I recently came across an article written by Warren Buffett wrote for Fortune magazine in 1977, titled ‘How inflation swindles the equity investor’. In the article Buffett explains how the high inflation prevailing at the time ‘swindles’ equity investors because corporate returns on equity were consistent at a pretax 12% through high and low inflationary periods. The problem being that companies retained earnings and invested them at 12%, while prices were rocketing along at higher rates.
But the article is particularly relevant at the moment, for the points Buffett makes about the reverse case when in the 1950s and 1960s ‘with bonds yielding only 3% or 4%, the right to reinvest automatically a portion of the equity coupon at 12% was of enormous value’.
‘If, during this period, a high-grade, noncallable, long-term bond with a 12% coupon had existed, it would have sold far above par,’ Buffett continued. ‘And if it were a bond with a further unusual characteristic – which was that most of the coupon payments could be automatically reinvested at par in similar bonds – the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a security. When their reinvestment rate on the added equity capital was 12% while interest rates generally were around 4%, investors became very happy – and, of course, they paid happy prices.’
Perhaps this explains why shares are in such demand right now, with 30-year US Treasuries yielding 3.2% and the 15-year Australian Government bond yielding 3.6%. But it suggests we might be better to favour the companies with the potential to reinvest capital at attractive rates, rather than those simply paying large dividends now.
Of course, this rosy thesis depends on two crucial assumptions: (1) that ROE stays high; and (2) that the bond yield stays low. As far as the ROE is concerned, that seems a fair bet. In the US it has been close to 14% pa post-tax over the past four years, while in Australia it has been somewhat less: averaging just under 10% post-tax, but still comfortably above the bond yield.
As for the bond yield, Buffett apparently once commented – when asked where interest rates were headed – that there are only two people who knew the answer to that, that they both lived in Switzerland, but that their views were diametrically opposed.
Buf if you can’t predict the direction of interest rates, then the long bond yield is probably the best thing we’ve got to go on – not least because it tends to average out the opinions of those two gentlemen in Switzerland.
There are arguments that there’s a bubble in bonds right now, pumped up by quantitative easing, but there’s still a very large gap between less than 4% and 10%.