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

by Carol J. Loomis

stocks, in economic substance, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another.

over the years, and in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter). For the moment, let’s think of those companies, not as listed stocks, but as productive enterprises. Let’s also assume that the owners of those enterprises had acquired them at book value. In that case, their own return would have been around 12 percent too. And because the return has been so consistent, it seems reasonable to think of it as an “equity coupon.”

It is also true that in the real world investors in stocks don’t usually get to buy at book value. Sometimes they have been able to buy in below book; usually, however, they’ve had to pay more than book, and when that happens there is further pressure on that 12 percent. I’ll talk more about these relationships later. Meanwhile, let’s focus on the main point: as inflation has increased, the return on equity capital has not. Essentially, those who buy equities receive securities with an underlying fixed return—just like those who buy bonds.

Of course, there are some important differences between the bond and stock forms. For openers, bonds eventually come due. It may require a long wait, but eventually the bond investor gets to renegotiate the terms of his contract. If current and prospective rates of inflation make his old coupon look inadequate, he can refuse to play further unless coupons currently being offered rekindle his interest. Something of this sort has been going on in recent years. Stocks, on the other hand, are perpetual. They have a maturity date of infinity. Investors in stocks are stuck with whatever return corporate America happens to earn. If corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate.

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...

To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales. And that’s it. There simply are no other ways to increase returns on common equity. Let’s see what can be done with these.

More leverage? American business already has fired many, if not most, of the more-leverage bullets once available to it. Proof of that proposition can be seen in some other Fortune 500 statistics: in the twenty years ending in 1975, stockholders’ equity as a percentage of total assets declined for the 500 from 63 percent to just under 50 percent. In other words, each dollar of equity capital now is leveraged much more heavily than it used to be.

An irony of inflation-induced financial requirements is that the highly profitable companies—generally the best credits—require relatively little debt capital.

A 12 percent return from an enterprise that is debt-free is far superior to the same return achieved by a business hocked to its eyeballs. Which means that today’s 12 percent equity returns may well be less valuable than the 12 percent returns of twenty years ago.

Even if you agree that the 12 percent equity coupon is more or less immutable, you still may hope to do well with it in the years ahead. It’s conceivable that you will. After all, a lot of investors did well with it for a long time. But your future results will be governed by three variables: the relationship between book value and market value, the tax rate, and the inflation rate.

Let’s wade through a little arithmetic about book and market value. When stocks consistently sell at book value, it’s all very simple. If a stock has a book value of $100 and also an average market value of $100, 12 percent earnings by business will produce a 12 percent return for the investor (less those frictional costs, which we’ll ignore for the moment). If the payout ratio is 50 percent, our investor will get $6 via dividends and a further $6 from the increase in the book value of the business, which will, of course, be reflected in the market value of his holdings. If the stock sold at 150 percent of book value, the picture would change. The investor would receive the same $6 cash dividend, but it would now represent only a 4 percent return on his $150 cost. The book value of the business would still increase by 6 percent (to $106) and the market value of the investor’s holdings, valued consistently at 150 percent of book value, would similarly increase by 6 percent (to $159). But the investor’s total return, i.e., from appreciation plus dividends, would be only 10 percent versus the underlying 12 percent earned by the business. When the investor buys in below book value, the process is reversed. For example, if the stock sells at 80 percent of book value, the same earnings and payout assumptions would yield 7.5 percent from dividends ($6 on an $80 price) and 6 percent from appreciation—a total return of 13.5 percent. In other words, you do better by buying at a disc...

Let’s also assume, in line with recent experience, that corporations earning 12 percent on equity pay out 5 percent in cash dividends (2.5 percent after tax) and retain 7 percent, with those retained earnings producing a corresponding market-value growth (4.9 percent after the 30 percent tax). The after-tax return, then, would be 7.4 percent. Probably this should be rounded down to about 7 percent to allow for frictional costs. To push our stocks-disguised-as-bonds thesis one notch further, then, stocks might be regarded as the equivalent, for individuals, of 7 percent tax-exempt perpetual bonds.

In the next ten years, the Dow would be doubled just by a combination of the 12 percent equity coupon, a 40 percent payout ratio, and the present 110 percent ratio of market to book value.

