How Inflation Swindles the Equity Investor.docx

How Inflation Swindles the Equity Investor.docx

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HowInflationSwindlestheEquityInvestor

HowInflationSwindlestheEquityInvestor-byWarrenBuffett

2011-05-1816:

25:

44

Thecentralprobleminthestockmarketisthatthereturnoncapitalhasn´trisenwithinflation.Itseemstobestuckat12percent.

byWarrenE.Buffett,FORTUNEMay1977

Itisnolongerasecretthatstocks,likebonds,dopoorlyinaninflationaryenvironment.Wehavebeeninsuchanenvironmentformostofthepastdecade,andithasindeedbeenatimeoftroublesforstocks.Butthereasonsforthestockmarket'sproblemsinthisperiodarestillimperfectlyunderstood.

Thereisnomysteryatallabouttheproblemsofbondholdersinaneraofinflation.Whenthevalueofthedollardeterioratesmonthaftermonth,asecuritywithincomeandprincipalpaymentsdenominatedinthosedollarsisn'tgoingtobeabigwinner.YouhardlyneedaPh.D.ineconomicstofigurethatoneout.

Itwaslongassumedthatstocksweresomethingelse.Formanyyears,theconventionalwisdominsistedthatstockswereahedgeagainstinflation.Thepropositionwasrootedinthefactthatstocksarenotclaimsagainstdollars,asbondsare,butrepresentownershipofcompanieswithproductivefacilities.These,investorsbelieved,wouldretaintheirValueinrealterms,letthepoliticiansprintmoneyastheymight.

Andwhydidn'titturnbutthatway?

Themainreason,Ibelieve,isthatstocks,ineconomicsubstance,arereallyverysimilartobonds.

Iknowthatthisbeliefwillseemeccentrictomanyinvestors.Thaywillimmediatelyobservethatthereturnonabond（thecoupon）isfixed,whilethereturnonanequityinvestment（thecompany'searnings）canvarysubstantiallyfromoneyeartoanother.Trueenough.Butanyonewhoexaminestheaggregatereturnsthathavebeenearnedbycompa-niesduringthepostwaryearswilldis-coversomethingextraordinary:

thereturnsonequityhaveinfactnotvariedmuchatall.

Thecouponissticky

Inthefirsttenyearsafterthewar-thedecadeendingin1955-theDowJonesindustrialshadanaverageannualreturnonyear-endequityof12.8percent.Intheseconddecade,thefigurewas10.1percent.Inthethirddecadeitwas10.9percent.Dataforalargeruniverse,theFORTUNE500（whosehistorygoesbackonlytothemid-1950's）,indicatesomewhatsimilarresults:

11.2percentinthedecadeendingin1965,11.8percentinthedecadethrough1975.Thefiguresforafewexceptionalyearshavebeensubstantiallyhigher（thehighforthe500was14.1percentin1974）orlower（9.5percentin1958and1970）,butovertheyears,andintheaggregate,thereturnonbookvaluetendstokeepcomingbacktoalevelaround12percent.Itshowsnosignsofexceedingthatlevelsignificantlyininflationaryyears（orinyearsofstableprices,forthatmatter）.

Forthemoment,let'sthinkofthosecompanies,notaslistedstocks,butasproductiveenterprises.Let'salsoassumethattheownersofthoseenterpriseshadacquiredthematbookvalue.Inthatcase,theirownreturnwouldhavebeenaround12percenttoo.Andbecausethereturnhasbeensoconsistent,itseemsreasonabletothinkofitasan"equitycoupon".

Intherealworld,ofcourse,investorsinstocksdon'tjustbuyandhold.Instead,manytrytooutwittheirfellowinvestorsinordertomaximizetheirownproportionsofcorporateearnings.Thisthrashingabout,obviouslyfruitlessinaggregate,hasnoimpactontheequity,couponbutreducestheinvestor'sportionofit,becauseheincurssubstantialfrictionalcosts,suchasadvisoryfeesandbrokeragecharges.Throwinanactiveoptionsmarket,whichaddsnothingto,theproductivityofAmericanenterprisebutrequiresacastofthousandstomanthecasino,andfrictionalcostsrisefurther.

Stocksareperpetual

Itisalsotruethatintherealworldinvestorsinstocksdon'tusuallygettobuyatbookvalue.Sometimestheyhavebeenabletobuyinbelowbook;usually,however,they'vehadtopaymorethanbook,andwhenthathappensthereisfurtherpressureonthat12percent.I'lltalkmoreabouttheserelationshipslater.Meanwhile,let'sfocusonthemainpoint:

asinflationhasincreased,thereturnonequitycapitalhasnot.Essentially,thosewhobuyequitiesreceivesecuritieswithanunderlyingfixedreturn-justlikethosewhobuybonds.

Ofcourse,therearesomeimportantdifferencesbetweenthebondandstockforms.Foropeners,bondseventuallycomedue.Itmayrequirealongwait,buteventuallythebondinvestorgetstorenegotiatethetermsofhiscontract.Ifcurrentandprospectiveratesofinflationmakehisoldcouponlookinadequate,hecanrefusetoplayfurtherunlesscouponscurrentlybeingofferedrekindlehisinterest.Somethingofthissorthasbeengoingoninrecentyears.

