Revealed: The error in the Buffett logic

March 10th, 2009

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In our previous article, we asked our readers to spot the flaw in Warren Buffett’s logic. Today, we will reveal the answers. Before you read on, please take the time to understand our guide, Value investing for dummies.

As Buffett said, staying in cash and cash equivalent (e.g. government bonds) is a bad move because price inflation is likely to be very high in the future. This, we agree. But does it mean one should switch from cash to stocks today? If the answer is “yes,” then there’s an error in logic.

First, by that very statement, Buffett was implying that the yields of government bonds are far too low. Essentially, this means that those who buy and hold those bonds will have their wealth frittered away by price inflation.

Next, as we explained in Value investing for dummies, value is a relative concept. Stocks are valued relative to risk-free government bonds, which in turn is suppose to reflect future price inflation. If the yields in government bonds are wrong by a long shot, then stock valuation will be wrong.

To explain this point better, let’s use an example. Let’s suppose the following conditions:

  1. 30-year Treasury bond yield is 3.5%.
  2. An almost risk-free business with monopolistic powers (let’s imagine it is Woolsworth).
  3. That business can raise prices and grow its earnings at 25% per year.
  4. The first year earnings of the business is $100.

If we apply a 5% discount rate on 10 years of that business’s earnings, we get a present value of $2358.76. That 5% is arbitrary chosen from the fact that it is a little above the Treasury bond yield.

As long as the long-run average price inflation is around the vicinity of the 30-year Treasury bond yield, buying the stock at below the present value of its earnings is a bargain. But what if the bond yield is way way way wrong? Let’s say the price inflation rate turns out to be, say 25% (in other words, the business earnings grow fast enough to merely keep up with inflation). You can see that applying a discount rate of only 5% will give you a return far below price inflation (but slightly higher than Treasury bond yields). If you want a return higher than price inflation, your discount rate will have to be north of 25%.

If we apply a 30% discount rate on 10 years of that business’s earnings, we get a present value of only $648.87! That 30% is arbitrary chosen from the fact that it is a little above the price inflation rate.

So, if you believe that government bonds are severely under-pricing future price inflation and you have no idea how the ravages of price inflation will look like, then how can you value stocks correctly? If the price inflation turns out to be Zimbabwean-style hyperinflation, then you will lose big money (in real terms) investing at today’s stock price.

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