Learning from Warren Buffett Shareholders Letters – Year 1981 – How equity can add value?
8th September 2024
Learning from Warren Buffett Shareholders Letters – Year 1981 – How equity can add value?
Dear Investors,
Namaste! Today we are dealing with the most important aspect of investment return – Value addition by equity. Does equity really add value when compared to other interest paying instruments? In 1981 – Tax free bonds used to give 14% return and with tax bonds used to earn 16% return. What to do when such a scenario exists.
Equity Value-Added
Master says – since equity investment is full of risk – it must earn more than the passive rates of return to justify the risk.
But is it? Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a “good” business. For, with long-term taxable bonds yielding 5% and long-term tax-exempt bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10% earned by the corporation to perhaps 6%-8% in the hands of the individual investor.
During that earlier period, American business earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were “good” businesses because they earned far more than
the return on long-term passive money.
That day is gone. During the past year, long-term taxable bond yields exceeded 16% and long-term tax-exempts 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. And this 14% will be substantially reduced by taxation before it can be banked by the individual owner. The extent of such shrinkage depends upon the dividend policy of the corporation and the tax rates applicable to the investor.
Thus, with interest rates on passive investments at late 1981 levels ie. 14% and 16%, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals. Assume an investor in a 50% tax bracket; if our typical company pays out all earnings, the income return to
the investor will be equivalent to that from a 7% tax-exempt bond. And, if conditions persist - if all earnings are paid out and return on equity stays at 14% - the 7% tax-exempt equivalent to the higher-bracket individual investor is just as frozen as is the coupon on a tax-exempt bond.
If, on the other hand, all earnings of our typical American business are retained and return on equity again remains constant, earnings will grow at 14% per year. If the p/e ratio remains constant, the price of our typical stock will also grow at 14% per year. But that 14% is not yet in the pocket of the shareholder.
Putting it there will require the payment of a capital gains tax, presently assessed at a maximum rate of 20%. This net return, of course, works out to a poorer rate of return than the currently available passive after-tax rate.
Simple Explanation: -
If the company is earning Return on Equity at 14% constantly and if the P/e ratio is the same – your stock prices can go up 14% year over year. However, when you sell this stock – you end up paying 20% tax – so your next income will be 11.20%. This is very low compared with the 14% tax free bonds.
This means the companies are failures after doing all the activities and taking so much risks.
Master says: -
Most American businesses pay out a significant portion of their earnings and thus fall between the two examples. And most American businesses are currently “bad” businesses economically - producing less for their individual investors after-tax than the tax-exempt passive rate of return on money. Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.
It should be stressed that this depressing situation does not occur because corporations are jumping, economically, less high than previously. In fact, they are jumping somewhat higher: return on equity has improved a few points in the past decade. But the crossbar of passive return has been elevated much faster. Unhappily, most companies can do little but hope that the bar will be lowered significantly; there are few industries in which the prospects seem bright for substantial gains in return on equity.
Simple Explanation: -
The situations where the Equity Returns are lower than the bonds is not due to the companies are not working hard. But the bond rates have gone up at much faster rates.
Master says: -
Inflationary experience and expectations will be major (but not the only) factors affecting the height of the crossbar in future years. If the causes of long-term inflation can be tempered, passive returns are likely to fall and the intrinsic position of American equity capital should significantly improve. Many businesses that now must be classified as economically “bad” would be restored to the “good” category under such circumstances.
1981 V/s. 2024 – the same situations.
If inflation comes down – the bond interest rates will come down.
Currently, the USA and the world over we are facing the same situations. We all are waiting for the USA to reduce the bond rates but since inflation is higher – the rates are not coming down.
Today Buffett has kept USD 189 Bln at 5% in the bonds.
Why Retained earnings?
A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the “bad” business. To continue operating in its present mode, such a low-return business usually must
retain much of its earnings - no matter what penalty such a policy produces for shareholders.
Reason, of course, would prescribe just the opposite policy. An individual, stuck with a 5% bond with many years to run before maturity will take the interest out and buy the highest return with safety currently available ( if he still wants to invest in bonds). Good money is not thrown after bad.
( Many investors love averaging in stocks. Read the above sentence).
When to give dividend and when not to give?
Master Says: -
What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend pay-out so that owners could direct capital toward more attractive areas.
Master quotes the Bible: -
The Scriptures concur. In the parable of the talents, the two high-earning servants are rewarded with 100% retention of earnings and encouraged to expand their operations. However, the non-earning third servant is not only chastised - “wicked and slothful” - but also is required to redirect all of his capital to the top performer. Matthew 25: 14-30
In the inflationary situations – Master says : -
But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the “bad” business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.
Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or “real” dividends. ( recently Vedanta is planning a fund raising to pay off the loans by
Rs.8500 Crs. This means the company is not able to generate profits to pay the loan back).
Why Berkshire Retains the Earnings?
Berkshire continues to retain its earnings for offensive, not defensive or obligatory, reasons. But in no way are we immune from the pressures that escalating passive returns exert on equity capital. We continue to clear the crossbar of after-tax passive return - but barely. Our historic 21% return - not at all assured for the future - still provides, after the current capital gain tax rate (which we expect to rise considerably in future years), a modest margin over current after-tax rates on passive money. It would be a bit humiliating to have our corporate value-added turn negative. But it can happen here as it has elsewhere, either from events outside anyone’s control or from poor relative adaptation on our part.
What NEXT?
The above discussions are amazing learning for the serious investors when he is planning an investments in the Equity Shares of any company.
Always see the Bond rates / inflations and the corporate return on equity.
This will give you the idea about your future earnings.
Follow me on Twitter @hiteshmparikh Or on Whatsapp - +91-9869425399.
Learn a Lesson. Live with Passion & Invest with Reason.
