Buffett's Stock Market Indicator

It makes a lot of sense that the aggregate value of a country's stock market should be correlated with its Gross National Product (GNP). Assuming the stock market contains most of the country's largest companies, the value of what those companies produce should constitute a large part of GNP and should also play a large role in determining what those companies are worth, hence the suggested correlation.

In this 2001 article, Buffett argues that while "the [stock market value to GNP] ratio has certain limitations in telling you what you need to know...it is probably the best single measure of where valuations stand at any given moment."

Here's a look at this ratio for the last several decades, as compiled by Carol Loomis and Doris Burke of Fortune:

What we see from the above chart is that stocks now have come down to a more normal historical value, after years of outperforming GNP! Indeed, even after the tech bubble burst, stocks were still expensive, and only after another bull market to 2007 did they come 'crashing' down to today's seemingly normal levels.

Of course, relying completely on this chart could lead one astray. As the market has become more sophisticated over the decades, there may now be a greater percentage of companies that are public, which would lead to an upward trend to this chart rather than a horizontal line. Public sentiment during certain periods may have also resulted in a skewed public to private comany ratio. For example, if we look back at the years during the Great Depression, it is likely that many companies, even many successful ones, remained private for lack of cheap public capital.

Nevertheless, this chart is immediately useful for demonstrating that over the last several years, stocks are clearly trading at a discount to what they were after even after accounting for a drop in the value of goods produced.

The Warren Buffett Way: Introduction

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

On my quest to learn more about Value Investing, several people have recommended that I read Robert Hagstrom’s The Warren Buffett Way. I recently had an opportunity to do so, and found it to be an excellent book that takes Benjamin Graham’s The Intelligent Investor one step further in its application to Warren Buffett’s methodology. If you're interested in a chapter-by-chapter review of this book, Reyer has done so here.

How Did Warren Buffett Become So Successful?
While many of us know Warren Buffett to be the most successful investor of all time, we often have very litte understanding of how he became that way. Hagstrom points to four individuals as major influences on his financial education. Today we'll look at Ben Graham:

Benjamin Graham

Benjamin Graham was Warren Buffett’s professor at Columbia University, and the author of The Intelligent Investor, which introduced the value investing philosophy. He taught Buffett the difference between investing and speculating (Investing is an operation which, upon thorough analysis, promises safety of principal and a satisfactory return) and the importance of building a margin of safety (which is really the core idea of value investing).

The Margin of Safety is the difference between what you pay for company and its intrinsic value. The less you pay, the greater the margin of safety, and the greater the company’s ability to withstand negative events. Because of the reversion to the mean, the company’s value is likely to increase to its intrinsic value.

The Margin of Safety can be increased by looking for companies selling at low prices relative to net current assets and low prices relative to earnings.

Graham’s influence on Buffett is that he taught Buffett the essential quantitative elements of value investing.

On to the rest of the chapters!

Securities Questions

In previous posts, we've discussed some of the legal requirements for those interested in starting up their own investment funds. We've also discussed some of the exemptions available for those who do not meet the requirements. Sometimes, however, the language of the requirements and exemptions leaves itself open to interpretation. So what are your options to get the answers you need?

Depending on your requirements, there are of course lawyers available that will do the research for you, but securities lawyers can charge up to $350 per hour for this kind of work, so a start-up fund will want to avoid this course. Luckily, the securities commissions of various jurisdictions offer the public the chance to ask questions directly. In the US, one can contact the SEC directly.

In Canada, things are a bit more complicated since each province has its own securities regulator. However, the Ontario Securities Commission (OSC) has the toughest rules of the bunch and is also home to almost one third of Canadians. As such, this is probably the first commission one would want to contact for a question about securities laws. One can send a question to the OSC directly here, and if they can't answer the question, they offer a program where an individual can speak to a securities lawyer for 30 minutes for only $6 (Details here).

I recently asked the OSC for clarification on the definition of "investment fund" as well as some of the operational restrictions on "private investment clubs" and distributions within the jurisdiction. Hopefully the quality of the answers they provide match up to their advertised assertions!

The Little Book Of Value Investing: Step 3

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

Step 3 Analysis: Interrogation
At this point, you have narrowed your list to just a few potential investments (perhaps just one or two). Now is the time to conduct an interrogation. This may involve asking questions of the company directly, or it may mean an internal dialogue you have with yourself, playing devil’s advocate. Here are the questions to ask:

