Warren Buffett: Buy Stocks With Price To Earnings Ratios Under 11x

Key Concepts

• Central Value Theory: Benjamin Graham’s approach to valuation, suggesting stocks should be valued at an earnings yield approximately one-third above bond yields.
• Margin of Safety: The difference between the intrinsic value of an investment and its market price, providing a buffer against errors in valuation or unforeseen events.
• Intrinsic Value vs. Market Price: The inherent worth of a business versus its current trading price, a core tenet of value investing.
• Relative vs. Absolute P/E Ratios: Understanding how a company’s P/E ratio compares to its industry peers (relative) versus its historical average or overall market (absolute).
• Efficient Market Hypothesis (EMH): The theory that asset prices fully reflect all available information, making it impossible to consistently outperform the market.
• Reinvestment of Capital: The process of a company using its profits to fund future growth and expansion.
• Future Earnings Potential: Focusing on a company’s projected earnings growth rather than solely relying on current earnings multiples.

Valuation and Investment Philosophy

The discussion centers around the principles of value investing, emphasizing a long-term perspective and a focus on intrinsic value rather than short-term market fluctuations. A rigid valuation formula is discouraged; instead, a general framework guided by the principles of Benjamin Graham is preferred. Graham’s Central Value Theory is cited, suggesting an average stock should be valued at an earnings yield about one-third above bond yields – currently around 11 times earnings. However, the speakers stress that the current multiple is less important than the future earnings potential.

As Warren Buffett states, “It’s the future that counts. It’s like what Wayne Gretzky says to go to where the puck is going to be, not where it is.” The interaction between the current multiple, the reinvestment of capital, and the rate of that reinvestment are key determinants of attractiveness. Interest rates are acknowledged as a factor, but not at a granular level (e.g., 7.3% vs. 7.0%). Significant shifts in long-term rates (e.g., 11% vs. 5%) would necessitate a different approach. The ultimate goal is to identify businesses that will be significantly more profitable in 10 years and remain attractive at that time.

Coca-Cola Case Study

The Coca-Cola investment in 1988-89 is presented as a prime example. The stock was purchased at an average price of $11 per share, while earnings were estimated at $2.30-$2.40 per share. This equates to under five times current earnings, but represented a reasonable multiple at the time of purchase, considering future growth prospects. This illustrates the importance of considering future earnings potential rather than solely relying on current multiples. The speakers acknowledge they didn’t formally calculate a precise valuation, but relied on a general understanding of the business’s future prospects.

Buffett notes, “We don’t think there’s that kind of precision to we think it’s the right way to think in a general way.” He further emphasizes the need for a substantial “margin of safety” – an investment should be so attractive that pinpoint accuracy isn’t required.

Price-Earnings Ratios and Market Sentiment

The discussion then shifts to the dynamics of Price-Earnings (P/E) ratios. Relative P/E ratios increase when investors expect a company or industry’s prospects to improve relative to others. Absolute P/E ratios rise with expectations of future returns on equity and changes in interest rates. The period since 1982 is cited as an example, with decreasing interest rates and increasing corporate profits driving up stock valuations. Enthusiasm for a specific business or industry further elevates its relative P/E ratio.

Simplicity and Avoiding Complexity

A key theme is the value of simplicity in investment strategy. Buffett draws an analogy to Olympic diving, arguing that there’s no extra reward for attempting complex investments. “You get paid just as well for the most simple dive as long as you execute it all right. And there’s no reason to try those three and a halfs when you get paid just as well for the one foot bars.” The focus should be on identifying easily understandable businesses with clear growth prospects, rather than attempting to analyze complex or obscure opportunities.

The Efficient Market Hypothesis and Academic Bias

The conversation addresses the Efficient Market Hypothesis (EMH), prevalent in many academic finance programs. The speakers criticize the EMH, suggesting it’s often taught with a strong mathematical focus that can lead to intellectual rigidity and a resistance to contradictory evidence. Buffett uses the analogy of a merchant shipping business where competitors believing the world is flat would be at a disadvantage. He advocates for encouraging the teaching of EMH theories in universities, ironically, because it creates opportunities for those who can see beyond them.

He observes that academics often become overly invested in the theories they learn in graduate school, making it difficult to revise their beliefs. Charlie Munger adds that the EMH was “massively” contaminating university teaching but is waning. He highlights that anomalies are often dismissed by academics rather than prompting a re-evaluation of their theories, referencing Darwin’s practice of immediately documenting any evidence contradicting his existing beliefs to prevent his mind from rejecting it.

Munger recounts an example of an EMH proponent attributing Buffett’s success to “six sigmas of luck,” a statistically improbable explanation that was later abandoned when it became widely ridiculed.

Logical Connections

The discussion flows logically from general valuation principles to specific examples (Coca-Cola), then to the mechanics of P/E ratios, and finally to a critique of academic finance. The emphasis on future earnings potential consistently ties together the different sections, reinforcing the core value investing philosophy. The critique of the EMH serves as a counterpoint to the academic perspective, justifying the speakers’ unconventional approach.

Data and Statistics

• Graham’s Central Value Theory: Earnings yield one-third above bond yields (approximately 11x earnings currently).
• Coca-Cola Purchase Price: Average of $11 per share (range $9-$13).
• Coca-Cola Earnings (estimated): $2.30 - $2.40 per share (at the time of purchase).
• Six Sigmas of Luck: Used to explain Warren Buffett’s success by an EMH proponent, later abandoned.
• Period of Rising Valuations: Since 1982, driven by decreasing interest rates and increasing corporate profits.

Conclusion

The core takeaway is that successful value investing requires a long-term perspective, a focus on intrinsic value, and a willingness to think independently. Rigid formulas are discouraged in favor of a general framework guided by principles like Graham’s Central Value Theory. Simplicity, a margin of safety, and a focus on future earnings potential are paramount. The speakers advocate for a pragmatic approach, recognizing that precise valuation is often impossible and that a substantial margin of safety is essential. Finally, they critique the academic bias towards the Efficient Market Hypothesis, arguing that it can hinder independent thinking and create opportunities for those who are willing to challenge conventional wisdom.