Warren Buffett Speaks
Warren Buffett, chairman of Berkshire Hathaway, almost never talks publicly about the general level of stock
prices--neither in his famed annual report, nor at Berkshire's thronged annual meetings, nor in the rare speeches
he gives. But in the past few months, on four occasions, Buffett did step up to that subject, laying out his opinions,
in ways both analytical and creative, about the long-term future for stocks. From those extemporaneous talks the
following account of what Buffett said is presented in an abbreviated form. Buffett, like every other value manager,
has been under pressure in 1999 given the poor performance of value investing when compared to trading the dot-com
stocks. His historical perspective and long-term views provide valuable insight and perspective on the markets
of 1999, and where we might head in the future.
Investors in stocks these days are expecting far too much, and I'm going to explain why. That will inevitably set
me to talking about the general stock market, a subject I'm usually unwilling to discuss. But I want to make one
thing clear going in: Though I will be talking about the level of the market, I will not be predicting its next
moves. At Berkshire we focus almost exclusively on the valuations of individual companies, looking only to a very
limited extent at the valuation of the overall market. Even then, valuing the market has nothing to do with where
it's going to go next week or next month or next year, a line of thought we never get into. The fact is that markets
behave in ways, sometimes for a very long stretch, that are not linked to value. Sooner or later, though, value
counts. So what I am going to be saying--assuming it's correct--will have implications for the long-term results
to be realized by American stockholders.
|Let's start by defining "investing." The definition is simple but often forgotten: Investing is laying
out money now to get more money back in the future--more money in real terms, after taking inflation into account.
Now, to get some historical perspective, let's look back at the 34 years before this one--and here we are going
to see an almost Biblical kind of symmetry, in the sense of lean years and fat years--to observe what happened
in the stock market. Take, to begin with, the first 17 years of the period, from the end of 1964 through 1981.
Here's what took place in that interval:
Dow Jones Industrial Average
Dec. 31, 1964: 874.12
Dec. 31, 1981: 875.00
Now I'm known as a long-term investor and a patient guy, but that is not my idea of a big move. And here's a major
and very opposite fact: During that same 17 years, the GDP of the U.S.--that is, the business being done in this
country--almost quintupled, rising by 370%. And yet the Dow went exactly nowhere.
To understand why that happened, we need first to look at one of the two important variables that affect investment
results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate,
the greater the downward pull. That's because the rates of return that investors need from any kind of investment
are directly tied to the risk-free rate that they can earn from government securities. So if the government rate
rises, the 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
upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can
only be determined by first looking at the risk-free interest rate.
|Consequently, every time the risk-free rate moves by one basis point--by 0.01%--the value of every investment in
the country changes. People can see this easily in the case of bonds, whose value is normally affected only by
interest rates. In the case of equities or real estate or farms or whatever, other very important variables are
almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the
effect--like the invisible pull of gravity--is constantly there.
In the 1964-81 period, there was a tremendous increase in the rates on long-term government bonds, which moved
from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect
on the value of all investments, but the one we noticed, of course, was the price of equities. So there--in that
tripling of the gravitational pull of interest rates--lies the major explanation of why tremendous growth in the
economy was accompanied by a stock market going nowhere.
Then, in the early 1980s, the situation reversed itself. You will remember Paul Volcker coming in as chairman of
the Fed and remember also how unpopular he was. But the heroic things he did--his taking a two-by-four to the economy
and breaking the back of inflation--caused the interest rate trend to reverse, with some rather spectacular results.
Now, what happened in the 17 years beginning with 1982? One thing that didn't happen was comparable growth in GDP:
In this second 17-year period, GDP less than tripled. But interest rates began their descent, and after the Volcker
effect wore off, profits began to climb--not steadily, but nonetheless with real power. The profit trend showed
that by the late 1990s, after-tax profits as a percent of GDP were running close to 6%, which is on the upper part
of the "normalcy" band. And at the end of 1998, long-term government interest rates had made their way
down to that 5%. These dramatic changes in the two fundamentals that matter most to investors explain much, though
not all, of the more than tenfold rise in equity prices--the Dow went from 875 to 9,181--during this 17-year period.
What was at work also, of course, was market psychology. Once a bull market gets under way, and once you reach
the point where everybody has made money no matter what system he or she followed, a crowd is attracted into the
game that is responding not to interest rates and profits but 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
|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 9:30 a.m.--they get fed. Through
this daily reinforcement, they become convinced that there is a God and that He wants them to get rich.
Today, staring fixedly back at the road they just traveled, most investors have rosy expectations.
A Paine Webber and Gallup Organization survey released in July shows that the least experienced investors--those
who have invested for less than five years--expect annual returns over the next ten years of 22.6%. Even those
who have invested for more than 20 years are expecting 12.9%.
|Bear in mind--this is a critical fact often ignored--that investors as a whole cannot get anything out of their
businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices.
Let's say the Fortune 500 was just one business and that the people in this room each owned a piece of it. In that
case, we could sit here and sell each other pieces at ever-ascending prices. You personally might outsmart the
next fellow by buying low and selling high. But no money would leave the game when that happened: You'd simply
take out what he put in. Meanwhile, the experience of the group wouldn't have been affected a whit, because its
fate would still be tied to profits. The absolute most that the owners of a business, in aggregate, can get out
of it in the end--between now and Judgment Day--is what that business earns over time.
Let me summarize what I've been saying about the stock market: I think it's very hard to come up with a persuasive
case that equities will over the next 17 years perform anything like--anything like--they've performed in the past
17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate--repeat,
aggregate--would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs,
it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however
inflation fluctuates), that's 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely
to be less as more.
