We Study Billionaires - The Investor’s Podcast Network - In-B-Tween : Intrinsic Value and Bond Market Pressures (Investing Podcast)

Episode Date: July 15, 2015

This In-B-Tween episode covers Warren Buffett's intrinsic value and current conditions in the bond market. Learn more about your ad choices. Visit megaphone.fm/adchoices Support our show by becoming a premium member! https://theinvestorspodcastnetwork.supportingcast.fm

Hey, how's everybody doing out there? This is Preston Pish and welcome to this week's In Between a Sode. So I originally planned to talk to you about competitive advantages, but the recent market activities encouraged me to talk about something a little bit different. The topic for this week's quick discussion is intrinsic value in the rising pressure in the U.S. Treasury market. So billionaire Warren Buffett says that one of the most fundamental elements in determining the value of an asset is constantly comparing the expected return to the 10-year Treasury note. The reason Warren Buffett recommends the 10-year Treasury is because he, use it as a zero risk investment because the Federal Reserve can simply print more money to service

the payments. So the best way to think about Buffett's use of the 10-year treasury is to imagine a ruler or a yardstick. When Buffett wants to determine the value of a stock, a corporate bond, or even a local business, he uses that zero-risk measurement tool to determine the risk versus the reward. So that's how you really need to think about this when he talks about this 10-year treasury. It's like a ruler or a measuring stick for him. So if we estimated that a local business on Main Street would give us a 10% return annually if we bought it at a certain price that would provide that return. Buffett might say that he's getting a 4x or a four times the return of the zero risk treasury note. And so that's how he's really looking at it. He's using that as a tool

for determining that value. Now, how I got four times is because right now the 10 year treasury is trading for 2.5%. So what do is you do is just say, hey, I'm getting a 10% return by owning that business. If the treasury is given me a 2.5%, then this invest. could potentially give me a four times higher return than that zero risk investment. This is an extremely important concept to understand because this is how Buffett values all of the assets on his Berkshire balance sheet. He's always comparing them how much of a return is this giving me over the 10-year treasury and how much risk is associated with that return. So when we look at the U.S. market as a whole, we can generally conclude that in the long term, the 10 years or more,

it's priced at right now at about a 3.7% return based on the current market price. The way this was determined, or the way I figured out that 3.7% return is I simply took the inverse of the Schiller PE ratio and that gives you a 3.7% return. So here's the key point. If stocks are potentially going to give you a 3.7% return and bonds are priced at 2.5%. I think most can agree that as an investor, you're potentially assuming a lot of risk by chasing that 100 basis points or 1% when you account for the risk that's associated in owning equities versus this. zero risk fixed income 10-year treasury. So here's something that's even more concerning. U.S. regulators have become increasingly interested in the instability of trading on the $12.6 trillion in the U.S. Treasury market. As of the last month, it would have taken the equivalent of 25 days

for all available treasuries to trade. This number is significantly higher than it was at the eight-day mark just a decade ago when the market was one-third of the size. The thing that the Fed and other regulators are worried about is if large treasury transactions are taking longer to complete in a sell-off, it could interfere with the market stability as the Fed moves to raise interest rates potentially by the year's end or even in the fall of this year in 2015. And that's over almost a decade where they haven't touched these rates. So there's this gentleman from JP Morgan. His name is Alex Rover.

And he's a rate strategist for fixed income bonds. And he said that the current U.S. Treasury is like trying to pour a bar. bucket of water through a straw, you can only move a limited amount. And so that was something that he said in the recent Wall Street Journal that came out this week. As Stig and I have said in the past, we have absolutely no idea how long the euphoria in the markets will persist. In fact, if some people say that they know when the market will crash, I think you need to run away from them, probably as fast as you possibly can. But what you can do during these times of high market prices is readjust your portfolio to protect your downside risk and principle. At the end of the day, the best advice that

Warren Buffett and any other billionaire investor will tell you is protect your principle. Well, that's all I have for you. Be sure to tune in this weekend as we have a fantastic episode about oil and its potential for the future. And as always, here at the Investors podcast, we try to pack a lifetime of experience into only five minutes.