NEW YORK, NY (Nov. 15, 1999) -- My column in this space last week triggered a flood of e-mails both agreeing and disagreeing with my commentary and the recent Fortune magazine article featuring Warren Buffett, Chairman of Berkshire Hathaway (NYSE: BRK.B). I'm not surprised, given the market's high level and the unprecedented national interest -- and wealth tied up -- in the market. I thought there were some excellent points and I'd like to share a few of them.
Optimistic Viewpoints
To Buffett's statement that "you have to be wildly optimistic to believe that corporate profits as a percentage of GDP can, for any sustained period, hold much above 6%," one person wrote:
"As the technology and communication improves, the overall corporate profit as a percentage of GDP may increase as U.S. companies will record increased profits from international sources. Revenues generated from foreign countries, excluding export sales, are not counted in the GDP. Frankly, I think that the international field will generate most of the profit growth in the next 20 years."
Another person agreed, noting that Buffett's "biggest mistake is treating the U.S. as a closed economic system. While U.S. corporations cannot be expected in the aggregate to grow earnings in excess of nominal GDP on their domestic operations, that restriction does not hold overseas. American multinationals with mature domestic operations are still in the high growth phase overseas (e.g., McDonald's, Philip Morris, etc.). With the end of the Cold War, the potential markets for world-class American companies have significantly expanded, and EPS growth from foreign operations can still substantially exceed domestic nominal GDP growth for years to come."
Another person made a supply and demand argument for stocks:
"The rise of the middle class in the '50s led to the massive consumer demand for cars and TVs, etc. The new, wealthier middle class created in the past decade or so has a lot more money available. What are they supposed to do with it? While many keep buying bigger houses and new cars, many are also worried about retirement with no social security and living much longer. I believe these factors will raise the P/E of all stocks, as what else are you supposed to do with this money? The Internet and cheap brokerages will also move more money out of CDs and into stocks or mutual funds, further driving up the demand for this limited resource."
This is a variation on the demographics argument: As the baby boomers reach peak earnings and savings years, demand for equities increases. I think this argument has some validity, but watch out when baby boomers start to draw down their assets in retirement!
Pessimistic Viewpoints
A number of people e-mailed me who did not share my slight optimism relative to Buffett's prediction, which may in fact be Buffett's most optimistic scenario, as one writer notes:
"I think Mr. Buffett actually toned down his true feelings on this market. If you read all his comments over the years it will be more apparent. Indeed, actions speak louder than words. He is sitting on $34 billion dollars of cash and bonds."
In the near future, I will be writing a column about Buffett's market calls over the years, but I think this person may very well be correct.
Another person asked me to "consider a post called 'Slightly Less Optimistic,' taking the other sides of the arguments, for balance" and wrote:
"For example: It may be unreasonable to expect the macroeconomic factors that have favored the American stock market to persist in the future. Technology leadership may lessen versus the rest of the world, the dollar's strength may lessen, inflation pressures may arise that result in higher interest rates, the European and Japanese markets may become more attractive to investors, etc.
"As the Internet matures, the improved access to information may greatly increase pricing pressures on businesses. As an example, in Europe prior to the Eurodollar, the prices for the same goods could vary greatly across countries or regions, depending upon local conditions. With the Eurodollar and the Internet, this could greatly lessen. This is already happening in the U.S., and is one of the factors holding down inflation, I believe, so it can both hurt and help. A cost-price squeeze can easily develop, and is already underway in some cases.
"U.S. businesses have enjoyed the fruits of lower taxes, downsizing, improved technology, and more 'creative' accounting in raising their ROE. What happens if these start reversing? How much have pension plan credits from the market helped, and what happens if these reverse?
"To paraphrase Paul Harvey, what is 'The Other Side of the Story?'"
I can't say it any better, and agree that there is a very credible "other side of the story" that should be considered.
