Buffett's 1977 Fortune Article On Inflation Yields Clues

For Dealing With Our Deflationary Era

seekingalpha.com/article/4397187-buffetts-1977-fortune-article-on-inflation-yields-clues-for-dealing-deflationary-
era

Jim Sloan January 4, 2021

Summary

Buffett's 1977 Fortune article on stocks and inflation has surprising applicability in
deflationary times; the central characteristic of equities in all environments is internal
compounding of capital.

Looking back in 1977 Buffett saw the incredible ability of businesses to compound capital
at 12% and the fact that dividends really represented a drag on this feature.

Inflation and debt caught up with weaker companies while great companies with strong
brands and moats and ability to increase volume and raise prices flourished.

Buffett wisely resists dividends for Berkshire, but buybacks are a great alternative; the
real challenge is finding great investments to reinvest surplus cash.

Internal compounding works in deflationary times too, and Buffett's rationale for
investing in an expensive market resembles Shiller's ECY which factors in negative real
returns on bonds.

In the May 1977 issue of Fortune Buffett published an article entitled "How Inflation
Swindles the Equity Investor." While rereading the 1977 article in 2020, it became
obvious to me that inflation was the least of it. The true subject of the article has to do
with the internal workings of a business and the interface between those internal
workings and the external forces within the economy and the financial markets. The
article is specifically concerned with the way external forces - forces beyond anyone's
control - affect corporate behaviors and how corporate choices in coming to grips with
these forces can harm investors.

No one is better than Buffett at giving a clear and simple explanation of facts that are
hidden right before your eyes. He cuts to the chase on the underlying realities of business
in a way that neither investment books nor Harvard Business School cases quite do.
Reading the 1977 Fortune article, you can more or less check off the few key numbers and
relationships that are actually important to investors and to Buffett himself as CEO of
Berkshire Hathaway (BRK.A)(BRK.B).

Nobody, including Buffett, could have known at the time he wrote the article that the
inflation problem would turn around within five years. In 1982 both inflation and interest
rates began a long irregular slide from disinflation to the brink of outright deflation by
2020. We have now reached the point of minuscule inflation rates and negative real

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interest rates. This is the flip side of the 1970s and early 1980s, but in a few respects the
two periods have similarities. For one thing, both eras had problems which had to be
addressed by heroic efforts on the part of the Fed.

The major problem then was inflation which threatened the purchasing power of wage
earners and savers. Today the major structural problem is deflation, which presents a
problem for small investors and savers as well as businesses. Deflation is, if anything,
more intractable then inflation. You can cool an economy down more easily than you can
heat one up. Most people in the course of a lifetime will experience both of these
extremes, so we shouldn't be taken entirely by surprise. Long reciprocal round trips from
inflation to deflation and back recur with some regularity. They upset a few apple carts
but eventually and gradually settle down into more normal and comfortable times. Both
individuals and corporations have managed to deal with them repeatedly over a long
history. Buffett's 1977 article has important things to tell us about how to think about
both.

Internal Compounding Is The Driving Force Of Stocks

Buffett's premise in the 1977 article was that the central problem in the stock market was
that return on capital had not risen with inflation, but seemed to be stuck at 12 percent, a
number he established by looking backward over three decades. Inflation and interest
rates had risen sharply to 10% at the time Buffett was writing, and were on their way to
15% five years later. Meanwhile corporations had proved helpless when it came to
increasing earnings to counteract the month after month decline in the value of a dollar.
Contrary to popular expectation, corporate earnings did not rise to offset inflation.
Instead stocks fell in close correlation with bonds. Here's Buffett:

In the first ten years after the war - the decade ending in 1955 - the Dow Jones industrials
had an average annual return on year-end equity of 12.8 percent. In the second decade, the
figure was 10.1 percent. In the third decade it was 10.9 percent... The figures for a few
exceptional years have been substantially higher (the high for the 500 was 14.1 percent in
1974) or lower (9.5 percent in 1958 and 1970), but 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).

Buffett then characterized stocks as providing "equity coupons" which unlike ordinary
bond coupons did not have a fixed amount but stood to increase via that 12% internal
compounding. This return on equity capital - return on book value, to use the term which
came to be a central number for Buffett - made stocks a fabulous deal when they traded
near book value as they did at the beginning of the great 1950s bull market. You couldn't
reinvest your bond coupons directly at par value - still can't - but with stocks the
corporation does it for you with no tax implications so that growth stocks of the 1950s
which paid small dividends or none at all were an amazing deal. They offered in aggregate
Buffett's 12% internal compounding at a time when bonds paid only 3-4%. (All of the

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historical numbers in this article are from Buffett, although they reflect facts I remember
very well from my early years as an investor.) Buffett then gave this very important piece
of history:

Looking back, stock investors can think of themselves in the 1946-66 period as having been
ladled a truly bountiful triple dip. First, they were the beneficiaries of an underlying
corporate return on equity that was far above prevailing interest rates. Second, a significant
portion of that return was reinvested for them at rates that were otherwise unattainable. And
third, they were afforded an escalating appraisal of underlying equity capital as the first two
benefits became widely recognized. This third dip meant that, on top of the basic 12 percent
or so earned by corporations on their equity capital, investors were receiving a bonus as the
Dow Jones industrials increased in price from 133 percent of book value in 1946 to 220
percent in 1966. Such a marking-up process temporarily allowed investors to achieve a
return that exceeded the inherent earning power of the enterprises in which they had
invested. This heaven-on-earth situation finally was "discovered" in the mid-1960's by many
major investing institutions."

