Warren Buffett: One metric tells

me the most about the future

Warren Buffett made a name for himself and became a multi-billionaire
by making some savvy moves in the stock market. So, it might surprise
some folks to hear him say that for stock market investors, the most
important metric to watch is found in the bond market.

Everything in valuation gets back to interest rates, Buffett said to

Yahoo Finances Andy Serwer in April.

Recently, Buffett has been fielding a lot of questions about stock

market valuations and how one should value individual businesses. And
repeatedly, Buffett responded by pointing to interest rates.

Its not as simple as CAPE or market cap to GDP

At Berkshire Hathaways recent annual shareholders meeting, an
investor asked Buffett about the relevance of two popular measures of
stock market value: 1) market cap-to-GDP, which Buffett once heralded
as probably the best single measure of where valuations stand at any
given moment and 2) the cyclically-adjusted price-earnings
ratio (CAPE), which was made famous by Nobel prize winner Robert
Shiller and was seen as accurately predicting the dot-com bubble and
the housing bubble.

Every number has some degree of meaning, Buffett said. It means

more sometimes than others. And both of the things that you
mentioned get bandied around a lot. Its not that theyre unimportant.
They can be very important. Sometimes they can be almost totally
unimportant. Its just not quite as simple as having one or two formulas
and then saying the market is undervalued or overvalued.

Having said that, Buffett does see a metric that is arguably more
significant than these two heralded measures of stock market value.

The most important thing is future interest rates, Buffett said. And
people frequently plug in the current interest rate saying thats the
best they can do. After all, it does reflect the markets judgment. And
the 30-year bond should tell you what people are willing to put out
money for 30 years and have no risk of dollar gain or dollar loss at the
end of the 30-year period. But what better figure can you come up
with? Im not sure I can come up with a better figure. But that doesnt
mean I want to use the current figure, either.
So, what does this all mean in the context of todays historically low
interest rate environment? In an interview with CNBCs Becky Quick,
Buffett said that if these rates were guaranteed to stay low for 10, 15
or 20 years, then the stock market is dirt cheap now.

Berkshires long-term returns depend on

interest rates
Early during Berkshires annual meeting, Buffett fielded a question
about calculating the intrinsic value and forecasting 10-year forward
returns for Berkshire Hathaway (BRK-A, BRK-B).

If you pick out 10 years, and youre back to May of 2007, you know, we
had some unpleasant things coming up, but I would say that weve
probably compounded about 10%, Buffett said. And I think thats
going to be tough to achieve in fact almost impossible to achieve,
if we continued in this interest rate environment.

In other words, Buffett is saying that low interest rates signal low
future returns for Berkshire. Indeed, the massive float in Berkshires
vast insurance businesses would be unable to generate much return
when rates are low. And so, knowledge of the path of rates is critical
for forecasting returns.

If I could only pick one statistic to ask you about the future before I
gave the answer, I would not ask you about GDP growth, I would not
ask you about who was going to be president a million things I
wouldnt [ask], he continued. I would ask you what the interest rate is
going to be over the next 20 years on average. The 10-year [Treasury
note yield] or whatever you wanted to do.

It all comes back to interest rates.

A bird in hand is worth two in the bush

To be clear, Buffett isnt so abstract and ambiguous that he wont share
explicitly how he calculates value. On the contrary. He very publicly
endorses discounted cash flow analysis, which will get you intrinsic
value. He calls it the ultimate formula.

Before you get freaked out about the finance jargon, let Buffett do the
explaining.

From the Berkshire Hathaways 2000 letter to shareholders: Indeed,

the formula for valuing all assets that are purchased for financial gain
has been unchanged since it was first laid out by a very smart man in
about 600 B.C. (though he wasnt smart enough to know it was 600
B.C.). The oracle was Aesop and his enduring, though somewhat
incomplete, investment insight was a bird in the hand is worth two in
the bush. To flesh out this principle, you must answer only three
questions. How certain are you that there are indeed birds in the bush?
When will they emerge and how many will there be? What is the risk-
free interest rate (which we consider to be the yield on long-term U.S.
bonds)? If you can answer these three questions, you will know the
maximum value of the bush and the maximum number of the birds
you now possess that should be offered for it. And, of course, dont
literally think birds. Think dollars.

Still struggling? From Buffetts 2010 letter to shareholders: To update

Aesop, a girl in a convertible is worth five in the phone book.

