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Coming Catastrophe in Bonds?

February 01, 2013 – Comments (4)

Board: Berkshire Hathaway

Author: EliasFardo

I don’t know how we can avoid a catastrophe in bonds; it is just simple math. I believe that individual investors should not own any medium to long term bond maturities at all.

I agree that stocks make more sense now, especially the names you mentioned. But, Buffett’s admonition to not own anything that you are not willing to see fall 50% in price holds for stocks also. The difference between stocks and bonds now is that the losses in bonds will be permanent, where the losses in stocks should ( may, might, could ) prove to be temporary.

Since easy, cheap credit will disappear, you need to own only large companies that can self-finance their operations. You need to own companies that do not require large capital expenditures to maintain their operations. You need to own companies whose customers do not need to borrow money to buy your products. You need to own companies that sell the types of things that people buy every week. You need to own companies with little debt. You need to own companies with strong internal cash flow. You need to own companies whose products are close to being a necessity purchase which can not be postponed for years. You need to own companies with low fixed costs.

Here is a test. Ask yourself: if there is a serious financial crisis which severely disrupts the economy for years, will such disruption create a temporary or permanent impairment for the company. If a company is growing at 3% a year, will three years of negative growth result in a company that can rebound at the end of the crisis and have its volume output where it would have been if it had continued to grow at 3%, or will it be permanently impaired or even destroyed? OK, bad sentence. Say a company is operating at 500 and growing at 3% a year. In the recovery after three years of financial crisis, will it rebound to 546, or will it still be sub 500. That is the test. If you don’t believe that it has a significant chance of passing that test, you don’t want to own it now. The companies you mentioned do, but they are the exception.

People do not want to think about the disaster waiting in bonds; it is too painful. Since so many have been burned in equities, they don’t believe that they have any alternatives other than fixed income. Good to great stocks and cash are the alternatives. I hold a lot of cash and I am losing purchasing power in it every day. However, when bad times come I will have an opportunity to deploy that cash at very attractive returns. But, I must be willing to suffer while waiting. I am but most are not. My willingness is nothing special to me. It comes mostly from just living long enough to actually experience the economic cycles. I can’t even begin to imagine what a 30 year old money manager makes of all this.

So, why hold any stocks at all? I could be wrong. And, from experience, I know that it easier to buy cheap shares of a company when I already own some. I own stock in order to create the emotional environment to allow me to buy more stock when it is being given away. Simple as that.