Thursday, July 9, 2009

Buffett: Screw the Homebuilders!

Warren Buffett is prescribing some serious medicine to remedy the economy. And it could be a bitter pill for many to swallow.

In an exclusive interview CNBC's Julia Boorstin reveals that the Oracle of Omaha advocates halting the construction of homes.

“If you want to end the recession as soon as possible do nothing to encourage new homebuilders,” says Buffett. "That’s tough on the homebuilders but that’s the prescription for getting supply and demand back in balance.”

Talk about tough love, that's downright brutal especially if you’re one of the millions who work for our nation’s homebuilders. But desperate times calls for desperate measure.

“There is no silver bullet,” Buffett adds. “The original cause of this was the housing bubble… we built a couple million housing units a year… surprise we had too many houses.. you can’t work that off in a day, week or month. The best thing we can do is not to be building a lot of new houses.”

And that’s not all Buffett told us. He’s also on board with a second stimulus. When asked if there should be another one he replied, “I think there probably should be.”

Friday, June 26, 2009

How Inflation Swindles the Equity Investor

This article orginally appeared in Fortune Magazine in May 1977.

How Inflation Swindles the Equity Investor

The central problem in the stock market is that the return on capital hasn´t risen with inflation. It seems to be stuck at 12 percent.

by Warren E. Buffett, FORTUNE May 1977

It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market's problems in this period are still imperfectly understood.

There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn't going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.

It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their Value in real terms, let the politicians print money as they might.

And why didn't it turn but that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.

I know that this belief will seem eccentric to many investors. Thay will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company's earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by compa-nies during the postwar years will dis-cover something extraordinary: the returns on equity have in fact not varied much at all.

The coupon is sticky

In the first ten years after the war - the decade ending in 1955 -the Dow Jones industrials had an average annual return on year-end equity of 12.8 percent. In the second decade, the figure was 10.1 percent. In the third decade it was 10.9 percent. Data for a larger universe, the FORTUNE 500 (whose history goes back only to the mid-1950's), indicate somewhat similar results: 11.2 percent in the decade ending in 1965, 11.8 percent in the decade through 1975. The figures for a few exceptional years have been substantially higher (the high for the 500 was 14.1 percent in 1974) or lower (9.5 percent in 1958 and 1970), but over the years, and in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter).

For the moment, let's think of those companies, not as listed stocks, but as productive enterprises. Let's also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an "equity coupon".

In the real world, of course, investors in stocks don't just buy and hold. Instead, many try to outwit their fellow investors in order to maximize their own proportions of corporate earnings. This thrashing about, obviously fruitless in aggregate, has no impact on the equity, coupon but reduces the investor's portion of it, because he incurs substantial frictional costs, such as advisory fees and brokerage charges. Throw in an active options market, which adds nothing to, the productivity of American enterprise but requires a cast of thousands to man the casino, and frictional costs rise further.

Stocks are perpetual

It is also true that in the real world investors in stocks don't usually get to buy at book value. Sometimes they have been able to buy in below book; usually, however, they've had to pay more than book, and when that happens there is further pressure on that 12 percent. I'll talk more about these relationships later. Meanwhile, let's focus on the main point: as inflation has increased, the return on equity capital has not. Essentially, those who buy equities receive securities with an underlying fixed return - just like those who buy bonds.

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, he can refuse to play further unless coupons currently being offered rekindle his interest. Something of this sort has been going on in recent years.

Stocks, on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate. In the aggregate, their commitment is actually increasing. Individual companies can be sold or liquidated and corporations can repurchase their own shares; on balance, however, new equity flotations and retained earnings guarantee that the equity capital locked up in the corporate system will increase.

So, score one for the bond form. Bond coupons eventually will be renegotiated; equity "coupons" won't. It is true, of course, that for a long time a 12 percent coupon did not appear in need of a whole lot of correction.

The bondholder gets it in cash

There is another major difference between the garden variety of bond and our new exotic 12 percent "equity bond" that comes to the Wall Street costume ball dressed in a stock certificate.

In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor's equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the universe to earn 12 percent also.

The good old days

This characteristic of stocks - the reinvestment of part of the coupon - can be good or bad news, depending on the relative attractiveness of that 12 percent. The news was very good indeed in, the 1950's and early 1960's. With bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent via s of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can't pay far above par for a 12 percent bond and earn 12 percent for yourself.

But on their retained earnings, investors could earn 22 percent. In effert, earnings retention allowed investots to buy at book value part of an enterprise that, :in the economic environment than existing, was worth a great deal more than book value.

It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12 percent rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it. In the early 1960's, investors eagerly paid top-scale prices for electric utilities situated in growth areas, knowing that these companies had the ability to reinvest very large proportions of their earnings. Utilities whose operating environment dictated a larger cash payout rated lower prices.

If, during this period, a high-grade, noncallable, long-term bond with a 12 percent coupon had existed, it would have sold far above par. And if it were a bond with a f urther unusual characteristic - which was that most of the coupon payments could be automatically reinvested at par in similar bonds - the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12 percent while interest rates generally were around 4 percent, investors became very happy - and, of course, they paid happy prices.

