Whenever I disagree with something Buffett says or does, I remind myself that he has usually been right and almost always on the really important stuff. I've learned to undertake serious research to discover what he sees that I don't. A case in point was his continuing to hold his large position in Coca-Cola (NYSE:KO) when it was absurdly overpriced in 2000 and seemed significantly overpriced for a low-growth company as recently as a couple of years ago. I did this SA article about it in 2014. I was dead wrong.
It turns out that Buffett had reasons for holding onto KO that I hadn't even considered. Buffett sees angles that you and I don't immediately see. In this recent piece, I recanted my erroneous view and discussed his reasons - the favorable corporate taxation of dividends and highly unfavorable corporate taxation of capital gains. He laid it all out clearly in the recent 2017 Shareholder Letter.
The latest surprising view of the world's greatest value investor is that market valuations aren't so bad. He did this even as other major investors concerned with value (recently Seth Klarman and Paul Tudor Jones, and I might add SA's own redoubtable Chuck Carnevale) were shaking their heads at the market and finding little to buy. I have myself been more or less in their camp, keeping a large cash reserve. Let's try to understand Buffett's reasons.
What Buffett Said
In recent years, Buffett has not been shy about expressing opinions on market valuation. In the run-up to the year 2000, he expressed skepticism about valuations associated with the dot-com bubble and backed his caution with the acquisition of General Re. Taking over Gen Re's large bond portfolio had the effect of diluting his heavy exposure to equities (including Coca-Cola) without having to sell outright and pay corporate taxes at a high rate.
During the 2007-2009 crack-up, Buffett passed on bailing out Lehman Brothers but stepped up to lend money to healthy businesses which were under temporary stress (on highly favorable terms, of course, with equity options). On October 16, 2008, he wrote a famous New York Times article entitled, "Buy American. I Am." He was a little early, but those who followed his advice have done very well indeed.
So what does Buffett think of market valuation right now?
Consider the interview he gave to CNBC on the Monday morning following the release of Berkshire's annual report and Shareholder Letter:
Buffett: Well... I've been talking this way for quite a while, ever since the fall of 2008. I was a little early on that actually. But I don't think you could time it. And we are not in a bubble territory or anything of the sort. Now, if interest rates were 7 or 8 percent, then these prices would look exceptionally high. But you have to measure, you know, you measure everything against - interest rates, basically, and interest rates act like gravity on valuation. So when interest rates were 15 percent in 1982 they'd pull down the value of any asset. So, what's the sense of buying a farm on a 4 percent yield basis if you can get 15 percent in governments? But measured against interest rates, stocks actually are on the cheap side compared to historic valuations. But the risk always is, is that - that interest rates go up a lot, and that brings stocks down. But I would say this, if the ten-year stays at 230, and they would stay there for ten years, you would regret very much not having bought stocks now.
Superficially, this sounds a good bit like the Fed model which says that it is okay to buy stocks as long as their earnings yield exceeds the 10-year Treasury yield. That's not much of a hurdle right now. But under close examination Buffett's rationale is not as simplistic and reductive as the Fed model.
The Fed model ties stock valuation to a moving target. I couldn't get myself to believe that Buffett would agree with a valuation anchor like that. He himself suggests as much in the casual mention that ten years of low rates would mean quite a lot. Buffett's real argument had to be more fundamental than simply becoming an interest rate forecaster, and I believe it is.
It turns out that the most important clue goes all the way back to his famous 1977 article in Fortune, "How Inflation Swindles Equity Investors." At the time, Buffett was primarily concerned about the damage done to stocks by inflation. Almost incidentally he laid out his deepest argument for owning stocks under almost all market conditions. It's all about looking under the hood at what a company is as a business and what partial ownership actually amounts to. To explain it, he introduced the term "equity bond."
Equity Bonds, The Magic Of 12%, And Internal Compounding
In his 1977 article, Buffett proposed the idea that stocks were more similar to bonds than most investors realized. He underscored his point by creating the term "equity bond," arguing that stocks are in effect a special kind of bond. This "equity bond" differs from ordinary bonds mainly in having infinite duration and the ability to keep and reinvest the portion of the "coupon" not paid out as dividends. He noted that the rate of internal compounding by the universe of stocks as a whole was very persistently around 12% annually.
That 12% number crops up repeatedly in Buffett's writing. It is the number used, for example, in the argument made in his 2012 annual letter that Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders were better off selling the amount of shares needed for income than receiving a dividend. Note also that the 12% number is not just pulled out of the air but is a fairly durable number for the average return on equity of the S&P 500. This may also help explain his confidence in the S&P 500 to win his 10-year bet with hedge funds as well as his choice of the index to support his wife comfortably after he is gone without the single-company risk of owning just Berkshire.
In 1977, Buffett's major purpose was to alert investors that contrary to the general assumption, stocks were not going to offer anything in the way of protection from inflation. Because of their nature as "equity bonds," they were likely to sink in price just like bonds themselves as inflation increased and interest rates rose to 6, 8, and ultimately 10 percent. The 1970s and early 1980s were all about this scenario which unfolded exactly as Buffett described and forecast. Stocks sank despite increased earnings fueled by the internal 12% return on capital.
Almost buried in this argument was a single paragraph explaining why the two decades from 1946 to 1966 were stock market "heaven on earth." The reason was simple: Stocks were busy internally compounding the value of retained earnings at 12% while the prevailing interest rate remained around 3-4%. They gave owners a return not available elsewhere.
The bull market from 1949 to 1966 derived from that fact, along with a general increase in PE ratios which came with the gradual recognition of its implications. Companies de-emphasized dividends in favor of internal compounding and investors gradually got the picture, causing the market valuation to rise from 133% to 220% of book value.
