in the future for investors
FORTUNE, December 6, 2001, By Warren
Buffett; Carol Loomis
years ago, following a July 1999 speech by Warren Buffett, chairman
of Berkshire Hathaway, on the stock market - a rare subject for
him to discuss publicly - FORTUNE ran what he had to say under
the title Mr.
Buffett on the Stock Market (Nov. 22, 1999). His main
points then concerned two consecutive and amazing periods that
American investors had experienced, and his belief that returns
from stocks were due to fall dramatically. Since the Dow Jones
Industrial Average was 11194 when he gave his speech and recently
was about 9900, no one yet has the goods to argue with him.
do we stand now - with the stock market seeming to reflect a dismal
profit outlook, an unfamiliar war, and rattled consumer confidence?
Who better to supply perspective on that question than Buffett?
that follow come from a second Buffett speech, given last July
at the site of the first talk, Allen & Co.'s annual Sun Valley
bash for corporate executives. There, the renowned stockpicker
returned to the themes he'd discussed before, bringing new data
and insights to the subject. Working with FORTUNE's Carol Loomis,
Buffett distilled that speech into this essay, a fitting opening
for this year's Investor's Guide. Here again is Mr. Buffett on
the Stock Market".
The last time I tackled
this subject, in 1999,
I broke down the previous 34 years into two 17-year periods, which
in the sense of lean years and fat were astonishingly symmetrical.
Here's the first period. As you can see, over 17 years the Dow
gained exactly one-tenth of one percent.
- Dow Jones
Dec. 31, 1964: 874.12
Dec. 31, 1981: 875.00
And here's the second,
marked by an incredible bull market that, as I laid out my thoughts,
was about to end (though I didn't know that).
- Dow Industrials
Dec. 31, 1981: 875.00
Dec. 31, 1998: 9181.43
Now, you couldn't explain
this remarkable divergence in markets by, say, differences in
the growth of gross national product. In the first period - that
dismal time for the market - GNP actually grew more than twice
as fast as it did in the second period.
- Gain In Gross
So what was the explanation?
I concluded that the market's contrasting moves were caused by
extraordinary changes in two critical economic variables - and
by a related psychological force that eventually came into play.
Here I need to remind
you about the definition of "investing," which though
simple is often forgotten. Investing is laying out money today
to receive more money tomorrow.
That gets to the first
of the economic variables that affected stock prices in the two
periods - interest rates. In economics, interest rates
act as gravity behaves in the physical world. At all
times, in all markets, in all parts of the world, the tiniest
change in rates changes the value of every financial asset. You
see that clearly with the fluctuating prices of bonds. But the
rule applies as well to farmland, oil reserves, stocks, and every
other financial asset. And the effects can be huge on values.
If interest rates are, say, 13%, the present value of a dollar
that you're going to receive in the future from an investment
is not nearly as high as the present value of a dollar if rates
So here's the record
on interest rates at key dates in our 34-year span. They moved
dramatically up - that was bad for investors - in the first half
of that period and dramatically down - a boon for investors -
in the second half.
Rates, Long-term Government Bonds
Dec. 31, 1964: 4.20%
Dec. 31, 1981: 13.65%
Dec. 31, 1998: 5.09%
The other critical
variable here is how many dollars investors expected to get from
the companies in which they invested. During the first period
expectations fell significantly because corporate profits weren't
looking good. By the early 1980s Fed
Chairman Paul Volcker's economic sledgehammer had, in fact, driven
corporate profitability to a level that people hadn't seen since
The upshot is that
investors lost their confidence in the American economy: They
were looking at a future they believed would be plagued by two
negatives. First, they didn't see much good coming in
the way of corporate profits. Second, the sky-high interest rates
prevailing caused them to discount those meager profits further.
These two factors, working together, caused stagnation in the
stock market from 1964 to 1981, even though those years featured
huge improvements in GNP. The business of the country grew while
investors' valuation of that business shrank!
And then the
reversal of those factors created a period during which
much lower GNP gains were accompanied by a bonanza for the market.
First, you got a major increase in the rate of profitability.
Second, you got an enormous drop in interest rates, which made
a dollar of future profit that much more valuable. Both
phenomena were real and powerful fuels for a major bull market.
And in time the psychological factor I mentioned was added to
the equation: Speculative trading exploded, simply because of
the market action that people had seen. Later, we'll look at the
pathology of this dangerous and oft-recurring malady.
