Buffett ratio tells us India is currently a great long-term buy; Do PE firms agree?

19 July, 2012

If there is one thing that I have learnt from crunching numbers for a good part of my working life, it is that the more you flog them, the higher the probability of statistics screaming and spewing out something which actually makes sense.

A few years ago, I came across the term Buffett ratio, which seemed to make a whole lot of logic at first glance, but has a big ceteris paribus tagged to it. To be fair, let me acknowledge that it probably deserves a discussion only because of the person who suggested it. After all, Warren Buffett is considered by many as the god of long-term investments.

Willy nilly, an upfront disclosure is on order for the use and interlinking of some numbers which could make a purist aghast.

The origin of the ratio is perhaps sourced to this article in Fortune, written more than a decade ago.

In short, Buffett looked at the data of around eight decades, tracking movements of the market value (or market cap) of all publicly traded securities in the US as a percentage of the country’s business, where gross national product or GNP was taken as a proxy.

For the uninitiated, GNP digresses from the more commonly used term GDP as it captures income by ownership rather than geography. So, if an American MNC produces in India, it is part of GDP but not of GNP and if an Indian multinational produces in Brazil, it is part of GNP but not of GDP.

Buffett honestly conceded that market cap to GNP linkage has its limitations but added, “It is probably the best single measure of where valuations stand at any given moment.”

His talisman was simple: Investors are playing with fire when this ratio approaches 200 per cent or the market cap of listed companies is out of proportion of the total income owned and produced by the citizens and their companies. On the flip side, buying stocks would work well if this percentage shrinks to the region of 70-80 per cent.

The first Molotov cocktail that can be thrown on this is the argument that valuations are, after all, a factor of earnings (that, too, expected future profits) more than revenues and therefore, this is a spurious correlation in the first place. Secondly, a whole lot of the economic output is actually outside of public-listed companies. Thirdly, and this is an extension of the second issue with the ratio, the stock market in India is much less mature compared to the US and so the ratio, perhaps, is more suited for the US (after all Buffett also based his interpretation on US data) than for India.

Indeed, I would have laughed it off 10 years ago. Here’s why. In December 1999, when the dotcom bubble was arguably at its peak in India, the market cap of the Bombay Stock Exchange was just shy of $185 billion or 44 per cent of the country’s GNP. Was it a good time to buy stocks (not from a very long-term perspective as on hindsight, barring IT firms, one could still have made a killing having invested then and selling now) from a valuation perspective? The answer is: No.

Cut to December 2007 (the last month before it all came crashing down with sub-prime mess) and the Buffett ratio for India stood at 157 per cent. Was it a good time to invest? Definitely no!

So what changed in the eight years to make 2007 a year when the ratio made sense, which it did not in 1999?

The stock market became much more representative of the economy as hordes of firms went public during the bull run that started in 2002-03 and gained pace in 2006-07. A couple of years ago, I had looked at the data and numbers showed that the revenues of public-listed companies were around two-thirds of the size of the economy. Some goliaths like Coal India listed thereafter.

Surely, one can argue much is outside the public equity market, be it the country’s vast agriculture sector, much of unorganised retail, numerous regional real estate developers and I would guess lakhs, if not millions, of small eateries dishing out Indian curries and so on and so forth.

But with all due respect to my former teacher and currently India’s chief statistician TCA Anant, I would counterpoint that I have serious doubts on how much of these sectors are covered by GDP or, for that matter, GNP. So in many ways, we are even.

Now let us look at another time point: March 2009, the month when investment pundits across board realised that India was oversold and started buying once again. The Buffett ratio stood at 0.6. Was it a good time to buy? Hell, yes.

So where does it leave us? The Indian stock market is currently at 75 per cent of FY12 GNP. Is it a good time to buy (after all Nouriel Roubini or Dr Doom is still sticking to his prediction of 2013 as the year of ‘perfect storm’ globally)? I would leave that to readers to interpret, depending on their investment style. But here are a few quick points.

Surely, for short-term investors, it is a factor of many unpredictable variables. These include: What does the world’s most powerful woman (aka Angela Merkel) and her ilk think about the descendants of Alexander (and in future, the home of Salvador Dali or Leonardo Da Vinci or that of Vasco Da Gama); will the rain gods make up after a poor start to this monsoon; how does the RBI governor walk the policy tightrope, balancing growth-boosting rate cuts with (till date unsuccessful) inflation-busting measures; and finally, will the Indian political masters wake up from their stupor.