Heading for the exits

Looking back, stock investors can think of themselves in the 1946-56 period as having been ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying corporate return on equity that was far above prevailing interest rates. Second, a significant portion of that return was reinvested for them at rates that were otherwise unattainable. And third, they were afforded an escalating appraisal of underlying equity capital as the first two benefits became widely recognized. This third dip meant that, on top of the basic 12 percent or so earned by corporations on their equity capital, investors were receiving a bonus as the Dow Jones industrials increased in price from 138 percent book value in 1946 to 220 percent in 1966, Such a marking-up process temporarily allowed investors to achieve a return that exceeded the inherent earning power of the enterprises in which they had invested.

This heaven-on-earth situation finally was "discovered" in the mid-1960's by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed-coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10 percent area), both the equity return of 12 percept and the reinvestment "privilege" began to look different.

Stocks are quite properly thought of as riskier than bonds. While that equity coupon is more or less fixed over periods of time, it does fluctuate somewhat from year to year. Investors' attitudes about the future can be affected substantially, although frequently erroneously, by those yearly changes. Stocks are also riskier because they come equipped with infinite maturities. (Even your friendly broker wouldn't have the nerve to peddle a 100-year bond, if he had any available, as "safe.") Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return - and 12 percent on equity versus, say, 10 percent on bonds issued py the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.

But, of course, as a group they can't get out. All they can achieve is a lot of movement, substantial frictional costs, and a new, much lower level of valuation, reflecting the lessened attractiveness of the 12 percent equity coupon under inflationary conditions. Bond investors have had a succession of shocks over the past decade in the course of discovering that there is no magic attached to any given coupon level - at 6 percent, or 8 percept, or 10 percent, bonds can still collapse in price. Stock investors, who are in general not aware that they too have a "coupon", are still receiving their education on this point.

Five ways to improve earnings

Must we really view that 12 percent equity coupon as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation?

There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes, (5) wider operating margins on sales.

And that's it. There simply are no other ways to increase returns on common equity. Let's see what can be done with these.

We'll begin with turnover. The three major categories of assets we have to think about for this exercise are accounts receivable inventories, and fixed assets such as plants and machinery.

Accounts receivable go up proportionally as sales go up, whether the increase in dollar sales is produced by more physical volume or by inflation. No room for improvement here.

With inventories, the situation is not quite as simple. Over the long term, the trend in unit inventories may be expected to follow the trend in unit sales. Over the short term, however, the physical turnover rate may bob around because of spacial influences - e.g., cost expectations, or bottlenecks.

The use of last-in, first-out (LIFO) inventory-valuation methods serves to increase the reported turnover rate during inflationary times. When dollar sales are rising because of inflation, inventory valuations of a LIFO company either will remain level, (if unit sales are not rising) or will trail the rise 1n dollar sales (if unit sales are rising). In either case, dollar turnover will increase.

During the early 1970's, there was a pronounced swing by corporations toward LIFO accounting (which has the effect of lowering a company's reported earnings and tax bills). The trend now seems to have slowed. Still, the existence of a lot of LIFO companies, plus the likelihood that some others will join the crowd, ensures some further increase it the reported turnover of inventory.

The gains are apt to be modest

In the case of fixed assets, any rise in the inflation rate, assuming it affects all products equally, will initially have the effect of increasing turnover. That is true because sales will immediately reflect the new price level, while the fixed-asset account will reflect the change only gradually, i.e., as existing assets are retired and replaced at the new prices. Obviously, the more slowly a company goes about this replacement process, the more the turnover ratio will rise. The action stops, however, when a replacement cycle is completed. Assuming a constant rate of inflation, sales and fixed assets will then begin to rise in concert at the rate of inflation.

To sum up, inflation will produce some gains in turnover ratios. Some improvement would be certain because of LIFO, and some would be possible (if inflation accelerates) because of sales rising more rapidly than fixed assets. But the gains are apt to be modest and not of a magnitude to produce substantial improvement in returns on equity capital. During the decade ending in 1975, despite generally accelerating inflation and the extensive use of LIFO accounting, the turnover ratio of the FORTUNE 500 went only from 1.18/1 to 1.29/1.

Cheaper leverage? Not likely. High rates of inflation generally cause borrowing to become dearer, not cheaper. Galloping rates of inflation create galloping capital needs; and lenders, as they become increasingly distrustful of long-term contracts, become more demanding. But even if there is no further rise in interest rates, leverage will be getting more expensive because the average cost of the debt now on corporate books is less than would be the cost of replacing it. And replacement will be required as the existing debt matures. Overall, then, future changes in the cost of leverage seem likely to have a mildly depressing effect on the return on equity.

More leverage? American business already has fired many, if not most, of the more-leverage bullets once available to it. Proof of that proposition can be seen in some other FORTUNE 500 statistics - in the twenty years ending in 1975, stockholders' equity as a percentage of total assets declined for the 500 from 63 percent to just under 50 percent. In other words, each dollar of equity capital now is leveraged much more heavily than it used to be.

What the lenders learned

An irony of inflation-induced financial requirements is that the highly profitable companies - generally the best credits - require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago - and are correspondingly less willing to let capital-hungry, low-profitability enterprises leverage themselves to the sky.

