How Inflation Swindles the Equity Investor
The central problem in the stock market is that the return on capital hasn´t rin with inflation. It ems to be stuck at 12 percent.
by Warren E. Buffett, FORTUNE May 1977
It is no longer a cret 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 curity with income and principal payments denominated in tho 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 el. 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 reprent ownership of companies with productive faci
lities. The, investors believed, would retain their Value in real terms, let the politicians print money as they might.乌龙茶是红茶吗
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 em eccentric to many investors. Thay will immediately obrve 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 cond decade, the figure was 10.1 percent. In the third decade it was 10.9 percent. Data for a larger univer, the FORTUNE 500 (who 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 tho companies, not as listed stocks, but as productive enterpris. Let's also assume that the owners of tho enterpris had acquired them at book value. In that ca, their own return would have been around 12 percent too. And becau the return has been so consistent, it ems reasonable to think of it as an "equity coupon".
In the real world, of cour, 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, becau 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 enterpri but requires a cast of thousands to man the casino, and frictional costs ri further.
Stocks are perpetual
亮丙瑞林说明书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 the relationships later. Meanwhile, let's focus on the main point: as inflation has incread, the return on equity capital has not. Esntially, tho who buy equities receive curities with an underlying fixed return - just like tho who buy bonds.
十圣Of cour, 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 refu 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 repurcha their
own shares; on balance, however, new equity flotations and retained earnings guarantee that the equity capital locked up in the corporate system will increa.
So, score one for the bond form. Bond coupons eventually will be renegotiated; equity "coupons" won't. It is true, of cour, 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 dresd in a stock certificate.
In the usual ca, 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 univer, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the univer to earn 12 percent also.
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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 univer whatever rate that univer was earning. You can't pay far above par for a 12 percent bond and earn 12 percent for yourlf.
幼儿园大班识字大全But on their retained earnings, investors could earn 22 percent. In effert, earnings retention allowed investots to buy at book value part of an enterpri 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 t
o pay for it. In the early 1960's, investors eagerly paid top-scale prices for electric utilities situated in growth areas, knowing that the companies had the ability to reinvest very
large proportions of their earnings. Utilities who operating environment dictated a larger cash payout rated lower prices.博大精深是什么意思
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 esnce, growth stocks retaining most of their earnings reprented just such a curity. 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 cour, they paid happy prices.
Heading for the exits
Looking back, stock investors can think of themlves 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 reinveste
d for them at rates that were otherwi 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 incread 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 enterpris in which they had invested.
吉他五线谱This heaven-on-earth situation finally was "discovered" in the mid-1960's by many major investing institutions. But just as the 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 rever itlf. 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 th
e future can be affected substantially, although frequently erroneously, by tho yearly changes. Stocks are also riskier becau 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.") Becau 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 univer does not em to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.
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But, of cour, 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 lesned attractiveness of the 12 percent equity coupon under inflationary conditions. Bond investors have had a succession of shocks over the past decade in the cour 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 collap 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 itlf upward in respon to a permanently higher average rate of inflation?
There is no such law, of cour. On the other hand, corporate America cannot increa earnings by desire or decree. To rai that return on equity, corporations would need at least one of the following: (1) an increa in turnover, i.e., in the ratio between sales and total asts 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 increa returns on common equity. Let's e what can be done with the.
We'll begin with turnover. The three major categories of asts we have to think about for this exerci are accounts receivable inventories, and fixed asts such as plants and machinery.
Accounts receivable go up proportionally as sales go up, whether the increa 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 becau of spacial influences - e.g., cost expectations, or bottlenecks.
The u of last-in, first-out (LIFO) inventory-valuation methods rves to increa the reported turnover rate during inflationary times. When dollar sales are rising becau of inflation, inventory valuations of a LIFO company either will remain level, (if unit sales are not rising) or
