Why Warren Buffett Refuses to Buy Stocks | 2022 Annual Letter

Every year I look forward to Warren Buffett's annual letter. This letter is full of advice and offers a sneak peek into how Buffett is thinking about the stock market and the overall investment landscape. Surprisingly, Buffett continues to hold cash and not buy stocks. This has many investors worried because if the greatest investor of all time can't find attractive investments in this market, that must mean the stock market is extremely overvalued.

In this video, we are going to go through the main takeaways that you need to know from Buffett's letter, including why Buffett continues to sell more stocks than he is buying. Now let's get into the video. But first, just an exciting announcement: for those of you who don't know, Buffett releases his letter every year a couple of months before the annual Berkshire Hathaway meeting. This meeting has around 40,000 people in attendance and is called the Woodstock for Capitalists. I went in 2019 and it was amazing. Unfortunately, it was virtual for the past couple of years, but thankfully the meeting is returning in person this year. And guess what? I will be going!

If you're also going to Omaha, Nebraska for the meeting, please let me know down in the comments below. I'm considering hosting a meetup with you guys so we can continue to build this community of investors. In true Buffett fashion, I plan to bring Dairy Queen Dilly Bars and Diet Coke to this meetup. Now let's dive into the letter.

One of the things that investors have been paying close attention to is the growing pile of cash at Berkshire Hathaway. The cash on Berkshire's balance sheet has been growing over the last 10 years but has become pretty extreme over the last few years, growing from around 100 billion in September of 2018 to a staggering 144 billion dollars at the end of 2021. When you hear this statistic, you may be asking yourself a question: isn't it a good thing that Berkshire and Buffett have so much cash? Yes and no. Let me explain.

So the good news is that Berkshire Hathaway's operations are extremely healthy and generating a ton of cash. That is great. On the other hand, the reason why that huge cash pile is bad is because this means Warren hasn't been able to find any attractive investments to make. Here's what he had to say: "Berkshire's balance sheet includes 144 billion dollars of cash and cash equivalents. Of this sum, 120 billion dollars is held in U.S. Treasury bills, all maturing in less than a year. That stake leaves Berkshire financing about one-half of one percent of the publicly held national debt."

I just have to interject real quick: it is absolutely crazy to think that Berkshire is holding so much cash that the company is financing one-half of one percent of the entire U.S. national debt. Okay, back to the letter. "Charlie and I have pledged that Berkshire, along with our subsidiaries other than BNSF and BHE, will always hold more than 30 billion dollars of cash and equivalents. We want your company to be financially impregnable and never dependent on the kindness of strangers or even that of friends. Both of us like to sleep soundly and we want our creditors, insurance claimants, and you to do so as well."

But 144 billion dollars—that's imposing! Some, I assure you, is not some deranged expression of patriotism, nor have Charlie and I lost our overwhelming preference for business ownership. Berkshire's current 80 or so positions in businesses is a consequence of my failure to find entire companies or small portions thereof that are marketable stocks which meet our criteria for long-term holding. Charlie and I have endured similar cash-heavy positions from time to time in the past. These periods are never pleasant; they are also never permanent and fortunately we have had a mildly attractive alternative during 2020 and 2021 for deploying capital.

In these comments, Buffett mentions that Berkshire needs to keep at least 30 billion dollars in cash at any given time. Think of this as sort of a safety net if the operations of the company start to struggle. So if we subtract out 30 billion from the 144 billion dollars of cash Buffett is holding, that means Buffett is holding 114 billion dollars more in cash than what the company needs to operate.

To put into perspective just how much cash that is, that is enough cash to buy the following entire companies at current market prices: Goldman Sachs, BlackRock, IBM, Starbucks, General Electric, and Boeing. Now, I'm not saying Buffett should buy any of these companies, but it really puts into perspective just how much cash Buffett has.

Now I want to draw your attention to one particular line from that passage, which I think is arguably the most important sentence in this entire letter: "Berkshire's current position is the consequence of my failure to find entire companies or stocks which meet our criteria for long-term holding." Now why is this line so important? This line is pretty much Buffett's way of calling the stock market overvalued without flat out just saying it.