1. What is the outlook for pricing for the company’s products? Can it raise prices? Consider Porter’s Five Forces.
2. Can the company sell more? What is the outlook for units? Will it have to decrease prices to sell more units?
3. Can the company increase profits on existing sales? What is the outlook for the gross profit margin? Do they have any control over their basic costs (no company has control over fuel or commodities!)?
4. Can the company control expenses? If not, what are the expected trends in these expenses? (e.g. are they heavily reliant on interest rates that will have to be refinanced periodically at a rate they don’t control? If so, what are the expected trends in interest rates?)
5. If the company raises sales, how much will flow to the bottom line? (Not much if the only way to increase sales is to increase marketing or incentives)
6. Can the company be as profitable as it used to be, or at least as profitable as its competitors? (e.g. GM just cannot compare to Toyota for profitability)
7. Does the company have unprofitable operations that it can shed? What happens to the calculations above if these operations were shed?
8. How does the company think it will do compared to the market’s estimates? How has it performed in the past based on its own estimates?
9. How much can the company grow in the next 5 years, and how will this growth be achieved?
10. What will thec ompany do with excess cash? If re-invested, will it earn a return to justify the reinvestment or should it have been distributing as dividends?
11. What do you expect its competitors to do?
12. How does this company compare financially to its competitors?
13. What is this company worth if it was sold? (Look at comparable sales multiples in the recent past)

This was a great book, and I would highly recommend the series.

Bailout Firms Or Workers?

Much has been made of the recent spate of government bailouts of private corporations. While these actions often spur short-term spending (as would dropping money from a helicopter) and can sometimes be popular moves with the public, economists generally believe these to be a band-aid solution: helping failed companies/industries prevents the economy from producing goods/services in the successful industries where they are most needed.

So should the government do nothing to help alleviate the negative effects of recessions? Not quite. A solution that still results in short-term spending increases but also allocates resources appropriately is one that provides for worker retraining. Government spending should be geared towards helping workers educate themselves so that they can help themselves as well as companies desperate for productive workers. To demonstrate the general need in the US for better trained workers, consider the unemployment rate for various levels of education:

The unemployment rate for those with at least a bachelor's degree is clearly far below the average, both in good times and bad. Furthermore, this chart covers only unemployment rates, not salaries, which we'll look at in a future post.While the number of post-secondary education graduates increases every year, the government should be focusing its spending on accelerating this process. Laid-off workers and unemployed workers should be offered the aid they need to increase their productivity and hence return to the work force in a position to make larger contributions to society. The opportunity is there; here are the compositions of the labour force by education level:

With 38% of workers showing no college education, both these workers and the economy stand to benefit from spending that encourages education.

Thain's Gains Or Losses

John Thain took the reigns as CEO of Merrill Lynch less than one year ago. He oversaw the company as its stock dropped nearly 70% and a deal was eventually struck to sell the company to Bank of America. Thain lobbied for a $10 million bonus following the takeover, but withdrew his request when there was a public outcry. Then, when the media sensationalized his office purchases, Thain reported that he would pay the firm back for the excessive purchases which "shouldn't have been made". Smart move, lest he be vilified like his fellow former CEO Richard Fuld, whom we discussed here.

Reviewing the list of items Thain purchased for his office definitely lends itself to some shock for the reader. When Thain purchased these, perhaps they seemed to make sense since it was the office that was footing the bill. In retrospect though, now that Thain is paying for these himself, he must also be wondering what he was thinking:

• Area Rug $87,784
• Mahogany Pedestal Table $25,713
• 19th Century Credenza $68,179
• Pendant Light Furniture $19,751
• 4 Pairs of Curtains $28,091
• Pair of Guest Chairs $87,784
• George IV Chair $18,468
• 6 Wall Sconces $2,741
• Parchment Waste Can $1,405
• Roman Shade Fabric $10,967
• Roman Shades $7,315
• Coffee Table $5,852
• Commode on Legs $35,115

If attracting intelligent CEOs requires allowing these types of expenses, maybe it's in the best interests of shareholders to allow this to take place: they are desperate for a manager that can pull them out of this mess. But on the other hand, it seems paradoxical that a competent management would see it fit to spend over $1400 on a garbage can, whether the company is tanking or not.

Spending of this nature would make our friends at Early Retirement Extreme cringe!

Microsoft Stock Dips

Last week, Microsoft (MSFT) reported quarterly earnings not that different from those of one year ago. Revenue was up 2%, while operating income was down 8%. MSFT decided to cut 5,000 jobs, and announced a large expected drop in operating expenses in the next six months. So from a profit point of view, things aren't too different from what they were one year ago. The stock, however, trades at about half of what it did one year ago.

Does this represent a buying opportunity? A quick look at MSFT stock reveals a characteristic fairly unique to Microsoft as compared to its peers of similar market cap: its large cash position. Microsoft carries far more cash ($21 billion) than it does debt ($2 billion)! When one subtracts this net cash position from MSFT's market cap, one is left with a $134 billion company with no debt.

So what is a buyer getting for that $134 billion? MSFT's trailing P/E is just 7.5 after taking into account all that cash. Is it a company in decline? Don't believe all the anti-Microsoft hype! The company has a strong position in a growing and lucrative international market, as seen by its revenue and net income growth in the last few years ($ billions):

MSFT hasn't traded at this price in 10 years, despite gigantic profit growth in that time. The sale currently taking place in the stock market is incredible!

Disclosure: None