Understanding Reversion to the Mean: Revisiting Buffett’s 1999 Fortune Article

In 1999, Warren Buffett gave a rare explanation of why he felt the stock market would generate poor returns for investors over the long haul.[1] He used simple arithmetic to show that elevated valuations and profit margins made equities vulnerable. The piece was 9 pages, over 4,000 words long, and had a single exhibit.

In an age of factually light 200-character Twitter “tribalism”, we are not surprised the work has faded from investors’ frontal lobes. The piece is also not conducive to frenetic IPOs, SPACs, and other recently popular activities. Having read the piece when it was published, the concept has survived in KCR’s collective memory due to its elegant simplicity and incontrovertible arithmetic truths.

Mr. Buffett explains that over the long-term, there are five principal drivers of returns. They are:

  • profit margins: subject to competition and policy, they cannot rise forever
  • interest rates: the “gravity” of valuation, we are coming off the zero bound
  • starting valuation: current valuations are now above the peak of the dot.com bubble
  • ending valuation: to each their own, influenced by sentiment and rates
  • the growth rate of GDP: aggregate economic activity is the source of long-run equity returns

Knowing where you are at any given moment can be of immense service in sizing risk appetites.

Warren Buffett’s Warning was Not a Forecast

Buffett’s missive was not a forecast. He was clear that market prices can decouple from value for long stretches. At the same time, he was equally clear that, eventually, valuation matters. The article starts off by defining investing as the act of “…laying out money now to get more money back in the future-more money in real terms, after taking inflation into account.”

Over the years, some KCR subscribers have taken umbrage at our frequent use of Buffett’s market cap to GDP chart. The objections usually come from…. interest rates and margins. So this piece will focus on past and present margins using Mr. Buffett’s 1999 article as the cornerstone from which we work.

We believe changing profit margins are one of the most interesting aspects of the simple algebra that underpins market returns. Over the long-term, the market’s valuation must be connected to the growth in the real economy (GDP). While most people are comfortable estimating 2%-5% GDP growth, margins are, in many ways, the great unknown.

History is clear that margins are subject to various economic cycles and mean reversion. Margins possess a sort of analytical aphrodisiac during boom times and can foment the irrational euphoria that characterizes market peaks. Contrarily, margins can also add to the “hangover” after such periods, amplifying negative sentiment.

KCR has read a great deal of precision work around the recent boom in margins, its sources, and possible persistence or lack thereof. While always interesting, we believe the specificity frequently professes a level of certainty outside our comfort zone.

This piece is designed to put today’s market valuations and margins in historical context. We believe forecasting the future is futile, but tremendous insights can be drawn by studying the past. In the spirit of that belief, our review of Mr. Buffett’s views in 1999 will hopefully highlight one of the most significant structural risks to investors today.

Our concerns should not be confused with a forecast. At the end of the paper, we explain a tool we offer to subscribers. You can input your own assumptions around margins, growth, valuations, and interest rates to see what 10-year returns various assumptions generate using Mr. Buffett’s arithmetic.

With that, we will dive into a brief review of Mr. Buffett’s 1999 missive on profit margins.

YOU ARE NOW READING BASIC MEMBER LEVEL CONTENT

Margins, Interest Rates & Extreme Pessimism:

Buffett explains that in the 17 years between

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[1] Mr. Buffett on the Stock Market, Fortune Magazine 1999, Carol J. Loomis, Warren Buffett

[2] Is America Heading for a Civil War, Edward Luce, May 31, 2022

[3] Recent Revisions to Corporate Profits: What We Know and When We Knew It, Charles P. Himmelberg, James M. Mahoney, April Bang, and Brian Chernoff, March 2004

As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for a simple, concentrated, low turnover, and hard-hitting GARP investing strategy, we would like to talk with you.  Similarly, if you are looking for a model portfolio of the most proven and durable dividend payers that is simple to implement, please let us know.  KCR also offers a wide range of easy-to-use but sophisticated tools like our Equity Duration product, which allows you to estimate a given portfolio’s interest rate and inflation risk. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.

Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.
The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seek independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling, or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as a result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

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July 22, 2022 |

Categories: White Papers

July 22, 2022

Categories: White Papers

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