Let me come back to what I said earlier: that there are three things that might allow investors to realize significant
profits in the market going forward. The first was that interest rates might fall,
|and the second was that corporate profits as a percent of GDP might rise dramatically. I get to the third point
now: Perhaps you are an optimist who believes that though investors as a whole may slog along, you yourself will
be a winner. That thought might be particularly seductive in these early days of the information revolution (which
I wholeheartedly believe in). Just pick the obvious winners, your broker will tell you, and ride the wave.
Well, I thought it would be instructive to go back and look at a couple of industries that transformed this country
much earlier in this century: automobiles and aviation. Take automobiles first: I have here one page, out of 70
in total, of car and truck manufacturers that have operated in this country. At one time, there was a Berkshire
car and an Omaha car. Naturally I noticed those. But there was also a telephone book of others.
All told, there appear to have been at least 2,000 car makes, in an industry that had an incredible impact on people's
lives. If you had foreseen in the early days of cars how this industry would develop, you would have said, "Here
is the road to riches." So what did we progress to by the 1990s? After corporate carnage that never let up,
we came down to three U.S. car companies--themselves no lollapaloozas for investors. So here is an industry that
had an enormous impact on America--and also an enormous impact, though not the anticipated one, on investors.
Sometimes, incidentally, it's much easier in these transforming events to figure out the losers. You could have
grasped the importance of the auto when it came along but still found it hard to pick companies that would make
you money. But there was one obvious decision you could have made back then--it's better sometimes to turn these
things upside down--and that was to short horses. Frankly, I'm disappointed that the Buffett family was not short
horses through this entire period. And we really had no excuse: Living in Nebraska, we would have found it super-easy
to borrow horses and avoid a "short squeeze."
U.S. Horse Population
1900: 21 million
1998: 5 million
The other truly transforming business invention of the first quarter of the century, besides the car, was the airplane--another
industry whose plainly brilliant future would have caused investors to salivate. So I went back to check out aircraft
manufacturers and found that in the 1919-39 period, there were about
|300 companies, only a handful still breathing today. Among the planes made then--we must have been the Silicon
Valley of that age--were both the Nebraska and the Omaha, two aircraft that even the most loyal Nebraskan no longer
relies upon. Move on to failures of airlines. Here's a list of 129 airlines that in the past 20 years filed for
bankruptcy. Continental was smart enough to make that list twice. As of 1992, in fact--though the picture would
have improved since then--the money that had been made since the dawn of aviation by all of this country's airline
companies was zero. Absolutely zero.
Sizing all this up, I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would
have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down.
I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did. I won't dwell on other glamorous
businesses that dramatically changed our lives but concurrently failed to deliver rewards to U.S. investors: the
manufacture of radios and televisions, for example. But I will draw a lesson from these businesses: The 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. The
products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
This talk of 17-year periods makes me think--incongruously, I admit--of 17-year locusts. What could a current brood
of these critters, scheduled to take flight in 2016, expect to encounter? I see them entering a world in which
the public is less euphoric about stocks than it is now. Naturally, investors will be feeling disappointment--but
only because they started out expecting too much.
Grumpy or not, they will have by then grown considerably wealthier, simply because the American business establishment
that they own
will have been chugging along, increasing its
profits by 3% annually in real terms. Best of all, the rewards from this creation of wealth will have flowed through
to Americans in general, who will be enjoying a far higher standard of living than they do today. That wouldn't
be a bad world at all--even if it doesn't measure up to what investors got used to in the 17 years just passed.
Warren Buffett doesn't mention the Internet on these pages. But he does talk about two other transforming
industries that failed to reward investors over time: autos and aviation. Only a fool would ignore his implicit
warning: A lot of people will lose a lot of money betting on the Internet. Amazon.com founder and CEO Jeff Bezos
was so intrigued by Buffett's talk at Herb Allen's gathering of business leaders in Sun Valley, Idaho, last July
that he asked Buffett for his lists of the automakers and aircraft manufacturers that didn't make it. "When
new industries become phenomenons, a lot of investors bet on the wrong companies," Bezos says. Referring to
Buffett's 70-page catalog of mostly dead car and truck makes, he adds, "I noticed that decades ago, it was
de rigueur to use 'Motors' in the name, just as everybody uses 'dot-com' today. I thought, Wow, the parallel is
|Value Investing: The purchase of companies, through the stock market, for less than their economic value due to
temporary unpopularity (lack of investor demand). This is the opposite of growth investing, which is buying companies
at a premium in hopes that other investors continue to push their prices higher and higher regardless of what the
business is actually worth.
13160 SW Butner Road
Beaverton, OR 97005
|Especially interesting to a billionaire like Bezos, who knows something about stock valuations from his previous
career as a hedge fund manager. Interesting also to Bezos the history buff, who likes to talk about the Cambrian
explosion about 550 million years ago, when multicelled life spawned unprecedented variation of species--and with
it, a wave of extinctions. Given this perspective, Bezos says, Buffett's analogies about bankrupt businesses "resonate
deeply." Now Bezos is spreading the gospel according to Buffett and urging Amazon employees to run scared
day. "We still have the opportunity to be a footnote in the e-commerce industry," he says.
Consolidation is coming in the dot-com industry, and there will be many more "have-nots" than "haves".
In the meantime, companies that provide actual profits without the benefit of a "dot-com" in their name
will still continue to be the vehicles that provide the greatest investment return over the next 17 years.