Buffett's Ratio Says Stocks Look Interesting

Warren Buffett's single best measure of valuation says stocks are attractive

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Warren Buffett's single best measure of valuation says stocks are attractive, writes The Motley Fool

One of the hardest things to grasp in investing is that when the present turns the darkest, the future becomes the brightest.

Warren Buffett once captured this with a famous and oft-repeated quote: "I will tell you how to become rich: Be fearful when others are greedy, and greedy when others are fearful."

There's another, more specific Buffett rule that gets less attention. In 2001, Buffett wrote an article for Fortune magazine laying out a few investing truisms.

The single best measure…

In short, you want to buy stocks when the total market capitalisation of all public companies looks cheap in relation to that country's gross national product (similar to gross domestic product, or GDP). He called this technique "probably the best single measure of where valuations stand at any given moment."

He even threw around some numbers. "If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you."

Where are we today? After the market bloodbath of the past few weeks, the ratio of U.S. stocks to GNP recently hit 79% — just below what I'd call Buffett's comfort zone.

Understand what this does not mean:

  • It does not mean stocks are bound to go up in the short run. No metric can predict that.
  • It does not mean stocks won't fall further from here. A ratio becoming mildly attractive doesn't rule out the possibility of it becoming much more attractive. In fact, that's usually how it works. The history of bear markets is that of stocks becoming not just a little cheap, but obnoxiously cheap.

And importantly, other valuation metrics, such as the cyclically adjusted P/E ratio created by Yale professor Robert Shiller, still peg U.S. stocks as slightly overvalued.

But Buffett's metric means things start getting interesting. Forty years of data show there's a fairly strong correlation between Buffett's ratio and stock returns two years hence. At 79%, today's ratio is in a range that has historically set investors up for decent future returns:

U.S. Stocks as % of GNP Ave. Subsequent 2-Year Return
<60% 21%
60% – 80% 24%
80% – 100% 13%
>100% (4%)

Source: Dow Jones, St. Louis Fed, author's calculations. Data since 1971.

The odds are in your favour

There are no certainties. There are no promises. But investing gets interesting when the odds of success are in your favour.

And although this is based off American data, Australian investors should know that where U.S. stocks go, the Australian stock market follows.

Buffett's ratio suggests the odds are in your favour now. If you were excited about stocks a month ago, you should be thrilled about them today. Indeed, many of us are.

In recent articles and discussions, fellow Fools have pointed out Telstra (ASX: TLS), Commonwealth Bank of Australia (ASX: CBA), ANZ (ASX: ANZ), Westpac Banking Corporation (ASX: WBC), National Australia Bank (ASX: NAB), CSL (ASX: CSL), Woolworths (ASX: WOW) and QBE Insurance (ASX: QBE) — among others — as opportunities we're excited about after the slump.

"The lower things go, the more I buy," Buffett said last week.

How about you?

Get more great stock ideas from this special free report from The Motley Fool. Inside, you'll find 2 Safe Ways To Play The Commodities Boom. Click here for instant access.

Motley Fool staff and freelancers may have interests in any of the stocks mentioned in this report. These interests can change at any time. The Motley Fool has a living, breathing disclosure policy.

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