Why Is The Stock Market’s Biggest Tightwad Buying?

As many of you know, we admire Warren Buffett and his “sidekick,” Charlie Munger. They seek out quality businesses at bargain prices and have a stunning record of success. Both personally and with stock ownership, they are notorious tightwads with their own money and the money of our common stock holding, Berkshire Hathaway (BRK-B). Recently, Buffett outlined his view on the current level of stock prices in his shareholder letter and on TV. He argued that if interest rates stay near the 2.3% level on ten-year Treasury bonds, common stock investors would get rewarded for their ownership and patience.

As we approach the Berkshire Hathaway Annual Meeting, we thought it was a good time to explore why Buffett would be buying stocks in a stock market which looks relatively expensive on a Price-to-Earnings ratio (P/E) basis compared to history, and in a stock market which trades for over 120% of U.S. Gross Domestic Product (GDP). Why do we at Smead Capital Management get excited every day to own the companies we hold in our portfolio, including BRK-B in that same stock market?

We looked to research from Jim Sloan, published in a piece called, “Why Buffett Isn’t As Worried About Valuations As Some of Us Are.” In his piece, Sloan quoted from Buffett’s 1977 Fortune article called, “How Inflation Swindles Equity Investors.” It showed how Buffett views stocks as “equity bonds” which tend to perpetually compound retained earnings at 12%. Buffett did that writing to argue for owning stocks in both inflationary and deflationary eras because of the “magic” of internal compounding.1

Buffett referred to the period from 1949 to 1966 in that Fortune article as “the good old days”:

The news was very good indeed in the 1950s and early 1960s. With bonds yielding only 3 or 4%, the right to reinvest automatically a portion of the equity coupon at 12% was of enormous value.

Therefore, we thought our readers would like to see a few visual examples of why, in Buffett’s theory, extended periods of low long-term interest rates deserve much higher capitalizations than normal. We will do this by reintroducing the way we use the “Modern Graham formula” for calculating the intrinsic value of a company. In doing so, we will seek to show how heavily Ben Graham, the dean of value investing, believed that interest rates affected intrinsic value calculations.2