Thread
Have been working on inflation and found Buffett essay from 1977 that -- as usual -- makes the complex simple. So, sharing in a thread: 1/n
First thread of size, am I doing this right?
First thread of size, am I doing this right?
1) "There is no mystery at all about the problems of bondholders in an era of inflation."
2) "For many years the conventional wisdom insisted that stocks were a hedge against inflation."
2) "For many years the conventional wisdom insisted that stocks were a hedge against inflation."
3) However, "stocks, in economic substance, are really very similar to bonds. I know this belief will seem eccentric to many investors."
4) Why? Because the ROE of stocks for the post-war decades has been very consistent. Basically 12%.
4) Why? Because the ROE of stocks for the post-war decades has been very consistent. Basically 12%.
5) The ROE on stocks does not seem to respond to inflation or price instability in general.
6) Assume owners of stocks, in aggregate, bought them at book value (I wish). The return would be 12%. In reality you pay a premium to that, reducing that 12%.
6) Assume owners of stocks, in aggregate, bought them at book value (I wish). The return would be 12%. In reality you pay a premium to that, reducing that 12%.
7) Main point: as inflation has increased (remember this is 1977), the ROE has not.
8) So in a sense stocks are a fixed return. But they are perpetual, unlike bonds. The maturity date is infinity.
8) So in a sense stocks are a fixed return. But they are perpetual, unlike bonds. The maturity date is infinity.
9) Another difference: bond coupons are paid out in cash. In stocks, you get part of it in dividends and the rest is reinvested to earn that 12%.
10) So how attractive is that 12% return? It all depends on what bonds are paying.
10) So how attractive is that 12% return? It all depends on what bonds are paying.
11) When bonds pay very little, you have to pay higher multiples for stocks, generally speaking. You have to pay above par, effectively, which limits your return.
12) But the reinvestment is actually done at par, which is pretty attractive.
12) But the reinvestment is actually done at par, which is pretty attractive.
13) Imagine a high grade, noncallable, LT bond with a 12% coupon (that could reinvest at par) in an environment of low rates. It would sell FAR above par.
14) Importantly, stock investors are generally not aware that they, too, live within the confines of a "coupon."
14) Importantly, stock investors are generally not aware that they, too, live within the confines of a "coupon."
15) Can you raise that 12% in aggregate? In theory, yes, by a) higher asset turnover b) cheaper debt c) more debt d) lower taxes or e) fatter margins.
16) Again, this is 1977, but he says basically, "good luck" with any of those -- which seems to be right for today as well.
16) Again, this is 1977, but he says basically, "good luck" with any of those -- which seems to be right for today as well.
17) So if 12% is immutable, what makes future returns? a) multiples b) tax rates c) inflation rates
18) If you are buying at book value, that 12% gets reduced to 7% by taxes (1977), and then to zero by a 7% inflation rate (again, 1977).
18) If you are buying at book value, that 12% gets reduced to 7% by taxes (1977), and then to zero by a 7% inflation rate (again, 1977).
19) "Inflation has a fantastic ability to simply consume capital."
20) Best line: "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."
20) Best line: "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."
21) The result is a challenge to capital accumulation. You cannot grow if you are paying 100% (or more) in income "tax."
22) In the 1970's, what companies did is grow capital by issuing stock. A natural response to inflation is to dilute your shareholders.
22) In the 1970's, what companies did is grow capital by issuing stock. A natural response to inflation is to dilute your shareholders.
23) Finally, with insufficient capital to fund real growth, competition ensues and the government inevitably gets involved in funneling capital to arbitrate the competition. I know this part scares people on fintwit for sure.
24) This government involvement worked reasonably well in Japan and disastrously in the UK. WB not hopeful (in 1977) that the US has the necessary cultural and historical underpinning for government collaboration that Japan has.
Last: in an era of inflation, all the investment alternatives are poor, so stocks may be the least bad choice.
Amazing in reading this how relevant bits seem to 2020, even though no inflation now and low rates, and book value feels meaningless today.
Amazing in reading this how relevant bits seem to 2020, even though no inflation now and low rates, and book value feels meaningless today.
