Don’t Blindly Trust Warren Buffett’s Market Bets

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On Wednesday the most famous investor in the world — Warren Buffett — told CNBC that he doesn’t believe that stocks are too frothy. He is bullish on stocks for the long term, and he advised viewers not to sell their solid long-term positions. Is he right?

Despite his reputation, which is beyond reproach, Mr. Buffett gives no concrete evidence for his claims. Nowhere does he cite valuations, dividend yields price to earnings ratios, price to book values, or any other metric that one should use in determining the appropriate value of stocks. This is odd considering that his mentor — the famous Benjamin Graham — wrote two of the most influential books on investing — The Intelligent Investor and Securities Analysis — which spend hundreds of pages detailing exactly how one should use the aforementioned metrics in order to determine the value of a particular investment. In fact he has written a forward and provided chapter by chapter commentary for the former of these two works.

Investors looking at the valuation of stocks in the aggregate (i.e. as measured by the S&P 500) will find that they are historically quite “frothy,” and that while there are plenty of exceptions to this, the blanket claim that stocks are not frothy is not true by historical standards.

The S&P trades at 22 times earnings, yet historically it has traded in the mid-teens; 10 to 12 times earnings is usually a good entry point, and 13 to 17 times earnings is a good level to hold stocks, but not necessarily to buy them unless they have particular strengths, and anything higher is a good level to sell stocks unless again they have particular strengths.

Similarly dividend yields average less than 2 percent on the S&P 500. However, historically stocks have averaged between 4 percent and 5 percent dividend yields, and a stock was only worth buying with a lower dividend yield if it was a high growth stock. Furthermore, a good time to buy stocks before a bull market began was when dividends were as high as 8 percent.

More recently, however, that is since the mid-1990s, higher P/E multiples and lower dividends have become acceptable. Investors, including Mr. Buffett, believe that because the U. S. economy is the biggest and strongest in the world, because interest rates are so low, and because the Federal Reserve can step in and support asset prices if there is a recession looming, that higher multiples are justified. This is simply not the case, and I think many investors who are simply listening to what Mr. Buffett has to say are in for a rude awakening.

That isn’t to say that I think stocks are going to simply collapse and lose 50 to 60 percent of their value — it is more complex than this. Investors need to position themselves in assets that are genuinely undervalued, and this takes more time and effort than listening to Mr. Buffett or looking at a list of his holdings.

Investors need to carefully consider their stock selections and make sure they understand why they will be able to grow their profits, even in a weak economic environment, and how valuable this growth is. For instance I agree with Mr. Buffett’s investment in Exxon Mobil (NYSE:XOM) because the company trades at an attractive 12 to 13 times earnings, management has an historical track record for allocating shareholders’ assets, and strong oil and gas prices will help support the company’s earnings.

On the other hand I disagree with his Procter & Gamble (NYSE:PG) stake, as this company trades at a rich 22 times earnings, it is barely growing, and it is seeing its margins compress. Furthermore, while the company has an historical track record of allocating assets in a way that benefits shareholders, there is little evidence that this is the case more recently.

Investors who apply this sort of thinking to their investments will do well, but those who simply buy stocks because somebody with past success tells them to are risking losses.

Disclosure: Ben Kramer-Miller is long Exxon Mobil.

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