Buffett’s favourite index reaches milestone

Buffett’s favourite index has now reclaimed its highs prior to the GFC. What should investors do now?

In the chart below you can see Warren Buffett’s favoured valuation metric, which divides the market value of US stocks by gross national product. The orange line represents the US market, and the blue line is our attempt at valuing the Aussie market.

Screen shot 2013-09-11 at 12.11.26 PM

We’ll leave a discussion of the technical difficulties we had calculating the Aussie ratio for another day, but the key point is that ratios above 100% have coincided with periods of overvaluation. You can clearly see the US tech bubble in 1999 and the strong run up in valuations until the GFC broke badly in 2008.

For value investors, the fact that the ratio in the US has reclaimed its high from 2007 is a mixed blessing. While investors that bought and held on through the uncertainty of the past four years are now being rewarded, the question now is whether to keep holding, sell out or at least start rebuilding cash holdings in anticipation of the next great buying opportunity.

While the US market has shown the Aussie market a clean set of heels (the Aussie market has only just recovered the losses since 2007 if you include dividends), the ratio for the Aussie market is now around 100%. Intelligent Investor Share Advisor’s buy list is also very short, as valuations for high quality and income stocks have increased dramatically and those stocks that look cheap statistically are largely indistinguishable from junk.

With interest rates at record lows, the impulse to take on more risk is stronger than ever as investors try to earn a decent return on the investments. So what is a conservative, risk-averse investor supposed to do?

First, don’t relax your standards. If you wouldn’t take certain risks when the official interest rate was 5%, there's no reason to accept them now that the official interest rate is half that. As frustrating as it might be, picking up a bit of extra yield for two or three years won’t compensate you for permanent losses of capital thereafter. Just ask those that were attracted to the high distributions and apparent safety of listed property trusts in the lead up to the GFC.

Second, forget about the index. Your job as a value investor is to find individual securities that compensate you for the risks you are willing to take. Even in an expensive market there will be bargains, just as there will be over-valued stocks at the bottom of a bear market.

An investment made in ARB Corporation – which boasts strong competitive advantages, first class management and a pristine balance sheet – at the peak of the boom in 2007 has increased three-fold if you include dividends. Focusing on the index would’ve meant missing out on buying one of Australia’s best businesses at a bargain price.

Third, look out for special situations that aren’t hitched to swings in the economy or the market. While it certainly wasn’t risk-free, investing in Australia Infrastructure Fund after The Future Fund announced it was acquiring most of the company’s assets has provided a tidy return in a short period, particularly for those on low tax rates.

Fourth, remind yourself that it’s ok to hold cash if you can’t find suitable opportunities. While holding cash for decades will produce abysmal returns, it’s great to have some around when the market falls sharply.

One reason share prices fell so far and so quick in 2009 was because highly geared investors were forced to meet margin calls and fund managers had to meet redemptions. These reasons had nothing to do with conservative assessments of intrinsic value, which meant those armed with cash that kept their emotions intact were able to purchase at values that marked a generational low.

Lastly, remember investing is a long game. ‘Profits can be made safely only when the opportunity is available and not’, as Don Brinkworth once said, ‘just because they happen to be desired or needed.’

With valuations not offering large margins of safety across the board, patience, the ability to act decisively when an opportunity comes along and the courage to go against the grain when the odds are in your favour will ensure you keep what you’ve made since the GFC and beat the market in the years ahead. It's simple, but not easy.

Note: Thanks to our friends at Greenbackd.com for supplying the US data.

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