Warren Buffett’s golden rule for when to buy

Warren Buffett used this rule of thumb

According to one of Warren Buffett’s rules of thumb the ASX is about fair value.

Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, says the best measure of value in the sharemarket is the market cap as a proportion of GDP. Bloomberg

There have been plenty of words written about Warren Buffett’s investment strategy and success over the years. Here’s a few more.

It’s been 15 years since the investment legend first said the best way to value the sharemarket was to look at its market cap as a proportion of gross national product.

With interest rates at record lows, the S&P ASX 200 index up 13 per cent since the major sell off in February – but off around 5 per cent over the past few weeks – and the reporting season just finished, what would Buffett think of the local sharemarket right now?

Graham Witcomb from InvestSMART has taken a look at this valuation method using gross domestic product around $1.62 trillion and the market cap of the major index at close to $1.49 trillion, and the answer is the major index isn’t overvalued at all.

Indeed, right now at 0.92 of GDP the ASX capitalisation is pretty much where it has been on average if investors take this measure and go back to 2001, which is when Buffett first mentioned it.

Not surprisingly there were two large spikes in this measure if you go back further, the first in 1987 when it got to around 1.2 and then in 2007, just before the global financial crisis when it got to almost 1.5.

But the standout point for Witcome is just how stable this measure has been since 2009 when stocks really started to take off.

Since then the measure has traded a tight range between 0.8 and 1.0.

According to Buffett, his golden rule is that, investors should buy when the total market capitalisation is between 0.7 and 0.8 of the country’s economic output (that is, gross domestic product). 

The Oracle from Omaha has said in the past that if you do that it is “likely to work very well for you”.

For all the hype around the sharemarket it’s at close to fair value. On this measure anyway.

“These days, we can’t read the financial news without being carpet bombed with the words ‘bubble’ and ‘crash’. Yet, at least as far as Buffett’s favourite valuation measure is concerned, the ASX as a whole doesn’t seem particularly overvalued” said Witcomb.

On the expensive side

If anything it’s probably surprising that with interest rates so low that the measure doesn’t show that stocks are more on the expensive side.

But it doesn’t.

Of course there’s other ways to measure value.

The well-known forward price earnings ratio for a start.

On this measure the major index is trading on a forward PE of just under 16 times, above its longer term average of around 14.5 times earnings.

Another favoured play is momentum investing.

This entails buying the 10 best performers from the year before and selling the 10 worst although the Dogs of the Dow theory says just buy the worst stocks from the year and watch them turnaround.

Hopefully.

In keeping with the market at fair value the analysts at InvestorSMART are finding there’s not exactly a lot of cheap stocks around, however some stocks in the housing sector is still in good shape.

Cost cutting

Cost cutting has helped the miners so any increase in commodity prices will help BHP Billiton and Rio Tinto although these stocks look like they are at the top of their recent trading ranges and might struggle to make further gains from here.

One bright spot was the retail sector as consumers look to be in reasonable shape, while according to BT Financial Management one third of all companies that reported in August talked up their chances of making money from China.

Airports and airline stocks will win as inbound tourism continues to rise.

Original [edited] article here

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