Throughout his entire career, Buffett has never been one to be loud about his thoughts on the market. He's never been one to do interviews screaming about how the market is overvalued and crashes just around the corner. Instead, he has been much more subtle in his approach. To show what I mean, let's take a look at his letter from 1999. This was during the middle of the dot-com bubble—a period of time when tech and internet stocks, even those without a sustainable business model, were trading at sky-high valuations. Stock prices were increasing rapidly and Buffett was being criticized for staying on the sidelines.

In response to this criticism, Buffett said, "Equity investors currently seem wildly optimistic in their expectations about future returns. If investor expectations become more realistic—and they almost certainly will—the market adjustment is apt to be severe, particularly in sectors in which speculation has been concentrated." This was Buffett's way of saying that the market was overvalued, and it turned out he was right. The Nasdaq, which is an index full of technology companies, topped out at around 5000 in March of 2000. That's when the bubble burst. By the end of 2002, the Nasdaq hit the 1200 mark, and the Nasdaq didn't recover to its March 2000 levels until the year 2015.

The Nasdaq was so overvalued at its peak that it took 15 years to return to the level seen at the height of the dot-com bubble. There are different valuation metrics investors look at to help them determine whether or not they think the stock market is over or undervalued. One of the most commonly used metrics is the price to earnings ratio, or P/E ratio for short. This is calculated by taking the price of a stock and dividing it by its annual earnings. All else being equal— and I emphasize all else being equal—the higher that number is, the more overvalued a stock is, and the lower that number is, the more undervalued a stock is.

The P/E ratio of the S&P 500, which consists of the 500 largest U.S.-based companies and is generally used as a proxy for the stock market, is currently at nearly 24x. If you look at the past 90 years, my research indicates the average P/E ratio of the S&P 500 has been around 15x. Okay, so the stock market appears overvalued on this particular metric.

But what if we look at the stock market using a method Buffett created himself, cleverly named the Buffett Indicator? The math behind the Buffett Indicator is simple: it is the value of all publicly traded companies added together, divided by the country's GDP. GDP is essentially a measure of the size of a country's economy. In the most simple terms, the Buffett Indicator is the value of all stocks in the country divided by the size of that country's economy. Buffett called this method the single best measure of where valuations stand at any given moment.

The current value of all publicly traded companies is around 46.2 trillion dollars. The GDP of the United States is currently estimated at 24.1 trillion dollars. So if we do the math, that gets us to 1.92. And if we turn that number into a percentage, it is 192 percent. So the famous Buffett Indicator is currently at 192. Which brings us to the trillion-dollar question: how does that compare to history? Well, the answer isn't all too good.

Unfortunately, since 1950, the historical trend line indicates that a score of 120 is a fairly valued stock market. The current Buffett Indicator score of 192 would seem to suggest that the stock market is significantly overvalued based on historicals. So even though Buffett is hinting pretty heavily that he thinks the stock market is overvalued, there has been one stock that he has been spending billions buying over the past two years—51.7 billion dollars to be exact. And that stock is not Apple or Bank of America or his iconic holding in Coca-Cola. Buffett's favorite stock to buy over the past two years has been his own.

That's right! Buffett has been repurchasing tens of billions of dollars of Berkshire stock. This really speaks to how crazy the market is right now—that the world's greatest investor can't really find anything to invest in besides buying back Berkshire stock. Here's what Buffett had to say: "Our final path to value creation is to repurchase Berkshire shares. Through that simple act, we increase your share of the many controlled, non-controlled businesses Berkshire owns. When the price to value equation is right, this path is the easiest and most certain way for us to increase your wealth. Periodically, as alternative paths become unattractive, repurchases make good sense for Berkshire's owners."

"During the past two years, we therefore repurchased nine percent of the shares that were outstanding at year-end 2019 for a total cost of 51.7 billion dollars. That expenditure left our continuing shareholders owning about 10 more of all Berkshire businesses—whether these are wholly owned, such as BNSF and Geico, or partly owned, such as Coca-Cola and Moody's."