Nevertheless, given inflationary conditions, many corporations seem sure in the future to turn to still more leverage as a means of shoring up equity returns. Their managements will make that move because they will need enormous amounts of capital - often merely to do the same physical volume of business - and will wish to got it without cutting dividends or making equity offerings that, because of inflation, are not apt to shape up as attractive. Their natural response will be to heap on debt, almost regardless of cost. They will tend to behave like those utility companies that argued over an eighth of a point in the 1960's and were grateful to find 12 percent debt financing in 1974.

Added debt at present interest rates, however, will do less for equity returns than did added debt at 4 percent rates it the early 1960's. There is also the problem that higher debt ratios cause credit ratings to be lowered, creating a further rise in interest costs.

So that is another way, to be added to those already discussed, in which the cost of leverage will be rising. In total, the higher costs of leverage are likely to offset the benefits of greater leverage.
Besides, there is already far more debt in corporate America than is conveyed by conventional balance sheets. Many companies have massive pension obligations geared to whatever pay levels will be in effect when present workers retire. At the low inflation rates of 1965-65, the liabilities arising from such plans were reasonably predictable. Today, nobody can really know the company's ultimate obligation, But if the inflation rate averages 7 percent in the future, a twentyfive-year-old employee who is now earning $12,000, and whose raises do no more than match increases in living costs, will be making $180,000 when he retires at sixty-five.

Of course, there is a marvelously precise figure in many annual reports each year, purporting to be the unfunded pension liability. If that figure were really believable, a corporation could simply ante up that sum, add to it the existing pension-fund assets, turn the total amount over to an insurance company, and have it assume all the corporation's present pension liabilities. In the real world, alas, it is impossible to find an insurance company willing even to listen to such a deal.
Virtually every corporate treasurer in America would recoil at the idea of issuing a "cost-of-living" bond - a noncallable obligation with coupons tied to a price index. But through the private pension system, corporate America has in fact taken on a fantastic amount of debt that is the equivalent of such a bond.

More leverage, whether through conventional debt or unbooked and indexed "pension debt", should be viewed with skepticism by shareholders. A 12 percent return from an enterprise that is debt-free is far superior to the same return achieved by a business hocked to its eyeballs. Which means that today's 12 percent equity returns may well be less valuable than the 12 percent returns of twenty years ago.


More fun in New York

Lower corporate income taxes seem unlikely. Investors in American corporations already own what might be thought of as a Class D stock. The class A, B and C stocks are represented by the income-tax claims of the federal, state, and municipal governments. It is true that these "investors" have no claim on the corporation's assets; however, they get a major share of the earnings, including earnings generated by the equity buildup resulting from retention of part of the earnings owned by the Class D sharaholders.

A further charming characteristic of these wonderful Class A, B and C stocks is that their share of the corporation's earnings can be increased immedtately, abundantly, and without payment by the unilateral vote of any one of the "stockholder" classes, e.g., by congressional action in the case of the Class A. To add to the fun, one of the classes will sometimes vote to increase its ownership share in the business retroactively - as companies operating in New York discovered to their dismay in 1975. Whenever the Class A, B or C "stockholders" vote themselves a larger share of the business, the portion remaining for Class D - that's the one held by the ordinary investor - declines.

Looking ahead, it seems unwise to assume that those who control the A, B and C shares will vote to reduce their own take over the long run. The class D shares probably will have to struggle to hold their own.


Bad news from the FTC

The last of our five possible sources of increased returns on equity is wider operating margins on sales. Here is where some optimists would hope to achieve major gains. There is no proof that they are wrong. Bu there are only 100 cents in the sales dollar and a lot of demands on that dollar before we get down to the residual, pretax profits. The major claimants are labor, raw materials energy, and various non-income taxes. The relative importance of these costs hardly, seems likely to decline during an age of inflation.

Recent statistical evidence, furthermore, does not inspire confidence in the proposition that margins will widen in, a period of inflation. In the decade ending in 1965, a period of relatively low inflation, the universe of manufacturing companies reported on quarterly by the Federal Trade Commission had an average annual pretax margin on sales of 8.6 percent. In the decade ending in 1975, the average margin was 8 percent. Margins were down, in other words, despite a very considerable increase in the inflation rate.

If business was able to base its prices on replacement costs, margins would widen in inflationary periods. But the simple fact is that most large businesses, despite a widespread belief in their market power, just don't manage to pull it off. Replacement cost accounting almost always shows that corporate earnings have declined significantly in the past decade. If such major industries as oil, steel, and aluminum really have the oligopolistic muscle imputed to them, one can only conclude that their pricing policies have been remarkably restrained.

There you have, the complete lineup: five factors that can improve returns on common equity, none of which, by my analysis, are likely to take us very far in that direction in periods of high inflation. You may have emerged from this exercise more optimistic than I am. But remember, returns in the 12 percent area have been with us a long time.


The investor's equation

Even if you agree that the 12 percent equity coupon is more or less immutable, you still may hope to do well with it in the years ahead. It's conceivable that you will. After all, a lot of investors did well with it for a long time. But your future results will be governed by three variable's: the relationship between book value and market value, the tax rate, and the inflation rate.