Stocks,ontheotherhand,areperpetual.Theyhaveamaturitydateofinfinity.InvestorsinstocksarestuckwithwhateverreturncorporateAmericahappenstoearn.IfcorporateAmericaisdestinedtoearn12percent,thenthatisthelevelinvestorsmustlearntolivewith.Asagroup,stockinvestorscanneitheroptoutnorrenegotiate.Intheaggregate,theircommitmentisactuallyincreasing.Individualcompaniescanbesoldorliquidatedandcorporationscanrepurchasetheirownshares;onbalance,however,newequityflotationsandretainedearningsguaranteethattheequitycapitallockedupinthecorporatesystemwillincrease.

So,scoreoneforthebondform.Bondcouponseventuallywillberenegotiated;equity"coupons"won't.Itistrue,ofcourse,thatforalongtimea12percentcoupondidnotappearinneedofawholelotofcorrection.

Thebondholdergetsitincash

Thereisanothermajordifferencebetweenthegardenvarietyofbondandournewexotic12percent"equitybond"thatcomestotheWallStreetcostumeballdressedinastockcertificate.

Intheusualcase,abondinvestorreceiveshisentirecouponincashandislefttoreinvestitasbesthecan.Ourstockinvestor'sequitycoupon,incontrast,ispartiallyretainedbythecompanyandisreinvestedatwhateverratesthecompanyhappenstobeearning.Inotherwords,goingbacktoourcorporateuniverse,partofthe12percentearnedannuallyispaidoutindividendsandthebalanceisputrightbackintotheuniversetoearn12percentalso.

Thegoodolddays

Thischaracteristicofstocks-thereinvestmentofpartofthecoupon-canbegoodorbadnews,dependingontherelativeattractivenessofthat12percent.Thenewswasverygoodindeedin,the1950'sandearly1960's.Withbondsyieldingonly3or4percent,therighttoreinvestautomaticallyaportionoftheequitycouponat12percentviasofenormousvalue.Notethatinvestorscouldnotjustinvesttheirownmoneyandgetthat12percentreturn.Stockpricesinthisperiodrangedfarabovebookvalue,andinvestorswerepreventedbythepremiumpricestheyhadtopayfromdirectlyextractingoutoftheunderlyingcorporateuniversewhateverratethatuniversewasearning.Youcan'tpayfaraboveparfora12percentbondandearn12percentforyourself.

Butontheirretainedearnings,investorscouldearn22percent.Ineffert,earningsretentionallowedinvestotstobuyatbookvaluepartofanenterprisethat,:

intheeconomicenvironmentthanexisting,wasworthagreatdealmorethanbookvalue.

Itwasasituationthatleftverylittletobesaidforcashdividendsandalottobesaidforearningsretention.Indeed,themoremoneythatinvestorsthoughtlikelytobereinvestedatthe12percentrate,themorevaluabletheyconsideredtheirreinvestmentprivilege,andthemoretheywerewillingtopayforit.Intheearly1960's,investorseagerlypaidtop-scalepricesforelectricutilitiessituatedingrowthareas,knowingthatthesecompanieshadtheabilitytoreinvestverylargeproportionsoftheirearnings.Utilitieswhoseoperatingenvironmentdictatedalargercashpayoutratedlowerprices.

If,duringthisperiod,ahigh-grade,noncallable,long-termbondwitha12percentcouponhadexisted,itwouldhavesoldfarabovepar.Andifitwereabondwithafurtherunusualcharacteristic-whichwasthatmostofthecouponpaymentscouldbeautomaticallyreinvestedatparinsimilarbonds-theissuewouldhavecommandedanevengreaterpremium.Inessence,growthstocksretainingmostoftheirearningsrepresentedjustsuchasecurity.Whentheirreinvestmentrateontheaddedequitycapitalwas12percentwhileinterestratesgenerallywerearound4percent,investorsbecameveryhappy-and,ofcourse,theypaidhappyprices.

Headingfortheexits

Lookingback,stockinvestorscanthinkofthemselvesinthe1946-56periodashavingbeenladledatrulybountifultripledip.First,theywerethebeneficiariesofanunderlyingcorporatereturnonequitythatwasfaraboveprevailinginterestrates.Second,asignificantportionofthatreturnwasreinvestedforthematratesthatwereotherwiseunattainable.Andthird,theywereaffordedanescalatingappraisalofunderlyingequitycapitalasthefirsttwobenefitsbecamewidelyrecognized.Thisthirddipmeantthat,ontopofthebasic12percentorsoearnedbycorporationsontheirequitycapital,investorswerereceivingabonusastheDowJonesindustrialsincreasedinpricefrom138percentbookvaluein1946to220percentin1966,Suchamarking-upprocesstemporarilyallowedinvestorstoachieveareturnthatexceededtheinherentearningpoweroftheenterprisesinwhichtheyhadinvested.

Thisheaven-on-earthsituationfinallywas"discovered"inthemid-1960'sbymanymajorinvestinginstitutions.Butjustasthesefinancialelephantsbegantramplingononeanotherintheirrushtoequities,weenteredanerao