Hitesh Parikh.
Learning from Warren Buffett Shareholders Letters – Year 1981 – How equity can add value?
Dear Investors,
Namaste! Today we are dealing with the most important aspect of investment return – Value addition by equity. Does equity really add value when compared to other interest paying instruments? In 1981 – Tax free bonds used to give 14% return and with tax bonds used to earn 16% return. What to do when such a scenario exists.
Equity Value-Added
Master says – since equity investment is full of risk – it must earn more than the passive rates of return to justify the risk.
But is it? Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a “good” business. For, with long-term taxable bonds yielding 5% and long-term tax-exempt bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10% earned by the corporation to perhaps 6%-8% in the hands of the individual investor.
During that earlier period, American business earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were “good” businesses because they earned far more than
the return on long-term passive money.
That day is gone. During the past year, long-term taxable bond yields exceeded 16% and long-term tax-exempts 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. And this 14% will be substantially reduced by taxation before it can be banked by the individual owner. The extent of such shrinkage depends upon the dividend policy of the corporation and the tax rates applicable to the investor.
Thus, with interest rates on passive investments at late 1981 levels ie. 14% and 16%, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals. Assume an investor in a 50% tax bracket; if our typical company pays out all earnings, the income return to
the investor will be equivalent to that from a 7% tax-exempt bond. And, if conditions persist - if all earnings are paid out and return on equity stays at 14% - the 7% tax-exempt equivalent to the higher-bracket individual investor is just as frozen as is the coupon on a tax-exempt bond.
If, on the other hand, all earnings of our typical American business are retained and return on equity again remains constant, earnings will grow at 14% per year. If the p/e ratio remains constant, the price of our typical stock will also grow at 14% per year. But that 14% is not yet in the pocket of the shareholder.
Putting it there will require the payment of a capital gains tax, presently assessed at a maximum rate of 20%. This net return, of course, works out to a poorer rate of return than the currently available passive after-tax rate.
Simple Explanation: -
If the company is earning Return on Equity at 14% constantly and if the P/e ratio is the same – your stock prices can go up 14% year over year. However, when you sell this stock – you end up paying 20% tax – so your next income will be 11.20%. This is very low compared with the 14% tax free bonds.
This means the companies are failures after doing all the activities and taking so much risks.
Master says: -
Most American businesses pay out a significant portion of their earnings and thus fall between the two examples. And most American businesses are currently “bad” businesses economically - producing less for their individual investors after-tax than the tax-exempt passive rate of return on money. Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.
It should be stressed that this depressing situation does not occur because corporations are jumping, economically, less high than previously. In fact, they are jumping somewhat higher: return on equity has improved a few points in the past decade. But the crossbar of passive return has been elevated much faster. Unhappily, most companies can do little but hope that the bar will be lowered significantly; there are few industries in which the prospects seem bright for substantial gains in return on equity.
Simple Explanation: -
The situations where the Equity Returns are lower than the bonds is not due to the companies are not working hard. But the bond rates have gone up at much faster rates.
Master says: -
Inflationary experience and expectations will be major (but not the only) factors affecting the height of the crossbar in future years. If the causes of long-term inflation can be tempered, passive returns are likely to fall and the intrinsic position of American equity capital should significantly improve. Many businesses that now must be classified as economically “bad” would be restored to the “good” category under such circumstances.
1981 V/s. 2024 – the same situations.
If inflation comes down – the bond interest rates will come down.
Currently, the USA and the world over we are facing the same situations. We all are waiting for the USA to reduce the bond rates but since inflation is higher – the rates are not coming down.
Today Buffett has kept USD 189 Bln at 5% in the bonds.
Why Retained earnings?
A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the “bad” business. To continue operating in its present mode, such a low-return business usually must
retain much of its earnings - no matter what penalty such a policy produces for shareholders.
Reason, of course, would prescribe just the opposite policy. An individual, stuck with a 5% bond with many years to run before maturity will take the interest out and buy the highest return with safety currently available ( if he still wants to invest in bonds). Good money is not thrown after bad.
( Many investors love averaging in stocks. Read the above sentence).
When to give dividend and when not to give?
Master Says: -
What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend pay-out so that owners could direct capital toward more attractive areas.
Master quotes the Bible: -
The Scriptures concur. In the parable of the talents, the two high-earning servants are rewarded with 100% retention of earnings and encouraged to expand their operations. However, the non-earning third servant is not only chastised - “wicked and slothful” - but also is required to redirect all of his capital to the top performer. Matthew 25: 14-30
In the inflationary situations – Master says : -
But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the “bad” business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.
Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or “real” dividends. ( recently Vedanta is planning a fund raising to pay off the loans by
Rs.8500 Crs. This means the company is not able to generate profits to pay the loan back).
Why Berkshire Retains the Earnings?
Berkshire continues to retain its earnings for offensive, not defensive or obligatory, reasons. But in no way are we immune from the pressures that escalating passive returns exert on equity capital. We continue to clear the crossbar of after-tax passive return - but barely. Our historic 21% return - not at all assured for the future - still provides, after the current capital gain tax rate (which we expect to rise considerably in future years), a modest margin over current after-tax rates on passive money. It would be a bit humiliating to have our corporate value-added turn negative. But it can happen here as it has elsewhere, either from events outside anyone’s control or from poor relative adaptation on our part.
What NEXT?
The above discussions are amazing learning for the serious investors when he is planning an investments in the Equity Shares of any company.
Always see the Bond rates / inflations and the corporate return on equity.
This will give you the idea about your future earnings.
Follow me on Twitter @hiteshmparikh Or on Whatsapp - +91-9869425399.
Learn a Lesson. Live with Passion & Invest with Reason.
Hitesh Parikh.
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