Buffett on the Stock Market (1999) - Fortune Magazine

Summary:
Buffet looking back in 1999 at the preceding 34 years and looking at the prospects for the stockmarket over the next 17 years. Preceding 34 years consisted of two contrasting 17 year periods. In first period, DJIA hardly moved; in second period, up nearly 10x. Main difference: interest rates and corporate profits. Interest rates down significantly in after 1982, and healthy corporate profits for period. Superimposed was market psychology. Many investors think next 17y will be more of the same. Buffett says this is unlikely: would require lowering of interest rates, and corporate profits after tax as a percentage of GDP to remain in excess of 6%. Profits cannot grow faster than GDP. Returns over next 17y more likely to be around 6%/year (4% reall return). Buffett on the chances of succesfully riding a wave of innovation: just look what happened to the automobile and aviation industries. Much easier to pick losers than to pick winners. However, key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. (Published: 22/11/1999)

Notes:

• explanation of why investors in 1999 are expecting too much
• investing = laying out money now to get more money back in the future in real terms, i.e. after taking inflation into account
• 1965 - 1999: 34 years, 2 periods of 17 years very different
• 1965 - 1981
• DJIA: hardly changed
  
• 31/12/1964: 874.12
• 31/12/1981: 875.00
• GDP: up 370% (almost 5x)
  
• Fortune 500 sales: up >6x
• rates on long-term bonds: tremendous increase
  
• 1964: 4%
• 1981: 15%
• corporate profits after tax as percentage of GDP
• mostly between 4 - 6.5% (normalcy range)
  
• down to 3.5% by 1981
  
• 1982 - 1999
• DJIA:
• 1981: 875.00
• 1999: 9,818.00
  
• GDP: up <3x
• rates on long-term bonds: going down
• 5% in 1998
  
• corporate profits after tax as percentage of GDP
• close to 6% by late 1998
  
• reasons for difference
• INTEREST RATE
  
• act on financial valuations the way gravy acts on matter
• the higher the rate, the greater the downward pull
• if government rate rises, prices of all other investments must adjust downward, to a level that brings their expected rates of return into line
• conversely, if government interest rates fall, the move pushes the prices of all other investments upwards
• basic proposition: what an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free rate
• every time the risk-free rate moves by one basis point - by 0.01% - the value of every investment in the country changes
• easy to see this in case of bonds
• value of which is normally affect exclusively by interest rates
• in case of equities, real estate, farms, etc. other variables also at work
• usually obscuring effect of interest rate changes
• yet effect always there, like the invisible pull of gravity
• huge increase in long-term government bond rates between 65 and 81
• gravitational pull of interest rate more than tripled
  
• huge depressing effect on the value of all investments, including equities
• major explanation of why tremendous growth in economy was accompanied by stock market going nowhere
• 1981-1983: interest rate situation reversed itself (Paul Volcker)
• effect on bonds
• e.g. put $1m into 14% 30-year US bond issued Nov 16 1981
• reinvest coupons, buying more of same bond
  
• end of 1998:
  
• bond selling at 5%
• made ~$8m, annual return >13%
• better than stocks in most 17 year periods
• effect on equities
  
• also pushed up by falling interest rate (in addition to other factors)
  
• e.g. put $1m in the Dow on Nov 16 1981
• reinvest all dividends
• end of 1998:
• made ~$20m, annual return of ~19%
  
• beats anything you can find in history
• AFTER-TAX CORPORATE PROFITS
• as percentage of GDP: portion of GDP that ended up with the shareholders of American business
• from 1951 to ~1980: within 4-6.5% range
• 1981 - 1982: down to 3.5%
• i.e. profits were sub-par and interest rates sky-high
• 1998: up to ~6%
• i.e. profits in upper part of normalcy range and interest rates low
• PSYCHOLOGY
• "Once a bull market gets underway, and once you reach the point where everybody has made money no matter what system he/she followed, a crowd is attracted into the game that is responding not to interest rates and profits by simply to the fact that it seems a mistake to be out of stocks. In effect, these people superimpose an I-can't-miss-the-party factor on top of the fundamental factors that drive the market. Like Pavlov's dog, these investors learn that when the bell rings - in this case the one that opens the New York Stock Exchange at 9:30am - they get fed. Through this daily reinforcement, they become convinced that there is a God and that He wants them to get rich."
• prospect for the next 17 years
• investors today have rosy expectations
• staring fixedly back at the road they just traveled
• expect 12 - 20% returns on 5 - 20 year investments
• Buffett: won't come close even to 12%
  
• 3 things need to happen for next 17 years to be as good as 17 years just passed
  
1. INTEREST RATES MUST FALL FURTHER
   
• if interest rates fell from 6% (now) to 3%, would come close to doubling the value of common stocks
  
• if you think interest rates are going to fall to e.g. 1%, you should buy bond options
  
2. CORPORATE PROFITABILITY IN RELATION TO GDP MUST RISE
   
• growth of a component factor cannot forever outpace that of the aggregate
• wildly optimistic to believe that corporate profits as a % of GDP can, for any sustained period, hold much above 6%
• e.g. competition will keep the percentage down
• also public policy element: if corporate investors, in aggregate, are going to eat an ever-growing portion of the economic pie, some other group will have to settle for a smaller portion
  
• would raise political problems
• reasonable assumption for GDP growth: 5% per year
• 3% real growth ("pretty darn good"), 2% inflation
• unless serious help from interest rates, aggregate value of equities can't grow much more than that
• GDP growth is limiting factor in returns you're going to get
• cannot expect to forever realize a 12% annual increase in valuation of American business if its profitability is growing only at 5%
• inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do
• note: future returns are always affected by current valuations
• and: investors as a whole cannot get anything out of their business except what the businesses earn
• minus "frictional costs", i.e. transaction, advice, fees
  
• e.g. Fortune 500
• 1998 profits: $334b
• 1999 market value: ~$10tr
• i.e. investors were saying in 1999 that they would pay $10tr for $334b in profits
• frictional costs ~$100b/year
  
• i.e. less than $250b return on $10tr
• is "slim pickings"
• Buffett's most probable return over next 17y?
• assuming constant interest rates, 2% inflation and frictional costs: 6%
• minus inflation: 4%
• could just as easily be less than that as more
  
3. SUCCESSFULLY RIDING THE WAVE OF INNOVATION
   
• e.g. IT revolution
• Buffett cautions by using automobile and aviation industries as example
• both transformed the country much earlier in the century
• automobile
• early days of cars: at one time at least 2,000 car makes
• industry was having incredible impact on people's lives
• in hindsight, revolutionized society
• with such knowledge investor would have said: "Here is the road to riches."
• 1990s: only 3 US car companies left, in dire shape
• aviation
• industry with plainly brilliant future, would have caused investors to salivate
• 1919-1939: 300 aircraft manufacturers
  
• today: only handful
• 129 airlines filed for bankruptcy in last 20y
• 1992: since dawn of aviation, money made by all of country's airline companies: zero
• note: much easier in such transforming events to figure out the losers and short them
  
• e.g. possible to grasp importance of car when it came along but how to pick winners?
• better to turn things upside down: short losers, e.g. horses

• "key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage"
• "products and services that have wide, sustainable moats around them are the ones that deliver rewards to investors"