It’s Alive! Buffett’s favourite valuation measure

Greetings!

After a long hibernation this blog has been brought back from the dead. In the meantime I have left Copenhagen, moved to sunny Sydney, and taken on a full time equity analyst position. After getting fired up by chatting to a few excellent Sydney-based investors recently I thought it was about time to get posting again.

The Australian market is less developed than the US. Which often makes it gloriously inefficient (nothing to complain about!). But it also means that there is just less data and analysis of the market available.

One area that doesn’t get a lot of press (beyond superficial coverage) is relative valuation of the Australian share market. We often hear about how much the market is up or down in a given week, month, or year, but there is not often a lot of context to those numbers. So I thought I’d recreate some of the measures that are commonly discussed in the US (if anyone knows of a good Aussie resource for this type of stuff please let me know!)

To start off lets look at the ratio of Market Capitalisation to GDP. A ratio that Buffett calls “probably the best single measure of where valuations stand at any given moment.” The logic is pretty straightforward, and most value investors will be familiar with the measure so I won’t rehash it all here.

The ‘Buffett ratio’ for Australia (2003-2014):

Buffett measure

(Source: ASX, Australian Bureau for Statistics)

I was surprised by just how closely correlated the ‘Buffett ratio’ has been to the All Ords (although given the influence of valuation on market capitalisation, a high correlation is not too surprising).

Over the 11 year period from 2003-2014 the average Buffett ratio has averaged just on 90%. Just by eyeballing the chart we can see that whenever the ratio has moved meaningfully above its long-term average it has tended to lead to poor returns in subsequent periods.

As of June 30th 2014 the Buffett ratio for Australia stood at 99%. This is still far from the 125% that it hit in 2007 however it should be a call for caution. A reminder to keep our standards high.

Below is a scatter plot of the quarterly Buffett ratio data (x-axis) and the corresponding 2 year return for the All Ordinaries index (y-axis). The dashed line indicates the current Buffett ratio for the ASX.

Over the past 11 years there has only been one quarter with a Buffett Ratio above 99% where the All Ords went on to generate a positive return over the following 2 year period. In all other cases the following 2-year return was negative. Applying a simple linear regression analysis to the current Buffett ratio would imply an expected return for the All Ordinaries over the next 2 years of -3.4%.2 Year Return 99

A value investing strategy performs best in falling and flat markets, so the prospect of a decline in general valuations should be exciting, not alarming. But its also a good reminder to stick to our strategy – now is not the time to start lowering our standards!

Note: This is still a small sample size so I will look to expand the number of periods for the next time that I update it.

P.S. For anyone interested I have also updated the ASX margin lending figures posted previously. Nothing to see here so I won’t post this one again until Mr Market gets giddy.

Margin Lending

 

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3 thoughts on “It’s Alive! Buffett’s favourite valuation measure

  1. Hello, great blog, I recently discover it and will certainly follow it. But I wanted to point out Buffett’s preferred measure was using Gross National Product instead of GDP. Without pulling out my economic text books to jump into the fine details of the difference, but GNP reflected the fractional ownership rights to income from investments and activities outside of the domestic country. Where as GDP only counts the domestic production.

    • Hi Jeffrey,

      Thanks for the feedback! Great point that you raise about GNP vs. GDP. I will see how the data looks with the difference.

      I think the ratio makes sense relative to each country’s history, rather than to an absolute level, so the GDP vs. GNP difference will only count to the extent that the relationship between GNP and GDP has diverged. That said, it certainly is possible that it has diverged over recent years, so its worth looking at.

      Thanks for the great constructive feedback Jeffrey!

      Cheers,
      Matt

  2. Pingback: Buffett Ratio Update | SoloThink

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