U.S. Markets closed

Berkshire Hathaway's Cash Balance Is Sending an Important Signal to Investors

Investors follow legendary investors for one reason: to receive signals about potential investment opportunities. However, closely studying the investment patterns of these well-known gurus could reveal much more than winning stocks and industries. For example, historical evidence suggests that the cash balance of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) is a leading indicator of upcoming market turbulence.

Over the last 10 years, the conglomerate's cash and short-term investments have continued to grow and are currently at an all-time high of $128 billion.

Source: Company filings.

This analysis will shine some light on whether investors need to worry about an upcoming recession or a market downturn, based on Berkshire's cash balance.

Buffett does not like cash

From the above illustration, an investor might get the impression that Warren Buffett (Trades, Portfolio) is someone who loves holding on to excess cash, which is not true. On the contrary, the Oracle of Omaha does not even consider cash as an investment. He once said:

"The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Cash is going to become worthless over time. But good businesses are going to become worth more over time."

The investment wizard seems to be holding a large pile of cash with a strategic objective as it's unusual for him to hold on to billions of dollars without making any investments. This is something value investors should pay attention to.

Buffett's strategy is to make big investments when there's fear in the market; this means holding on to cash when others are being greedy

Berkshire Hathaway, with the guidance of Buffett and Charlie Munger (Trades, Portfolio), has made some of its best bets during times when the general investing public was overwhelmed by a fear of further losses. For example, according to regulatory filings, the company invested $5 billion in Goldman Sachs (GS) in the aftermath of the financial crisis in 2008, despite the uncertainty surrounding the banking and finance sector. This investment now pays more than $500 million in dividends per year for Berkshire.

In addition, the company invested in General Electric (GE), Dow Chemical (DOW) and Wrigley during the last recession. These investments were worth billions in aggregate and were supported by the mammoth cash balance the company had accrued before the crisis.

The below graph depicts Berkshire's trend of accumulating cash right before the last two recessions: the dotcome bubble and the financial crisis.

In both these instances, the cash balance declined drastically following the market downturn, indicating the massive investments made by the company. Today, the company is holding on to a historic amount of liquid assets and the S&P 500 Index has continued to soar over the last three years. These are ominous signs for investors and Buffett issued an early warning in his 2018 annual letter to shareholders.

"Charlie and I will continue our search for large equity investments or, better yet, a really major business acquisition that would absorb our liquid assets," he wrote. "Currently, however, we see nothing on the horizon."

Even though months have passed by and the markets have delivered another strong year of performance, this warning should not be taken lightly. Admittedly, no investor or analyst would be able to predict when exactly a downturn would occur, but Buffett believes it's around the corner.

Other important indicators confirm the overvalued status of markets

The Shiller price-earnings ratio is one of the most widely used indicators to evaluate the overvalued or undervalued status of the S&P 500 Index. This ratio sends a warning signal as well and has topped the highs it reached prior to the financial crisis.

The ratio reached an all-time high of 44.19 in December 1999, just before the dotcom bubble burst. The current level of 30.24 is well above the ratio seen before Black Tuesday, Black Monday and the recession in 2008.

Buffett is optimistic about the long-term performance of equities

It's difficult to find a value investor who is more optimistic about the American economy than the Oracle of Omaha. Over the years, on numerous occasions, Buffett has confirmed his belief that the American economy will grow in each decade in the foreseeable future. In an article published in the New York Times in 2008, during the financial crisis, he reiterated this belief:

"A simple rule dictates my buying: Be fearful when others are greedy and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now."

If a recession hits the U.S, a prudent value investor would look to invest in bargains in a bid to secure attractive long-term returns. To be in a position to benefit from low stock prices, however, investors need to allocate a portion of their portfolios to cash. This could turn out to be an important strategic decision that would help deliver stellar returns in a few years.

Investors need not be alarmed, but better be ready

Despite the warning signs issued by Buffett, the American economy is still running smoothly for now. Both the World Bank and the International Monetary Fund believe an economic growth slowdown is likely, but positive that a recession will not occur in the next couple of years.

This outlook provides a window for investors to prepare their portfolios for the next downturn by diversifying their investments across asset classes and defensive industries. Holding on to cash as a strategic move could also turn out to be a rewarding decision. In any case, the legendary investors have no doubt that the long-term performance of equities will be stellar. There's no need to panic, but at the same time, failing to make the necessary changes to steer away from overvalued sectors could result in significant losses for investors.

Disclosure: I do not own any stocks mentioned in this article.

Read more here:

  • Yield Curve Inversion: The Complete Picture
  • How to Invest in a Declining Interest Rate Environment
  • 5 Reasons Behind Emerging Market Investments of Gurus

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.