We start this week with two quick follow-ups to previous Beach Readings.
A client asked us to elaborate on how one would use the Leading Economic Index (LEI), which we discussed last week, in trying to predict a recession. Below is a different version of the LEI chart which I pulled directly from The Conference Board’s website this week. The LEI is in blue, which was the only index featured in last week’s chart, alongside the Coincident Economic Index (CEI) in red and recessions highlighted in the gray shaded areas.
As you can see, the CEI tends to flatline and then turn down concurrently with the onset of a recession which, in isolation, is not a particularly useful indicator. But when the LEI (which gives plenty of fair warning) is declining precipitously through a “topping” or flatlining CEI, history would suggest the odds of a recession in the near future are high. In other words, tracking the relationship between leading and coincident indicators is likely the most reliable predictor of economic downturns. Together, these indicators are still reflecting positive economic growth but we will stay tuned and follow up as future data is released.
From there we move to one last follow up chart from Beach Reading three weeks ago. We mentioned then that Berkshire Hathaway is “close to the valuation level (~1.2x book value) at which Buffett has said that he would buy back almost limitless amounts of Berkshire stock which should support the share price going forward.” Someone asked what book value was and why it is important in the context of this investment.
In short, book value is the net worth of a company. And while Berkshire is moving away from book value as the main methodology for valuing the company (explaining why would require far more digital ink so we’ll leave that for another day!) it's still a decent metric for tracking what you’re getting vs. what you’re paying for it. We think Berkshire’s intrinsic value is likely between 1.5x and 2x book value. Below is a snapshot of Berkshire’s 5 year historical Price to Book ratio taken on Tuesday of this week.
You can see from the chart above that the stock tends to trade at a decent premium to book value. In the last five years the valuation has ranged between just under 1.2x book value to over 1.55x book value. Keep in mind this isn’t a price chart, but rather a valuation chart. So even though the stock is up substantially over the last five years, at ~1.28x book value it’s actually one of the most opportune times to own the stock in the last half-decade from a valuation perspective. Good news for shareholders!
We finish this week by diving into the wild world of corporate credit with a WSJ article entitled “Deere Sells 30-Year Corporate Bonds at Record Low Yields.”
John Deere just borrowed money for 30 years at 2.877% interest per year, a record low yield. It’s yet another example of how low bond yields are and how desperate some investors are for what they perceive as safe income. Disney, Apple and others are following suit by borrowing money they have no real need for simply because they can at such low rates. From their perspective, this makes perfect sense; borrow cheaply and invest in the future (or buy back stock). It’s also unequivocally positive for American businesses that such cheap long term funding is available to them in public markets.
But from the creditor’s perspective, we can’t see the logic in loaning money out (even to great companies who will almost certainly repay the debts) at levels barely above today’s already low inflation rates. Keep in mind that the 30 year Treasury, which is backed by the U.S. Government (which can print infinite amounts of money) yielded MORE than 2.9% as recently as May of this year! And while the 30 year Treasury yield dropped below 2% recently, who’s to say yields will always (or at least for the next few decades) be this low?
This may be a bold prediction, but at some point in the next 30 years, the folks lending to a company (that cannot print their own money) at 2.877% may wish they’d passed on that offer. If the 30 year Treasury yield merely returns to its May 2019 levels, these John Deere bondholders will be sitting on substantial face value losses. The best-case scenario is making less than 3% and the worst case is losing substantially more than that. The risk/reward seems highly skewed towards the risk side of the equation from our perspective. For this reason, we continue to eschew new investment-grade bond purchases in most cases.