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The Next Warren Buffett

The Motley FoolA young investor recently asked me why stock markets fall when interest rates rise. He was referring, in case you haven’t already guessed, to the latest market chatter about the American Federal Reserve’s decision to start winding back the amount of cheap money that it pumps into the markets.

He went on to say that if interest rates go up because the economy is improving, then surely stock markets should rise because companies could be more profitable.

His exquisitely simple logic took me by surprise.

I looked at the young investor and thought to myself that, with such an analytical mind, standing before me could be the next Warren Buffett in the making. My only hope is that his innocence will never be tainted by the gibberish that is peddled by so many so-called city experts.

But the young investor is right.

Time and again we see stock markets react badly to interest rate increases.

But why do stock markets fall when interest rates rise?

We can thank (or should that be blame) Myron J Gordon for this somewhat predictable stock market behaviour.

Gordon, who was an American economist, established a simple method for valuing stocks. He stated that the price of a stock was directly proportional to the expected dividends.

That makes perfect sense. If a stock pays out oodles of cash, then you should expect to pay more to own it.

He also said the price of a stock was inversely proportional to the discount rate. Actually, he said that the price was inversely proportional to the difference between the required rate of return from the stock and the rate at which dividends are expected to grow.

That also makes perfect sense.

You might be prepared to pay more for a stock if you lower the rate of return you require from the investment. Similarly, you can expect to pay more for a stock if it grows its payout more quickly.

So thanks to Myron J Gordon and his elegantly simple equation we know that the value of a stock is related to the required rate of return. Consequently, as interest rates increase, our required rate of return might also rise. The upshot is that stock prices could fall.

But this is where things get a little more interesting.

If interest rates are going up because the economy is expanding, then it could mean that the rate at which dividends grow could increase too. Additionally, companies might also hike their payout to shareholders because they are making more money.

So when you put all the pieces together, it is not inconceivable that interest rate rises, or what economists call a tightening of monetary policy, could be good news for stocks.

Here in Singapore, companies are, on average, not heavily indebted. The average leverage ratio for the 30 companies that make up the Straits Times Index (SGX: ^STI) is around 1.7.

However, averages can be deceptive. As the man with his head in a bucket of ice and his feet in the oven once said – on average I should feel quite comfortable.

So spend a few moments to look critically at the companies you are interested in and determine how interest rates might affect them.

More importantly, always question the way that markets behave and ask if the reaction of the masses to economic news is rational, logical and reasonable. Often, you will find that the market is not only irrational but illogical and unreasonable too.

Warren Buffett once said: “The business schools reward difficult complex behaviour more than simple behaviour, but simple behaviour is more effective.

So let’s all take a leaf from the young investor’s book. His simple logic about the economy, interest rates and stock prices, quite frankly, puts many experts to shame.

This article first appeared in a SIAS newsletter.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.