Berkshire Hathaway 2003 Annual Meeting Audience Question # 5

Lack of inflation is a plus for owners

Warren Buffett:

Let’s go to number 5.

Audience Member:

Good morning. Good morning, my name is Matt Sauer and I’m from Durham, North Carolina.

In a 1977 Fortune magazine article titled “How Inflation Swindles the Equity Investor,” you argued that corporate earnings in aggregate acted like a bond coupon, and thus, were negatively impacted by high inflation.

Due to high inflation at the time, you posited a world where a 12 percent return on corporate equity would…was reduced to 7 percent after taxes, and netted out to 0 percent in real terms.

You have been sounding downcast about the prospects for equities for several years, much of which we assume relates to extreme starting valuations.

If inflation was decidingly (sic) bad for investors in 1977, isn’t the relative lack of it in today’s economy at least one mark in the plus column for equity owners?

Is there also a future inflation expectation component in your warnings that investors are likely to be disappointed by equity results?

Warren Buffett:

Well, I would… there’s no question that the lack of inflation is a plus for owners. I mean, the real return you will obtain, in my view, from owning American business… if purchased at similar prices… the real return will be higher if we have long periods of lower or close to no inflation, than if we had long periods of high inflation.

I don’t think there’s any question about that. Because that article went onto explain how you got taxed on nominal returns and fictitious returns in real terms.

So your question about which period is better for investors… a low inflation period over any long period is better for investors.

And the problem, as you pointed out also, was the starting point, in terms of predicting modest returns for equity investors.

The returns weren’t necessarily so modest, I predicted. They were just modest compared to what people had begun to think returns would be during that long bull market from 1982 to 1999.

There were polls taken by Gallup working with, I think, PaineWebber at the time… now they’ve moved it over to UBS Warburg… that showed the expectancy of people in the stock market. And those returns that people expected got up to 14 or 15 percent, as I remember.

And they were thinking they were going to get 14 or 15 percent in a low-inflation environment.

Well that, you know, that was dreaming. And there’s nothing wrong, in a low-inflation environment, at all, in earning, you know, 6 or 7 percent. That’s probably as well…

Well, it is as good as will happen, because in a low inflation environment how much is GDP going to grow? Well, GDP, you know, if you have a 2 percent inflation and even 3 percent real growth, you’re talking about 5 percent, in nominal terms, GDP growing.

If GDP grows at that rate, over time corporate profits will grow at… more or less, at that rate.

And if corporate profits grow at 5 percent a year, the value of those corporate profits, the capitalized value, will probably grow at something like that over any long term with sort of a normal starting point.

And add that to dividends and, you know, you will get 6 or 7 percent before frictional costs. Investors incur a lot of frictional cost.

They don’t have to, but they do. And that often is 1 1/2, 2 percent of their investment.

So the math isn’t bad, it’s just bad for those people that got used to, or expected, very high returns based on looking in the rearview mirror back in 1998 or 1999.


Charlie Munger:

My general attitude is just slightly more negative than Warren’s.

Warren Buffett:

You’ve heard it, folks.

That isn’t the end of the world. I mean, in effect, if the people who own American business get 5 to 6 percent of the pie… $10 trillion economy now, someday a $20 trillion economy.

But if we get 5 or 6 percent of the pie, those of us who put our capital out to produce goods and services for American business… for American consumers, American population… is that a, you know, I don’t know whether that’s… you know, that’s exactly what somebody who designed the universe would come up with.

But it doesn’t strike me as crazy in either direction. You know, I think that… that’s a lot of goods and services to go to people that put up the capital, but you… and you’ve got, you know, a hundred million-plus people in the working force that are working to turn that out for you, using your capital.

And it provides a… what I would regard as a pretty decent real return if you have low inflation.

If you get into high inflation, as I wrote about back in ’77, you could easily have the real return, to investors, get to a very, very low number, and perhaps negative.

I mean, inflation can swindle the equity investor, as I wrote back then, and I used 7,000 words to explain why, and will be glad to send you a copy of that article if anyone’s still interested.

But inflation is the one thing that, over a long period of time, can turn investors’ results, in aggregate, into a negative figure. And it’s the investors’ enemy.

Charlie, does that bring forth any further thoughts?

Charlie Munger:

I don’t think you’ll get perfect help on these subjects from the economics profession, either. They have certain standard formulas.

To an economist, when a manufacturing job goes to China, that’s just so much productivity increase. And if you ask one, well suppose all of the manufacturing jobs in America went to China. Wouldn’t that be a little too much efficiency increase?

And the answer would be no. And people actually get paid for thinking like this in major universities.

Warren Buffett:

Yeah, if… what would get across the point, of course, is if all the teaching of economics got exported to China, in which… at that point a new insight would appear.

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