Warren Buffett: Why The CAPE Ratio Doesn’t Work Any More

Key Concepts

• Market Valuation: Assessing the worth of markets or companies, using metrics like Market Cap to GDP and Cyclically Adjusted PE ratios.
• Intrinsic Value: The true, underlying value of a business, determined by the present value of its future cash flows.
• Return on Capital: A measure of profitability reflecting how efficiently a company uses its capital to generate earnings.
• Wholesale Distribution: A business model focused on high volume, low margin sales, relying on rapid inventory turnover.
• Reputational Advantage: The benefit derived from a consistent track record of reliability, speed, and fulfilling commitments.

Market Valuation & Berkshire’s Investment Approach

Warren Buffett and Charlie Munger emphasize that relying solely on formulas like Market Cap to GDP or Cyclically Adjusted PE ratios for valuation is insufficient. While these metrics can offer some meaning, they are not “paramount” in Berkshire Hathaway’s investment decisions. Buffett states, “Evaluation of a business is…not reducible to any formula where you can actually put in the variables uh perfectly.” He acknowledges the theoretical ideal of valuing a business as the present value of all future cash flows, but highlights the difficulty in accurately determining the variables. He points out that current interest rates, often used as a benchmark, aren’t necessarily the rates one wants to use in valuation.

Munger adds a pragmatic perspective, stating, “The first rule of fishing is to fish where the fish are,” implying that market opportunities exist in various locations (like China) but aren’t determined by specific valuation metrics. He clarifies this isn’t about using the mentioned “yardsticks” to compare markets, but rather identifying where opportunities exist.

The Value of Experiencing Business Failure

Buffett stresses the significant learning opportunity derived from running a “lousy business for a while.” He argues that struggling with a poorly performing business provides more valuable insights than operating a successful one where inherent strengths mask operational weaknesses. He explains, “You learn a whole lot more about business by actually struggling with a a terrible business for a couple of years then you run by then you learn by getting into a very good one where the business itself is so good that you can’t mess it up.” He and Munger both emphasize the importance of “personal painful experience” in developing business acumen, noting that IQ alone doesn’t solve the problems encountered in struggling businesses.

MLAN: A Case Study in High-Volume, Low-Margin Business

A question from the audience prompted a detailed discussion of MLAN, a Berkshire Hathaway subsidiary contributing significantly to revenue but receiving limited attention in the annual report. Buffett explains that MLAN’s high sales volume relative to its net income triggers specific SEC reporting requirements.

MLAN operates as a massive wholesale distributor, primarily serving Walmart and Sam’s Club (representing over 20% of its volume). Its business model is characterized by extremely thin margins – 6% gross, 5% operating, resulting in a 1% pre-tax margin. Success hinges on exceptionally rapid inventory and receivable turnover. Specifically, receivables are turned over 30 times, payables 30 times, and inventory 35 times. Despite the low margins, MLAN generates a “very decent” return on capital due to its high velocity of goods. Buffett highlights the exceptional management under Roger, who has been with the company since its acquisition from Walmart.

The acquisition itself was remarkably swift. Walmart, needing capital, approached Berkshire, and a deal was struck quickly, with the CFO immediately securing approval from the CEO. Buffett notes this speed was facilitated by Berkshire’s established reputation for being “quick and simple and doing what we promised.”

Berkshire’s Operational Flexibility & Reputational Advantage

The discussion extends to Berkshire’s ability to execute deals rapidly, citing the example of the Northern Natural Gas Company acquisition. Buffett recounts completing the deal in a single weekend, even providing the funds before final legal documentation was completed, contingent on regulatory clearance. He emphasizes that this level of flexibility is uncommon in larger organizations due to bureaucratic processes and multiple approval layers.

Buffett attributes this operational agility to Berkshire’s strong reputation, stating, “We wouldn’t have made that deal without essentially having that reputation.” This reputation, built on reliability and swift execution, has repeatedly proven advantageous for Berkshire Hathaway.

Synthesis/Conclusion

The conversation reveals Berkshire Hathaway’s investment philosophy as deeply rooted in fundamental analysis, prioritizing intrinsic value over reliance on simplistic formulas. Buffett and Munger emphasize the importance of practical experience, particularly learning from business failures, and the value of a strong reputation for speed and reliability in facilitating advantageous deals. The detailed explanation of MLAN illustrates Berkshire’s willingness to invest in businesses with unconventional characteristics – high volume, low margins – provided they generate acceptable returns on capital and are managed effectively. The core takeaway is that successful investing requires nuanced judgment, operational flexibility, and a long-term perspective, rather than adherence to rigid rules or formulas.