Two years ago
I believed the favorable fundamental trends had largely run their
course. For the market to go dramatically up from where it was
then would have required long-term interest rates to drop much
further (which is always possible) or for there to be a major
improvement in corporate profitability (which seemed, at the time,
considerably less possible). If you take a look at a
50-year chart of after-tax profits as a percent of gross domestic
product, you find that the rate normally falls between 4% - that
was its neighborhood in the bad year of 1981, for example - and
6.5%. For the rate to go above 6.5% is rare. In the very good
profit years of 1999 and 2000, the rate was under 6% and this
year it may well fall below 5%.
So there you have my
explanation of those two wildly different 17-year periods. The
question is, How much do those periods of the past for the market
say about its future?
To suggest an answer,
I'd like to look back over the 20th century. As you know, this
was really the American century. We had the advent of autos, we
had aircraft, we had radio, TV, and computers. It was an incredible
period. Indeed, the per capita growth in U.S. output, measured
in real dollars (that is, with no impact from inflation), was
a breathtaking 702%.
The century included
some very tough years, of course - like the Depression years of
1929 to 1933. But a decade-by-decade look at per capita GNP shows
something remarkable: As a nation, we made relatively consistent
progress throughout the century.
So you might think
that the economic value of the U.S. - at least as measured by
its securities markets - would have grown at a reasonably consistent
pace as well.
That's not what happened.
We know from our earlier examination of the 1964-98 period that
parallelism broke down completely in that era. But the whole century
makes this point as well. At its beginning, for example, between
1900 and 1920, the country was chugging ahead, explosively expanding
its use of electricity, autos, and the telephone. Yet the market
barely moved, recording a 0.4% annual increase that was roughly
analogous to the slim pickings between 1964 and 1981.
- Dow Industrials
Dec. 31, 1899: 66.08
Dec. 31, 1920: 71.95
In the next period,
we had the market boom of the '20s, when the Dow jumped 430% to
381 in September 1929. Then we go 19 years - 19 years - and there
is the Dow at 177, half the level where it began. That's true
even though the 1940s displayed by far the largest gain in per
capita GDP (50%) of any 20th-century decade. Following that came
a 17-year period when stocks finally took off - making a great
five-to-one gain. And then the two periods discussed at the start:
stagnation until 1981, and the roaring boom that wrapped up this
To break things down
another way, we had three huge, secular bull markets that
covered about 44 years, during which the Dow gained more
than 11,000 points. And we had three periods of stagnation,
covering some 56 years. During those 56 years
the country made major economic progress and yet the Dow actually
lost 292 points.
How could this
have happened? In a flourishing country in which people
are focused on making money, how could you have had three extended
and anguishing periods of stagnation that in aggregate - leaving
aside dividends - would have lost you money? The answer lies in
the mistake that investors repeatedly make - that psychological
force I mentioned above: People are habitually guided
by the rear-view mirror and, for the most part, by the vistas
immediately behind them.
The first part of the
century offers a vivid illustration of that myopia. In the century's
first 20 years, stocks normally yielded more than high-grade bonds.
That relationship now seems quaint, but it was then almost axiomatic.
Stocks were known to be riskier, so why buy them unless you were
paid a premium?
And then came along
a 1924 book - slim and initially unheralded, but destined to move
markets as never before - written by a man named Edgar Lawrence
Smith. The book, called Common Stocks as Long Term Investments,
chronicled a study Smith had done of security price movements
in the 56 years ended in 1922. Smith had started off his study
with a hypothesis: Stocks would do better in times of inflation,
and bonds would do better in times of deflation. It was a perfectly
But consider the first
words in the book: "These studies are the record of a failure
- the failure of facts to sustain a preconceived theory."
Smith went on: "The facts assembled, however, seemed worthy
of further examination. If they would not prove what we had hoped
to have them prove, it seemed desirable to turn them loose and
to follow them to whatever end they might lead."
Now, there was a smart
man, who did just about the hardest thing in the world to do.
Charles Darwin used to say that whenever he ran into something
that contradicted a conclusion he cherished, he was obliged to
write the new finding down within 30 minutes. Otherwise his mind
would work to reject the discordant information, much as the body
rejects transplants. Man's natural inclination is to
cling to his beliefs, particularly if they are reinforced by recent
experience - a flaw in our makeup that bears on what happens during
secular bull markets and extended periods of stagnation.
To report what Edgar
Lawrence Smith discovered, I will quote a legendary thinker -
John Maynard Keynes, who in 1925 reviewed the book, thereby putting
it on the map. In his review, Keynes described "perhaps Mr.