Another person offered a different set of arguments:
"For a different perspective, talk to some of the grunts in the manufacturing world. Machinists that see drawings that are unmakeable. Engineers in their 70s who have to spend their time cleaning up drawings by young 'engineers' that are no more than glorified CAD computer operators. They have no idea what a machine can do. Gone is the system where someone started in the shop and learned all the machines and their capabilities before they made a single drawing. Goods may be made in the end these days, but what will happen when the old guard that really makes things work is gone. (Is this part of the reason we have so many large recalls these days?) Add to that, have you talked to, say, a middle school teacher these days to see what there is in the pipeline for future workers? Computers and Internet may be fine, but there have to be goods and services other than computer related."
I share this person's concerns about this country's educational system -- especially through high school and in our major cities -- but relative to previous decades, a far higher percentage of people today have college degrees.
Regarding a general increase in returns on equity, one writer attributed much of the recent gains to "accounting changes and games," while another wrote:
"I believe Buffett in the past has addressed the potential increase in median return on capital that you seem to believe technology will have. However, he has compared these advances with standing on your tiptoes at a parade to get a better view. Yes, initially you may have an edge, but ultimately everyone else has the same thing, i.e., everyone else stands one their tiptoes thus negating any initial advantage. This drives ROC back down toward the mean."
I suspect this person has captured Buffett's view well, but I'm not sure I agree with it. Return on capital is a function of two things: profits and capital. Consider a typical industry, where let's say technology has allowed companies to reduce costs by reducing the number of middle managers necessary to operate the business. This reduces SG&A and, all other things being equal, increases profits and therefore ROC. But all other things aren't equal. Given that competitors likely have access to the same technology, they will rapidly adopt the same innovations, prices will fall, and overall industry profits -- and ROC -- will remain unchanged. This is the "everyone standing on their tiptoes" argument.
However, let's turn to the denominator of ROC. Let's say that technology allows a company to better predict customer demand, deliver product more quickly, etc., thereby permanently reducing the amount of inventory necessary. While this lowers costs and improves margins, it also reduces the amount of capital tied up in the business. To the extent that competitors follow, the benefit of increased profits may disappear, but now the entire industry has become more capital efficient. I see no reason why this would reduce profitability. Thus, the result is higher ROC. The PC business over the past few years is a perfect example of what I'm talking about, and I see it happening in industry after industry.
There's another, broader benefit from this type of transformation. Using the first example above, there is now a group of middle managers who can start their own businesses, lend their talents to another company to fuel its growth, and so on. (I don't want to appear insensitive to the plight of laid-off managers -- a touchy subject to be sure -- but it's beyond the scope of this column.) Surely, the country as a whole is better off, just as it was better off -- after a similar period of painful dislocation -- earlier this century when advances in farming technology allowed nearly all of the 50% of the U.S. population that worked on farms to join other sectors of the economy.
Conclusion
I've weighed both sides and -- call me naive -- come down slightly in the optimistic camp, but recognize that I could be wrong. In any case, I don't spend a lot of time worrying about it for two reasons. First, I'm a stock picker, not an indexer. While it has been nice to have the wind at my back for quite a while, I look forward to the challenge of generating good returns even if the market is flat.
Second, even if Buffett is right that the market will generate below-average returns over the next 17 years -- and I think he is right, plus or minus a few percentage points -- I think true long-term investors should stay the course and remain fully invested. Seventeen years may sound like a long time, but it's not -- at least if you're under age 60. According to a chart based on actuarial tables published in Stocks for the Long Run, the average 60-year-old man who plans to retire at age 65 (that's early these days) and die with 50% of his assets remaining has a 16-year investment horizon. A comparable 60-year-old woman has a 19-year horizon. For every year that you're under 60, add a year to these figures. I'm in my 30s and am blessed to have no health risk factors, so I have an investment horizon of approximately 50 years. Do I really care that stocks might (but might not) perform below their historical average for the next 17 years? Not really.
-- Whitney Tilson
Tilson appreciates your feedback at [email protected]. To read his previous guest columns in the Boring Port and other writings, click here.
