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
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
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.
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
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
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.
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
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.
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
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
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.)
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
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
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
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
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."