Book: Tap Dancing to Work
Author: Carol Loomis
This is a good summary of the important article that have been written by and on Warren Buffett by the Fortune magazine (mostly by Carol Loomis, the Fortune writer who has now followed Buffett for 40+ years). As an investor, there are 3-4 articles in there that will make you sit up and take notice, but otherwise, you’d know the content of most of the other stories. Still, a very enjoyable read. Below, I will try to summarize the takeaways from the articles that I found most interesting.
How Inflation Swindles the Equity Investor (1977)
It is crucial to note the timing of this article (right before a massive bull market when S&P went from 90 to 900 in two decades, and before Volcker came in and tackled high inflation). In this article, Buffett attacks the notion that stocks do well in inflationary times. Buffett says that post-war market returns have been consistent–12.8% from 1945-55, 10.1% in the decade after, and 10.9% after that while inflation increased. Essentially “as inflation has increased, return on equity capital has not.”
Buffet argues that it would be hard to beat the 12% return on equity capital because it would need the following items (what follows in the article, is an excellent exercise in FSA) :
- Turnover (sales/assets employed – there are three classes of assets (a)A/R, (b) inventory, and (c)PP&E. A/R usually goes up along with sales, so no room for improvement here; inventory would keep pace with sales over the long run, but LIFO can help increase inventory turnover; but there will medium-term benefit from PP&E as that is spent
- Cheaper leverage
- More leverage
- Lower income taxes
- Higher operating margins
This is his math on 12% return on equity – assume that 50% is invested in dividends and that inflation is 2%, which means that 4% of the return is available for investment in real assets to product more physical goods. The 2% attributable to inflation means that 2% of the return is used in receivables, inventory and fixed assets only to duplicate the current year’s physical output. If we assume 1% population growth, we get 3% residual per capital income growth–which is what we have seen historically. But, to be honest, I don’t think I understand the complete math… does this explain the 3% terminal growth that we have often seen in DCF model calculations everywhere? I think not, because 3% in DCF is the owner income growth and is used with our without dividends. Is 3% GDP growth? That sounds more like it, but why is population growth excluded from it? Whose net income are we talking about here? I would love to have some educate me on this.
In this paper, he also mentions that large gains in capital assets (modern production facilities) are required to produce large gains in economic well-being, and no amount of labor availability, consumer demand and government support will offset that. He says that this concept was understood well by the Rockefellers, Japan and Germany.
The Bill and Warren Show (1998)
On a questions whether he’d use a higher P/E multiple than before for the market, Buffett said that the multiple would depend on the level of the interest rate. I found this to be very instructive as often we talk about multiples without any reference to the underlying interest rates at the point, and plan to do some research on this.
Mr. Buffett on the Stock Market (1999)
Buffett talks about two different eras in investing–first from 1964-81 when stock market didn’t move at all while the GDP rose 370%. In the next 17 years, while the GDP less than tripled, Dow went from 875 to 9,181, a 10x move. Buffett explains the difference by the following factors: different in the interest rates, corporate profits as a % of GDP, which had been declining and was at a nadir in 1981 and finally, the market psychology was vastly different in the two eras as the everyone was attracted in the game.
One of the articles names other investors comparable to Buffett: Jim Chanos, Glenn Greenberg, John Shapiro, Seth Klarman, Eddie Lampart, Richard Perry, Michael Price, John Constable, Randy Updyke, Tom Sweeney