Here are Buffett's own words on that era, which even in 1977 he called, "The Good Old Days."
This characteristic of stocks - the reinvestment of part of the coupon - can be good or bad news, depending on the relative attractiveness of that 12%. The news was very good indeed in the 1950s and early 1960s. With bonds yielding only 3 or 4%, the right to reinvest automatically a portion of the equity coupon at 12% was of enormous value. Note that investors could not just invest their own money and get that 12% return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can't pay far above par for a 12% bond and earn 12% for yourself. But on their retained earnings, investors could earn 12%. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.
Thus, the idea of "growth" became part of equity investing, really for the first time. The key moment of recognition may have been 1958 when the yield on high grade bonds reversed a historic relationship by rising above stock dividend yields (a flip not reversed again until the post-2009 crisis, briefly) and Phil Fisher came out with the first great book on growth investing, Common Stocks And Uncommon Profits. Yes, stocks (equity bonds) were riskier than ordinary bonds, but they compounded money like nothing else - and all the more if they paid out little or nothing in dividends.
Are We Living In The Good Old Days?
Buffett seems to believe that we are living in a second era of "heaven on earth" for stocks, lacking a few things from the 1949-1966 bull market but retaining the main one. Have we come full circle?
There are indeed similarities between the 1946-1966 period and the era which began in 2009. There are also a few obvious differences, the most important of which are demographics and the much lower initial valuation of the earlier period (single-digit PE in 1949, for example). Let's consider them.
- Demographics. The demographics of the 1950s and 1960s were much more favorable for growth than the present. You could make simple everyday products like refrigerators and dishwashers and depend upon a rising population to produce growth. Today, "growth" is impeded by static population in developed countries and is to be found mainly in true innovation or somewhat cannibalistic niches such as the new car-hire industry or possibly even Amazon (NASDAQ:AMZN).
On the other hand, less robust demographics and slower growth may also produce less risk of economic overheating resulting in serious inflation and significantly higher rates. The only nagging question is whether the deflationary undertow may impact that magical 12% return on equity. Buffett does not appear to think so.
- Lower initial valuation in 1949. This is indisputable. The 1949 bull market started at one of the lowest valuation levels in market history. The 2009 low by most measures was just a tad under the average of long-term valuations. If nothing else, this probably takes away much further rerating upward in valuation. What it doesn't necessarily do is undercut the favorable effect of internal compounding at 12%. I think that in essence, this is Buffett's view.
It wasn't valuations per se that killed the bull market of the 1950s and 1960s. As Buffett noted in the 1977 article, it was sharply higher inflation which reached an inflection point in the mid-1960s. As it happened, this took place just as institutional investors were falling to the huge advantage stocks offered and bidding up valuation.
But note: By serious inflation and increase in interest rates, Buffett was talking about something well beyond the currently feared nickels and dimes of Fed rate increases. He implied that you don't need to worry much until the 10-year Treasury yield more than doubles from its present rate. That could mean we are at least a decade away from a bond yield which begins to offer real competition to a stock market internally compounding the value of retained earnings at a rate around 12%.
Conclusion And A Couple of Takeaways
The valuation argument which appears central to current market narratives consists of a camp which cites indisputable valuation statistics for the market being dangerously overpriced and a camp which focuses on more day-to-day practical things like earnings and the persistence of low interest rates. The latter camp, which includes favorite SA writer Jeff Miller, generally doesn't make much of an attempt to present a rigorous argument for not worrying about overall market valuation except for noting that market valuations have historically been all over the place and are not very predictive.
In his 1977 Fortune article, Buffett may have provided that missing rationale. The article provides both detail and a model with some rigor for his recent comments that stocks could do pretty well with a decade of continuing fairly low rates. He doesn't appear to pay much attention to shorter-term ups and downs of either corporate earnings or interest rates. It's the long term that matters. As for our being in a bubble, he appears to employ the Potter Stewart rule - he knows one when he sees it, and he doesn't see one now.
For me personally, the Buffett model for looking at valuations provides a good enough rationale for a larger stock allocation than most individual investors of my age (72). It does not make me wish to rush to get 100% invested and get rid of my large cash reserve. It leaves me squarely in the middle, with an eye on valuations but no immediate desire to sell anything because of them.
I'm in the middle on arguments like the valuation debate partly because both sides have a coherent view and also because, hey, I'm an old guy and with the long-term future of Illinois pensions somewhat iffy, I need to avoid excessive commitments in my portfolio. If you are an old guy too, or about to become one, take note.
Buffett does not seem to believe that bull markets generally die of overvaluation nor does he appear to see a huge economic crisis on the horizon which would lead to a huge downward revaluation of stocks. That does not mean we won't have a recessionary bear market at some point in the future. What his view does support is that a recessionary bear market is likely to be contained in the 20-30% area, scary enough but manageable. Stocks are just too favorable a way to compound capital for stocks to return quickly to historically cheap valuations barring a major crisis.
Finally, a note about Berkshire itself. It is a company built to the model. It was constructed specifically to allow highly centralized and efficient redeployment of capital by Buffett and a few of his senior lieutenants. I can't resist noting that Berkshire benefits tremendously from not having the dilutive drag on capital formation of paying out dividends.
He spent a couple of paragraphs on that point, the 1977 article prefiguring his 2012 Shareholder Letter section justifying Berkshire's decision not to pay dividends. For the life of me I can't understand the preference for dividends, which reduces shareholder return on solid companies by making them more bond-like. However rationalized - here I agree wholeheartedly with Buffett - a dividend at Berkshire would undercut the unique privilege of its "equity bond" holders to internally compound capital at a rate of 12% or quite possibly higher.
Disclosure: I am/we are long BRK.B.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.