From the Archives: Buffett Would Rather Buy Junk Bonds Than Telecoms
The telecommunications sector has always been more of an income market than a growth market. Telecom companies tend to produce reliable, steady cash flows, but at the same time, they require a lot of capital investment. These companies need to invest every year just to offset depreciation, and there's no escaping from this.
Buffett on telecoms
Warren Buffett (Trades, Portfolio) outlined the drawbacks of these businesses in a lecture in 1991. He compared the figures of American Telegraph in the 1970s to those of Thomson Newspapers.
Buffett noted that over an eight or nine year period, the assets of American Telegraph had grown from around $50 billion to nearly $100 billion. Over the same time, the firm's net income had risen by around 100%, from $2.5 billion to $5 billion. So, the company's earnings had grown, but as Buffett put it, "you can get more money from a savings account if you keep adding money to it every year." To grow earnings, American Telegraph had to shovel more money into the pot.
This trend has only become more apparent in recent years. For example, between 2017 and 2019, AT&T's (NYSE:T) operating income rose 23% from $23.9 billion to $29.4 billion. However, total assets also increased by 24% from $444 billion to $552 billion over the same time frame. AT&T was shovelling more money into the pot to achieve the same result.
These poor returns are just one of the reasons why Buffett and his partner Charlie Munger (Trades, Portfolio) have stayed away from telecom stocks over the years. They've also said they like to stay away because they don't understand the sector, and the risk/reward of buying such investments does not stack up.
Speaking at the 2003 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of investors, Munger said:
"Mostly, Berkshire, in its history, has bought common stocks that practically couldn't fail. But occasionally, Berkshire just makes an intelligent gamble where there's plenty of chance of failure, but there's enough chance of success so the gamble is worth taking. And I think it's fair to say that telecommunications falls in that so far."
In other words, it seems that the duo just wasn't convinced that the risk of investing in the sector was worth the reward. In fact, as Buffett went on to explain, Berkshire preferred telecom junk bonds as investments because they had the potential for high returns if the situation worked out, while coming with limited risk. Specifically, Buffett said:
"We might buy some junk bonds in that business. In fact, we have in several areas. But as I put in the annual report, we expect losses in junk bonds. We expect, over all the probabilities, we'll have a decent result -- maybe better than decent. But we do expect losses, because we are dealing with institutions that have demonstrated that they don't have large margins of safety in their operations."
He went on to add that buying junk bonds was "like being an insurer of substandard risks. You'll have more accidents, but you can charge a premium that makes it work out."
It's very easy to get caught up in the belief that Buffett will only buy safe investment, but that's not correct at all. He's interested in investments that will yield a high return, either through cash returns to investors (companies with high returns on equity) or substantial capital returns with a near-zero risk of permanent capital loss. Telecom companies didn't offer the right level of return.
So, while they might seem like safe investments, their poor economics appear to make telecoms the exact opposite in Buffett's opinion. He'd rather buy their junk bonds.
Disclosure: The author owns shares in Berkshire Hathaway.
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This article first appeared on GuruFocus.
