The Valor Blog.
Investment News and Views, Direct from Our Team.

Single best measure

Warren Buffett outlaid his recommendation on how to think about whether markets are relatively expensive or cheap in 1999. He describes the stock market to GNP ratio as:

probably the best single measure of where valuations stand at any given moment

In Australia, we now stand the test of this measure as stock prices have risen significantly in the last six months to push the ratio up to just over 100% and now stands at approximately 103%. The periods where the ratio has been over 100% in the past have been the precursor to well below average returns in the preceding years.

Using these figures, it is possible to have an educated guess that the average investor will not return anywhere near the average stock market returns of the last 100 years over the next 5 to 10 years and so going forward, they should dampen their expectations.

Unfortunately animal spirits seem to have kicked in and when the good times are rolling, most don’t think about rational measures of valuation and only think about the recent past in estimating their future returns.

The US stocks markets are also trading at elevated levels when compared to their GNP. See here for more details.

As Buffett always says:

Be fearful when others are greedy and greedy when others are fearful.

We suggest that investors be more fearful than greedy at this point in time.

There is one point to make. In any market there will be above average franchises that have the ability to make higher returns on their equity than the average business and so will do better than the total stock market as a whole. These businesses are those that display characteristics that give them higher earning power through competitive advantages that are durable. There are very few of these businesses and if you own a collection of them bought at rational prices, you have a reasonable chance to earn more than the average return.

This sounds easy in theory, but few have the temperament to follow this method. This method of buying companies with durable competitive advantages requires 3 things to be successful. First you have to be able to identify the long lasting protective moats of the businesses correctly. Second you have to buy them at reasonable prices and if they are not available below their fair worth then wait until they are and thirdly, you have to hold them for very long periods of time.

Most investors fail on the first point, so there is very little chance that they can truly outperform the average indicies over time. Many look at recent business growth as a competitive advantage. Often this growth is due to cyclical margin expansion rather than any competitive advantage. This is the rising tide theory where most companies seem to perform well. As Buffett says, “It is only when the tide goes out that you learn who has been swimming naked” and the truly wonderful companies show their enduring competitive advantages. At present, interest rates are at all time lows and the tide only seems to be going coming in, but at some stage over the next few years, interest rates are likely to rise and those investing in average and below average businesses are unlikely to return satisfactory results.

This theory applies to those buying low yielding real estate in Australia (mid to low single digits) using the past 20 years as a guideline for the next 20 years. Over the last 20 years, interest rates have generally trended in one direction – down. At some stage in the next 20 years, interest rates are likely to trend upwards. Those investing in properties with low yields may find they also achieve a less than satisfactory return when this reversal in rates occurs. I think this may be a few years off as Australia struggles with a slowing mining boom, but I would be very surprised if interest rates stay near emergency settings for decades. If average interest rates return nearer to 6-7% (more than double where they are now and closer to average) then I would suspect the current average property investor is unlikely to be returning above their cost of capital. This speculation of future capital gains is unlikely to prove overly profitable for many. Unfortunately this speculation of future gains is what a good many pre-retirees are banking their entire retirement on. They are making these bets either through highly geared property or through large holdings in Australian banks which are also addicted to above income loan growth which I believe is unlikely to persist indefinitely.

For those defined benefit and pension funds that are expecting greater than 7% returns (in a world of sub 3.5% bonds and greater than 100% market cap to GNP) for their calculations, I would suggest either find a Gretchen Tai or a Warren Buffett to manage your money to make this hurdle rate after fees and taxes going forward. If you are investing in businesses with large pension and defined benefit obligations, you may need to factor in some capital outlays by the businesses to top up their retirees funds.

There is currently a very strong “fear of missing out” syndrome that is beginning to pervade the markets. Those that get swept up in this phenomenon may over pay for their assets and have unsatisfactory results.  What looks to be an unattractive 4.5% return from a high yielding cash account may be better than the returns from overpaying for growth assets. Patience is a virtue with very high returns.