Timely lessons from Buffett's 1999 Fortune article

[LearningMachine]

Stumbled into re-reading Buffett's 1999 Fortune article.  So, full of insights. 

 

Interest Rates(https://fred.stlouisfed.org/series/DGS10)

• #1. From Dec 31, 1964 to Dec 31, 1981, Dow Jones went from 874.12 to 875 because "there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981."
• #2. "If government interest rates, now at a level of about 6%, were to fall to 3%, that factor alone would come close to doubling the value of common stocks." 

 

Corollary of #2 is that if government interest rates were to double from 3% to 6%, it would come close to halving the value of common stocks. 

 

Any thoughts on when Mr. Market will realize this for S&P 500? 

 

Corporate Profits as a percent of GDP(https://fred.stlouisfed.org/graph/?g=1Pik)

Maybe Mr. Market will notice when higher interest rates start lowering some debt-laden companies' profits such that overall corporate profits as a percent of GDP go down from current high of around 10%, a percentage that was unthinkable to Buffett in 1999?

• #3. "[F]rom 1951 on, the percentage settled down pretty much to a 4% to 6.5% range. By 1981, though, the trend was headed toward the bottom of that band, and in 1982 profits tumbled to 3.5%. So at that point investors were looking at two strong negatives: Profits were sub-par and interest rates were sky-high."
• #4. "[Y]ou have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well. In addition, there's a public-policy point: If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems--and in my view a major reslicing of the pie just isn't going to happen."

 

 

Is Mr. Market waiting to notice both strong negatives at the same time, and can't just notice the headline interest rate that has already arrived? 

 

Thoughts?

 

 

Edited July 23, 2023 by LearningMachine

[KCLarkin]

2 hours ago, LearningMachine said:

Corollary of #2 is that if government interest rates were to double from 3% to 6%, it would come close to halving the value of common stocks. 

 

Any thoughts on when Mr. Market will realize this for S&P 500? 

 

The question is whether 3% interest rates were ever priced into the S&P 500. Many investors made the assumption those rates were temporary and demanded higher "yields" for stocks.

 

“I think stocks are ridiculously cheap if you believe ... that 3% on the 30-year bonds makes sense,” Buffett says.

 

[ValueArb]

If the Fed is really intent on raising rates further (and I do) it should pop this mini-bubble that the techs have enjoyed this year.

[LearningMachine]

3 hours ago, KCLarkin said:

 

The question is whether 3% interest rates were ever priced into the S&P 500. Many investors made the assumption those rates were temporary and demanded higher "yields" for stocks.

 

“I think stocks are ridiculously cheap if you believe ... that 3% on the 30-year bonds makes sense,” Buffett says.

 

 

Buffett said that in May 2019, when S&P 500 was 2932, and S&P 500 P/E was 21.15 (earnings yield of 4.7%), and 10 year treasury yield was 2.39%.  In other words, S&P 500 earnings yield was almost double of 10 year treasury yield. 

 

Today S&P 500 is 55% higher at 4536, and S&P 500 P/E is 24% higher at 26.26 (earnings yield of 3.8%), and 10 year treasury yield is 3.84%. In other words, S&P 500 yield is lower than 10 year treasury yield. 

 

Edited July 23, 2023 by LearningMachine

[Viking]

@LearningMachine great trip down memory lane. Thanks for posting. Lots about investing has not changed much. For small investors, costs have come way down. And much better information is available. What hasn’t changed with small investors? If i had to pick one thing it is probably psychology… still making the same mistakes.

[LearningMachine]

53 minutes ago, Viking said:

@LearningMachine great trip down memory lane. Thanks for posting. Lots about investing has not changed much. For small investors, costs have come way down. And much better information is available. What hasn’t changed with small investors? If i had to pick one thing it is probably psychology… still making the same mistakes.

 

@Viking, right on, psychology is the biggest one. 

 

Buffett is such a genius and so generous at sharing his learnings.  Loved how he explained that after no increase from 1964 to 1981, 10X increase from 1981 to 1998 was not just due to interest rates going down and corporate profits' share of GDP going up, but also due to "market psychology":

 

"Once a bull market gets under way, and once you reach the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the game that is responding not to interest rates and profits but simply to the fact that it seems a mistake to be out of stocks. In effect, these people superimpose an I-can't-miss-the-party factor on top of the fundamental factors that drive the market. Like Pavlov's dog, these "investors" learn that when the bell rings--in this case, the one that opens the New York Stock Exchange at 9:30 a.m.--they get fed. Through this daily reinforcement, they become convinced that there is a God and that He wants them to get rich."

 

Indeed some other things have changed since 1999.  "Helpers" have invented new ways of taking a cut of transactions, e.g. SPACs, traffic-routing, options trading, hedge funds, IPOs, acquisition fees, spin-off fees, etc.  Wall street has to stay fed. 

 

Buffett was not able to imagine corporate profits going above 6% of GDP to 10% of GDP without causing political issues.  He was still right on S&P 500 not doing too well from annual growth rate perspective in subsequent 17 years, and political issues cropping up, for example, some folks getting so fed up at not getting their economic share without understanding what's going on that they are getting drawn to conspiracists & demagogues, and ok with putting democracy at risk, and pushing for continued money printing. 

