Buffettspeak: In productive assets I trust

March 1st, 2012

The wait is over for followers of Warren Buffett’s annual letters. As in the past, this time too he uses the letter to convey his views on investing. He makes interesting observations on three major asset classes — equity, treasury or bonds and gold.

Let us see what he has to say about investing and these three assets classes.

The basic choices for investors and the one we (Berkshire) strongly prefer investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire, we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is foregoing consumption now in order to have the ability to consume more at a later date.

Effectively, Buffett stresses on investing in assets that can, over time, retain and increase purchasing power or provide a good hedge against inflation. He also says the risk of an investment is not measured by beta, but by the reasoned probability that it will cause its owner a loss of purchasing power over his contemplated holding period. He further explains that an investment could fluctuate significantly in price but could still hold its purchasing power. On the other hand, an investment that does not fluctuate in price could be perceived safe, but what if over the period of time one loses purchasing power?

Here is why he emphasises on risk

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth, they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. Even in the US, where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.” For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of US Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points.

Importantly, he explains during this period, the implicit inflation “tax” was more than thrice the explicit income tax that our investor probably thought of as his main burden. In hindsight, we all want our investment to at least beat the rate of inflation and take care of taxes. And if both objectives aren’t achieved, there could be erosion in purchasing power, which could be riskier than what is explained to be safe by way of looking at the beta of an investment. This comes at a time when the world is debating the role of fixed-income securities in the portfolio particularly given perception of risk-free returns.

Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.

But if fixed-income securities aren’t able to retain and increase purchasing power, what about gold, which is making all the news and noise of being the perfect hedge against the inflation? In fact, the advocates of gold as an investment are convinced that it is the only asset class that has retained its purchasing power against the inflation along with having the advantage of money of last resort. In the event of a crisis, gold is supposed to be a better option than equity or buying businesses.

Buffett puts gold in the second category of investments that will never produce anything. Buyers invest in such assets in the hope someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. He compares this phenomena with the buyers of tulips in the 17th century. During this period, which was also known as Tulip Mania, contract prices for bulbs reached significantly high levels and then suddenly collapsed. Studies suggest that at the peak of tulip mania, during the year 1637, bulbs sold for more than 10 times the annual income of a skilled craftsman. It was generally seen to be the first speculative bubble in the history of financial markets.

The major asset in this category (second) is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. As “bandwagon” investors join any party, they create their own truth – for a while. Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

One can always debate about gold and its drivers but this is what the legend has to say. In fact he has made some very interesting calculations, which is worth taking a look.

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. Let’s now create a pile B costing an equal amount. For that, we could buy all US cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B? Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain equilibrium at present prices. A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond. Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

In a nutshell fixed income has the drawbacks of not being able to take care enough of the purchasing power that its owners need. Gold is unproductive and is of practically no use except being marginally used in some of the industrial applications. What about the productive assets such as equity cAan it address both the issues?

Says Buffett: the first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly US obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to non-productive or currency-based assets. Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle.

Buffett is considered to be a firm believer of investing in the productive asset class, which typically means investing in assets which use the capital for the productive purposes and thus grow as productivity goes up. Such assets are also considered to be having the ability to retain and increase the purchasing power of its owner.

The choice is yours — buy and hold the gold for the next ten years in the hope that somebody at the end of the decade will buy it at higher prices. If not with the same money you can start your own business may be making soaps and detergents or invest in Hindustan Unilever, which is the leading player in the segment, because at least there will be somebody using or consuming those products every morning for the years to come.

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