Asset management
A victim of non-stationarity of data
There is a dilemma. About twenty-five years ago, about a year after the collapse of the Dot Com bubble, Warren Buffett wrote an article about the stock market in which he said that, in spite of certain limitations, the market value of all publicly traded securities as a percentage of GNP is “probably the best single measure of where valuations stand at any given moment.” (Emphasis added)
Here’s the article: Warren Buffett On the Stock Market with Carol Loomis
Dozens of commentators and analysts have taken this to heart. One regularly reads comments that the Buffett Indicator, as they call it, shows the stock market is grossly overpriced, especially today and especially for a number of years as well!!
Here is the dilemma
Warren Buffett does not invest in the stock market as a whole but in individual stocks. I do not invest in index funds but in individual stocks. Warren Buffett has made it clear that valuation is central to investing and that the value of an individual stock is best approached by doing a discounted cash flow analysis. The dilemma is that the ‘Buffett Indicator’ is saying the stock market is currently grossly overpriced. But, a discounted cash flow valuation of the individual stocks in my portfolio suggests they are trading around fair value.
This is what I will discuss in this post.
Wilshire 5000 market cap to GDP
Analysts frequently use this ratio illustrate the Buffett Indicator. It is a good benchmark for the US equity market. It suggests how the total stock market capitalization is performing relative to US economic performance. This chart comes from Longtermtrends.net.
Charts are a wonderful way to illustrate data. We notice a couple of things. First, the ratio is currently at about 200%, which is way higher than the peak of about 130% in 2000 at the height of the Dot Com bubble. If Dot Com was nosebleed territory, the current reading is blowing our heads off. Second, the mean line is at about 80%. In the last 25 years the line has only briefly dipped below mean. From 1970 to the late 1990s the line was consistently below mean. In fact, if you do a linear regression (straight line which is best fit over the years) it slopes up and to the right. This suggests to me that something else is going on. Is it possible that this is not a data series that reverts to the mean?
Non-stationarity of data
If you ask me what the expected temperatures will be in Toronto in the month of August in 2025, we could look at the mean August temperature over the last hundred years and conclude it will be pretty close to that. The problem is that, with Global Warming, the temperature data series is not mean reverting. It has been going up and is predicted to continue to do so. This is called the non-stationarity of the underlying data.
When I see a graph like the above Wilshire 5000 market cap to GDP moving up to the right over an extended period of time I wonder if something else is going on.
Profits and post tax free cash flow as a percentage of GDP
In an article in The Economist of March 26, 2016, the magazine argued that the profits of corporate America were too high, leading to inequality and consumer prices that are too high. It was suggested that what America needs is a “burst of competition to shake up the incumbents”.
The main evidence the article cites as to why profits are so high is data showing increasing consolidation of corporations through mergers and acquisitions in various industries and sectors of the economy. They characterize the different sectors as ‘fragmented’, ‘concentrated’ and ‘oligopolistic’ and look at how revenues, post-tax profits, post-tax Free-Cash-Flow and return on invested capital have fared over time for the top four companies in each sector. The following chart displays the data:
13 U.S. domestic corporate profits and global return on capital
The charts suggest that profits, cash flow and return on capital have been increasing over the previous 30 years (i.e. since about 1980) and when this is combined with data on consolidation it shows that competition is lessening especially in concentrated and oligopolistic sectors.
I think there may be another explanation as well.
What is particularly striking about the chart of corporate profits as a percent of GDP is that since 1980 the post-tax Free-Cash-Flow percent has shown a very notable and quite large increase. Also, since 1980 global percent return on capital has been increasing. From 1980 corporate profits were also increasing, but not nearly so quickly as the big increase in Free-Cash-Flow.
The Free Cash Flow is close to Warren Buffett’s Owner Earnings. If companies have cash left over after: 1) all capital expenses to maintain and upgrade property, plant and equipment and other assets, both tangible and intangible; and 2) additional working capital that may be needed, they have capital left over to invest in the business and grow the business. If no opportunities are available for investment with a good return the money can be paid to shareholders or used to repurchase shares.
For purposes of today’s post, the key thing to note is that the key input to assess the fair value of companies is cash flow. The best cash flow measure is Warren Buffett’s Owner Earnings. If that is increasing faster than GDP, the fair value of companies will increase faster than GDP.
It appears from the Economist article and accompanying chart that the percentage of companies with truly extraordinary returns on invested capital is increasing. In fact, the chart may be misleading as goodwill is excluded from the tally of capital used to calculate return on invested capital. With the 2001 change in the accounting treatment of goodwill it becomes all the more important to include goodwill in a tally of capital. After all, boards and management are responsible for astute capital deployment, including both tangible and intangible assets. Some commentators and analysts think goodwill and other intangible assets are not real enough to be considered assets. See my post The emergence of a new model of capitalism and other posts on the topic of intangible assets .
The Economist article and chart are ten years out of date. Let’s try to bring it current.
Corporate Profits Share of Domestic Income
The next chart we need to look at is a current chart showing how much companies are making as a percent of gross domestic income. The following chart from the Federal Reserve Bank of St. Louis shows that in 1980 corporate profits were around 4% of gross domestic income. Today, corporate profits are around 8%, an approximate doubling in 45 years.
U.S. Bureau of Economic Analysis, Shares of gross domestic income: Corporate profits with inventory valuation and capital consumption adjustments, domestic industries: Profits after tax with inventory valuation and capital consumption adjustments [W273RE1A156NBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/W273RE1A156NBEA , March 23, 2025.
If corporate profits have doubled, the fair value of companies will also have increased substantially.
There’s more to it
Go back to the Economist Magazine chart. It shows that after 1980 Pre-tax Free-Cash-Flow was increasing at a faster rate than profits. That is largely on account of the huge increase in corporate investment in intangibles of lasting value, which are expensed against income, which has had the effect of depressing reported profits while generating cash returns on these investments.
Unfortunately, I haven’t been able to find an up-to-date chart of Post-tax Free-Cash-Flow as a percentage of GDP. I imagine the trend after 2014 is similar to the trend before 2014 shown in the Economist chart.
Conclusion
I think the economy and world of business and corporate cash flows have changed. I suspect the Buffett Indicator is a victim of non-stationarity of data. I much prefer to rely on conservative estimates of company fair value for my little portfolio based on well recognized discounted cash flow analysis than be spooked by a measure Warren Buffett thought had some value twenty-five years ago.
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