Quote of the Day

"It's probably true that hard work never killed anyone, but why take the chance?" - Ronald Reagan

Notes:

• Buffett on how the management of large organizations is extremely hard work, which is why he has taken the "easy route": just sitting back and working through great managers who run their own shows. "My only task is to cheer them on, sculpt and harden our corporate culture, and make major capital-allocation decisions."

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Quote of the Day

"We shape our buildings, and afterwards our buildings shape us." - Churchill

Notes:

• Buffet uses this quote in reference to organizations apparently becoming slow-thinking, resistant to change, and smug as they grow bigger
  

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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"
  

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Squanderville versus Thriftville (2003) - Fortune Magazine

Summary:
Warren Buffet, writing in 2003. Predicts the dollar will decline in value and is therefore buying foreign currencies. Decline will have serious consequences for US economy. Growing trade-deficit is to blame. Explains this by means of tale: Squanderville vs. Thriftville. Thriftville owning Squanderville bonds. Government devalues Squanderville national currency to reduce value of IOUs (bonds). Thriftville sells bonds and buys Squanderville assets (direct ownership) with proceeds. Ends up owning all of Squanderville. One generation of Thrifters gets a free ride for which future generation pay (rent, interest) in perpetuity. Story similar to that of US since late 1970s. Declining dollar value not the solution. Buffet proposes system of Import Certificates in order to rebalance trade. (Published: 10/03)

Notes:

• Buffett: "Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in - and today holds - several currencies. It is largely irrelevant which currencies they are. What does matter is the underlying point: to hold other currencies is to believe that the dollar will decline. Both as an American and as an investor, I actually hope these commitments prove to be a mistake. Any profits Berkshire might make from currency trading would pale against the losses the company and our shareholders, in other aspects of their lives, would incur from a plunging dollar."
• our trade deficit has greatly worsened, to the point that our country's "net worth," so to speak, is now being transferred abroad at an alarming rate
• a perpetuation of this transfer will lead to major trouble
• see tale of Squanderville and Thriftville
• Tale of Squanderville and Thriftville
• two isolate, side-by-side islands of equal size
• land only capital asset
• communities primitive: need only food and produce only food
• working 8hrs/day, each inhabitant can produce enough food to sustain himself
• each society self-sufficient if everybody works 8hrs/day
• Thriftville citizens decide to do some serious saving and investing
• start to work 16hrs/day
• continue to live of food produced in 8hrs, and export remainder to Squanderville
• Squanderville citizens decide to live their lives free of toil and eat as well as ever
• pay Thrifts with bonds
• bonds at their core represent claim checks on the future output of Squanderville
• a few Squanderers smell trouble coming but are ignored
• the debt Squanderville is piling up will eventually require them to work more than 8hrs/day
• Thrifts begin to get nervous
• question the value of the Squanderville IOUs
• sell most of the bonds to Squanderville residents for Squanderbucks
• use proceeds to buy Squanderville land
• eventually the Thrifts own all of Squanderville
• Squanderers have nothing left to trade
• must return to working 8hrs/day in order to eat
• must also work additional hours to service the debt and pay Thriftville rent on the land imprudently sold
• Squanderville has been colonized by purchase rather than by conquest
• present value of the future production of Squanderville must forever ship to Thriftville
• can be argued that both have received a fair deal:
• equates the production Thriftville initially gave up
• however, dramatic "intergenerational inequity" has arisen
• one generation of Squanderers got a free ride and future generations pay in perpetuity for it
• Squanderville government facing ever greater payments to service debt
• sooner or later will decide to embrace highly inflationary policies
• i.e. issue more Squanderbucks to dilute the value of each
• Squanderbonds are simply claims on specific numbers of Squanderbucks, not on bucks of specific value
• making Squanderbucks less valuable would ease the island's fiscal pain
• in response, residents of Thriftville opt for direct ownership of Squanderville land rather than bonds of the island's governement
• most governments find it much harder morally to seize foreign-owned property than they do to dilute the purchasing power of claim checks foreigners hold
• "Theft by stealth is preferred to theft by force"
• comparison with US
• 1945 - ~1970: operated in industrious Thriftville style
• regularly selling more abroad than purchased
• invested surplus abroad
• net investment increased
• i.e. holdings of foreign assets less foreign holdings of US assets
• country's net worth consisted of all the wealth within borders plus a modest portion of the wealth of in the rest of the world
• late 1970s: trade situation reversed, producing deficits
• running initially at ~1% of GDP
• net investment income remained positive
• net ownership balance hit its high in 1980 at $360b, due to power of compound interest
• since then downhill
• pace of decline rapidly accelerating
• 2003:
• trade deficit exceeds 4% of GDP
• US consuming 4% more than it produces
• roughly equal to $500b per year, at this rate
  
• net foreign ownership of $2.5tr
• rest of the world owns $2.5tr more of the US than US owns of other countries
• roughly 5% of national wealth (~$50tr)
  
• some of this $2.5tr investested in claim checks (US bonds, both private and governmental)
• some of it invested in assets, e.g. property and equity securities
• at current trade-deficit level (4% of GDP), foreign ownership will grow at about $500b/year
• will be adding 1% annually to foreigners' net ownership of national wealth
• as that ownership grows, so will the annual net investment income flowing out of the country
• will leave US paying ever-increasing dividents and interest to the world rather than being net receiver as in the past
• "We have entered the world of negative compounding - goodbye pleasure, welcome pain."
• Economics 101:
• countries can not for long sustain large, ever-growing trade deficits
• at some point, the spree of the consumption-happy nation would be braked by currency-rate adjustments and by the unwillingness of creditor countries to accept an endless flow of IOUs from the big spenders
• but: US enjoys special status
• can behave today as it wishes because past financial behaviour was exemplary and because it is so rich
• neither its capacity nor its intention to pay is questioned
• continues to have a mountain of desirable assets to trade for consumables
• Buffet: time to halt this trading of assets for consumables and to balance trade
• proposal: Import Certificates
• Import Certificates
• issued to all US exporters in an amount equal to the dollar value of their exports
• exporter can sell the ICs to parties wanting to get goods into the country
  
• exporters abroad
• importers here
• inevitable result: trade balance
• price of certificates determined by supply and demand
• if our exports were to increase and the supply of ICs were therefore to be enlarged, their market price would be driven down
  
• e.g. certificates selling for 1o cent
  
• means 10 cents per dollar of exports behind them
• means producer could realize 10% more by selling his goods in the export markets than by selling them domestically
• extra 10% coming from sale of ICs
• no such thing as a free lunch
  
• foreigners selling to us would face tougher economics
• not nice, but that's a problem they're up against no matter what trade "solution" is adopted
• but: plan does not penalize any specific industry or product
• in the end, free market would determine what would be sold in the US and who would sell it
• ICs only determine aggregate dollar volume of what was sold
• also negative consequences for US citizens
• prices of most imported goods would increase
• so would prices of certain competitive products manufactured domestically
• cost of ICs would act as a tax on consumers
• but: also drawbacks to letting the dollar continually lose its value or to increasing tariffs on specific products or instituting quotas on them
• "The pain of higher prices for goods imported today dims beside the pain we will eventually suffer if we drift along and trade away ever larger portions of our country's net worth"

• A gently declining dollar does not provide the answer
• would reduce our trade deficit to a degree
• but: not by enough to halt the outflow of our country's net worth and the resulting growth in our investment income deficit
• action to halt the rapid outflow of our national wealth is called for
  

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