We often mistake the absence of warning signals for the absence of danger.
–Benjamin Graham, Storage and Stability
In an article appearing in the Wall Street Journal on March 30, two scholars from the American Enterprise Institute put this question to the newspaper's readers: “Are stocks overvalued?”
An apt topic coming as it did at the end of a quarter during which stocks defied precedent and rose at rates which, if annualized, would result in yet another year of 20% plus returns. Expectations had been that the market, “tired” after three years of record runs, would settle down to more normal gains of 8-10% this year. Needless to say, markets are not living organisms subject to fatigue and are fully capable of going on like this for quite some time. Baffled market seers needed only to lift their targets by a few percentage points to accommodate the new reality. The art of forecasting, after all, requires one to make adjustments to accommodate prevailing trends.
Overvalued? “Not a chance,” argued our scholars: stocks are actually undervalued by 50% or more due to a declining “equity risk premium.” Thanks to the educational impact of mutual funds, so the argument goes, investors are gradually getting wise to the fact that stocks, if held for long periods, are actually less risky than U.S. Treasury securities! Hence, there is no need for equity valuations to be inhibited by a factor that accounts for their presumed greater risk: a more appropriate valuation level should be fifty times earnings, or higher, versus about twenty-three times at present, itself a record high.
We will suppress our urge to compare this kind of logic to that found in the 1924 scholarly book, Common Stocks as Long-term Investments, which helped to fan the flames of speculation in the 1920s by arguing, similarly, that stocks always provide superior returns over long periods. We will instead focus on the Journal article's claim to provide the “numbers and theory” to support a recent statement by investor Warren Buffett that stocks are not necessarily too expensive.
The Chairman Speaks
Warren Buffett's annual chairman's letters to shareholders of Berkshire Hathaway Corporation have long been required reading among investment cognoscenti, due to the insights they provide into the thought processes of one of the most successful investors in financial history. With the simultaneous growth of public interest in financial matters and Mr. Buffett's fame as an investor, an increasing segment of the general public looks to the annual letters for his investment views, and apparently, for some guidance as to where stock prices are headed. On Monday, March 16, for example, two days following the release of Berkshire's 1997 annual report, the Dow Jones Industrial Average rose 116 points to record highs, at least partly because of excitement over a widely quoted sentence from Mr. Buffett's letter which stated that “there is no reason to think of stocks as generally overvalued.” We find it surprising that the public would interpret Buffett's remarks in such a positive fashion, or find in them any encouragement at all given the action following some of his earlier “market comments.” Seemingly forgotten is the quote from last year's letter (when Buffett said that investors ran the risk of overpaying for “virtually all stocks”) which helped to touch off a market slide. Subsequent market gains of over 25% would seem to indicate that in order to be a great investor it is not necessary to be a great forecaster, if, indeed, that is what he intended. In this regard, forgotten also, if noticed to begin with, is Buffett's persistent denial of any effort on his part to predict market movements. Putting a positive or negative slant on his comments regarding stock prices would seem to have more to do with speculators seeking justification for their own activities than anything else.
Just what did Mr. Buffett say and mean in his latest letter when he spoke of stock prices? While insisting that he never makes market forecasts, he explained that he did pay attention to market valuations, “in a very rough way.” Specifically, he said that he would not consider stocks overvalued as long as “interest rates remained where they were or fall, and American business continued to earn the remarkable returns on equity that it had recently recorded.” However, Buffett continues, “returns on equity are not a sure thing to remain at, or even near, their present levels.”
What Berkshire's chairman is trying to do here is give his readers an idea of the risks inherent in the markets at current price levels. Yes, stocks may continue to rise, but buyers are going further and further out on a limb. Perhaps it would help to quantify this notion of risk to better understand the implications. We'll assume, with Buffett, that the market's ability to maintain lofty valuations is dependent upon the continuation of both stable or lower interest rates and high corporate profitability. As elementary statistics teaches us, the probability of two events occurring in conjunction with each other is equal to the product of the probabilities of each event occurring. For example, if we are optimistic and assign a probability of 90% to both low rates and high profitability, then we can feel fairly confident (81% probability) that high valuations will prevail. However, what if strong corporate profitability is, as Buffett says, “not a sure thing,” and we give it only a 60% probability? In this case, the chances of stock valuations staying at current levels fall to 54%, or barely 50/50. If we were to assign 60% probabilities to both favorable rates and profitability (still somewhat positive, we might add), then the odds of continuing robust stock valuations (at 36%) seem far from assured. This line of reasoning may explain Mr. Buffett's remark that current market prices reflect “a very cheery consensus” that has “materially eroded the ‘margin of safety’ that Ben Graham identified as the cornerstone of intelligent investing.” It may also help to explain why he has been a seller of stocks lately and has turned to so-called “unconventional commitments,” such as silver and zero-coupon bonds.
Like many of his readers, our Wall Street Journal scholars seem to have mistaken Mr. Buffett's warnings about risk for an endorsement of stock purchases at high prices. Nevertheless, they may be correct: valuations of fifty or one-hundred times earnings are possible (we certainly would not object to them being applied to our current holdings), but so, unfortunately, is 8 times. Before scholars become mutual fund portfolio managers, it might be a good idea for them to test their “numbers and theory” with their own money.
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Warren Buffet is in some ways a remarkable figure in the annals of American business history. He certainly exhibits a rare sense of responsibility towards the larger community that is seldom noted, especially in the business press. We close with an excerpt from his 1996 annual letter that reveals his enlightened views on corporate obligations to society:
In 1961, President Kennedy said that we should ask not what our country
can do for us, but rather ask what we can do for our country. Last year, we
decided to give his suggestion a try - and who says it never hurts to ask?
We were told to mail $860 million in income taxes to the U.S. Treasury....
Charlie [Munger - Berkshire Vice Chairman] and I believe that large tax
payments by Berkshire are entirely fitting. The contribution we thus make to
society's well-being is at most only proportional to its contribution to
ours. Berkshire prospers in America as it would nowhere else.
Dennis Butler, MBA, CFA