What Buffett Didn't Tell You

Last Thursday, Berkshire Hathaway (NYSE: BRK-B  ) Chairman Warren Buffett published "Why stocks beat gold and bonds," an adapted excerpt from his upcoming shareholder letter. There is little to disagree with in the letter, but Buffett's exposition is a bit misleading, or at the very least, incomplete because he isn't explicit enough in spelling out his assumptions. Investors who follow his advice blindly, without understanding those assumptions, could achieve a very different result from the one Buffett describes.

The crux of Buffett's argument is that stocks will beat gold and bonds because, unlike the latter, they're a productive asset, i.e., a good-quality business like farmland or rental property that provides a product or service on a recurring basis that people will be willing to pay for. That's true, as far as it goes, but it's not enough.

Valuation matters
Considering that he is arguably the greatest value investor of all time, it's odd that Buffett doesn't make more of the impact of valuations on the expected performance of different asset classes.

Consider, for example, that over the 10-year period from 2002 through 2011, the S&P 500 managed to produce an annualized return, after inflation, of just 0.4%. Meanwhile, the equivalent figure for gold is a whopping 15.8%! U.S. stocks barely kept pace with inflation -- did the productive capacity of top U.S. corporations collapse during that decade? Of course not -- just look at the earnings growth data for the S&P 500 along with four high-quality businesses that Berkshire owns (Buffett refers to two of them, ExxonMobil and Coca-Cola, in his article):

Company

10-Year Real Earnings-per-Share Growth (annual)

2002-2011

10-Year Total Real Return (annual)

2002-2011

Coca-Cola (NYSE: KO  )

6.1%

1.5%

ExxonMobil (NYSE: XOM  )

11.8%

5.4%

Procter & Gamble (NYSE: PG  )

9.6%

2.8%

Wells Fargo (NYSE: WFC  )

8.4%

(0.1%)

S&P 500

10.8%

0.4%

Gold

0%

15.8%

Source: Capital IQ, Kitco, Robert Shiller, author's calculations.

In each case, the individual companies and the S&P 500 generated earnings growth well in excess of their total stock return -- and that doesn't even account for the income return from dividends! Clearly, there's something else going on here; the answer is contained in the following table:

Company

Beginning-of-Period P/E Ratio (Dec. 3, 2001)

End-of-Period P/E Ratio (Dec. 31, 2011)

10-year P/E growth

Coca-Cola

29.5

19.0

(4.3%)

ExxonMobil

18.2

10.1

(5.7%)

Procter & Gamble

37.3

19.6

(6.2%)

Wells Fargo

22.1

9.8

(7.8%)

S&P 500

46.4

14.2

(11.2%)

Source: Capital IQ, Robert Shiller, author's calculations.

While earnings grew nicely during the decade, stock P/E ratios collapsed. In this case, valuations reverted from absurd levels to something more sensible, hobbling stock investors in the process. As this example demonstrates, changes in valuation can have a huge effect over a period as short as a decade, which brings me to my second point: Investors must accept that when it comes to stocks, 10 years -- much less three to five years -- is not "the long run." If you consider a three- to five-year period adequate to achieve stocks' expected return, you could be in for a very nasty surprise.

Time horizon matters
In the concluding paragraph of his article, Buffett writes: "I believe that over any extended period of time this category of investing [owning first-class businesses] will prove to be the runaway winner among the three we've examined."

I entirely agree -- assuming your "extended period of time" is sufficiently extended (and your purchase price is reasonable, as we saw above). Buffett doesn't specify how long his expected holding period is, but I suspect that, much like a foundation -- it is essentially infinite. In fact, Buffett is investing on behalf of a foundation since he has bequeathed the bulk of his shares to the Bill & Melinda Gates Foundation. In his 1988 chairman's letter, Buffett wrote that when Berkshire owns "portions of outstanding businesses with outstanding managements, our favorite holding period is forever." There is every reason to believe that it is a literal statement and no mere quip.

