Warren Buffett: Some Stocks Are Still Very, Very Cheap
- By Robert Stephens, CFA
Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) chairman Warren Buffett (Trades, Portfolio) was asked for his views on present day company valuations at the 2021 annual shareholder meeting. Specifically, he was asked about the "crazy valuations" of technology stocks, such as Berkshire's holding in Apple (NASDAQ:AAPL), that have made large gains over the past few years. In response, he said:
"If present (interest) rates were destined to be appropriate, if the 10 year (yield) should really be at the price it is, those companies that the fellow mentioned in this question, they're a bargain. I mean, they have the ability to deliver cash at a rate that, if you discounted back and you're discounting at present interest rates, stocks are very, very cheap."
His answer is likely to have taken many value investors by surprise. After all, the stock market is currently trading at an all-time high in spite of ongoing risks to economic and company performance, such as global trade wars, rising taxes and the pandemic.
However, in my view, the point Buffett is making is extremely relevant in today's investing environment. The Federal Reserve has reduced interest rates to an historic low. As a result, investors are unable to generate a positive after-inflation return from cash, or from many fixed-income securities. Therefore, there are few attractive asset options other than equities. This has increased demand for shares over recent years.
In addition, a low interest rate means that a discounted cash flow calculation produces a higher company valuation. The discount rate applied to forecast future cash flows is extremely low, which means they are likely reduced to a lesser extent than they have been at any other point in history. This can help to justify higher stock market valuations and higher stock prices (as long as low interest rates persist).
A potential threat on the horizon
Of course, low interest rates are unlikely to remain in place in perpetuity. Economic growth prompted by vast fiscal and monetary policy stimulus can cause higher inflation in the absense of sufficient deflationary pressures to act as a counterweight. This may lead the Federal Reserve to ultimately raise interest rates to try and cool the economy. This could have a detrimental impact on stock prices. Other assets may become relatively more appealing compared to the current status quo, while a higher discount rate may make today's cheap shares appear relatively expensive.
This view was alluded to later on in the Berkshire annual meeting. Buffett said:
"It's a fascinating time. We've never really seen what shoveling money in on the basis that we're doing it on a fiscal basis, while following a monetary policy of something close to zero interest rates, and it is enormously pleasant. But in economics, there's one thing always to remember, you can never do one thing, you always have to say, 'and then what'?"
Buffett was also asked about whether he is currently seeing any signs of increasing inflation. He responded by saying:
"We're seeing very substantial inflation. It's very interesting. We're raising prices. People are raising prices to us, and it's being accepted."
In my opinion, this point is pertinent in today's bull market. Recent monetary and fiscal policy decisions could have unfavorable consequences in the long run.
Some stocks may appear to be very cheap based on today's interest rates. However, the track record of the economy and stock market shows that change is a constant. Therefore, expecting a perpetually-low interest rate may be a dangerous assumption for investors to make, since they have never remained at any specific level over the long run.
In addition, interest rates are extremely difficult, if not impossible, to accurately predict on a consistent basis. Therefore, in my view, it may be prudent to only purchase stocks at a discount to their intrinsic values in today's market environment. This may provide a margin of safety should interest rates ultimately rise and put pressure on company valuations.
Disclosure: The author has no position in any stocks mentioned.
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This article first appeared on GuruFocus.
