FOOL ON THE HILL
Buffett on the Stock Market

Two years after publishing a prescient article warning investors about the perils of tech stocks and urging them to reduce their expectations from investing in the stock market, Warren Buffett is back with further insights into the market's valuation today, an estimate of what returns the market might deliver to investors over the next decade or two, and strong words for how companies are handing pension fund accounting.

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By Whitney Tilson
November 27, 2001

Almost exactly two years ago, Warren Buffett published in Fortune magazine a brilliant, prescient article, warning investors to lower their expectations regarding stock market returns and, in particular, to be wary of a tech stock bubble. He traced the history of other "glamorous businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors," and concluded with some of the most important words ever written on investing:

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

With the Internet and tech stock mania gripping the country, Buffett was dismissed as an out-of-touch old fogey. My, how times have changed! Though the tech stock bubble continued to inflate for another four months after Buffett published his article, his predictions have come true. Investors who failed to listen have paid the price: The Nasdaq is since down 43%, and the S&P 500 15%, while the stock of Berkshire Hathaway (NYSE: BRK.A), Buffett's holding company, is up 17%.

Perhaps investors today will pay more attention to Buffett's latest thinking, Warren Buffett on the Stock Market, which appears in this week's Fortune. I urge you to read it before you continue with this column, as Buffett's thinking and writing are a lot better than mine, and my comments will make more sense.

Market forecast
In the first part of the article, Buffett repeats and then expands upon his thinking two years ago, when he concluded that for stocks to continue to rise at the double-digit rate investors then expected, either corporate profitability would have to become a larger and larger fraction of Gross Domestic Product or interest rates would have to continue to fall. Neither, he felt, was very likely.

He expected, therefore, "equity returns over the next decade or two (with dividends included and 2% inflation assumed) of perhaps 7%." (Or 6% net after frictional costs such as commissions and fees.) Today, he's bumped that forecast up by one percentage point to 7% net, given that "the country's economy has grown and stocks are lower, which means that investors are getting more for their money."

The profitability/interest rate trade-off
I think Buffett's forecast is virtually certain to be correct, plus or minus a few percentage points, because I agree that it's highly unlikely that corporate profitability will boom once again and interest rates will stay low. Consider the past two years: Corporate profits have fallen markedly while long-term interest rates have remained roughly flat.

A skeptic might argue that Buffett's forecast was only half right, but that would mean ignoring a critical insight: Alan Greenspan has kept interest rates low because the economy is weakening and corporate profitability is falling. When the economy picks up again, Greenspan (or his successor) will become less concerned about a recession and focus instead on combating inflation -- and, therefore, boost rates, which will act as a brake on the stock market.

I'm not ruling out the possibility that low rates and a booming economy could happen again -- I'm certainly not an expert in this area -- but I'd argue that it's equally likely that high rates and a recession could occur.

Looking in the rear-view mirror
Despite the power of Buffett's arguments, few investors appear to see the logic of his long-term market forecast. Most investors -- including corporations and pension funds, as discussed below -- still believe the market will deliver double-digit returns, studies show. Buffett attributes this unwarranted optimism to "the mistake that investors repeatedly make: People are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them."

It's quite reasonable to apply patterns to most things in life. If your car breaks down repeatedly, for example, it probably will again. If someone lies to you, would you trust them again? But when it comes to investing, don't think this way! Yes, some patterns continue -- often for a long time -- but there is a powerful force at work called "regression to the mean."

Applied to individual businesses, this means high-return-on-capital companies are likely to become less-high-return-on-capital companies over time. The fierce competitiveness of our capitalist system is generally wonderful for consumers and the country as a whole, but bad news for companies that seek to make extraordinary profits over long periods of time. Applied to macroeconomic factors, it means, for example, that as interest rates fall further and further below their historical levels, the odds become greater and greater that higher interest rates will follow. The same is true of oil prices, inflation, GDP growth, and so forth.

