|
The central problem in the stock market
is that the return on capital hasnīt 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 one out.
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 that matter).
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.
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 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 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 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 inventory.
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.
Nevertheless, given 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 sharaholders.
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.
Recent statistical 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 inflation rate.
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 inflation rate.
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.)
Discussions regarding 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 it").
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 87― 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 Intervention.
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 original cost.
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 our economy.
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." |
