A Little Bit of History Repeating

by on February 2, 2013  •  In Warren Buffett

In 1977, Warren Buffett wrote an article for Fortune Magazine titled “
How Inflation Swindles the Equity Investor.” In the article, Buffett outlines the parallels between equities and bonds, and the impact of interest rates & inflation movements on both asset classes.

Given the interest rate and inflation debate raging today, I thought it worthwhile to revisit and study what had transpired in the past.

Interestingly, if we applied the lessons of this 1977 article to today’s environment, contrary to the article’s title, it actually bodes well for future equity prices (see bold below), especially those companies compounding and reinvesting earnings rather than paying dividends.

Inflation, Duration, Compounding, Opportunity Cost

“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment…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…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…

…I believe…that stocks, in economic substances, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on 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 companies during the postwar years will discover something extraordinary: the returns on equity have in fact no varied much at all…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…

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’…

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, the can refuse to play further unless coupons currently being offered rekindle his interest…

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…Individual companies can be sold or liquidated and corporations can repurchase their own shares; on the balance however, new equity flotations and retained earnings 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…

There is another major difference between the garden variety of bond and or 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.”

Here is where things get interesting:

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 was of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period raged far above book value…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 12 percent. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then 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…

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 further 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.

Looking back, stock investors can think of themselves in the 1946-1956 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…

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 percent and the reinvestment ‘privilege’ began to look different.

Stocks are quite properly though of as riskier than bonds…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 by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

As Mark Twain said, “history does not repeat itself, but it does rhyme.” Food for thought. 


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