The best way to think of share repurchases and why they can be so powerful is to think of an example of a house that five people own. Let's say the market value of the house is five hundred thousand dollars. This is what the house could receive if it is sold on the open market. This means that each person's share of the house is worth one hundred thousand dollars, calculated simply by taking the five hundred thousand dollar value of the house and dividing it by the five owners.

Let's say one of the owners wants to sell their interest in the house because they need the money quickly to make a different investment. Instead of going through the process of selling the house on the market, this person is willing to be bought out for eighty thousand dollars. This means that each of the four remaining owners will have to pay twenty thousand dollars to buy out the owner that wants to sell. Twenty thousand dollars times four equals eighty thousand dollars.

Now that one of the owners has been bought out, there are now only four owners left that own the house that’s still worth five hundred thousand dollars. This means that each of the four remaining owner’s share of the house is worth one hundred twenty-five thousand dollars. This is twenty-five thousand dollars more than what each share was worth before they bought out the fifth owner. So essentially, each of the owners spent twenty thousand dollars to get twenty-five thousand dollars in additional value for each of their shares of the ownership of the house. Each of the owner's net worth increased by five thousand dollars as a result of buying the previous partner that wanted to sell.

This same logic applies to share repurchases, assuming the share purchases are made below the true value of the business. This is what Buffett was referring to when he said he used share purchases to increase the wealth of the remaining shareholders of Berkshire Hathaway. Here’s another way to think about the power of share repurchases. Imagine that a stock earns one thousand dollars a year in earnings. The stock also has one thousand shares outstanding. This means that each year represents one dollars worth of earnings.

This is calculated simply as taking the entire earnings of the company, the one thousand dollars, and dividing it by the number of shares outstanding one thousand. This gets us with the one dollar of earnings per share or EPS for short. Now let's see what happens when we throw share purchases into the equation. Let's say the company in our example repurchases 100 of their shares, bringing the total shares down to 900. Doing the same math as before, this means each year now represents 1.11 cents in earnings.

Earnings per share has increased not because the overall earnings of the company increased, but rather because the same amount of earnings is just split among fewer shares. If the company buys back another 100 shares, bringing our total shares outstanding to 800, our earnings per share increases to one dollar and 25 cents. This is a 25% increase in EPS based purely on share purchases.

This is why share purchases can be so powerful if done correctly, but that's a big if. In the letter, Buffett lays out his thoughts on when share purchases make sense. I want to underscore that for Berkshire, repurchases to make sense our shares must offer appropriate value. We don't want to overpay for the shares of other companies, and it would be value destroying if we were to overpay when we are buying Berkshire.

The fact that Buffett is buying back shares instead of buying other stocks means a couple of things. First, it’s further proof that he thinks the current stock market is overvalued. Remember how earlier I mentioned that Buffett is subtle? This is a huge difference compared to the average CEO. I meet a lot of CEOs through my job as an investment analyst at an investment fund, and every CEO I have ever met will probably claim that even in today’s stock market, their stock is extremely undervalued. In fact, I don't think I have ever met a CEO who said that their stock was fairly valued by the stock market.

I honestly can't blame these CEOs. The higher the stock price goes up, the more money they get paid. Buffett is not like most CEOs, and that's putting it mildly. He likes to speak with his actions rather than words. He clearly laid out his preference for buying stocks in other companies over buying back shares for Berkshire. All else being equal, the fact that he's repurchasing shares shows that he doesn't find current valuations for stocks that he would want to buy attractive.

Second, him buying back shares in Berkshire shows that he currently thinks Berkshire Hathaway stock is undervalued at current prices because if Berkshire stock wasn't undervalued, he wouldn't be buying back billions of dollars worth of shares. I could spend all day analyzing this letter, but I can't make this video five hours long. Make sure to like this video and subscribe to the Investor Center because it helps out a ton. If you are interested in accessing the tools I use to analyze stocks and make investment decisions, you can access all of that through my Patreon at the link in the description. Thanks again for watching and talk to you soon.