Recently, Warren Buffett was a guest on CNBC’s morning show Squawk Box. It was the first Friday in October, which meant he was present and on air for the release of the monthly jobs report. Upon release of the figures, the hosts and other guests immediately began discussing and debating the meaning of the report. A few minutes later one of the hosts turned to a still-silent Mr. Buffett and effectively said, “You don’t care about any of this, do you?” Mr. Buffett laughed and replied, “No.”
All Warren Buffett really cares about when it comes to investing is the value of individual businesses. As a value investor, he likes cheap businesses—those in which his estimation of the company’s fair value is substantially less than the market price. And within his holding company, Berkshire Hathaway, Mr. Buffett employs an army of like-minded security analysts to ferret out cheap companies.
One of Mr. Buffett’s preferred methods of stock analysis is the discounted cash flow (DCF) analysis. You start by making a set of assumptions about a company’s prospects for growth; you then project their cash flow years into the future. Next, you discount those cash flows back into a present-day value to determine the overall value of the company. Divide that value by the number of shares outstanding, and (voilà!) you have an estimate of the fair value of the company’s stock. You can then compare your estimate of the stock price to the market’s price to determine if the stock is overvalued, undervalued, or appropriately valued.
But the analysis does not end there. Any security analyst worth his or her salt will then test their analysis at the margins. That means constructing reasonable best-case and worst-case assumptions of the company’s future, and then re-running the discounted cash flow calculation with those altered assumptions.
For example, the consensus of Wall Street analysts is that Apple will grow 12% per year over the next five years. A starting point for analysis of Apple stock is to calculate what the shares should be worth today if they achieve that level of growth. But that is just a starting point because it only informs you where the stock is priced relative to market expectations. You have to then test at the margins to determine where the stock is priced relative to best-case and worst-case scenarios.
In the case of Apple, what if they don’t grow over the next five years? What if there is another major global recession and sales actually decline? On the flip side, what if they invent another hit product like the iPhone or iPad and sales surge by 20% per year over the next decade?
If the market price of Apple stock is closer to the worst-case scenario than the best case, you likely have an undervalued stock—assuming of course the worst-case scenario does not actually happen. This is why security analysts joke that the future does not have to be bright; it just has to be less bad than everyone expects.
Testing Your Retirement Plan at the Margins
Retirement planning should involve the same type of margin testing that is used in stock analysis. At Bell Investment Advisors, it is a process that we use in all of our retirement plans.
As with stock analysis, we start with a reasonable view of the future based on expected returns and expected volatility for various asset classes and model portfolios. But even for plans that pass that test with flying colors, we then want to understand the best-case and worst-case scenarios.
The best-case scenario typically makes our clients laugh because it is seemingly so ridiculous. It often involves making it to age 100 with hundreds of millions of dollars in the bank. Granted that dollar figure is a future value decades down the road that is worth much less in today’s dollars, but even after discounting it to a present value, it is still a very large number that clients have difficulty wrapping their mind around. However, keep in mind that this is the best-case scenario of the many thousands that we run. There is the possibility that you have the good fortune of retiring at the start of a 1990s-like bull market run while inflation and volatility remain subdued; it is just not that likely to actually occur.
The conversation gets more serious when we turn our attention to the worst-case scenario. This scenario involves running out of assets at some point during the client’s lifetime. Even the strongest retirement plans have a worst-case scenario in which the client outlives their money. Again, remember that it is the worst-case scenario among thousands (think retiring at the outset of The Great Depression). But if your worst-case scenario is running out of money in your 70s or 80s, there should be some comfort in that it is as unlikely to happen as joining Warren Buffett in the billionaire’s club as a centenarian.
Even if something close to the worst-case scenario plays out in your future, adjustments can be made along the way to make your assets last longer. The most important takeaway from this exercise is understanding the worst-case scenario in your retirement plan and being prepared to deal with it in the unlikely event that it does occur. But hopefully your future turns out less bad than that.