Two caveats for would-be stock investors
Will stocks, as an asset class, beat bonds and gold over an "extended period"? Almost certainly. However, that assessment is an indictment of the disastrous long-term prospects for gold and bonds, not a tribute to the attractiveness of the stock market (investors who wish to avoid seeing their capital devastated by "safe assets" should steer well clear of the SPDR Gold Shares and the iShares 20+ Year Treasury Bond ETF).

With regard to the segment of high-quality companies like the four stocks I discussed above -- all four of which I expect to generate decent absolute returns -- investors must first ensure that their investing time frame is at least somewhat consistent with equity investing. It needn't match Buffett's per se, but just a couple of years won't do the trick.

If you're focused on the long term, you need to consider these "3 Stocks That Will Help You Retire Rich."

Fool contributor Alex Dumortier holds no position in any company mentioned. Click hereto see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Wells Fargo, Berkshire Hathaway, and Coca-Cola. The Fool owns shares of and has created a covered strangle position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Procter & Gamble, and Berkshire Hathaway. Motley Fool newsletter services have recommended shorting iShares Barclays 20+ Year Treasury Bond. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (26) | Recommend This Article (45)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 14, 2012, at 3:40 PM, Ironbob wrote:

    Everything Warren Buffet says is misleading. Tell us something new.

  • Report this Comment On February 14, 2012, at 4:13 PM, rmondave2 wrote:

    Great, insightful analysis -- it always depends on your objective, and your horizon. Investment horizon of Warren Buffett is 60years+

    But if you are already 60 and need your money/income for retirement in 5 to 10 years, it is VERY risky to put your money into any USdollar denominated financial asset. We are already there, our spending power is being purposely destroyed by the Obama run FED and Uncle Ben will continue to obediently churn out more dollars than grains of rice!

  • Report this Comment On February 14, 2012, at 4:34 PM, Hawmps wrote:

    “The crux of Buffett's argument is that stocks will beat gold and bonds because, unlike the latter, they're a productive asset, i.e., a good-quality business like farmland or rental property that provides a product or service on a recurring basis that people will be willing to pay for.” Excellent article; Buffet's comparisom of a "good-quality business" to farmland or rental property is spot on. The chart showing P/E ratios declining over the time period is priceless. You could see the opposite trend in investment grade real estate over the time period where cap rates declined and put the squeeze on profit margins. Basically, buyers were willing to purchase at a lower rate of return today speculating on increasing cash flow tomorrow (unrealistic growth rates in a flawed DCF model helps too). Then many of your tenants can't afford the rent anymore (because they are running on debt too) and they do whatever they can, including filing bankruptcy, to get out from under their leases and then you have businesses suing each other for breach.

    So, one could suggest that money was flowing out of equities and into real estate during that time period; why? Well… for one, 46.4 times earnings for an INDEX? That’s crazy talk. The market was overvalued (an overgeneralization, I know, but work with me). Credit was cheap and easy to get to go buy property; investors are watching the money leaving equities as the stock valuations have been run up on speculation (pop), and all of a sudden real estate is sexy, and its monkey see monkey do, and real estate valuations get run up on speculation (pop). The buyers, major lenders, and the smaller mezzanine lenders couldn't get enough of it until it was too late because it was so easy and “real estate never goes down”. 2012/2013 will be very interesting in investment real estate as all the 5yr notes from 2007/early 2008 mature and properties need to be refinanced at more realistic valuations. Companies like RIOC are well poised to take advantage of strip mall or power center owners that will have difficulty refinancing and they will score underperforming assets at a discount that they can work with.

    10+ years ago price to earning was way out of balance (too high, overvalued), now it looks like it is out of balance in the other direction, but by how much? But one major difference this time around is the huge population of baby boomers that will need to start spending their dividends to live rather than re-invest them, and slowly and steadily sell assets to live on as well.