Let's wade through a little arithmetic about book and market value. When stocks consistently sell at book value, it's all very simple. If a stock has a book value of $100 and also an average market value of $100, 12 percent earnings by business will produce a 12 percent return for the investor (less those frictional costs, which we'll ignore for the moment). If the payout ratio is 50 percent, our investor will get $6 via dividends and a further $6 from the increase in the book value of the business, which will, of course, be reflected in the market value of his holdings.

If the stock sold at 150 percent of book value, the picture would change. The investor would receive the same $6 cash dividend, but it would now represent only a 4 percent return on his $150 cost. The book value of the business would still increase by 6 percent (to $106) and the market value of the investor's holdings, valued consistently at 150 percent of book value, would similarly increase by 6 percent (to $159). But the investor's total return, i.e., from appreciation plus dividends, would be only 10 percent versus the underlying 12 percent earned by the business.

When the investor buys in below book value, the process is reversed. For example, if the stock sells at 80 percent of book value, the same earnings and payout assumptions would yield 7.5 percent from dividends ($6 on an $80 price) and 6 percent from appreciation - a total return of 13.5 percent. In other words, you do better by buying at a discount rather than a premium, just as common sense would suggest.

During the postwar years, the market value of the Dow Jones industrials has been as low as 84 percent of book value (in 1974) and as high as 232 percent (in 1965); most of the time the ratio has been well over 100 percent. (Early this spring, it was around 110 percent.) Let's assume that in the future the ratio will be something close to 100 percent - meaning that investors in stocks could earn the full 12 percent. At least, they could earn that figure before taxes and before inflation.


7 percent after taxes

How large a bite might taxes take out of the 12 percent? For individual investors, it seems reasonable to assume that federal, state, and local income taxes will average perhaps 50 percent on dividends and 30 percent on capital gains. A majority of investors may have marginal rates somewhat below these, but many with larger holdings will experience substantially higher rates. Under the new tax law, as FORTUNE observed last month, a high-income investor in a heavily taxed city could have a marginal rate on capital gains as high as 56 percent. (See
"The Tax Practitioners Act of 1976.")

So let's use 50 percent and 30 percent as representative for individual investors. Let's also assume, in line with recent experience, that corporations earning 12 percent on equity pay out 5 percent in cash dividends (2.5 percent after tax) and retain 7 percent, with those retained earnings producing a corresponding market-value growth (4.9 percent after the 30 percent tax). The after-tax return, then, would be 7.4 percent. Probably this should be rounded down to about 7 percent to allow for frictional costs. To push our stocks-asdisguised-bonds thesis one notch further, then, stocks might be regarded as the equivalent, for individuals, of 7 percent tax-exempt perpetual bonds.

The number nobody knows
Which brings us to the crucial question - the inflation rate. No one knows the answer on this one - including the politicians, economists, and Establishment pundits, who felt, a few years back, that with slight nudges here and there unemployment and inflation rates would respond like trained seals.

But many signs seem negative for stable prices: the fact that inflation is now worldwide; the propensity of major groups in our society to utilize their electoral muscle to shift, rather than solve, economic problems ; the demonstrated unwillingness to tackle even the most vital problems (e.g., energy and nuclear proliferation) if they can be postponed; and a political system that rewards legislators with reelection if their actions appear to produce short-term benefits even though their ultimate imprint will be to compound long-term pain.

Most of those in political office, quite understandably, are firmly against inflation and firmly in favor of policies producing it. (This schizophrenia hasn't caused them to lose touch with reality, however; Congressmen have made sure that their pensions - unlike practically all granted in the private sector - are indexed to cost-of-living changes after retirement.)

Discussions regarding future inflation rates usually probe the subtleties of monetary and fiscal policies. These are important variables in determining the outcome of any specific inflationary equation. But, at the source, peacetime inflation is a political problem, not an economic problem. Human behavior, not monetary behavior, is the key. And when very human politicians choose between the next election and the next generation, it's clear what usually happens.

Such broad generalizations do not produce precise numbers. However, it seems quite possible to me that inflation rates will average 7 percent in future years. I hope this forecast proves to be wrong. And it may well be. Forecasts usually tell us more of the forecaster than of the future. You are free to factor your own inflation rate into the investor's equation. But if you foresee a rate averaging 2 percent or 3 percent, you are wearing different glasses than I am.

So there we are: 12 percent before taxes and inflation; 7 percent after taxes and before inflation; and maybe zero percent after taxes and inflation. It hardly sounds like a formula that will keep all those cattle stampeding on TV.

As a common stockholder you will have more dollars, but you may have no more purchasing power. Out with Ben Franklin ("a penny saved is a penny earned") and in with Milton Friedman ("a man might as well consume his capital as invest it").


What widows don't notice

The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is "taxed" in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn't seem to notice that 6 percent inflation is the economic equivalent.

If my inflation assumption is close to correct, disappointing results will occur not because the market falls, but in spite of the fact that the market rises. At around 920 early last month, the Dow was up fifty-five points from where it was ten years ago. But adjusted for inflation, the Dow is down almost 345 points - from 865 to 520. And about half of the earnings of the Dow had to be withheld from their owners and reinvested in order to achieve even that result.

