We can learn a lot from the way Warren Buffett behaved when the stock market was bounding ahead in a burst of enthusiasm. Even though the story takes place over 30 years ago it is highly relevant for where we are today. In the mid-1980s Berkshire’s controlled subsidiaries and security investments were bringing in hundreds of millions of dollars for Buffett and Munger to invest – see Table 1.
Table 1. Net earnings after taxes attributable to Berkshire Hathaway from operating businesses
$m | 1985 | 1986 | 1987 | |||
Insurance underwriting | -23.6 | -29.9 | -20.7 | |||
Insurance investment income (dividends and interest) | 79.7 | 96.4 | 136.7 | |||
Realised security gains | 325.2 | 150.9 | 19.8 | |||
Buffalo News | 14.6 | 16.9 | 21.3 | |||
Fechheimer | – | 3.8 | 6.6 | |||
Kirby | – | 10.5 | 12.9 | |||
Nebraska Furniture Mart | 5.2 | 7.2 | 7.6 | |||
Scott Fetzer Mfg. Group | 0 | 13.4 | 17.6 | |||
See’s Candies | 14.6 | 15.2 | 17.4 | |||
Wesco – other than Insurance | 9.7 | 5.6 | 5.0 | |||
World Book | – | 11.7 | 15.1 | |||
Other | 19.9 | -4.9 | 4.3 | |||
Interest on debt | -7.3 | -12.2 | -5.9 | |||
Charity donations by BH shareholders | -2.2 | -2.2 | -3.0 | |||
TOTAL EARNINGS | 435.8 | 282.4 | 234.6 |
(Source: Warren Buffett’s Letters to Berkshire Hathaway shareholders 1986-87)
But there was a problem for any value investor at that time: the stock market had been zooming away. The Dow, a mere 800 in the early 1980s, more than tripled in five years to reach 2,709 in August 1987 – see Figure 1.
Figure 1. Dow Jones Industrial Average January 1980 – August 1987
The shape of the Dow curve is remarkably similar to the last seven years – see Figure 2.
Figure 2. Dow Jones Industrial Average 2012-2019
Investors had been so pessimistic in 1980 and 1981 that they priced the typical American share at a mere 7 – 9 times the previous years’ earnings. Then, as recession was put behind them, companies and shareholders gradually grew in confidence, and PERs rose to double figures – see Figure 3.
Figure 3. S&P 500 price earnings ratio, 1980 – 90
Things started to get out of hand in 1986, and by August 1987 US shares we
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