[Newsphopick=Kingsley Lim] As the markets celebrate a victorious recovery from the depths of March 2020, the global economy’s engine starts to falter. In a strange departure of economic fundamentals to stock market prices, market watchers are left puzzled as to what will happen next.
Will the global economy go through an unprecedented period of depression just as in 1929? No one knows. But one thing is for sure. We have been warned by investors who have beaten the odds of surviving in the game of finance.
One such investor which I admire is Jeremy Grantham of GMO asset management. Jeremy and his team had more than a few things to say about today’s economy.
In the first quarter 2020 report to investors, Jeremy and his team wrote that “The current P/E on the U.S. market is in the top 10% of its history. The U.S. economy in contrast is in its worst 10%, perhaps even the worst 1%. In addition, everything is uncertain, perhaps to a unique degree. The market’s P/E level typically reflects current conditions.”
The report added “Markets have historically loved fat margins, low inflation, stability and, by inference, low levels of uncertainty. This is apparently one of the most impressive mismatches in history. That being said, this is a new type of crisis and much will be different. There are no certainties but there are probably still some better and safer themes. Caution and patience are likely to be two of them.”
Another investor, Seth Klarman has also warned that the market’s levels are extremely irrational at these levels, not unlike many investors who have cautioned against investing into today’s hot stocks.
Of course, we need to talk about the Oracle of Omaha himself – Warren Buffett. The man and the legend known for his investing prowess has been quiet of late. Lately, he sold out of airline stocks, calling them ‘mistakes’ on hindsight. The other thing was that Buffett did not make many purchases as the markets fell.
When asked about this, Charlie Munger defended his long-time friend and partner by saying that Buffett was trying to protect what he has created. Of course, while that is not a direct message of doom and gloom, it does point to a certain conservatism.
Meanwhile as all these were going on, Buffett was really eyeing Barrick Gold, a gold mining company with a market capitalisation of US$48 billion. Since Buffett has been quite outspoken on his ideas around gold, why has he decided to invest in gold recently.
“Gold is a way of going long on fear,” said Warren Buffett. Buffett explained that if people “become more afraid, you make money, if they become less afraid you lose money, but the gold itself doesn't produce anything.”
Surely, the above quote does not explain Buffett’s actions today. Why did he buy a gold mining company? For months, I have witnessed Buffett’s conservatism first hand when he did not make as many purchases when the markets were down. I thought that Buffett may be saving for a rainy day. Quite certainly, the companies which Berkshire Hathaway own are not immune to Covid-19.
When his companies need the money, his priority is to help his companies first before making any investments. As Berkshire Hathaway is a conglomerate parent, what happens at the subsidiary level will affect Berkshire.
Still, Buffett has gone ahead and purchased a stake in Barrick Gold. And I can see why. We are living through unprecedented times and it may be a long way before a full recovery in the global economy. While fear has not set in yet in a big way, Barrick’s valuations are quite low as compared to the smaller mining companies.
The company’s price-to-earnings ratio is just 10.7 at the present even after rising from lows of US$13 per share to the current US$27 per share. Despite that, the company only has a debt to equity ratio of 0.24. While gold is a direct bet on the fear in markets, Buffett understands that the rising prices of gold will inadvertently affect the price of the company.
Every incremental dollar of profit which the company produces will eventually affect Barrick’s market capitalisation and valuation. As the price of gold rises, the revenue stream of Barrick will rise as well. With a cost structure that is relatively well contained by the company, it is quite likely to see increased profitability.
For example, if the company creates an additional $2 in profit over 2020, that will lead to a rise of at least $20 in share price because the price-to-earnings ratio is 10.72. Hence, there is a multiplier effect on the company’s earnings and Buffett knows that. At the same time, since Barrick has a conservative capital structure, that definitely adds to the investment thesis of Barrick Gold.