In the next ten years, the Dow would be doubled just by a combination of the 12 percent equity coupon, a 40 percent payout ratio, and the present 110 percent ratio of market to book value. And with 7 percent inflation, investors who sold at 1800 would still be considerably worse off than they are today after paying their capital-gains taxes.

I can almost hear the reaction of some investors to these downbeat thoughts. It will be to assume that, whatever the difficulties presented by the new investment era, they will somehow contrive to turn in superior results for themselves. Their success is most unlikely. And, in aggregate, of course, impossible. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I Would like to be your broker - but not your partner.

Even the so-called tax-exempt investors, such as pension funds and college endowment funds, do not escape the inflation tax. If my assumption of a 7 percent inflation rate is correct, a college treasurer should regard the first 7 percent earned each year merely as a replenishment of purchasing power. Endowment funds are earning nothing until they have outpaced the inflation treadmill. At 7 percent inflation and, say, overall investment returns of 8 percent, these institutions, which believe they are tax-exempt, are in fact paying "income taxes" of 87½ percent.


The social equation

Unfortunately, the major problems from high inflation rates flow not to investors but to society as a whole. Investment income is a small portion of national income, and if per capita real income could grow at a healthy rate alongside zero real investment returns, social justice might well be advanced.

A market economy creates some lopsided payoffs to participants. The right endowment of vocal chords, anatomical structure, physical strength, or mental powers can produce enormous piles of claim checks (stocks, bonds, and other forms of capital) on future national output. Proper selection of ancestors similarly can result in lifetime supplies of such tickets upon birth. If zero real investment returns diverted a bit greater portion of the national output from such stockholders to equally worthy and hardworking citizens lacking jackpot-producing talents, it would seem unlikely to pose such an insult to an equitable world as to risk Divine Intervention.

But the potential for real improvement in the welfare of workers at the expense of affluent stockholders is not significant. Employee compensation already totals twenty-eight times the amount paid out in dividends, and a lot of those dividends now go to pension funds, nonprofit institutions such as universities, and individual stockholders who are not affluent. Under these circumstances, if we now shifted all dividends of wealthy stockholders into wages - something we could do only once, like killing a cow (or, if you prefer, a pig) - we would increase real wages by less than we used to obtain from one year's growth of the economy.

The Russians understand it too

Therefore, diminishment of the affluent, through the impact of inflation on their investments, will not even provide material short-term aid to those who are not affluent. Their economic well-being will rise or fall with the general effects of inflation on the economy. And those effects are not likely to be good.

Large gains in real capital, invested in modern production facilities, are required to produce large gains in economic well-being. Great labor availability, great consumer wants, and great government promises will lead to nothing but great frustration without continuous creation and employment of expensive new capital assets throughout industry. That's an equation understood by Russians as well as Rockefellers. And it's one that has been applied with stunning success in West Germany and Japan. High capital-accumulation rates have enabled those countries to achieve gains in living standards at rates far exceeding ours, even though we have enjoyed much the superior position in energy.

To understand the impact of inflation upon real capital accumulation, a little math is required. Come back for a moment to that 12 percent return on equity capital. Such earnings are stated after depreciation, which presumably will allow replacement of present productive capacity - if that plant and equipment can be purchased in the future at prices similar to their original cost.


The way it was

Let's assume that about half of earnings are paid out in dividends, leaving 6 percent of equity capital available to finance future growth. If inflation is low - say, 2 percent - a large portion of that growth can be real growth in physical output. For under these conditions, 2 percent more will have to be invested in receivables, inventories, and fixed assets next year just to duplicate this year's physical output - leaving 4 percent for investment in assets to produce more physical goods. The 2 percent finances illusory dollar growth reflecting inflation and the remaining 4 percent finances real growth. If population growth is 1 percent, the 4 percent gain in real output translates into a 3 percent gain in real per capita net income. That, very roughly, is what used to happen in our economy.

Now move the inflation rate to 7 percent and compute what is left for real growth after the financing of the mandatory inflation component. The answer is nothing - if dividend policies and leverage ratios Terrain unchanged. After half of the 12 percent earnings are paid out, the same 6 percent is left, but it is all conscripted to provide the added dollars needed to transact last year's physical volume of business.

Many companies, faced with no real retained earnings with which to finance physical expansion after normal dividend payments, will improvise. How, they will ask themselves, can we stole or reduce dividends without risking stockholder wrath? I have good news for them: ready-made set of blueprints is available.

In recent years the electric-utility industry has had little or no dividend-paying capacity. Or, rather, it has had the power to pay dividends if investors agree to buy stock from them. In 1975 electric utilities paid common dividends of $3.3 billion and asked investors to return $3.4 billion. Of course, they mixed in a little solicit-Peter-to-pay-Paul technique so as not to acquire a (Con Ed reputation. Con Ed, you will remember, was unwise enough in 1974 to simply tell its shareholders it didn't have the money to pay the dividend, Candor was rewarded with calamity in the marketplace.

The more sophisticated utility maintains - perhaps increases - the quarterly dividend and then asks shareholders (either old or new) to mail back the money. In other words, the company issues new stock. This procedure diverts massive amounts of capital to the tax collector and substantial sums to underwriters. Everyone, however, seems to remain in spirits (particularly the underwriters).