  • Report this Comment On February 14, 2012, at 4:36 PM, TheDumbMoney wrote:

    Hi Alex, right on. I very much agree the preferred investing lifetime is forever. While it it common to think of an investor's "lifespan" of investing as no more than about thirty to forty years, max (assuming investing lifetime starts at 25 and ends around 65 when the investor starts spending down his or her investments), I think we should all invest as if we are investing forever. Maybe in the end we won't, but maybe we will. I certainly hope to be able to bequeath shares to a foundation, or to my kids. It would be really cool to come back to life 150 years from now and find my grandkids' grandkids are still holding KO shares I purchased, collecting dividend checks or watching them get reinvested. As I believe you have said in the past, the bare minimum holding period for a long-term investor is three to five years. Many of my mistakes have certainly come from violating that. Also, even if one needs to live off one's portfolio at a certain point of one's life, one can still maintain a portion of it as the forever portfolio.

    Finally, another thing Buffett didn't say is that while his 'preferred' holding period in his relatively unconcentrated portfolio of public and private holdings is forever, it isn't always so. Theses change. For years he owned Cap Cities/ABC. No more. He has also steadily been selling down his COP holdings, and there are many other examples.

    All best,

    DTAF

  • Report this Comment On February 14, 2012, at 4:48 PM, DJDynamicNC wrote:

    Great article which raised some very valid points worth considering. Thank you!

  • Report this Comment On February 14, 2012, at 7:09 PM, ChrisZuber83 wrote:

    I don't disagree with Mr. Buffett that, over time, buying shares of productive businesses is the best way to enhance wealth. But I do take issue with the idea that bonds and/or gold has no place as an asset. In my opinion, bonds/gold are to stocks as apples are to oranges. I argue that the former are places to keep your money, not to grow it.

    In regards to bonds, Mr. Buffett himself acknowledges:

    "Berkshire holds significant amounts of [bonds], primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions."

    Going farther back, delving into the book The Intelligent Investor, "the best book on investing ever written" per Buffett himself, Ben Graham advocates holding at least 25% of your portfolio in bonds, and leans toward a 50/50 split. I understand it was a different time (the last edition of the book was written in 1972), but the point still stands that at least some of your non-cash holdings should be in bonds.

    In regards to gold, again, Buffett's article (and yours) is applicable to those who talk about the metal as an investment. But, as I've seen written in the comment section of another site where Buffett's article is the topic of discussion: "Gold isn't supposed to earn you 'returns'. It's money. The 'returns' you're making are from currency devaluation. Right?" I agree. And that would render Buffett's "big gold cube" example misleading: by that logic if there was a $9.6 trillion pile of money in the infield, his comparison of it to productive assets would still be valid, because dollars aren't productive either. Gold should be compared to dollars. Doing so, someone who holds gold would argue that if someone has a stack of $100 bills and someone else has the equivalent in gold, than in 50 years it would take many more stacks of $100 bills to buy that same amount of gold.

    Just my 2 cents, because judging from your article (especially the 2nd to last paragraph), you are an advocate for keeping 100% (or at least a large portion) of your assets in stocks. Feel free to correct me if I'm misinterpreting that. Thanks for the article, I read your site daily.

  • Report this Comment On February 14, 2012, at 7:22 PM, Hawmps wrote:

    ^ "But I do take issue with the idea that bonds and/or gold has no place as an asset"

    I don't recall the article stating this. Perhaps I'm wrong. Stocks, bonds, gold, real estate, may be apples, oranges, grapefruit, and papaya, but they are all part of the fruit basket and all are a substitute for your cash when you CHOOSE an investment vehicle. So, yes, there is a justified comparison.

    quote "The crux of Buffett's argument is that stocks will beat gold and bonds because..."

    I don't see where it says that gold and bonds have no place as an asset, mearly that stocks will beat, and why. "they're a productive asset... that provides a product or service on a recurring basis that people will be willing to pay for."

    diclosure- long on stocks, real estate, and I have some gold somewhere in a safe deposit box... it's pretty.

  • Report this Comment On February 14, 2012, at 8:10 PM, TMFAleph1 wrote:

    @ChrisZuber83

    You wrote:

    <<But, as I've seen written in the comment section of another site where Buffett's article is the topic of discussion: "Gold isn't supposed to earn you 'returns'. It's money. The 'returns' you're making are from currency devaluation. Right?" I agree.>>

    But that argument doesn't justify a trailing 10-year *inflation-adjusted* return of 15.8% per annum. Currency devaluation can't explain away a *real* return on a metal that exceeds the real return observed on the S&P 500 in the 1990s, -- a huge bull market for stocks (a bubble, in fact.)