What about our dear private equity investors? Surely, they were far too risk-averse back in the 2008-2009 bloodbath and understandably so. For one, no one knew where the bottom was and valuations were so volatile that by the time the due diligence was done and the term sheet was signed, value moved up and down like a turbo-charged seesaw (I am not bringing in the PE firms who follow the mutual fund style investments in listed companies, some of whom have made money in the period). Most importantly, there were not too many promoters of good companies looking to raise cash from PE firms at sinking valuations either (besides the distressed assets cases). Therefore, blaming PE firms for not investing won’t be too fair. Then again, public markets are, at best, a proxy to valuations of private firms where much of PE investments happen.

But what about now? Would 2012 turn out to be a good vintage for PE firms from a five-year investment perspective? Surely, deal activity (barring tiny ticket, early-stage investments) has slowed down to first gear.

Even as both could be clubbed as long-term investors, the jury is still out on whether what works for Buffett, whose investment period can be forever, works for PE firms as well. It is tricky to say how long is too long but as Keynes said: In the long run, we are all dead.

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kishan . 5 years ago

Good article.

krdalal . 5 years ago


vivek.sinha . 5 years ago

Thanks for your feedback KRD. Apologies, if the write-up took a Kafkaesque turn for you. If you could point out which portions were confusing maybe I could help clear that. Since you mentioned GNP, just to clarify, GNP figures are officially available for India as is GDP (since most people use GDP, reporters do not report on GNP). Its part of economic survey by the government every year. In case you are curious still, Indian’s GNP for FY12 was $1.49 tn (with current exchange rates). Happy to clarify more queries if you have any.

njain@ccag.in . 5 years ago

Last couple of lines just add literature, not meaning. Such an article must end with an opinion on either side, based on some stats.

vivek.sinha . 5 years ago

Nipun, as I mentioned a few paras before ending whether its good time to invest or not, depends on investment style. If a PE firm is looking to bet on ‘long’ term (which in my opinion would mean even willing to roll it over across funds after the term expires in 10 years, very rare in India) then the ratio would say its a good time to invest. Of course recent history (as the data shows) tells us even in the medium term this rule could apply which implies PE firms should look at investing now, which they are shying away from or rather cautious about. My idea was to present facts and reasons to support the linkage with latest data and leave the PE fund managers to decide for themselves. Endgame is how long is too long and that nobody knows.. As you might have missed, there’s a question mark in the headline too 🙂 Nice to have your feedback, thanks.

SV . 5 years ago

Problem with such pessimistic times is that the deal flow dries out for the PE funds. In 2008-09, we were looking for deals and promoters of good companies would just want to wait for good companies. Its a different story for listed companies, given that the seller is a third party. Hence per my experience, low valuation doesn’t mean their are good deals waiting for PE funds.

Hardik Shah . 5 years ago

Vivek, What you are suggesting is essentially a Price/Sales Ratio with one added variable being proportion of GNP covered by the sales of all listed companies).

Wouldn’t it just be simpler if we looked at the Price/Sales ratio over time? No different from looking at any other ratio and how the current number compares to history?

Deepak Jain . 5 years ago

Interesting perspective. But it would have made sense to plot the Buffet Ratio alongside the Sensex over the last 13 year period.

vivek.sinha . 5 years ago

Very true @SV, good deals are hard to come by. Personally I feel PE firms would need to go out and find good companies who are conservative in their expansion plans and sell them the growth trajectory. I know its easier said than done, eod old promoters are too cautious. But it won’t be before that changed with the nextgen.

@Hardik you are mapping out a macro relationship into the micro-fold. That may be difficult to establish even though i know price/sales is one of the many ratios tracked for assessing valuation. My inference from Buffett’s ratio is a broader market (and I repeat a mature mkt) valuation at a point of time. I wouldn’t take it down to a micro level..just for checks look at mkt cap of JSPL and Tata Steel. Tata Steel despite many times the size has I believe marginally lower market cap than JSPL. May sound unbelievable but its true! Many such examples.

@Deepak, nice suggestion but as I said taking this ratio too long back may not help much as the market has matured in the real sense only in the past 5-7 years.

Buffett ratio tells us India is currently a great long-term buy; Do PE firms agree?

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