More joy at AT&T

Encouraged by such success, some utilities have devised a further shortcut. In this case, the company declares the dividend, the shareholder pays the tax, and - presto - more shares are issued. No cash changes hands, although the spoilsport as always, persists in treating the transaction as if it had.


AT&T, for example, instituted a dividend-reinvestment program in 1973. This company, in fairness, must be described as very stockholder-minded, and its adoption of this program, considering the folkways of finance, must he regarded as totally understandable. But the substance of the program is out of Alice in Wonderland.


In 1976, AT&T paid $2.3 billion in cash dividends to about 2.9 million owners of its common stock. At the end of the year, 648,000 holders (up from 601,000 the previous year) reinvested $432 million (up from $327 million) in additional shaves supplied directly by the company.


Just for fun, let's assume that all AT&T shareholders ultimately sign up for this program. In that case, no cash at all would be mailed to shareholders - just as when Con Ed passed a dividend. However, each of the 2.9 million owners would be notified that he should pay income taxes on his share of the retained earnings that had that year been called a "dividend". Assuming that "dividends" totaled $2.3 billion, as in 1976, and that shareholders paid an average tax of 30 percent on these, they would end up, courtesy of this marvelous plan, paying nearly $730 million to the IRS. Imagine the joy of shareholders, in such circumstances, if the directors were then to double the dividend.


The government will try to do it

We can expect to see more use of disguised payout reductions as business struggles with the problem of real capital accumulation. But throttling back shareholders somewhat will not entirely solve the problem. A combination of 7 percent inflation and 12 percent returns with reduce the stream of corporate capital available to finance real growth.


And so, as conventional private capital-accumulation methods falter under inflation, our government will increasingly attempt to influence capital flows to industry, either unsuccessfully as in England or successfully as in Japan. The necessary cultural and historical underpinning for a Japanese-style enthusiastic partnership of government, business, and labor seems lacking here. if we are lucky, we will avoid following the English path, where all segments fight over division of the pie rather than pool their energies to enlarge it.


On balance, however, it seems likely that we will hear a great deal more. as the years unfold about underinvestinent, stagflation, and the failures of the private sector to fulfill needs.



About Warren Buffett

The author is, in fact, one of the most visible stock-market investors in the U.S. these days. He's had plenty to invest for his own account ever since he made $25 million running an investment partnership during the 1960's. Buffett Partnership Ltd., based in Omaha, was an immensely successful operation, but he nevertheless closed up shop at the end of the decade. A January, 1970, FORTUNE article explained his decision: "he suspects that some of the juice has gone out of the stock market and that sizable gains in the future are going to be very hard to come by."

Buffett, who is now forty-six and still operating out of Omaha, has a diverse portfolio. He and businesses he controls have interests in over thirty public corporations. His major holdings: Berkshire Hathaway (he owns about $35 million worth) and Blue Chip Stamps (about $10 million). His visibility, recently increased by a Wall Street Journal profile, reflects his active managerial role in both companies, both of which invest in a wide range of enterprises; one is the Washington Post.

And why does a man who is gloomy about stocks own so much stock? "Partly, it's habit," he admits. "Partly, it's just that stocks mean business, and owning businesses is much more interesting than owning gold or farmland. Besides, stocks are probably still the best of all the poor alternatives in an era of inflation - at least they are if you buy in at appropriate prices."

Friday, June 19, 2009

Buffett On Life"

Buffett On Life"

1. “Chains of habit are too light to be felt until they are too heavy to be broken.”
2. “We enjoy the process far more than the proceeds.”
3. “You only find out who is swimming naked when the tide goes out.”
4. “Someone’s sitting in the shade today because someone planted a tree a long time ago.”
5. “A public-opinion poll is no substitute for thought.”

Wednesday, June 17, 2009

Buffett On Helping Others

Warren Buffett's quotes on helping others:

1. “If you’re in the luckiest 1 per cent of humanity, you owe it to the rest of humanity to think about the other 99 per cent.”
2. “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”
3. “I don’t have a problem with guilt about money. The way I see it is that my money represents an enormous number of claim checks on society. It’s like I have these little pieces of paper that I can turn into consumption. If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the GNP would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching, or nursing. I don’t do that though. I don’t use very many of those claim checks. There’s nothing material I want very much. And I’m going to give virtually all of those claim checks to charity when my wife and I die.”
4. “It’s class warfare, my class is winning, but they shouldn’t be.”
5. “My family won’t receive huge amounts of my net worth. That doesn’t mean they’ll get nothing. My children have already received some money from me and Susie and will receive more. I still believe in the philosophy - FORTUNE quoted me saying this 20 years ago - that a very rich person should leave his kids enough to do anything but not enough to do nothing.”

Sunday, June 14, 2009

Buffett's Funny Quotes

Buffett's Funny Quotes:

1. “A girl in a convertible is worth five in the phonebook.”
2. “When they open that envelope, the first instruction is to take my pulse again.”
3. “We believe that according the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.’”
4. “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
5. “In the insurance business, there is no statute of limitation on stupidity.”