Smith's most important point ... and certainly his most novel
point. Well-managed industrial companies do not, as a rule, distribute
to the shareholders the whole of their earned profits. In good
years, if not in all years, they retain a part of their profits
and put them back in the business. Thus there is an element of
compound interest (Keynes' italics) operating in favor
of a sound industrial investment."
It was that simple.
It wasn't even news. People certainly knew that companies were
not paying out 100% of their earnings. But investors hadn't thought
through the implications of the point. Here, though, was this
guy Smith saying, "Why do stocks typically outperform
bonds? A major reason is that businesses retain earnings, with
these going on to generate still more earnings - and dividends,
ignited an unprecedented bull market. Galvanized by Smith's
insight, investors piled into stocks, anticipating a double dip:
their higher initial yield over bonds, and growth to boot. For
the American public, this new understanding was like the discovery
long that same public was burned. Stocks were driven
to prices that first pushed down their yield to that on bonds
and ultimately drove their yield far lower. What happened then
should strike readers as eerily familiar: The mere fact that share
prices were rising so quickly became the main impetus for people
to rush into stocks. What the few bought for the right
reason in 1925, the many bought for the wrong reason in 1929.
Astutely, Keynes anticipated
a perversity of this kind in his 1925 review. He wrote: "It
is dangerous... to apply to the future inductive arguments based
on past experience, unless one can distinguish the broad reasons
why past experience was what it was." If you can't do that,
he said, you may fall into the trap of expecting results in the
future that will materialize only if conditions are exactly the
same as they were in the past. The special conditions he had in
mind, of course, stemmed from the fact that Smith's study
covered a half century during which stocks generally yielded more
than high-grade bonds.
The colossal miscalculation
that investors made in the 1920s has recurred in one form or another
several times since. The public's monumental hangover from its
stock binge of the 1920s lasted, as we have seen, through 1948.
The country was then intrinsically far more valuable than it had
been 20 years before; dividend yields were more than double the
yield on bonds; and yet stock prices were at less than half their
1929 peak. The conditions that had produced Smith's wondrous results
had reappeared - in spades. But rather than seeing what
was in plain sight in the late 1940s, investors were transfixed
by the frightening market of the early 1930s and were avoiding
re-exposure to pain.
Don't think for a moment
that small investors are the only ones guilty of too much attention
to the rear-view mirror. Let's look at the behavior of professionally
managed pension funds in recent decades. In 1971 - this was Nifty
Fifty time - pension managers, feeling great about the market,
put more than 90% of their net cash flow into stocks, a record
commitment at the time. And then, in a couple of years, the roof
fell in and stocks got way cheaper. So what did the pension fund
managers do? They quit buying because stocks got cheaper!
- Private Pension
Funds % of cash flow put into equities
1971: 91% (record high)
This is the
one thing I can never understand. To refer to a personal
taste of mine, I'm going to buy hamburgers the rest of my life.
When hamburgers go down in price, we sing the "Hallelujah
Chorus" in the Buffett household. When hamburgers go up,
we weep. For most people, it's the same way with everything in
life they will be buying - except stocks. When stocks go down
and you can get more for your money, people don't like them anymore.
That sort of behavior
is especially puzzling when engaged in by pension fund managers,
who by all rights should have the longest time horizon of any
investors. These managers are not going to need the money in their
funds tomorrow, not next year, nor even next decade. So they have
total freedom to sit back and relax. Since they are not operating
with their own funds, moreover, raw greed should not distort their
decisions. They should simply think about what makes the most
sense. Yet they behave just like rank amateurs (getting paid,
though, as if they had special expertise).
when I felt stocks were a screaming buy, I wrote in an article,
"Pension fund managers continue to make investment decisions
with their eyes firmly fixed on the rear-view mirror. This generals-fighting-the-last-war
approach has proved costly in the past and will likely prove equally
costly this time around." That's true, I said, because
"stocks now sell at levels that should produce long-term
returns far superior to bonds."
Consider the circumstances
in 1972, when pension fund managers were still loading up on stocks:
The Dow ended the year at 1020, had an average book value of 625,
and earned 11% on book. Six years later, the Dow was 20% cheaper,
its book value had gained nearly 40%, and it had earned 13% on
book. Or as I wrote then, "Stocks were demonstrably
cheaper in 1978 when pension fund managers wouldn't buy them than
they were in 1972, when they bought them at record rates."
At the time
of the article, long-term corporate bonds were yielding about
9.5%. So I asked this seemingly obvious question: "Can better
results be obtained, over 20 years, from a group of 9.5% bonds
of leading American companies maturing in 1999 than from a group
of Dow-type equities purchased, in aggregate, around book value
and likely to earn, in aggregate, about 13% on that book value?"
