Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2013

by Carol J. Loomis

There is another major difference between the garden variety of bond and our new exotic 12 percent “equity bond” that comes to the Wall Street costume ball dressed in a stock certificate. In the usual case, a bond investor receives his entire coupon in cash and is left to reinvest it as best he can. Our stock investor’s equity coupon, in contrast, is partially retained by the company and is reinvested at whatever rates the company happens to be earning. In other words, going back to our corporate universe, part of the 12 percent earned annually is paid out in dividends and the balance is put right back into the universe to earn 12 percent also. This characteristic of stocks—the reinvestment of part of the coupon—can be good or bad news, depending on the relative attractiveness of that 12 percent. The news was very good indeed in the 1950’s and early 1960’s. With bonds yielding only 3 or 4 percent, the right to reinvest automatically a portion of the equity coupon at 12 percent was of enormous value. Note that investors could not just invest their own money and get that 12 percent return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can’t pay far above par for a 12 percent bond and earn 12 percent for yourself. But on their retained earnings, investors could earn 12 percent. In effect, e...