Buffett On Success

Warren Buffett on success:

1. “Of the billionaires I have known, money just brings out the basic traits in them. If they were jerks before they had money, they are simply jerks with a billion dollars.”
2. “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.”
3. “You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.”
4. “Can you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value.”
5. “You only have to do a very few things right in your life so long as you don’t do too many things wrong.”

Buffett On Investing

Here are Buffett's most famous quotes on Investing:

1. “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
2. “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
3. “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
4. “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
5. “Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful”.”

Friday, May 8, 2009

Berkshire Hathaway 2009 Annual Shareholder meeting

Warren E. Buffett says investing isn’t about being a genius — it’s about keeping it simple.

And after spending a weekend at Berkshire Hathaway’s annual meeting in Omaha with the world’s most famous value investor, Andrew Ross Sorkin writes in his latest DealBook column that this kind of wisdom might have saved a lot of heartache had investors heeded it over the last decade. Instead, it was roundly ignored in the period leading up to the financial crisis.

Omaha — “If you have a 150 I.Q., sell 30 points to someone else. You need to be smart, but not a genius.”

So said Warren Buffett, the world’s most famous value investor, at Berkshire Hathaway’s annual meeting here on Saturday, a regular pilgrimage for some 35,000 shareholders that many call Woodstock for capitalists. This year there wasn’t as much free-flowing love, given what a difficult year it’s been for capitalists, Mr. Buffett included.

But shareholders still hung on every word from the 78-year-old investor’s lips. Between sips of Cherry Coke and bites of peanut brittle, he served up some wisdom that might have saved a lot of heartache (not to mention jobs and untold financial losses) had investors heeded it over the last decade: keep it simple.

During the boom, the country became too enamored with the idea that the best and brightest could predict the future; too dependent on complicated financial models developed by quant jocks; and too reactive to every uptick or slight drop in the market. It still may be today.

“If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it,” he said. Given that the stress tests for the banking system — developed with complex spreadsheets and using sophisticated formulas predicting the next two years’ worth of earnings and write-downs — are being released this week, it was timely advice. (He still likes his investment in Wells Fargo, by the way, and suggests it has enough capital already. Though, it’s worth noting, he seemed less optimistic about the economy than officials in Washington.)

Charlie Munger, Mr. Buffett’s 85-year-old business partner, added his two cents: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you, but it doesn’t. They teach that in business schools because, well, they’ve got to do something.”

I had traveled to Omaha to sit on stage, along with two other journalists, to pepper Mr. Buffett and Mr. Munger with questions — some quite tough — for more than five hours. Shareholders had sent in thousands of them by e-mail before I left. Even while I was on stage, they kept arriving, stuffing my BlackBerry.

Some questions I received showed flashes of real anger. Mr. Buffett, who had earned the nickname “the Oracle of Omaha” for his long-term performance, had let some of these shareholders down, they said. This last year was his worst ever. Like everyone else, he missed the credit crisis and subprime debacle.

Not surprisingly, however, his fan club is still strong, dismissing his bad year as part of the “markets go up and markets go down” inevitability of value investing. Even so, Mr. Buffett himself acknowledged, “I didn’t cover myself in glory” in 2008.

Others, though, wanted to know why Mr. Buffett was still invested in Moody’s, whose credibility took a huge hit in the bust along with other credit rating agencies after it doled out Triple-A ratings the way McDonald’s sells hamburgers (a shareholder’s analogy, not mine). There were plenty of questions about Mr. Buffett’s succession plan (or lack thereof, to the dismay of many investors). And if it was not about Mr. Buffett’s successor, it was about his reinsurance guru, Ajit Jain, who runs Berkshire’s wildly profitable reinsurance business. “The Titanic-like ending of A.I.G., after Greenberg left, has me spooked,” wrote Ben Knoll, in reference to Maurice Greenberg, A.I.G.’s former chief. He wanted to know who was next in line to take over a job that requires assessing risk.

Mr. Buffett sometimes meandered, but he did not skirt the questions. It “would be impossible” to replace Mr. Jain, he said, saying that “we won’t find a substitute for him.” He suggested that if Mr. Jain were ever to leave, Berkshire didn’t have anyone it would allow to write the same size insurance policies. Most chief executives I know would have said they had a succession plan even if they didn’t.

To the question about Moody’s, he said the company “eagerly sought stupid assumptions that enabled them to do clever mathematics.” As to why he didn’t exert his influence, he said: “I don’t think I’ve ever made a call to Moody’s. We don’t tell Burlington Northern what safety procedures to put in or AmEx who they should lend to. When we own stock, we are not there to try and change people.”

When asked why the conglomerate structure seemed to work so well for him, he remarkably — and surprisingly, to me — explained the structure is efficient and comes in handy around April 15. “We’ve got this ability in terms of moving money around into various opportunities” without tax consequences, he said, describing how he can invest the profits from one business into another without being taxed.

Most of what Mr. Buffett said was basic and obvious — and was roundly ignored during the period leading up to this mess. “Leverage is what causes people real trouble in this world,” Mr. Buffett said. “You don’t want to be in a position where someone can pull the rug out from under you or, emotionally, where you pull it out from under yourself.”

