Warren Buffett likes to drink Cherry Coke. He enjoys playing the ukelele. He likes to play bridge. But guess what Buffett doesn't seem to like doing very much these days? Buying stocks.
The legendary investor has become one of the wealthiest people in the world by buying and holding stocks for his beloved Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B). However, Buffett isn't buying many stocks right now. And there's one simple reason why.
Image source: The Motley Fool.
Lots of cash, few new stocks
That reason definitely isn't that Buffett doesn't have enough cash at his disposal. Berkshire ended the second quarter with a cash stockpile (including cash, cash equivalents, and short-term investments) totaling $140.7 billion.
However, in the second quarter of this year, Berkshire didn't use much of its cash buying stocks. Buffett added to Berkshire's stakes in only three companies: Aon, Kroger, and RH.
Sure, Berkshire also reported a brand-new position in Organon. However, that new stock in the conglomerate's portfolio was the result of Merck's spin-off of its women's health business.
A value investor at heart
Buffett's mentor was Benjamin Graham, the father of value investing. Over the years, Buffett has drifted away from a purist focus on stock valuations. However, it's probably fair to say that he's still a value investor at heart.
With that in mind, take a look at the following chart. It shows the cyclically adjusted price-to-earnings (CAPE) for the S&P 500 index over the last 60 years. The CAPE metric, popularized by Yale professor and author Robert Shiller, reflects the price of the S&P 500 divided by the average earnings over the previous 10 years adjusted for inflation.
Data source: Robert Shiller, Yale University. Chart by author.
Right now, the S&P 500's valuation is at its second-highest level that Buffett has seen since he took over Berkshire Hathaway. The only time the CAPE for the index was higher was during the period leading up to and shortly after 2000.
Of course, we all know what happened after the market valuation reached such a lofty level. Stocks plunged. It took seven years for the S&P to fully bounce back. (And then it nose-dived again with the financial crisis of 2008 and 2009.)
I don't know for sure if Buffett is looking at a chart like the one shown above. However, you can bet your bottom dollar that he's closely watching the overall market valuation. And he knows that buying stocks when they're really expensive usually doesn't work out all that well.
Be like Buffett?
Some investors might dismiss the idea of following a similar strategy as Buffett. They could correctly point out that Berkshire's total return over the last 10 years has lagged well behind that of the S&P 500 index. And CAPE levels were higher during much of that period than they had been in a long time.
However, my view is that Buffett's cautious approach makes sense right now. Stocks truly are trading at a premium that hasn't been seen in more than two decades. Historically, there's a compelling inverse correlation between the CAPE value of the S&P 500 and the returns over subsequent years.
The Oracle of Omaha is doing two things that other investors should seriously consider. First, he's built up a big cash stockpile. Second, he's still buying stocks but is much more judicious in doing so than in the past.
No, I don't think every investor needs to necessarily have as great a percentage in cash as Buffett does with Berkshire. Neither do I believe that the only stocks worthy of buying are those that Berkshire has bought. But the more frothy valuations become, the more cash investors should accumulate and the more selective they should be about using that cash to buy stocks.
I don't like Cherry Coke. I can't play the ukelele. And I've never played bridge in my life. I do know, though, that Buffett didn't achieve his tremendous success by overpaying for stocks. Investors who take the same perspective as the multibillionaire in this regard will probably be better off over the long run than those who don't.
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