  • Report this Comment On February 14, 2012, at 8:19 PM, TMFAleph1 wrote:

    @ChrisZuber83

    <<Just my 2 cents, because judging from your article (especially the 2nd to last paragraph), you are an advocate for keeping 100% (or at least a large portion) of your assets in stocks. Feel free to correct me if I'm misinterpreting that.>>

    Certainly not! Even if we were to assume that all asset classes are fairly valued, I wouldn't recommend 100% exposure to stocks for an investor (even one with an equity-appropriate time horizon.) I *would* recommend a higher allocation to stocks than bonds in those circumstances.

    In the real world, you can't count on all asset classes to be fairly valued at the same time. There is no fixed rule in terms of asset allocation, but there is a fundamental principle: You want to be underweight asset classes that are overvalued and overweight asset classes that are undervalued.

    Let me finish by adding that I don't think stocks are undervalued right now.

  • Report this Comment On February 14, 2012, at 10:32 PM, longertime01 wrote:

    Great article.

    The Intelligent Investor states not to invest in an equity with PE higher than 25 for a growth stock. I think 16 is my upper comfort level.

    coke is an excellent example for not going up the share price since 2000. MSFT is another, yet another is wmt.

    These companies all make tons of money; their share prices are going no where since 2000.

  • Report this Comment On February 14, 2012, at 10:50 PM, ChrisZuber83 wrote:

    @ Hawmps

    To be honest, you're correct, Alex didn't say that there was no place for bonds/gold in your portfolio. I might have read a bit too much into the following statement:

    "However, that assessment is an indictment of the disastrous long-term prospects for gold and bonds, not a tribute to the attractiveness of the stock market (investors who wish to avoid seeing their capital devastated by "safe assets" should steer well clear of the SPDR Gold Shares and the iShares 20+ Year Treasury Bond ETF)."

  • Report this Comment On February 14, 2012, at 11:04 PM, ChrisZuber83 wrote:

    @ TMFAleph1

    It's interesting that you say you don't think stocks are undervalued. But since you do state:

    "However, that assessment is an indictment of the disastrous long-term prospects for gold and bonds, not a tribute to the attractiveness of the stock mark"

    So I guess that position makes more sense. As I mentioned in my comment to Hawmps, I might have read too much into the article the 1st time (i.e. I looked at it a bit too simply as a pro-stocks, anti-bonds/gold article). Thanks for the clarification in your two comments.

  • Report this Comment On February 15, 2012, at 12:04 AM, funspirit wrote:

    Basically your article states that we have to consider the valuations when we incest. Buffet CERTAINLY does.

    Price that you buy something matters of course! DUH.

    That doesn't take away the fact that this is a good article, with value though ...

    also, it's my belief that gold's primary value is it;s pretty to look at. for a look at how tech has supplanted gold as a store of value, try here--

    <a href="http://www.richmakesyourich.com/2011/10/why-your-gold-is-wor... Your Gold is Worth(less)- Google It</a>

    Thanks again for the article though, even with my "duh" comment :)

  • Report this Comment On February 15, 2012, at 11:47 AM, sikiliza wrote:

    "While earnings grew nicely during the decade, stock P/E ratios collapsed"

    I don't understand why this is a bad thing. One more thing, in determining the total returns for the companies invested, did you consider dividends reinvested, which is what many investors would do?

  • Report this Comment On February 15, 2012, at 1:08 PM, TMFAleph1 wrote:

    @sikiliza

    <<"While earnings grew nicely during the decade, stock P/E ratios collapsed"

    I don't understand why this is a bad thing.>>

    It's a bad thing if you happened to own those stocks during that period! Otherwise, it's not a good or bad thing, it's just an observation of fact.

    The returns data assume that the dividends are re-invested, yes.

