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Friday Five: Buffett on Market Valuations

Jason Stipp
Jeremy Glaser

Jason Stipp: I'm Jason Stipp for Morningstar, and welcome to The Friday Five, Morningstar's take on five stories in the market this week.

Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: First this week, you were at the Berkshire Hathaway Annual Shareholders' Meeting last weekend--great coverage. Interesting topics, as usual, from the meeting, including current stock valuations.

Glaser: The meeting always covers a variety of topics, and this year was no different, but one that really stood out to me was Buffett's discussion of stock valuations, which he did call "high," but he said that you really need to view those valuations in the context of the interest rate environment we're in. When you have interest rates that are so low and you look at the returns that are priced into bonds right now, maybe that explains a lot about why stocks are priced so high. He said buying into stocks is really a bet on the interest rate environment. He didn't give any kind of forecast of what he thinks interest rates are going to do, but he did point to interest rates as the biggest driver.

Janet Yellen, the chairwoman of the Fed, had similar comments this week. She said that she saw stock valuations as being "quite high" and again compared that to the returns that are available to bonds. But she did say she doesn't see valuations as being a systemic risk right now. She doesn't think it provides any kind of potential for financial instability, which is something the Fed is looking at, but she did give a warning about the valuation levels right now.

Stipp: For our part, what are our analysts saying about the current valuation levels of the market?

Glaser: We still see the market, and particularly the large-cap U.S. market, as being fully valued, maybe a little bit overvalued. I think it's important that investors really pay attention to the margin of safety, and make sure they are buying stocks at a reasonable price, given that there are some areas of the market that do look pretty pricey. This is definitely a time where caution is warranted.

Stipp: McDonald's talked about its turnaround plan this week, and you might say that investors weren't really "lovin' it."

Glaser: It was not particularly well received when the new CEO, Steve Easterbrook, rolled out the plans that they've been hinting at for quite some time now. I don't think there was anything particularly wrong with what he said. I just think that investors expected something a little bit more far reaching or getting a little bit more information about some of the big changes that are going to happen.

Our analyst R.J. Hottovy called them "practical measures"--things like reorganizations, refranchising some restaurants that McDonald's currently owns, and trying to cut costs at the corporate level. We've seen a lot of other fast-food restaurants, like Burger King, for example, under 3G Capital, do very similar moves.

I think that investors are really waiting to see, how are they going to innovate with the menu, how are they going to get operational efficiency better at the restaurants? Those are the big questions that are really going to drive the future returns in terms of getting people back into the restaurants and competing against the fast-casual names like Chipotle. We didn't see a lot about how they're going to do that.

So I think it's still very much wait-and-see if this new management team is going to be able to deliver.

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Stipp: Whole Foods reported a disappointing quarter and their stock slid. But what's interesting from their report was a new store concept they are looking at.

Glaser: Their same-store sales growth continued to see slowing growth. It's still positive at 3.6%, but slowing from the quarter before, and that's the second quarter where that's happened.

But as you said, the big news was that they want to launch this new, more value-focused brand that they said will be targeted toward younger millennial consumers. They didn't provide a lot of detail about what the store will look like. Some suggestions to them might be having pretty wide aisles to make sure that shoppers' selfie sticks don't get in the way as they're moving. Maybe instead of a customer service desk, they can have an "I can't even" desk where people can come in and register their complaints. Let's see if they pick up on those.

But generally speaking, this is somewhat of a risky move for them to invest capital into these stores. They probably will have lower margins that could potentially cannibalize their major franchise where they still think that they have room for growth of the big Whole Foods stores.

Ken Perkins, our Whole Foods analyst, thinks there is a possibility that this could work out well, depending on some of the details. Having a bigger store count, even if some of them are lower margin, can help spread some costs around and could help mitigate some of those margin worries.

But even after the sell-off, Whole Foods shares still don't look particularly cheap. Investors who are interested in this narrow-moat company might want to wait for an even better entry point than they can get after the sell-off this week.

Stipp: Disney reported this week, and they had a pretty good quarter. Management had some interesting thoughts on how they're managing through a changing media landscape.

Glaser: Disney has been on a roll recently, and this quarter was no exception. They saw strength across almost all of their businesses. The film business was a little bit weak year-over-year, but a lot of that was just because they were still showing Frozen overseas last year, which they weren't this year. So no major worries there.

The discussion over how they think about the new media landscape and where to put their content was one of the most interesting things. Neil Macker, our Disney analyst, said management really pointed to three areas: Does it make sense financially? That one is pretty obvious.

Does it make sense strategically? Are these the kind of customers, the kind partners we want?

But the third thing that they look at--is it good for consumers? What's the consumer benefit? That is somewhat more unusual. Disney sees that if they make their content relatively easy to get, if they organize it well and people are able to get the content they want, they are going to consume more of it, which is something that's good for Disney in the long term.

Those are the things that they think about when they're inking these deals, and they've shown themselves to be very successful so far. Amongst the major media companies, Disney seems among the best positioned to take advantage of these new distribution platforms. … I think we very much saw that in the discussion that they had.

Disney shares do look about fairly valued right now. And I should mention that I am myself a Disney shareholder.

Stipp: Lastly, we know now that Comcast and Time Warner Cable won't be tying the knot. Comcast reported earnings this week, giving us a chance to size them up as a stand-alone entity. What's the picture look like?

Glaser: This quarter's results really give us a chance to take a step back now that we see Comcast is not going to absorb Time Warner Cable. We still very much think that Comcast is a strong competitor and that they have a wide economic moat, even without Time Warner Cable.

Comcast didn't have to pay a big breakup fee; they knew there was a good chance the regulators weren't going to allow this to go through, which is what happened. But even if there are some legal costs there, for the most part Comcast remains strong even after the deal.

When we look at cable's results--how they able to drive higher pricing, that's good for them. They were able to sign up a lot more Internet access customers. Mike Hodel, our Comcast analyst, thinks that's really crucial to their long-term growth. That's obviously heartening for Comcast shareholders.

And then you look at even the strength at NBCUniversal. It had a pretty good quarter, with everything from the theme parks to even the movie studio to just the basic broadcast network actually looking fairly strong as well.

The big question here is valuation. The shares do look overvalued right now, trading in 2-star territory. It's not a great entry point, but even without Time Warner Cable, Comcast still looks like a strong firm.

Stipp: Great insights on the news of the weeks, and great coverage of Berkshire last weekend, Jeremy. Thanks for joining me.

Glaser: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.