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):

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:

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."