The question answered itself.
Now, if you
had read that article in 1979, you would have suffered - oh, how
you would have suffered! - for about three years. I was no good
then at forecasting the near-term movements of stock prices, and
I'm no good now. I never have the faintest idea what the stock
market is going to do in the next six months, or the next year,
or the next two.
But I think
it is very easy to see what is likely to happen over the long
term. Ben Graham told us why: "Though the stock
market functions as a voting machine in the short run, it acts
as a weighing machine in the long run." Fear and greed play
important roles when votes are being cast, but they don't register
on the scale.
By my thinking,
it was not hard to say that, over a 20-year period, a 9.5% bond
wasn't going to do as well as this disguised bond called the Dow
that you could buy below par - that's book value - and that was
earning 13% on par.
Let me explain what
I mean by that term I slipped in there, "disguised bond."
A bond, as most of you know, comes with a certain maturity and
with a string of little coupons. A 6% bond, for example, pays
a 3% coupon every six months.
A stock, in contrast,
is a financial instrument that has a claim on future distributions
made by a given business, whether they are paid out as dividends
or to repurchase stock or to settle up after sale or liquidation.
These payments are in effect "coupons." The set of owners
getting them will change as shareholders come and go. But the
financial outcome for the business' owners as a whole will be
determined by the size and timing of these coupons. Estimating
those particulars is what investment analysis is all about.
Now, gauging the size
of those "coupons" gets very difficult for individual
stocks. It's easier, though, for groups of stocks. Back
in 1978, as I mentioned, we had the Dow earning 13% on its average
book value of $850. The 13% could only be a benchmark, not a guarantee.
Still, if you'd been willing then to invest for a period of time
in stocks, you were in effect buying a bond - at prices that in
1979 seldom inched above par - with a principal value of $891
and a quite possible 13% coupon on the principal.
How could that
not be better than a 9.5% bond? From that starting point,
stocks had to outperform bonds over the long term. That, incidentally,
has been true during most of my business lifetime. But as Keynes
would remind us, the superiority of stocks isn't inevitable. They
own the advantage only when certain conditions prevail.
Let me show you another
point about the herd mentality among pension funds - a point perhaps
accentuated by a little self-interest on the part of those who
oversee the funds. In the table below are four well-known companies
- typical of many others I could have selected - and the expected
returns on their pension fund assets that they used in calculating
what charge (or credit) they should make annually for pensions.
Now, the higher the
expectation rate that a company uses for pensions, the higher
its reported earnings will be. That's just the way that pension
accounting works - and I hope, for the sake of relative brevity,
that you'll just take my word for it.
As the table shows,
expectations in 1975 were modest: 7% for Exxon, 6% for GE and
GM, and under 5% for IBM. The oddity of these assumptions is that
investors could then buy long-term government noncallable bonds
that paid 8%. In other words, these companies could have loaded
up their entire portfolio with 8% no-risk bonds, but they nevertheless
used lower assumptions. By 1982, as you can see, they had moved
up their assumptions a little bit, most to around 7%. But now
you could buy long-term governments at 10.4%. You could in fact
have locked in that yield for decades by buying so-called strips
that guaranteed you a 10.4% reinvestment rate. In effect, your
idiot nephew could have managed the fund and achieved returns
far higher than the investment assumptions corporations were using.
Why in the world would
a company be assuming 7.5% when it could get nearly 10.5% on government
bonds? The answer is that rear-view mirror again: Investors who'd
been through the collapse of the Nifty Fifty in the early 1970s
were still feeling the pain of the period and were out of date
in their thinking about returns. They couldn't make the necessary
to 2000, when we had long-term governments at 5.4%. And what were
the four companies saying in their 2000 annual reports about expectations
for their pension funds? They were using assumptions of 9.5% and
I'm a sporting
type, and I would love to make a large bet with the chief financial
officer of any one of those four companies, or with their actuaries
or auditors, that over the next 15 years they will not average
the rates they've postulated. Just look at the math,
for one thing. A fund's portfolio is very likely to be one-third
bonds, on which - assuming a conservative mix of issues with an
appropriate range of maturities - the fund cannot today expect
to earn much more than 5%. It's simple to see then that the fund
will need to average more than 11% on the two-thirds that's in
stocks to earn about 9.5% overall. That's a pretty heroic assumption,
particularly given the substantial investment expenses that a
typical fund incurs.
do wonders, however, for the bottom line. By embracing
those expectation rates shown in the far right column, these companies
report much higher earnings - much higher - than if they were
using lower rates. And that's certainly not lost on the
people who set the rates. The actuaries who have roles in this
game know nothing special about future investment returns. What
they do know, however, is that their clients desire rates that
are high. And a happy client is a continuing client.
