. He may have sold out close to the bottom in airline stocks, and the non-stop rise since then has had many calling the legendary investor as being past his prime. Some have also embraced day trading and decided that the minute-by-minute action is the easiest way to beat Buffett at this game.

Source: Marketwatch

Buffett’s defensiveness and his indicator

While the day traders might be having an early laugh at his expense, the legend continues to play defense today and has built up a fortress balance sheet. Berkshire Hathaway (BRK.A) (BRK.B) has amassed over $137.3 billion of cash on its balance sheet and Warren seems in no hurry to deploy that amount. His caution seems to fly (pun intended) in the face of the euphoria felt everywhere. He did not even show a modicum of desire to chase stocks at the March bottom. So what is bugging him today? Well, we cannot speak to the exact state of his mind but we are certain that one thing that he is pondering about is his indicator.

The Buffett Indicator

Yes, there is actually a Buffett Indicator and it looks at the equity market capitalization relative to the country’s GDP.

One of those measures, in particular, has popped up on investor radars lately, and that’s the “Buffett indicator.” The Berkshire boss called it “the best single measure of where valuations stand at any given moment.” If historical patterns hold true, a thrashing could be in store for complacent investors.

Put simply, the indicator is the total market cap of all U.S. stocks relative to the country’s GDP. When it’s in the 70% to 80% range, it’s time to throw cash at the market. When it moves well above 100%, it’s time to lean toward risk-off.

Source: Market Watch

That snippet was from 2018. Today the indicator stands at a jaw-dropping 156.3%.

Source: Advisor Perspectives

Even more impressively, if current stock prices hold and we use actual Q2-GDP numbers, this ratio will be sailing well into 180%-190% range. GDP is expected to rebound in the third and fourth quarters, but it will be some time before the Q1-2020 rolling four-quarter GDP will be exceeded. Even at 156%, forward stock market returns do not appear exceptionally promising. Looking at an older study from 2017, we can see that Market Cap/GDP ratios in the vicinity of this have produced negative 4% annualized returns over the next decade.

Source: Munknee

One positive point to note in today’s market is that interest rates were not as low as they are today, so returns should be better going forward. However, whether the indexes’ returns over the next few years are flat a negative 4%, or slightly positive, the average returns of +15% that we saw in the past few years are unlikely to repeat themselves. Things look rather murky for investors. Berkshire may not exactly be wrong in being defensive here. So what is an investor to do? Accept the horrible low returns as being a given part of the hand dealt to him or her?

Learn from the best

In soccer, few players have been able to bend and curve the ball better than David Beckham and in finance, few have been able to bend the return curve like Warren Buffett. One way that Warren Buffett has been trying to leverage better deals is by trying and aiming for the sweet spot on the return curve, without exposing himself to the problems of overvalued stocks.

For example, in 2008-2009, Warren Buffett was unsure of the safety of Goldman Sachs (NYSE:GS) common shares and made a very big capital infusion via preferred shares. Berkshire made $3.7 billion, of which $1.27 billion was dividends on a $5 billion investment. When Buffett made the original investment, he also received warrants to buy $5 billion of common shares at $115 a share. In 2013, Buffett exercised the warrants, receiving $2 billion in cash and 13.1 million shares of Goldman Sachs stock.

Buffett recently helped out Occidental Petroleum (OXY), again via a preferred share bet. The $10 billion invested pays a high dividend but also comes with call options on the common shares. Granted, that the pandemic has taken the shine off the call options today, but the preferred shares pay a very hefty dividend and should provide good income to Berkshire.

Can You Bend It Like Buffett?

While the sweet deals offered to the legend may not be easily available to you, you can take advantage of the market turmoil in a more nimble manner. During the recent meltdown in March 2020, several sound preferred shares traded at massive discounts to liquidation value. The yield on market price in many cases was over 15%. Case in point, Global Net Lease preferred shares (GNL.PA) traded with a 15% yield on March 18.

Source: Seeking Alpha

The preferred shares are such a small part of the capital structure for Global Net Lease (GNL) and with predominantly non-recourse mortgages financing the properties, the chances of an investor losing money on the preferred shares are slim. More importantly, locking in a high dividend yield on the preferred shares allows investors to bypass the risks that are currently inherent in the common shares of the broad indices. The preferred shares of GNL, GNL-A (GNL.PA) and GNL-B (GNL.PB) currently yield about 7.3% and are very attractive at the current price.

Preferred shares have also outperformed the indices in each of the last three recessions (1991, 2001 and 2008) though the jury is out on this one. In the 2001 recession, they actually did spectacularly well. With current inflated values on equities alongside low returns from Treasuries and corporate bonds, we believe preferred shares may make the most sense for investors wanting a better risk-adjusted return.

Conclusion

Buffett’s caution is certainly justified with his own indicator implying rather poor returns. While that indicator by itself is not the final authority on forward returns (see here for its flaws), many other indicators support the idea that the 2009-2019 type returns are extremely unlikely from this point. But select preferred shares are offering investors a low-risk, modest-return chance that we believe should be embraced here. There are other areas too that offer better returns than the broad indices, including defensive (non-cyclical) high-yield stock, and Property REITs. With a view that capital gains going forward are likely to be limited, investors are best served by allocating funds to quality dividend stocks with a strong cash flow.

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Disclosure: I am/we are long GNL.PA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article was originally published on Seeking Alpha

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