In May of 1977, Warren Buffett wrote an article in Fortune talking about how inflation swindles the equity investor. In this blog post, I will summarize and outline some of the key takeaways.
Buffett pointed out that the corporate return on equity capital (i.e. Net Income divided by Shareholder’s Equity) remained stuck at 12% over the whole postwar period. Buffett described that part of this 12% earned annually is paid out in dividends and the balance (retained earnings) is put right back into the universe to earn 12% again.
The good old days: When bonds yielded 3 or 4%, the right to reinvest (retained corporate earnings) automatically at 12% was of enormous value. It’s important to note that investors simply could not earn 12% return on their own money; stock prices traded far above book value, so the premium prices prevented them from earning higher returns. However, the corporation’s retained earnings allowed investors to buy at book value part of the enterprise that, according to the market, was a great deal more than book value.
Headings for the exits: Rising interest rates reduced the value of all existing fixed-coupon investments. Because of the additional risks tied to stocks, it is only natural for investors to expect an equity return that is comfortably above the bond return. In other words, as the spread between the equity and bond returns narrows, equity investors start looking for the exits.
Five ways to improve earnings: To raise the return on equity, corporations need at least one of the following:
- An increase in turnover (i.e. the ratio between sales and total assets employed in the business) – accounts receivable, inventories, and fixed assets. Accounts receivables go up proportionally as sales go up, so no room for improvement here. When dollar sales are rising because of inflation, LIFO inventory valuation method would show an increase in the reported turnover of inventory. With the rise in inflation, sales will immediately rise reflecting the new price level, however, the fixed asset account will reflect the change only gradually (as existing assets are replaced at the new price). Buffett concluded that the gains tied to increase in turnover are modest, and not of a magnitude to produce substantial improvement in returns on equity capital.
- Cheaper leverage – Higher rates of inflation generally causes borrowing to become more expensive, not cheaper. Buffett points out that even if interest rates don’t rise, leverage will get more expensive because the cost of debt will rise, and replacement will be required as that debt matures. In short, higher inflation is likely to have mildly depressing effect on the return on equity.
- More leverage – Buffett pointed out that in 20 years ended in 1975, stockholder’s equity as a percentage of total assets declined for the S&P500 from 63% to just under 50%. In other words, each dollar of equity capital was more leveraged that it used to be. Additionally, Buffett says that it’s easy for a company to lever up and show a higher ROE number. So, a 12% return from an enterprise that is debt free is far superior to the same return achieved by a business that is heavily in debt.
- Lower income taxes – Lower corporate income taxes seem unlikely. The federal, state, and municipal governments take a piece of the corporation’s earnings. Buffett believes that it’s unwise to assume a reduction in taxes over the long run.
- Wider operating margins on sales – Buffett accurately states that there are only 100 cents in the sales dollar, and a lot of demands on that dollar before we get down to residual, pre-tax profits. The major claimants are labor, raw material, energy, and various non-income taxes. These above mentioned costs are unlikely to decline during an age of inflation.
The investor’s equation: Buffett says that your future results will be governed by three variables: the relationship between book value and market value, the tax rate, and the inflation rate. When a security is bought above book value, the percent yield from dividend is reduced. Buffett also describes how the 12% ROE would become 7% after taxes are applied to dividends and retained earnings. Lastly, Buffett describes the inflation component, which on one knows the answer to. Buffett summarizes the situation with investors getting 12% before taxes and inflation, 7% after taxes and before inflation, and maybe 0% after taxes and inflation.
What widows don’t notice: Buffett gave a hypothetical example of a widow who earns 5% on her savings account would essentially be taxed at 120% when inflation is 6%.
5% x $100 = $5 in interest income; 120% x $5 = $6.
6% inflation x $100 = $6 inflation.
$6 inflation / $5 interest income = 120% equivalent tax.
In conclusion, the widow is “taxed” in a manner that leaves her with no real income whatsoever. If inflation is 6%, then the first 6% earned each year is simply replenishing the purchasing power.
The social equation: The major problems tied to inflation also affect the society as a whole. However, distributing cash from the affluent stockholders to the workers is not the answer. Buffett pointed out that employee compensation already totals 28 times the amount paid out in dividends, and a lot of those dividends go to pension funds, non profits, and individual shareholders who are not affluent. Shifting all dividends into wages would increase real wages by less than the wages obtained from one year’s growth of the economy.
Towards the end of the article, Buffett shows how the percentage of equity capital goes hand in hand with the country’s GDP. For instance, a 6% of equity capital available to finance for future growth will be reduced to 3% gain in real per capital net income, once 2% inflation, and 1% population growth is taken into account. A rise in GDP mean a rise in demand for products/services, which mean a rise in employment and increased demand for workers in factories, which means more money in people’s pockets. As inflation runs rampant and companies’ cash needs increase, companies issue stock to pay dividends, and end up diluting existing shareholders’ ownership. Buffett points how the IRS takes a big cut every time dividend is paid out. Buffett expects governments to intervene as private capital accumulation methods falter under inflation. Lastly, as inflation stays higher for longer, Buffett says that we would hear more about underinvestment, stagflation, and the failures of the private sector to fulfill needs.
Hope you found this summary helpful. You can find the Fortune article here.
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