Yet investors as a group do not appear to understand regression to the mean. For instance, I recently observed a class of very bright MBA students who presented evaluations of numerous companies. In nearly every case, the companies' results were poor over the past year, so guess what the students did? They projected the companies' most recent weak cash flows far into the future, discounted them back to the present -- using elaborate spreadsheets, of course -- and concluded that the stocks were overvalued.

I don't recall much independent thinking about whether the companies' cash flows might be temporarily depressed or what catalysts might boost results, but this is exactly what is required for successful investing. (The professor, interestingly, noted that two years ago, a similar group of students evaluated a similar group of companies and made the same mistake -- in the opposite direction: They projected then-booming cash flows forever into the future, concluding that the stocks were cheap despite much higher prices than today.)

Valuing the market
Given that the market is prone to bouts of euphoria and depression, how can an investor determine which condition is present at any given time? There are, of course, countless metrics -- P/E ratio, dividend yield, etc. -- but Buffett presented only one: The market value of all publicly traded securities as a percentage of U.S. Gross National Product. He admits that it has "certain limitations," but argues that "it is probably the best single measure of where valuations stand at any given moment."

So where are we today? Buffett refers to a chart showing this ratio over the past 80 years (there's no link in the online article, so I guess you'll have to buy the magazine to see it) and concludes that if it "falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% -- as it did in 1999 and part of 2000 -- you are playing with fire. As you can see, the ratio was recently 133%."

In other words, the market is still richly valued by Buffett's measure. In fact, it's at nearly twice the level at which he would be excited about buying stocks in general.

The scandal of pension fund accounting
Buffett saves his strongest language for the topic of pension fund accounting. (You can read my rant on this topic in last week's column. The long-running bull market, in short, inflated the value of the funds many companies had set aside to pay future pension obligations, such that the plans became overfunded. This, in turn, allowed companies to apply such gains toward reducing product or operating costs, thereby inflating earnings.)

Buffett uses similar statistics to those I presented, but adds a powerful twist: He compares the expected pension fund returns certain representative companies are using today with the expected returns the same companies used in 1975 and 1982.

Despite far lower interest rates today (a significant fraction of pension funds are invested in bonds), these companies are projecting far higher returns, which Buffett thinks are ludicrous: "I'm a sporting type, and I would love to make a large bet with the chief financial officer of any one of [ExxonMobil (NYSE: XOM), GE (NYSE: GE), General Motors (NYSE: GM), and IBM (NYSE: IBM)], or with their actuaries or auditors, that over the next 15 years they will not average the rates they've postulated."

So why are the assumptions so high? To some extent, Buffett notes, it's "that rear-view mirror again," but he also notes that "heroic assumptions do wonders... for the bottom line. By embracing those expectation rates... these companies report much higher earnings -- much higher -- than if they were using lower rates."

Buffett then proceeds to blast the actuaries: "The actuaries who have roles in this game know nothing special about future investment returns. What they do know, however, is that their clients desire rates that are high. And a happy client is a continuing client."

After effectively calling actuaries corrupt, Buffett then targets companies and their boards of directors:

"Unfortunately, the subject of pension assumptions, critically important though it is, almost never comes up in corporate board meetings. (I myself have been on 19 boards, and I've never heard a serious discussion of this subject.) And now, of course, the need for discussion is paramount because these assumptions that are being made, with all eyes looking backward at the glories of the 1990s, are so extreme."

"Considering how poor returns have been recently and the reprises that probably lie ahead," he continues, "I think that anyone choosing not to lower assumptions -- CEOs, auditors, and actuaries all -- is risking litigation for misleading investors. And directors who don't question the optimism thus displayed simply won't be doing their job."

Wow! Buffett does not lightly use words and phrases like "critically important," "extreme," "litigation for misleading investors," and "won't be doing their job." In fact, having read a great deal of what Warren Buffett has written for public consumption over his career, I can safely say that I can't recall any instance of him using such strong language, even for other corporate evils about which he feels strongly.

-- Whitney Tilson

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/