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Buffett: Interest Rates Key to Understanding Stock Valuation

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here with Matt Coffina--he is the editor of Morningstar StockInvestor newsletter. We're at the midway point of the Berkshire Hathaway meeting. We're going to get his take on that first half.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: So, one of the most interesting discussions that Buffett had was about stock valuation and how it relates to interest rates. He said that stocks do seem to be pretty fully valued or to have high valuations, but that that might be justified with rates. What did you think of this discussion and what do you think about stock valuations?

Coffina: So, one metric that Buffett has brought up in the past is the ratio of the total stock market value to the gross domestic product of the United States, and that's definitely at the high end of its historical range. I think if you look at a variety of other measures like Shiller P/E or the price to trailing peak operating earnings, we get a similar story; the S&P is trading at a relatively rich valuation, but Buffett really emphasized the point that it all depends on interest rates.

Interest rates remain very low by historical standards. If you are comparing the expected returns from stocks against the expected returns from other asset classes like bonds, stocks still look very attractive. And so, I think you are in a situation where if interest rates stay as low as they are, stocks could still be very cheap and there could still be additional upside. And if we go back to a normal interest-rate environment, then stocks are probably more on the expensive side. And they didn't really give a clear answer as to that. They basically said it's up to you--do you think interest rates are sustainable here or not? And if interest rates are going higher, then in all likelihood, stocks are fully valued to overvalued.

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Glaser: One area where Buffett has been seeing value is consumer packaged goods. He mentioned that there could be even more consolidation there after he picked up Kraft with 3G Capital and Heinz. Do you think that there are really a lot of prospects for more deals in this space? Can they find more?

Coffina: Yes, there was a lot of conversation about 3G and Berkshire's relationship with 3G. There were a lot of shareholders who were a little skeptical of that relationship. 3G has a reputation for coming in and really slashing cost, laying a lot of people off as soon as they come into an operation, and that's really how they see themselves adding value.

Buffett basically said that he agrees with their approach. He doesn't think that it's a company's job to employ people that they don't need; they shouldn't have more workers on staff than they really need. He is willing to tolerate maybe some of that inefficiency in other Berkshire subsidiaries, because he has a very hands-off approach, but ideally he would like to see all of the subsidiaries run like 3G runs an operation.

With regard to consumer staples in particular, he definitely hinted that there is the opportunity for more deals, and I won't be surprised if we see that. I would say 3G will probably be pretty busy over the next couple of years integrating Kraft and Heinz; but over the longer run, I think there is a sense that a lot of these consumer-staples companies have great brands.

He talked a lot about how a lot of these brands are the same as they were 30, 50, or 100 years ago. They have a lot of staying power. In a lot of cases, these companies may have become complacent over long periods of time of being very successful, and there may be room for cost-cutting. So, I think you'll see more consumer-staples names, even internally, focused on cost-cutting and becoming more efficient; but then, over the longer run, I think there is room for further consolidation. And especially if there are some companies that aren't able to bring their own profit margins up to the standards of the industry, and as the competitors are improving, there will be more pressure from activist investors and others to find a new management team that is able to make those tough decisions.

Glaser: One acquisition that Berkshire did make last year was of a car-dealership chain, and they said that they don't see a lot of scale advantage to this business, yet they want to make more purchases there. Can you explain why Buffett is so interested in the business if it doesn't have that scale advantage?

Coffina: It's interesting because you would think that Berkshire would want to be adding value in some way to these businesses as they are acquiring them. Buffett basically said they are very good businesses on their own. They are very locally oriented. Often, local regulations prevent a lot of competitors from entering the market, which can give an advantage to those companies that have these mini-geographic monopolies.

So, I think he sees it as a good standalone business. He thinks that Van Tuyl Group, which they acquired, is a very good operator, able to run these businesses efficiently. He plans to buy more of these companies; hopefully, they are already run well. And if they are not, they now have the management from Van Tuyl that can come in and hopefully improve operations and run these things as efficiently as possible. So, basically, he just sees it as an area that's very fragmented, where there's a lot of opportunity to do additional deals over time, and that he finds relatively attractive--again, having that local-geographic-monopoly advantage.