Are we talking big
numbers here? Let's take a look at General Electric, the country's
most valuable and most admired company. I'm a huge admirer myself.
GE has run its pension fund extraordinarily well for decades,
and its assumptions about returns are typical of the crowd. I
use the company as an example simply because of its prominence.
If we may retreat to
1982 again, GE recorded a pension charge
of $570 million. That amount cost the company 20% of
its pretax earnings. Last year GE recorded a
$1.74 billion pension credit.
That was 9% of the company's pretax earnings.
And it was 2 1/2 times the appliance division's profit of $684
million. A $1.74 billion credit is simply a lot of money. Reduce
that pension assumption enough and you wipe out most of the credit.
GE's pension credit,
and that of many another corporation, owes its existence to a
rule of the Financial Accounting Standards Board that
went into effect in 1987. From that point on, companies
equipped with the right assumptions and getting the fund performance
they needed could start crediting pension income to their income
statements. Last year, according to Goldman Sachs, 35
companies in the S&P 500 got more than 10% of their earnings
from pension credits, even as, in many cases, the value
of their pension investments shrank.
subject of pension assumptions, critically important though it
is, almost never comes up in corporate board meetings. (I myself
have been on 19 boards, and I've never heard a serious discussion
of this subject.) And now, of course, the need for discussion
is paramount because these assumptions that are being made, with
all eyes looking backward at the glories of the 1990s, are so
extreme. I invite you to ask the CFO of a company having
a large defined-benefit pension fund what adjustment would need
to be made to the company's earnings if its pension assumption
was lowered to 6.5%. And then, if you want to be mean, ask what
the company's assumptions were back in 1975 when both stocks and
bonds had far higher prospective returns than they do now.
With 2001 annual reports
soon to arrive, it will be interesting to see whether companies
have reduced their assumptions about future pension returns. Considering
how poor returns have been recently and the reprises that probably
lie ahead, I think that anyone choosing not to lower assumptions
- CEOs, auditors, and actuaries all - is risking litigation for
misleading investors. And directors who don't question
the optimism thus displayed simply won't be doing their job.
The tour we've taken
through the last century proves that market irrationality of an
extreme kind periodically erupts - and compellingly suggests that
investors wanting to do well had better learn how to deal with
the next outbreak. What's needed is an antidote, and in
my opinion that's quantification. If you quantify, you won't necessarily
rise to brilliance, but neither will you sink into craziness.
On a macro
basis, quantification doesn't have to be complicated at all. Below
is a chart, starting almost 80 years ago and really quite fundamental
in what it says. The chart shows the market value of all publicly
traded securities as a percentage of the country's business -
that is, as a percentage of GNP. The ratio has certain limitations
in telling you what you need to know. Still, it is probably the
best single measure of where valuations stand at any given moment.
And as you can see, nearly two years ago the ratio rose to an
unprecedented level. That should have been a very strong warning
ככל הנראה, באפט "גנב"
את הרעיון הזה מהמאמרים האלה
the Stock Market Overvalued, Mcgrattan and Prescott,
Regulations, and the Values of US and UK Corporations,
Mcgrattan and Prescott,
For investors to gain
wealth at a rate that exceeds the growth of U.S. business, the
percentage relationship line on the chart must keep going up and
up. If GNP is going to grow 5% a year and you want market values
to go up 10%, then you need to have the line go straight off the
top of the chart. That won't happen.
For me, the
message of that chart is this: If the percentage relationship
falls to the 70% or 80% area, buying stocks is likely to work
very well for you. If the ratio approaches 200% - as it did in
1999 and a part of 2000 - you are playing with fire.
As you can see, the ratio was recently 133%.
Even so, that
is a good-sized drop from when I was talking about the market
in 1999. I ventured then that the American public should expect
equity returns over the next decade or two (with dividends included
and 2% inflation assumed) of perhaps 7%. That was a gross figure,
not counting frictional costs, such as commissions and fees. Net,
I thought returns might be 6%.
market "hamburgers," so to speak, are cheaper. The country's
economy has grown and stocks are lower, which means that investors
are getting more for their money. I would expect now to see long-term
returns run somewhat higher, in the neighborhood of 7% after costs.
Not bad at all - that is, unless you're still deriving your expectations
from the 1990s.