In one sentence: More from the 2017 Berkshire meeting: Buffett would not say the market's classic valuation gauges are decisive and pointed to interest rates instead, Buffett and Munger dismiss EBITDA, USG shows a moat can be real while the industry's capacity wrecks returns, and the choice for most people is an index or doing the work yourself.
Key ideas
- Market-wide gauges. Phil describes two: total stock market value compared with GNP (high at 120–150%, as in 2000) and Shiller's cyclically adjusted P/E (about 29, with 23–24 called high). Asked whether they still apply, Buffett said valuation can't be reduced to a formula and the most important input is future interest rates. [00:00–06:00]
- Rates change what you can pay. Compared with a 2.6% ten-year Treasury, an 8% earner looks good. If Treasuries paid 8%, you'd need 12–16% from stocks. So very low rates support higher P/Es, and rising rates may take "the starch" out of the market. Phil thinks the Fed's long-running intervention may have broken the old gauges, and Danielle notices Buffett hedged rather than saying the market was too high. [05:00–10:00]
- Waiting is still a strategy. Phil points to Berkshire's $95B in cash and Munger not buying a stock in three years. If you can't sit in cash for years while learning, an index is the alternative. [09:00–10:30]
- Legacy. Buffett said he'd like to be remembered as a teacher. Munger didn't answer. [10:00–12:00]
- EBITDA is a mass delusion, per Buffett and Munger. It is earnings before interest, taxes, depreciation and amortization. Supporters say it smooths out things that fluctuate and makes levered and unlevered firms comparable. Buffett and Munger say removing depreciation and amortization ignores real costs of keeping the business running, and that it flatters valuations and borrowing capacity. Munger compared it to a landlord counting your deck and roof as living space. Phil says it is used all over hedge funds and bankruptcy courts. [12:00–17:00]
- USG (SheetRock). The company has gone bankrupt twice under Buffett's ownership (asbestos, then the housing bust). Phil says its brand earns about a 15% price premium over equivalent drywall, which is real pricing power, with large market shares in the US, Canada and Mexico. But capacity was overbuilt, supply exceeded demand for years, and the stock went nowhere. [17:00–21:00]
- "Price down" versus "value". Danielle asks whether this fits the rule that you want the price to fall. Phil: the price only matters when value is intact. If the business doesn't make money, ask what is happening to value first. [21:00–23:00]
- Financial advisors and indexes. Buffett said he knows about a dozen people he would back to beat the average, Munger among them, but paying about 1% to an advisor in the hope of beating the S&P 500 by about 1% isn't worth it. In aggregate active professionals can't beat sitting tight. The street-level investor who buys an index does better than most advisors. Phil's version: either buy the index or learn to invest like Buffett. Buffett's bottom line, as Phil reports it, is to think of stocks as businesses and follow your own course. [23:00–29:00]
How it maps to RuleOne
- The screen doesn't try to time the market. The market-level gauges are context for how many names pass the MOS price at once, not a signal to sell. The event watch shows when fear is making individual businesses cheap.
- RuleOne avoids EBITDA and builds on owner earnings and operating cash flow (the Big Five numbers, see m4), which count the cost of keeping up the business.
- USG's story is a lesson for the moat check on /stock/TICKER/: look for pricing power and supply discipline in the industry.
Buffett, Munger and Graham links
- Buffett's market-value-to-GNP gauge appears in his 2001 Fortune piece (adapted from a talk, Dec 2001, and an earlier 1999 article). Phil reads the figures from memory.
- Buffett's EBITDA objections are in the Berkshire letters of the early 2000s (for instance the 2000 letter). The "deck as living space" analogy is Phil's report of Munger's remark and is not a verified quote.
- Buffett's advice that most people should buy a low-cost S&P 500 index fund is in the 2013 letter (instructions for his trustee) and the 1996 letter. Phil reports the 2017 meeting remarks.
Words to know
- EBITDA: earnings before interest, taxes, depreciation and amortization.
- Pricing power: the ability to charge more than rivals for a similar product (see Mercedes versus SheetRock in the episode).
- Overcapacity: more supply than demand, which pushes prices and profits down.
Try this
Open a stock page and compare operating cash flow, net income and EBITDA if shown. Subtract capital spending from operating cash flow to see how much real cash is left. Write one line on how different the "EBITDA story" is from the cash story.
Check yourself
- What did Buffett say matters most for valuing the whole market?
Answer
Future interest rates, not a single ratio such as value-to-GNP or CAPE. - Why do Buffett and Munger dislike EBITDA?
Answer
It leaves out depreciation and amortization, which are real costs of staying in business, so it makes businesses look better than their earnings. - How can a company with pricing power still be a poor investment?
Answer
If the industry has too much capacity, prices and profits fall (the USG story). - What are the two choices Phil gives people who don't want to pay advisors?
Answer
Buy an index fund, or learn to invest like Buffett and do the work yourself.
Short quotes
"Figure out what makes sense and follow your own course." (Phil, paraphrasing Buffett, ~25:30, auto-transcribed)