Edited July 24, 2023 by LearningMachine

[KCLarkin]

4 hours ago, LearningMachine said:

 

Buffett said that in May 2019, when S&P 500 was 2932, and S&P 500 P/E was 21.15 (earnings yield of 4.7%), and 10 year treasury yield was 2.39%.  In other words, S&P 500 earnings yield was almost double of 10 year treasury yield. 

 

Today S&P 500 is 55% higher at 4536, and S&P 500 P/E is 24% higher at 26.26 (earnings yield of 3.8%), and 10 year treasury yield is 3.84%. In other words, S&P 500 yield is lower than 10 year treasury yield. 

 

 

Correct. But Earnings Yield < treasury yield is common. The divergence over the last two decades is the anomaly.

 

So if the market crashes, it won’t be due to interest rates.

 

Edit to add: assuming rates don’t rise significantly from here.

Edited July 24, 2023 by KCLarkin

[changegonnacome]

20 hours ago, LearningMachine said:

Maybe Mr. Market will notice when higher interest rates start lowering some debt-laden companies' profits such that overall corporate profits as a percent of GDP go down from current high of around 10%, a percentage that was unthinkable to Buffett in 1999?

 

It's interesting - alot to unpack.

 

Low inflation twinned with low interest rates......allows government to run larger fiscal deficits.....larger deficits have a very good correlation with larger profits for the private sector.

 

Unclear yet whether we are going back to the old regime (ZIRP) or entering a new era (sea change). Lot of arguments in favor of the latter, but let's see.

 

If we are entering non-ZIRP......and interest rates have already started that move.......that will impose, in time, a level of fiscal discipline on government that will shrink annual budget deficits.....which in turn will have knock-on effects for corporate profits.

 

I've been banging on about it since late 2021.....but the most dangerous thing in this environment IMO are relatively slow FCF growers with high multiples........the multiple compression these instruments could be subject too if we are entering a new era makes them dangerous. That these instruments in the main now are recognized as 'best' companies in the market makes them doubly dangerous. You can feel safe buying Apple at 35 times earnings......its far from it however.

[scorpioncapital]

3 hours ago, changegonnacome said:

I've been banging on about it since late 2021.....but the most dangerous thing in this environment IMO are relatively slow FCF growers with high multiples........the multiple compression these instruments could be subject too if we are entering a new era makes them dangerous. That these instruments in the main now are recognized as 'best' companies in the market makes them doubly dangerous. You can feel safe buying Apple at 35 times earnings......its far from it however.

 

Is operating margin also propping up fcf ratios? op margins are an indirect proxy for 'moat quality'. I've observed slow fcf growers with high margins and good moat tend to have higher p/e ratios but they will also compress, but perhaps less?

[Intelligent_Investor]

A lot of it is simply the math of compounding. If a company is able to compound equity at 20% a year for decades, its damn near impossible to overpay for it based on near term multiples. 35x earnings on a company that compounds at high double digits for several decades is not expensive, if the moat doesn't collapse.

[LearningMachine]

2 hours ago, Intelligent_Investor said:

A lot of it is simply the math of compounding. If a company is able to compound equity at 20% a year for decades, its damn near impossible to overpay for it based on near term multiples. 35x earnings on a company that compounds at high double digits for several decades is not expensive, if the moat doesn't collapse.

 

Looking backwards, it is easy to say in hindsight which companies compounded equity at 20% a year for decades. 

 

Looking forward, much harder to do.  Even where the general consensus is that the company will compound equity at 20% a year for decades and is reflected in price, I think neural nets are getting persuaded by the story telling around the company by others more than actually figuring out that certainty is high, and a lot of times, they are going to be disappointed.

 

Any companies that you think will compound equity at 20% a year for decades?

[Intelligent_Investor]

I think some of the great Chinese companies have a chance plus there's a margin of safety due to the geopolitical uncertainties right now. The top American companies are trading at a premium so not exactly a margin of safety. Tencent I feel is probably the best bet for a relatively longer term compounder with an almost impenetrable moat.

[Intelligent_Investor]

The other thing to take into account is that for many top companies that have a large net cash position where that net cash position is growing, P/E is misleading because it is generally overstated relative to EV/FCF simply due to the fact that the large net cash position inflates market cap. So you might see one of these companies with a P/E of 35 but an EV/FCF of 22. 

[mattee2264]

Buffett has only a limited ability to time the market and to the extent he can it is not because he uses simple metrics like earning yield compared to bond yield or trends in corporate margins, market cap to GDP etc. And he has a habit of oversimplifying things and failing to mention all the other factors he would take into consideration as well as his general intuition he has developed from walking talking breathing  markets for most of his adult life. And I think he is a lot more careful about making market prognostications as a result as well as knowing people take his advice at face value and rely too heavily on it because of his fame and fortune. 

 

Interest rates are related to stock prices. But it is not as simple as saying if interest rates double then stock prices will halve. The risk free rate is just one input into equity valuation. An increase in the interest rate can be offset by more confident investors (i.e. a lower equity risk premium), better growth prospects (and inflation actually increases growth prospects for companies with pricing power) and changing composition of the market. 

 

And market cap as a percentage of GDP and corporate profits as a percentage of GDP are useful but not conclusive because they also are not time consistent and there are reasons why they are a lot higher such as increased market power, change in the composition of the economy towards technology and services, and lower tax rates etc. 

 

 

 

 

Edited August 5, 2023 by mattee2264