  • Report this Comment On February 15, 2012, at 1:13 PM, TMFAleph1 wrote:

    @sikiliza

    <<I don't understand why this is a bad thing.>>

    It's a bad thing if you happened to own those stocks during that period! in truth, I'm not sure what you really mean by 'bad' in this context; I was just making an observation of fact.

    The returns data assumes that dividends are re-invested, yes.

  • Report this Comment On February 15, 2012, at 1:31 PM, toastedseeds wrote:

    So you think the S&P, with a PE of 14, is still over valued? Or would you say that is about right?

    Thanks,

    ts

  • Report this Comment On February 15, 2012, at 2:18 PM, TMFAleph1 wrote:

    @kahunacfa

    Long may your investing success continue, but just because Buffett's logic eludes you does not mean that he is a hypocrite.

  • Report this Comment On February 15, 2012, at 2:23 PM, TMFAleph1 wrote:

    @toastseeds

    I'm not a fan of using PE multiples based on a single year's earnings. In this report, I explain why I think stocks are presently overvalued:

    http://longrunreturns.blogspot.com/2012/01/first-issue-of-re...

  • Report this Comment On February 15, 2012, at 2:28 PM, Foosballking wrote:

    Buffet is a blow-hard and a liar. Yeah I know - he's done extremely well with his investments. But to get on stage with Barack Mussolini and beat the drum with that socialist/fascist about who has an unjust tax rate should rate him being publicly flogged (along with BO). If they have angst about his secretary's tax rate - LOWER IT!!! Buffet pays 15% because that's the rate on his type of income. Increase taxes on investment income and guess what....LESS INVESTMENT and more damage to our economy. But that's the end game anyway...

  • Report this Comment On February 15, 2012, at 2:56 PM, TMFAleph1 wrote:

    @Foosballking

    Buffett, a liar? I don't see it. Can you provide an example of his lies?

  • Report this Comment On February 15, 2012, at 3:12 PM, Darwood11 wrote:

    Alex, thanks for an interesting and informative article.

    I have become concerned about Mr. Buffett's statements and also how he is portrayed in the press.

    For example, his op-ed piece in the NY Times on 10/17/2008 in which he extolled us to "Buy American stocks." He did as he was suggesting, but he also got a wonderful sweetheart deal from GE. For anyone else who purchased GE back then, at $19.63 a share, they didn't get special preferred stock, or any of the other perks that Mr. Buffett negotiated. How much reward has he reaped from that deal, as compared to the average "American" who purchased GE when he did? My point is, if the average investor could get the deals that Mr. Buffett does, and wasn't investing for their personal future, but for that of a behemoth company, we might be inclined to follow his advice.

    That said, I have purchased stocks in the "dark days" of 2008 and since. However, I have no illusions about my chances in the market. With the exception of my dividend stocks, it's quite likely my purchases will be worth little more than they are today, 10 years into the future.

    I remain very skeptical of Mr. Buffett.

  • Report this Comment On February 15, 2012, at 4:17 PM, jwinnik wrote:

    My new favorite investing line. "You can fondle the cube, but it will not respond." Great.

  • Report this Comment On February 17, 2012, at 12:07 PM, jrj90620 wrote:

    It seems like Buffett made his fortune by taking advantage of lower capital gains taxes over the last several decades.If he had paid 30%+ taxes each year,for decades,his fortune would be much smaller.Now,that he has made a fortune and near lifes end,he want to raise taxes and not allow others to do what he did.I think he's just a senile old guy who wants all the envious Democrats to love him,before he dies.

  • Report this Comment On February 17, 2012, at 7:18 PM, TMFAleph1 wrote:

    @jrj90620

    Buffett's wealth has little or nothing to do with the level of capital gains taxes since Berkshire Hathaway shares represent the bulk of his wealth.

    And if Buffett is a "senile old guy," I hope to achieve the same level of senility when I reach his age.

  • Report this Comment On February 21, 2012, at 9:47 PM, CrankyTexan wrote:

    >>> And if Buffett is a "senile old guy," I hope to achieve the same level of senility when I reach his age. <<<

    Will you beg to pay more taxes like he does even though he owes back taxes?

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