Mark Hulbert: Warren Buffett had a tough year — how might he explain it?

CHAPEL HILL, N.C. — Last year may have been one of Warren Buffett’s worst years ever.

We won’t know for sure until Berkshire Hathaway BRK.A, +0.51%BRK.B, +0.15%, of which Buffett is chairman and CEO, releases its earnings Feb. 22, at which point we will learn how much the company’s net asset value grew last year. The company’s stock gained only 10.9% in 2019, 20.6 percentage points lower than the S&P 500’s SPX, +0.18% total return. Reached by me Feb. 10, Berkshire wouldn’t comment or confirm when the shareholder letter would be released.

Buffett’s worst performance in any prior calendar year, as judged by the difference between Berkshire’s net asset value and the S&P 500, was 1999, when it lagged behind by 20.5 percentage points.

Buffett may owe his investors an explanation. And that is why Wall Street is so eagerly awaiting his annual shareholder letter, which is expected to be released along with the company’s earnings.

To help you make sense of what Buffett is likely to say, and what it means for your investment strategy, watch for comments in these areas:

Does Buffett still subscribe to the Buffett Indicator?

The so-called “Buffett Indicator” is the ratio of the total stock market to GDP. It got its name two decades ago when Buffett said that the ratio is “probably the best single measure of where valuations stand at any given moment.”

Look in his upcoming shareholder letter to see if Buffett modifies his endorsement of this indicator in light of its recent failures, not just last year but over the last decade. As you can see from this chart, the indicator has been above average for a number of years now, even as the stock market has marched inexorably higher. Its level at the end of 2019 was double its seven-decade average, and higher than any other year-end reading of the last seven decades — with just one ominous exception at year-end 1999, at the top of the internet bubble.

My hunch is that far from modifying his endorsement of this indicator, Buffett will double down. He has built up Berkshire Hathaway’s cash pile to a record $122 billion, which sends an unambiguously bearish message. With interest rates as low as they are, the only way Buffett can hope to outperform the market going with that much cash is for the stock market to fall.

How willing are you to take the other side of a bet from the most successful investor alive today? Don’t forget that, over Berkshire’s entire five-decade-plus history, Buffett has grown its NAV at an annualized rate of 18.8%, versus 9.7% annualized for the S&P 500’s total return.

I’m also curious to see if Buffett responds to one of the more common criticisms of the Buffett Indicator — that it has lost relevance because U.S. corporations now derive so much of their business outside of the U.S. Though this argument’s premise is undeniably true — U.S. corporations are now far more globally diversified than they were several decades ago — it doesn’t rescue the market from a bearish forecast.

That’s because a global Buffett indicator — the ratio of total world market cap to global GDP — is also at one of its highest levels currently. The only other sustained periods in which this global ratio was higher than today was in the late 1990s (as the internet bubble was inflating) and prior to the Great Recession in 2008.

Those are perilous precedents.

Bigger is not better

Watch also to see what comments Buffett make about the difficulties he has finding a company to invest in that is big enough to make a meaningful difference to his company’s bottom line. He has hinted at this problem in prior shareholder letters, but it has not received the attention it deserves.

Berkshire Hathaway’s sheer size poses a huge challenge to Buffett. That’s because the most undervalued companies aren’t big enough to interest him. And the companies that are big enough have been so heavily picked over that there is little undervaluation left.

The consequences of this challenge show up in Buffett’s declining alpha — his margin of victory over an S&P 500 index fund. Notice from the accompanying table that his alpha steadily shrinks as we focus on more recent periods. Over the last decade, in fact, his alpha is negative.

Last 10 years Last 20 years Last 30 years Since 1965
Annualized alpha of NAV over S&P 500 -1.5 percentage points +3.4 percentage points +5.3 percentage points +9.1 percentage points
Look, therefore, for a bearish message from Buffett

The bottom line? The only real question is how bearish Buffett will be in his shareholder letter. But a declining alpha on top of a declining market has to add up to a gloomy outlook indeed.

I’d love to be proven wrong, but I’m not holding my breath.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]