Not that Mr. Buffett doesn’t have a rug or two of his own. For a man who preaches the virtues of simplicity in all things investing, he is wrapped up in a lot of complicated investments, namely the very same derivatives that he has called “weapons of mass destruction.” On Saturday, he acknowledged that he had futures and options contracts on stock indexes and foreign currencies, but added that, in and of themselves, “derivatives aren’t evil.”

Insurance, by the way, is not exactly simple, either. There is a crystal-ball aspect to the industry, papered over with spreadsheets of probability calculations.

On Sunday morning, the day after the meeting, I attended a private brunch for the company’s directors and managers. It was a star-studded affair (for financial types): Bill Gates, Don Graham of The Washington Post, Charlie Rose, Steve Wynn, Mr. Jain and even a movie star, Glenn Close.

It had been a long weekend. Everyone was heading to the airport. One chief executive told me, “If I can just hold on and try to think like Warren for a couple of days when I get home every year after this weekend, it’s a success.”

I shook Mr. Buffett’s hand goodbye and tried to remember his words from the day before: “There is so much that’s false and nutty in modern investing practice and modern investment banking,” he said. “If you just reduced the nonsense, that’s a goal you should reasonably hope for.”

Monday, April 27, 2009

Ready For The Annual Berskhire Shareholder's Meeting?

Berkshire Hathaway’s Annual Meeting is this coming Saturday 2 May 2009 in Omaha, NE at the Qwest Center. Given the financial turmoil and all of the ruckus over Berkshire’s credit rating, it should be a very interesting affair.

In conjunction with the Annual meeting, Berkshire CEO Warren Buffett’s son Peter is hosting a unique event, a discussion really, where he talks about his life and upbringing. Details are below.

Peter’s ‘Concert and Conversation’ serves as an entertaining and informative look into the life of a man with a very unique upbringing. His open discussion about the lessons he’s learned as the son of one of the most noteworthy investors of our time and its effect on creating the man he’s become, acts as a true testament that life is never a straight road. The evening will include live performances of selections from Peter’s album releases including his latest, Imaginary Kingdom, punctuated with videos from his film/television work and philanthropic activities.

EVENT DETAILS:
An Evening of Concert and Conversation with Peter Buffett
WHEN: Saturday, May 2nd at 7:30 pm
WHERE: The Rose, 2001 Farnam Street, Omaha, NE
TICKETS: $42, with $25 of the cost being tax deductible
http://rosetheater.org/season-events.asp

Monday, April 6, 2009

Learning From Buffets Mistaks

Buffett is the Chairman and CEO of Berkshire Hathaway, and the second- richest man in the world according to the Forbes list of the 400 richest people. He's also known as the world's best investor.

So then, why is he outing his mistakes to millions?

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action," he announced in his latest letter to shareholders.

But it's that very admission of guilt that makes Buffett what every investor should aspire to be. It's what separates Buffett from the stockerati that tries so hard to imitate him.

After all, Buffett's performance could have been much worse for the year. In 2008, Berkshire Hathaway outperformed the S&P 500 by 27.4%, meaning that the Oracle of Omaha's investments held up significantly better than the rest of the stock market.

Others would have touted the year as a success - after all, he performed better than most mutual funds, a plethora of hedge funds, and most individual investors - Buffett didn't.

Three Lessons to Learn from the Oracle's Mistakes

Because those who forget their stock market mistakes are doomed to repeat them:

Don't Seek Approval - Per Buffett, "Approval, though, is not the goal of investing. In fact, approval is often counter-productive because it sedates the brain and makes it less receptive to new facts or a re- examination of conclusions formed earlier. Beware the investment activity that produces applause; the great moves are usually greeted by yawns."

Understand What You Own - "Recent events demonstrate that certain big- name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie [Munger] and me in this hapless group," he said.

The Market Can Be Wrong - "The investment world has gone from underpricing risk to overpricing it. This change has not been minor; the pendulum has covered an extraordinary arc. A few years ago, it would have seemed unthinkable that yields like today's could have been obtained on good-grade municipal or corporate bonds even while risk- free governments offered near-zero returns on short-term bonds and no better than a pittance on long-terms."

It's hard to see the market clearly when things look as ominous as they do only three months into 2009. Sellers are overwhelmingly pushing the direction of the market today, but that pace can only be kept up for so long. Keep Warren Buffett's advice in mind, and you'll end this debacle with your head above water.

Friday, March 13, 2009

BRK Downgraded!

Fitch Ratings downgraded Berkshire Hathaway's so-called Issuer Default Rating (IDR) and senior unsecured debt ratings to double A+ and double A, respectively. Berkshire's insurance arm maintained its triple A, but all divisions are on negative watch. Fitch also said having Warren Buffett as head of the company is a risk...

Fitch views this risk as unrelated to Mr. Buffett's age, but rather Fitch's belief that Berkshire's record of outstanding long-term investment results and the company's ability to identify and purchase attractive operating companies is intimately tied to Mr. Buffett.

And yesterday, Standard & Poor's stripped GE of its triple-A rating. That leaves only five triple-A-rated companies. They are ExxonMobil, Microsoft, Johnson & Johnson, ADP, and Pfizer.

Saturday, January 10, 2009

Warren Buffett on super SIV 2007-12-11

Check out this great Buffett video on Structured Investments Vehicles.