Learning from Warren Buffett Shareholders Letters – Year 1980 – Part 2 Real Return to Investors.
3rd September 2024
Namo Narayan! In the USA – corporate taxes were 46% in 1980 and Inflation rate was 12%. In this backdrop – Buffett is writing a 1980 letter in 1981. He talks about the REAL RETURN for the investors. In the past letters also we have seen this but this letter deals with the real return from a different perspective.
Master Says: -
Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment.
(Say a company comes out with 50% gain in NET PROFIT. Does this means that you are richer? )
Master gives beautiful example: - ( read as many times as you can)
If you (a) forego ten hamburgers to purchase an investment;
(b) receive dividends which, after tax, buy two hamburgers; and
(c) receive, upon sale of your holdings, after-tax proceeds that
will buy eight hamburgers, then (d) you have had no real income from
your investment, no matter how much it appreciated in dollars.
You may feel richer, but you won’t eat richer.
The CULPRITS for your poor performance?
Master Says:-
High rates of inflation create a tax on capital that makes much corporate investment unwise - at least if measured by the criterion of a positive real investment return to owners. This “hurdle rate”
the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners - has increased dramatically in recent years.
The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.
For example, in a world of 12% inflation a business earning 20% on equity (which very few manage consistently to do) and distributing it all to individuals in the 50% bracket is chewing up their real capital,
not enhancing it. (Half of the 20% will go for income tax; the remaining 10% leaves the owners of the business with only 98% of the purchasing power they possessed at the start of the year - even though they have not spent a penny of their “earnings”). The investors in this bracket would actually be better off with a combination of stable prices and corporate earnings on equity capital of only a few per cent.
Our explanations: -
Say you have made a profit of 20% ( Rs.20 on Rs.100). 46% of the same will go to income tax. (Buffett has taken 50%). So, you paid Rs.9.2 will go to income tax. You are left with Rs.10.80. Your inflation is Rs.12. So, you have earned a negative return of Rs.1.20.
Master Says: -
Explicit income taxes alone, unaccompanied by any implicit inflation tax, never can turn a positive corporate return into a negative owner return. (Even if there were 90% personal income tax rates on
both dividends and capital gains, some real income would be left for the owner at a zero inflation rate.) But the inflation tax is not limited by reported income. Inflation rates not far from those recently experienced can turn the level of positive returns achieved by a majority of corporations into negative returns for all owners, including those not required to pay explicit taxes. (For example, if inflation reached 16%, owners of the 60% plus of corporate America earning less than this rate of return would be
realizing a negative real return - even if income taxes on dividends and capital gains were eliminated. ( read this twice or more – very important).
Of course, the two forms of taxation co-exist and interact since explicit taxes are levied on nominal, not real, income. Thus you pay income taxes on what would be deficits if returns to stockholders were measured in constant dollars.
At present inflation rates, we believe individual owners in medium or high tax brackets (as distinguished from tax-free entities such as pension funds, eleemosynary institutions, etc.) should expect no real long-term return from the average American corporation, even though these individuals reinvest the entire after-tax proceeds from all dividends they receive. The average return on equity of corporations is
fully offset by the combination of the implicit tax on capital levied by inflation and the explicit taxes levied both on dividends and gains in value produced by retained earnings.
As we said last year, Berkshire has no corporate solution to the problem. (We’ll say it again next year, too.) Inflation does not improve our return on equity.
Indexing is the insulation that all seek against inflation. But the great bulk (although there are important exceptions) of corporate capital is not even partially indexed. Of course, earnings and dividends per share
usually will rise if significant earnings are “saved” by a corporation; i.e., reinvested instead of paid as dividends. But that would be true without inflation.
A thrifty wage earner, likewise, could achieve regular annual increases in his total income without ever getting a pay increase - if he were willing to take only half of his paycheck in cash (his wage “dividend”)
and consistently add the other half (his “retained earnings”) to a savings account. Neither this high-saving wage earner nor the stockholder in a high-saving corporation whose annual dividend rate increases while its rate of return on equity remains flat is truly indexed.
For capital to be truly indexed, return on equity must rise, i.e., business earnings consistently must increase in proportion to the increase in the price level without any need for the business to add to capital - including working capital - employed. (Increased earnings produced by increased investment don’t count.) Only a few businesses come close to exhibiting this ability. And Berkshire Hathaway isn’t one of them.
We, of course, have a corporate policy of reinvesting earnings for growth, diversity and strength, which has the incidental effect of minimizing the current imposition of explicit taxes on our owners. However, on a day-by-day basis, you will be subjected to the implicit inflation tax, and when you wish to transfer your investment in Berkshire into another form of investment, or into consumption, you also will face
explicit taxes.
Current Indian Scenario: -
As an investor – we are charged with CGST / IGST / STAMP DUTY / STT / Long term gain tax / Short term gain tax and plus INFLATION.
You will only make money – if you have any profit left after paying the above taxes.
Share your feed-back on the email given and share with like-minded investors.
Follow me on Twitter @hiteshmparikh Or on Whatsapp - +91-9869425399.
Learn a Lesson. Live with Passion & Invest with Reason.
Hitesh Parikh.
Comments
Post a Comment