To understand the impact of inflation upon real capital accumulation, a little math is required. Come back for a moment to that 12 percent return on equity capital. Such earnings are stated after depreciation, which presumably will allow replacement of present productive capacity—if that plant and equipment can be purchased in the future at prices similar to their original cost. Let’s assume that about half of earnings are paid out in dividends, leaving 6 percent of equity capital available to finance future growth. If inflation is low—say, 2 percent—a large portion of that growth can be real growth in physical output. For under these conditions, 2 percent more will have to be invested in receivables, inventories, and fixed assets next year just to duplicate this year’s physical output—leaving 4 percent for investment in assets to produce more physical goods. The 2 percent finances illusory dollar growth reflecting inflation and the remaining 4 percent finances real growth. If population growth is 1 percent, the 4 percent gain in real output translates into a 3 percent gain in real per capita net income. That, very roughly, is what used to happen in our economy. Now move the inflation rate to 7 percent and compute what is left for real growth after the financing of the mandatory inflation component. The answer is nothing—if dividend policies and leverage ratios remain unchanged. After half of the 12 percent earnings are paid out, the same 6 percent is left, but it is all c...

Most chairmen’s letters describe how well everything went, under the circumstances, hoping the shareholders will buy it. Buffett’s stress the negative, knowing that they won’t. In the most recent report, immediately after observing that Berkshire Hathaway’s 18-year rise in book value represents a 22% compound annual rate of growth, he adds: “You can be certain that this percentage will diminish in the future. Geometric progressions eventually forge their own anchors.”

“All managements say they’re acting in the shareholders’ interests,” he observes. “What you’d like to do as an investor is hook them up to a machine and run a polygraph to see whether it’s true. Short of a polygraph, the best sign of a shareholder-oriented management—assuming its stock is undervalued—is repurchases. A polygraph proxy, that’s what it is.”

“Things aren’t right just because they are unpopular,” Buffett says with a chuckle, “but it is a good pond in which to fish. You pay a lot on Wall Street for a cheery consensus.”

Before you rush to your telephone, however, be warned that not just any potential acquisition will do. The company must have “at least $10 million of after-tax earnings and preferably much more” according to the ad, and must also boast good return on equity, little or no debt, and a management in place. It should also be in a simple business: “If there’s lots of technology, we won’t understand it.”

in his 1987 annual report, Buffett the businessman comes out of the closet to point out just how good these enterprises and their managers are. Had the Sainted Seven operated as a single business in 1987, he says, they would have employed $175 million in equity capital, paid only a net $2 million in interest, and earned, after taxes, $100 million. That’s a return on equity of 57%, and it is exceptional. As Buffett says, “You’ll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.”

“If we get on the main line, New York to Chicago, we don’t get off at Altoona and take side trips. We also have a reverence for logic around here. But what we do is not beyond anybody else’s competence. I feel the same way about managing that I do about investing: It’s just not necessary to do extraordinary things to get extraordinary results.”

Michael Goldberg, 41, who runs Berkshire’s insurance operations and occupies the office next to Buffett’s in Omaha, thinks that he saw people as smart at the Bronx High School of Science, “but they all went into math and physics.” Buffett’s intellectual power is totally focused on business, which he loves and knows incredible amounts about. Says Goldberg: “He is constantly examining all that he hears: ‘Is it consistent and plausible? Is it wrong?’ He has a model in his head of the whole world. The computer there compares every new fact with all that he’s ever experienced and knows about—and says, ‘What does this mean for us?’” For Berkshire, that is. Buffett owns a few stocks personally but spends little time thinking about them. Says he: “My ego is wrapped up with Berkshire. No question about that.”

But he believes that over the years his largest mistakes in investing have been the failure to buy certain “good business” stocks just because he couldn’t stomach the quality of management. “I’d have been better off trusting the businesses,” he says. So in the stocks he has sometimes held, though not in the businesses he owns directly, he has on occasion gritted his teeth and tolerated a fair amount of management inanity.

“With few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

Buffett had an unwritten rule at the time that he would not put more than 25% of the partnership’s money into one security. He broke the rule for American Express, committing 40%, which was $13 million.

Last year at a Los Angeles party, Munger’s dinner partner turned to him and coolly asked, “Tell me, what one quality most accounts for your enormous success?” Recalling this delicious moment later, Munger said, “Can you imagine such a wonderful question? And so I looked at this marvelous creature—whom I certainly hope to sit by at every dinner party—and said, ‘I’m rational. That’s the answer. I’m rational.’”

