Warren Buffett. A man famous for investing in lesser known, undervalued companies through his holding vehicle Berkshire Hathaway now runs a portfolio that’s concentrated in the following stocks:
· Kraft Heinz
· Wells Fargo
· American Express
· Coca Cola
And, most recently, Apple…
This boring portfolio of large cap dividend stocks, many of them without much upside, isn’t what most imagine when they think of what the best investor in the world is holding. But I’m not interested so much in what’s in his portfolio, as he entered many of his positions a while ago, at far lower prices than these companies trade at today. Instead, I’m interested in his recent purchases (Apple) and what that means for my clients, young individual investors.
Over the past 15 months, Buffett purchased 120 million shares of Apple, building a position worth over $18 billion.
It likely will turn out to be a solid investment as Apple is a relatively safe company which was trading at a reasonable price. But Apple is a mature company, and it’s unlikely they’ll outperform the S&P 500 over the next decade.
But I’m not so convinced that Buffett’s intention is to outperform. Rather I think that the real reason why he built such a large stake in Apple is because he wanted more exposure to the U.S. stock market and had no other alternatives. THIS IS A GOOD THING FOR INDIVIDUAL INVESTORS.
In my book The Millennial Advantage, I discuss certain advantages that individual investors have over institutions. For one, I argue that large institutional investors (like Berkshire) are too large to create a meaningful position in a small company without being forced to pay an average price well above market value. For example, a $1 billion investment in a small public company (a small cap stock) would create so much demand that market prices could potentially double before Berkshire is done buying. This may cause a good investment opportunity to turn into a bad one.
This is a disadvantage because, historically, smaller companies outperform larger ones. There are a number of theories about why this is true. One is that because a smaller company is generally in the earlier stages of their life cycle, it is therefore likely to have a bigger upside. In other words, a 20% or 30% increase in earnings is easier to achieve in a small company worth millions than in a large one worth billions.
The small-cap effect was given a major boost in 1981 when Nobel Prize-winning economist Eugene Fama acknowledged the long-term superior performance of small stocks. After his study, some reports indicated that the small-cap effect began to diminish — supporting a contention by EMH proponents that once an anomaly is discovered and publicized, investors won’t find it as easy to use it to their advantage. But a major study in 2015 found that by using simple filters to adjust for the financial health of companies, small stocks continue to hold a considerable advantage over large ones. In other words, over time, small high-quality stocks seem to outperform large high-quality stocks.
Berkshire’s investors trust that Buffett will outperform the S&P 500. (Unlike hedge funds, individual investors won’t pay a management fee but they purchase the stock for a specific earnings multiple that’s based on the expected growth of Berkshire’s portfolio.) If they didn’t expect that Buffett would outperform the S&P 500, they would simply invest in a Vanguard ETF.
But as late as mid-2016, Berkshire had $84 billion in cash. Cash makes it difficult to outperform, since a lot of investor money is on the sidelines. (It is however, a risk management tool and can be a great decision if the market tanks and Berkshire can buy low.) Holding too much cash for too long also makes investors angry as they don’t want to be paying Buffett and co. money to sit on cash, when they can do so themselves. So Buffett, in a sense, was forced to invest some of that money. And he had four options:
1. Have his team to find 5–10 undervalued companies
2. invest in an index fund
3. Buyback his own stock.
4. Invest in a large, stable company like Apple.
Choosing option #1 would have likely been his strategy a decade ago, but 7 years into a bull market, bargains are much tougher to find. In this market, trying to find many undervalue companies is difficult, even for the Oracle himself.
Choosing option #2 is out of the question. If Buffett diversified his holdings, investors would flee, open up an e*trade account and invest in Vanguard.
Option #3 maybe a good decision and is what many other companies are now doing with their cash. But buybacks are only beneficial if the stock is undervalued, and Berkshire, right now, likely isn’t. The question here would be: does Buffett trust that Berkshire can outperform investor’s growth expectations? Based on his own activity it seems like that answer is a NO!
Option #4 is really the obvious choice here, and Buffett made the right decision. Since Berkshire wouldn’t be able to put $18 billion (let alone $5 billion) to work in smaller companies (without overpaying), his only choice was to bet big on a huge company that is relatively safe (meaning that has steady sales, strong brand value, low debt, high cash and trades for a reasonable price). And Apple is really the only company out there today that fits this bill.
The takeaway for individual investors is that, in today’s market, large institutions are unable to invest in the most lucrative segment of the stock market, small caps. Less institutional demand makes that segment even more attractive. They are also restricted from holding too much cash for an extended period of time. This creates opportunity for individual investors, Millennials specifically who have the asset of time on their side (and who can invest in less liquid investments), to locate smaller companies with higher upside potential. Because $10,000 and two ten-baggers (investments that grow 10x) makes you a million dollars!
Also, I can’t conclude this article without addressing the fact that holding cash can be a valuable for individuals also. The best investments (those that are bought low and sold high) have been made when the market crashes and investors with cash to spend are able to pick up stocks at bargain prices.
This article first appeared at the official website of Grow.
Disclaimer: This article is in no way, shape or form an investment recommendation. The information above is just my personal observation and not the observation of any Registered Investment Advisory firm. .As always, consult your investment advisor before making an investment. Understand the risks.