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Buffett acolyte warns passive investors of mediocre future returns

Everyone knows Warren Buffett.

The guy is 94 years old and has been smashing the market since he was in primary school.

But as he steps down from running Berkshire Hathaway at the end of the year, it’s time to discover and follow some ‘new’ investment legends.

There is one Buffett-style investor you may not have heard of. His name is Christopher Bloomstran.

He runs Semper Augustus Investments Group. If you know your tulip bubble history, you’ll know the relevance of the fund name.

He started the fund back in 1998. He correctly identified the 1999 bubble and avoided it. As a result, his long-term track record is outstanding. Since its inception, the Semper Augustus fund has returned 11.4%, compared to the S&P500’s 8.2%.

That might not sound like much. But as you’ll see below, over time it makes a massive difference.

Each year, Chris writes a letter to clients. It’s no ordinary letter. The 2024 edition is 168 pages. He published it back in February, and I’m still only about halfway through.

But from what I have read, there are a few very important insights worth passing on.

These insights are for genuine long-term investors who understand value.

By that I don’t mean you’re a ‘value investor’. I mean you understand that your future long-term returns are a function of the price you pay.

The higher the price (for a given level of earnings growth) the lower your future return.

In his letter, Chris made this clear in a few different ways.

Peak prices, poor returns

Firstly, he pointed out that in the 25 years since the 1999 secular peak, the S&P500’s annual return was 7.7%. That might not seem too bad. But consider that the S&P500 didn’t break out to new highs until 2013!

The annualised return in the 11 years to 31 December 2024 was 13.1%. Nearly all the returns over the 25 years from the 1999 secular peak came in the last 11 years.

Investing at a cyclical low is much more appealing over the long run. From the August 1982 secular low to the end of 2024, the S&P500 produced compound returns of nearly 20%.

The message is clear: paying high prices for individual investments, or passively via an index, is detrimental to long-term returns.

Chris writes:

We believed stocks were at a secular peak in March 2000, at least in the capitalization-weighted S&P 500 that grew to be dominated by several incredibly overvalued technology, media, telecommunications and dot-com companies. We were correct.

The index spent much of the next 15 years underwater and to this day its returns are way below the long-run return from stocks and way, way below expectations of the day.

At the same time, we also believed in March 2000 that despite the S&P perched at a secular peak, there were a growing number of genuine bargains that would allow an intelligently-invested portfolio to outperform the index over the coming decades. We were also correct.

As mentioned, from inception to 31 December 2024, the Semper Augustus fund compounded at an average 11.4% compared to the S&P500 at 8.2% over the same period. Over a long period of time, those few percentage points make a huge difference to overall returns.

At its inception, a $1 million investment in the Semper Augustus fund turned into $16.4 million, and the same investment in the S&P500 turned into $7.7 million.

The $8.7 million difference boils down to paying a sensible price that will deliver adequate returns. It’s as simple (and difficult) as that.

Chris reflected on the benefit of launching a fund at the height of a bubble:

‘…it was a great time if you have a stock market on one hand and a market of stocks on the other…Those patient enough to not react by chasing the bubble fared far better over the subsequent quarter century. Our experience couldn’t have been better. Parallels today to the stock market and market of stocks we navigated then are uncanny.

Needless to say, with markets at all-time highs at the end of 2024 (and again now), Chris believes investors shouldn’t expect too much from future long-term returns.

The S&P 500 is valued to produce disappointing returns over the coming decade and beyond. Valuations in most metrics are in line with those at prior secular peaks over the past century. Despite back-to-back mid-20% returns in 2023 and 2024, given 2022’s 18.1% loss, price relative to fundamentals matches or exceeds that of 2021, which we expect will go down as one of the great secular tops.

While the US and Aussie markets are expensive again following the recent rebound, it’s not a case of prudent investors having to move to cash. There is hope for patient, active investors who are prepared to avoid wildly overvalued index stocks like Commonwealth Bank and invest in appropriately valued but unpopular companies.

But passive investors and index huggers should be prepared for mediocre long-term returns from these levels.

Who cares about capital allocation?

In his letter, Chris also touched on an important but little-known topic: capital allocation. This refers to the ability of a company’s management team to create or destroy shareholder value by choosing where to allocate the company's resources.

That is, do management understand the value of their company well enough to know when to issue and buy back stock that will enhance, and not destroy, shareholder value.

The reality is that not nearly enough companies do this well. Banks, for example, tend to buy back shares when capital is plentiful and share prices are high. But in a downturn, when prices are low (and the cost of equity capital is high) they tend to issue shares.

In Australia, thanks to franking credits, dividends represent a big part of the capital allocation pie. Share repurchases don’t feature as much.

But in the US, it’s the opposite. Management incentive packages are all about options and getting the share price higher so their options are well ‘in the money’. As a result, profits go towards share repurchases much more than dividend payments.

Companies also issue shares as a form of employee compensation. This is especially prevalent in the tech world. So you have a situation where, in aggregate, billions of dollars in stock buybacks don’t actually reduce the amount of shares on issue. They simply offset the newly issued shares given to insiders.

Chris reckons S&P500 companies pay out around one-third of profits as dividends, with the rest going towards share repurchases. But these repurchases barely offset the issuance of shares that gave ‘2% of the average company to insiders each year, paid as options and restricted shares.’

‘…index companies spent roughly two-thirds of profits purchasing 2.7% of their market capitalization each year, yet only reduced the share count by 0.6% annually. Retained earnings for the index are NOT reinvested at the return on equity but are spent repurchasing expensive shares. Repurchasing shares at high prices destroys capital. Shares bought at today’s 25.2x P/E earn just under 4.0% for shareholders, not the index’s 19.9% return on equity that one might expect.

To reiterate…

Over more than a quarter century, the companies in the S&P 500 spent two-thirds of net income repurchasing shares. They purchased 2.7% of market value on average each year. Over the same quarter century there has been no change in shares outstanding. The transfer of wealth to insiders is beyond comprehension.

To have spent vast sums of earnings on repurchases and not have reduced the aggregate net share count has proven an extraordinary destruction of capital.

The harm was masked by driving prices to record multiples of all fundamental measures of value. When asset prices revert to value, only then will the giant transfer of wealth to insiders be apparent to most.

To be clear, this isn’t a warning to get out of the market because the bubble is about to burst. Who knows how long this can go on for?

But it is a gentle reminder that the price you pay drives future returns. The market might look expensive, but that doesn’t mean every company in it is. Distinguish between these two things, and you’ll be on your way to beating the market over the long term.

 

Greg Canavan is the editorial director of Fat Tail Investment Research and Editor of its flagship investment letter, Fat Tail Investment Advisory. This information is general in nature and has not taken into account your personal circumstances. Please seek independent financial advice regarding your own situation, or if in doubt about the suitability of an investment.

 

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