Buffett sets the pay of the top man in an operating company but plays no role in compensation beyond that. All the top people are paid through incentive plans that Buffett carefully tailors to achieve whatever objectives fit—higher profit margins in a business, for example, or reductions in the capital it employs, or improved underwriting results for the insurance operation and more “float” for Buffett to invest.

Schey’s prize example is his current intention to decentralize the World Book organization, which has been hunkered down at Chicago’s Merchandise Mart forever. Schey’s old board, he says, would probably have resisted the risk of restructuring; Buffett waved him ahead. Schey says, with a grin, that Buffett has also solved the recurring problems that Scott Fetzer had finding a use for all the cash its very good businesses throw off. “Now,” says Schey, “I just ship the money to Warren.”

“Whenever I read about some company undertaking a cost-cutting program, I know it’s not a company that really knows what costs are all about. Spurts don’t work in this area. The really good manager does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ any more than he wakes up and decides to practice breathing.”

When they criticize him, which they do only mildly, Buffett’s operating managers tend to think him too rational and demanding about numbers. No one can quite imagine him paying up for a small “seed” business with a possible future but no present. Buffett and Munger are not in the least suffused with animal spirits, and they do not even consider making discretionary capital expenditures—say for flashy offices—that aren’t going to do them any economic good.

Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised.

In his opinion, Federal Home Loan Mortgage Corp., otherwise known as Freddie Mac, is just such an opportunity. A quasi-public corporation like its older cousin Fannie Mae (the Federal National Mortgage Association), it earns an impressive 23% return on equity and sells for less than eight times estimated 1988 earnings. “Freddie Mac is a triple dip,” says Buffett. “You’ve got a low price/earnings ratio on a company with a terrific record. You’ve got growing earnings. And you have a stock that is bound to become much better known to equity investors.”

Freddie Mac helps make the American dream of owning a house a reality. Chartered by Congress in 1970, the company buys residential mortgages from lenders, guarantees the mortgages against default, packages them as securities, and sells them to investors, including many S&Ls. From 1970 through 1987, the market for conventional residential mortgages grew at a compound annual rate of more than 13% and never at less than 5.5% a year. Not bad, but what makes the business outstanding is the paucity of competition. Fannie Mae is the only other major player; the chief difference between them is that Freddie resells virtually all its mortgages, while Fannie holds onto a substantial amount of them. Together, Freddie and Fannie control 90% of the market. Says Buffett: “It’s the next best thing to a monopoly.” The future of the Freddie-Fannie family duopoly looks encouraging. The market could expand for years to come. So far only 33% of conventional residential mortgages are securitized, leaving plenty of room for growth.

“I’m doing what I would most like to be doing in the world, and I have been since I was 20.” What keeps him going, he says, is the admiration he holds for his business colleagues. “I choose to work with every single person I work with. That ends up being the most important factor. I don’t interact with people I don’t like or admire. That’s the key. It’s like marrying.”

Buffett says he would invest only with someone who handled his mother’s money too (as he did).

Like all master craftsmen, Buffett prizes consistency. Marshall Weinberg of the brokerage firm Gruntal & Co. recalls going to dinner with him in Manhattan. “He had an exceptional ham-and-cheese sandwich. A few days later, we were going out again. He said, ‘Let’s go back to that restaurant.’ I said, ‘But we were just there.’ He said, ‘Precisely. Why take a risk with another place? We know exactly what we’re going to get.’ And that,” says Weinberg, “is what Warren looks for in stocks too. He only invests in companies where the odds are great that they will not disappoint.”

Our consistently conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default. We wouldn’t have liked those 99:1 odds—and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds—though we have learned to live with those also.

