The world’s most popular and successful investor Mr. Warren Buffet who created his most of his wealth by investing in the share market uses which indicator to figure out when to invest more in the market when to invest less? Do you wish to know about it? Come. Let us understand more about it, in our blog.
When do we use the term ‘Indicator’? Primarily, we use the term indicator while driving a vehicle. For example, while driving when we wish to take the right turn, we should first give the right indicator and then take the right turn, though in India people mostly take the turn first and give the indicator later. That’s a different story. Jokes apart, so is there any indicator that can guide us as to when the share market is expensive to invest in or when is the right time to invest in?
In the year 2001, the world’s most successful investor Mr. Warren Buffet had reported/ described such an indicator. That indicator helps in detecting when the market is less expensive and when it is more expensive to invest in. It is known as ‘Market Cap to GDP Ratio.’
What is this Market Cap to GDP Ratio all about? But first, let us see what Market Cap is? Market Cap refers to Market Capitalisation. Let us understand it with a simple example. Consider a company named XYZ limited. The share price of XYZ limited is Rs. 10 per share. Now it is obvious that it would be having a lot many shares in the market. Let us consider there are 1000 shares of XYZ ltd in the market. So, 1000 shares multiplied by share price per share will give you the total amount (value) of the shares that are available in the market. Thus, 1000 * 10 = Rs. 10,000 so the total value of shares of XYZ ltd in the market is of Rs. 10,000. Therefore, the market capitalization of XYZ ltd is equal to Rs. 10,000 in the market.
Now, the fact that the share market is made up of too many companies, thus if we sum up the market capitalization of each of the companies in the market together, then we’ll get the market capitalization of the entire share market.
Let us now understand, what GDP is? GDP refers to the Gross Domestic Product. Let us understand this with a simple example. Consider a company which manufactures pens. Consider that a pen costs Rs. 10 each. If that company manufactures around 1000 pens a year, so 1000 multiplied by 10 equals 10,000. So their total production in a year amounts to Rs. 10,000. Thus, if we sum up the production of all the companies in a country, we’ll get the GDP of that particular country.
Mr. Warren Buffet often says and believes that a country’s entire share market capital should always be less than that country’s GDP. If the share market capital is more than a country’s GDP, then it signifies that the market valuation has become expensive. And if the share market capital is less than a country’s GDP, then there is a scope for investing. So if there’s a niche for value creation then you might get an opportunity to earn good returns by investing.
It is crucial to note that Mr. Warren Buffet never invests his entire money in the share market. Kindly pay attention to this point. If we take a look at the cash position of the chart of Mr. Buffet’s company Berkshire Hathaway, we’ll find that only when Buffet thinks the market valuation is suitable for investing, is the time when he invests more in the market. On the other hand, if he finds that the market valuation is expensive then he chooses to sit on cash rather than investing more in the market.
From Market Cap to GDP Ratio we’ll get a picture of whether the market valuation is expensive or not, but is there a scope for valuation creation in such a market? Which ratio will tell us how much can if earn if we invest a particular amount? That ratio is known as the ‘Price Earning Ratio.’ We all are aware of this ratio.
For example, Price Earning Ratio, simply depicts what amount we are supposed to invest in order to earn Re. 1. So if the Price Earning Ratio is 10 it simply means that if we invest Rs. 10, we’ll earn Re. 1. So, in total, we are earning a return of 10% here. And suppose if the Price Earning Ratio is 30, then it simply means that if we invest Rs. 30, we’ll earn a return of Re. 1. So, in total, we are earning a return of only 3% here.
Now, if we observe Mr. Buffet’s Cash Position Chart and their Market’s PE chart then it clearly indicates that when the market valuation is expensive, Mr. Buffet invests less at that time and when the market valuation is not that expensive, Mr. Buffet invests more in the market. Hence, after observing the Market Cap to GDP Ratio, we can calculate the value based on PE Ratio and thus, get a clear picture of how much to invest in the market.
So, now when a common investor comes in the market, he doesn’t pay much attention to the Market Cap to GDP Ratio, PE Ratio, etc. He comes to the market and begins to form a cone of Ice-cream using his investments. Let us seek to understand how a common investor forms an ice - cream cone in the market.
The common investor enters the market. He says the share market is a bit risky place to be in, so let me first invest just a small amount and see what happens. If I am able to get good returns, they will invest more. Consider he invests a small amount in the market and the market goes down, thereby losing all his investments. So after this happens, he won’t enter the market again at all thinking that the share market is nothing but a gamble.
On the other hand, if the common investor invests and the market goes up, then it boasts its confidence. He won’t pay much attention to PE Ratio, etc. and start investing more just seeing the market go up. This cycle continues, seeing the market go up, he again invests more. Thinking; he has understood the market well. Without understanding and observing the PE, he continues his investment in the market. And later, when the market becomes expensive, at that point is an investment in the market is at a peak level. Similar to that of an ice-cream cone.
According to Warren Buffet’s Market Cap to GDP Ratio Formula as well as PE Ratio, it can be observed that Mr. Buffets forms a ‘Pyramid’ of his investments in the market based upon these formulae.
So, if we observe the above two figures, we’ll find that the common investor does the exact opposite of what Mr. Buffet does when he invests in the market. The common investor forms an ice-cream cone rather than a pyramid of his investments in the market, as his investments are more when the market valuation is expensive and vice-versa. And, so when the market collapses due to higher valuation, the common investor suffers a huge loss as his investments were on the higher side at that point in time.
The Intelligent Investor does the exact opposite of this. He invests more when the market valuation is least expensive and invests less when the market valuation is high or expensive. So, even when the market collapses, he does not lose much as his investment was limited.
Thus, if you wish to become a successful investor in the market, then you too like Mr. Warren Buffet are supposed to form a pyramid of our investments in the market. Only if we form a pyramid, will we be able to earn good returns from the market.
According to the Warren Buffet Indicator, by observing the Market Cap to GDP Ratio, we can rightly predict whether the market valuation is expensive or not. But, along with it, we are required to observe the PE Ratio too as to find out how much scope is there for value creation in the market.
So whether you are trading in the market or investing in the market, it is very important to check the market valuation. You all are aware of our ‘Smart Investor Training Program’ in our Aryaamoney app, we have covered the topic of how to invest / trade accordingly by observing the market valuation with the help of a simple case-study. So, hope you take the benefit of it.
The next question here is, what is the current Market Cap to GDP Ratio a well as what is the current PE Ratio? If you wish to know more about it, you can simply view it in our ‘Aryaamoney’ app. We have made it readily available there. You just need to go there and check it out!!!
Therefore, if you wish to become a successful investor in the market, then we too like Buffet should form a pyramid of your investments in the market & not a cone of ice-cream.
Until our next blog…
Happy Trading, Happy Investing!!!
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