In business, those birds in the bush or girls in the phone book

represent future cash flows, which is roughly future sales less future
costs and expenses. All of that is adjusted for the fact that youre not
guaranteed those birds, girls, or cash. Once you make those
projections, you then discount those future cash flows to the present
by applying a discount rate. Add up all of those discounted cash flows
and youll have the theoretically-sound value of a business.
View photos
This bird is worth two in the bush.
More
The trouble is you dont know what to stick in for the
variables, Buffett said at Berkshires annual shareholders meeting this
past weekend. So, while the model is theoretically sound which
Buffett loves the values youll get will be fantastically off if your
assumptions are wrong. Garbage in, garbage out.

But of the inputs, one variable is by far the most important: the
discount rate, which is tied to the market interest rates Buffett has
been talking about.

NYU finance professor Aswath Damodaran calls it the critical

ingredient, noting that errors in estimating the discount rate or
mismatching cashflows and discount rates can lead to serious errors in
valuation.

So, once again, it all comes back to interest rates.

To summarize, Buffett has told us: Everything in valuation gets back to

interest rates; The most important thing is future interest rates;
and If I could only pick one statistic to ask you about the future before
I gave the answer, I would not ask you about GDP growth, I would not
ask you about who was going to be president a million things I
wouldnt [ask] I would ask you what the interest rate is going to be
over the next 20 years on average.

Buffett: Low Rates Make Stocks

'Dirt Cheap'
Over the past few days, some of the most influential investors in the world
have publicly shared views on some of their best ideas.
First, over the weekend, it was Buffett at his annual shareholders meeting.
The take away, as I said yesterday, "stocks are dirt cheap" if you think rates
will stay low for longer (i.e. below long-term averages). His assumption in
that statement is that the Fed's benchmark rate goes to 3%-ish and done--
well below the long run average neutral rate of 5%.
In addition, he was quite vocal on Apple, a stake he picked up as others
were selling in fear in the first half of last year (being greedy when others
are fearful). And he doubled his stake earlier this year, now holding north of
$20 billion worth of the stock. The analyst community thinks Apple is a
juggling act, with balls that will drop if they don't come up with another
revolutionary product every quarter. Buffett thinks Apple is cheap even if it
doesn't have another single new invention in the future. Why? Because
Apple has developed a services business around its hardware that has
quickly become one of the biggest and fastest growing businesses in the
world.
Remember, back on February 1, I made the case for why Apple could
double. You can see that here. It's gone from a $560 billion company to an
$800 billion company since we added it in our Forbes Billionaire's Portfolio
early last year. Even at $154 a share (today's levels), if we strip out the
quarter of a trillion dollars in cash, we get the existing business for 12 times
earnings.
Now, let's talk about one of the big ideas presented yesterday at the annual
Sohn Conference in New York, where many of top billionaire investors and
hedge fund managers give their outlook on the stock market, the economy,
and talk about their favorite long and/or short picks.
Billionaire investor Jeff Gundlach, who oversees the world's largest bond
fund likes selling the S&P 500 against emerging markets stocks. He thinks
value is distorted relative to global GDP. But it's more a view on
undervaluation of EM, rather than overvaluation of U.S. stocks. He took to
Twitter to defend that view...

Assuming a stable-to-improving world economy, emerging markets stocks

have lagged and offer a great opportunity to catch up with the strength in
the U.S. stock market. It also requires that emerging markets currencies
are a good bet against the dollar, if policy makers around the world are able
to follow the lead of the Fed, where rising interest rate cycles follow. This is
a very similar view to the one we discussed yesterday, where Spanish
stocks (supported by a stronger euro) present a big catch up trade
opportunity--to the tune of about 40% to revisit the 2007 highs--with the
destabilization risk of the French elections in the rear-view mirror.
Follow This Billionaire To A 172% Winner
In our Forbes Billionaire's Portfolio, we have a stock in our portfolio that is
controlled by one of the top billion dollar activist hedge funds on the planet.
The hedge fund manager has a board seat and has publicly stated that this
stock is worth 172% higher than where it trades today. And this is an S&P
500 stock!
Even better, the company has been constantly rumored to be a takeover
candidate. We think an acquisition could happen soon as the billionaire
investor who runs this activist hedge fund has purchased almost $157
million worth of this stock over the past year at levels just above where the
stock is trading now.
So we have a billionaire hedge fund manager, who is on the board of a
company that has been rumored to be a takeover candidate, who has
adding aggressively over the past year, on a dip.