Warren E. Buffett, 62, billionaire CEO of Berkshire Hathaway, on why the cost of executive stock options should be recognized on companies’ income statements: “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

Says Buffett: “If you run across one good idea for a business in your lifetime, you’re lucky, and fundamentally this is the best large business in the world.[Its product] sells for an extremely moderate price. It’s universally liked—the per capita consumption goes up almost every year in almost every country. There isn’t any other product like it.” …

For owners of a business—and that’s the way we think of shareowners—the academic’s definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market—as had Washington Post when we bought it in 1973—becomes “riskier” at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly reduced price? In fact, the true investor welcomes volatility … because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

What does Gates enjoy most about Buffett? The conversation. Says he: “Warren is so humble and yet so good at describing complicated things. At the surface level it’s funny for him to quote, say, Mae West when talking about his investment philosophy, but of course he is really saying something much deeper. He’s like that all the time, so I’m always learning something about him.”

As Warren once explained in a letter to his partners, “This is the cornerstone of our investment philosophy: Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.”

On that first day, he introduced me to an intriguing analytic exercise that he does. He’ll choose a year—say, 1970—and examine the ten highest market-capitalization companies from around then. Then he’ll go forward to 1990 and look at how those companies fared.

When he explains stuff, it’s never “Hey, I’m smart about this, and I’m going to impress you.” It’s more like “This is so interesting, and it’s actually very simple. I’ll just explain it to you, and you’ll realize how dumb it was that it took me a long time to figure it out.”

Warren doesn’t outperform other investors because he computes odds better. That’s not it at all. Warren never makes an investment where the difference between doing it and not doing it relies on the second digit of computation. He doesn’t invest—take a swing of the bat—unless the opportunity appears unbelievably good.

How I got here is pretty simple in my case. It’s not IQ, I’m sure you’ll be glad to hear. The big thing is rationality. I always look at IQ and talent as representing the horsepower of the motor, but that the output—the efficiency with which that motor works—depends on rationality. A lot of people start out with 400-horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-horsepower motor and get it all into output. So why do smart people do things that interfere with getting the output they’re entitled to? It gets into the habits and character and temperament, and behaving in a rational manner. Not getting in your own way. As I said, everybody here has the ability absolutely to do anything I do and much beyond. Some of you will, and some of you won’t. For the ones who won’t, it will be because you get in your own way, not because the world doesn’t allow you. So I have one little suggestion for you: Pick out the person you admire the most, and then write down why you admire them. You’re not to name yourself in this. And then put down the person that, frankly, you can stand the least, and write down the qualities that turn you off in that person. The qualities of the one you admire are traits that you, with a little practice, can make your own, and that, if practiced, will become habit-forming. The chains of habit are too light to be felt until they are too heavy to be broken. At my age, I can’t change any of my habits. I’m stuck. But you...

They say success is getting what you want and happiness is wanting what you get. I don’t know which one applies in this case, but I do know I wouldn’t be doing anything else. I’d advise you that when you go out to work, work for an organization of people you admire, because it will turn you on. I always worry about people who say, “I’m going to do this for ten years; I really don’t like it very well. And then I’ll do this….” That’s a little like saving up sex for your old age. Not a very good idea.

To get involved with people who cause your stomach to churn—I say it’s a lot like marrying for money. It’s probably a bad idea under any circumstances, but it’s absolutely crazy if you’re already rich, right?

I look for businesses in which I think I can predict what they’re going to look like in 10 or 15 or 20 years. That means businesses that will look more or less as they do today, except that they’ll be larger and doing more business internationally. So I focus on an absence of change. When I look at the Internet, for example, I try and figure out how an industry or a company can be hurt or changed by it, and then I avoid it.

But I think that there’s no magic to evaluating any financial asset. A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present at the same interest rate. There wouldn’t be any risk premium, because you’d know what coupons were printed on this “bond” between now and eternity. That method of valuation is exactly what should be used whether you’re in 1974 or you’re in 1998. If I can’t do that, then I don’t buy. So I’ll wait.

Would you look for a higher price-to-earnings ratio at this point than you did in 1969? BUFFETT: That ratio would be affected by interest rates. The difference between now and 1969 or any other time, in terms of calculating a valuation, wouldn’t be affected by anything else. Now, if you looked at the overall market, returns on equity are much higher than they were in 1969 or 1974, or any other time in history. So if you’re going to say you’re going to value the overall market, the question becomes: “Do you crank in the present 20% returns on equity for American business in aggregate, and say that’s a realistic figure to stick on for this future that runs out until eternity?” I’d say that’s a fairly reckless assumption and doesn’t leave much margin of safety. And I would say that present market levels discount a lot of that, and so that makes me quite cautious.