Buffett went on to provide this caveat:

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...It was a situation that left very little to be
said for cash dividends and a lot to be said for earnings retention. Indeed, the more money
that investors thought likely to be reinvested at the 12 percent rate, the more valuable they
considered their reinvestment privilege, and the more they were willing to pay for it. In the
early 1960's, investors eagerly paid top scale prices for electric utilities situated in growth
areas, knowing that these companies had the ability to reinvest very large proportions of
their earnings. Utilities whose operating environment dictated a larger cash payout rated
lower prices."

The short version of the argument on the persistence of 12% returns was that it cannot be
improved. Buffett carefully explored five ways investors hoped return on book value could
be improved, the most interesting of which were adding more leverage and getting
cheaper leverage. With rising inflation and interest rates, however, the latter was
obviously impossible. The reality was that virtually every debt rollover was at a more
expensive rate. Meanwhile companies were trying to add leverage, with equity percentage
of total capital for the FORTUNE 500 (a commonly used index in those days) falling from
63% to 50% over the period from 1955 to 1975. That increase in debt quickly became
burdensome as debt was rolled over at inevitably higher rates.

To me, the most interesting takeaway from Buffett's argument about leverage is that he
did not subscribe to the modern view that debt and equity were interchangeable and could
be balanced at will to achieve whatever debt to equity ratio served a company's purpose.
His favored measure of profitability was then and has remained ROE (return on equity
capital) rather than ROIC (return on total invested capital). He has been willing at times
to buy debt, when the rate of return was sufficient to justify the risk, but he has resisted

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issuing any significant amount of debt to serve Berkshire's capital needs. He has issued
debt only under very favorable conditions in which debt was essentially free money (as the
debt in yen he used to buy the $6.5 billion of Japanese trading companies).

Book Value Gives Way To Business Value

Buffett famously used Berkshire Hathaway's Book Value as the measure when comparing
Berkshire's returns with the S&P 500 until 2014 when he acknowledged that the shift
from ownership of publicly traded stocks to ownership of whole companies had, because
of accounting rules not allowing upward revision of purchase price, made Berkshire's
Book Value a significantly understated measure of Berkshire's "business value." That
being said, the tenacity with which Buffett hung on the to the Book Value measure is
worth remembering. In 1977, when most American companies required a lot of capital,
there was little question of its importance, and the concept that replaced it, "business
value," is in many ways just as elusive, being frequently derived using a notoriously
difficult estimate of discounted future cash flow.

At the time of the 1977 article, most businesses required large amounts of capital
investment, so Book Value was an important measure. Buffett used it without feeling the
need to use other measures such as intellectual capital, arguing that,

...your future results will be governed by three variables: the relationship between book
value and market value, the tax rate, and the inflation rate. 10 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... 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 discount rather than a premium, just as common sense
would suggest. During the postwar years, the market value of the Dow Jones industrials has
been as low as 84 percent of book value (in 1974) and as high as 232 percent (in 1965);
most of the time the ratio has been well over 100 percent. (Early this spring, it was around
110 percent.) Let's assume that in the future the ratio will be something close to 100 percent
- meaning that investors in stocks could earn the full 12 percent. At least, they could earn
that figure before taxes and before inflation."

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It's worth remembering those numbers by which the market moved from about 133% of
Book Value in 1946 to 233% in 1966, part of the triple play stocks provided over those two
decades. By 1974, however, the Price to Book ratio had made a round trip and then some,
to 84% of BV. By that time the price earnings ratio, which had risen well into the 20s was
below 8. Notwithstanding the problems presented by inflation, Buffett had been buying
stocks beginning in 1974. He told the interviewer in his famous 1974 Forbes interview
entitled "Look At All Those Beautiful Scantily Clad Girls Out There," that he "felt like an
oversexed guy in a harem. This is the time to start investing." The fact that stocks as a
whole were selling at 84% of book value juiced the returns so much (about 14.4%
internally compounding with no dividend, or 13% if paying a dividend with yield of 7%)
that it didn't matter much what inflation was doing. Nevertheless thanks to inflation and
high rates, with high bond yields offering tough competition, stocks were dirt cheap.

The article goes on to describe several other ways inflation impacted companies and
individuals including the fact that pension liabilities after inflation were much more of a
problem than they appeared to be while dividends after taxes and inflation were much
less of a benefit than they seemed. My own Illinois state pension is a case in point. Set up
in 1979, it was written into law with a 3% annual inflation adjustment, which seemed like
a good idea at the time for State University Retirement System. Thanks to falling inflation,
it wasn't. Since my retirement in 2001, the compounding at 3% has caused my pension
payments to almost double. Buffett has quite a lot more to say about the effects of
inflation, but since that's not my main subject, here's a link for those who wish to read the
entire article.

Phantom Dividends? Buffett Offers Something Better

The underlying insight driving Buffett's reluctance to commit to a dividend by Berkshire is
contained in the case of what happened to shareholders of those "growth utilities" cited
above. They were so wonderful to own in the low-rate high-growth era of the 1950s that I
think I can recall Texas Utilities selling at 40 times earnings. Here's how Buffett described
the way utility companies solved the problem of insufficient cash flow in the 1970s.

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 How, they will ask themselves, can we stop or reduce dividends without risking stockholder
wrath? I have good news for them: a ready-made set of blueprints is available. In recent
years the electric-utility industry has had little or no dividend-paying capacity.

Or, rather, it has had the power to pay dividends if investors agree to buy stock from them.
In 1975 electric utilities paid common dividends of $3.3 billion and asked investors to return
$3.4 billion. Of course, they mixed in a little solicit-Peter-to-pay-Paul technique so as not to
acquire a Con Ed reputation. Con Ed, you will remember, was unwise enough in 1974 to
simply tell its shareholders it didn't have the money to pay the dividend. Candor was
rewarded with calamity in the marketplace. The more sophisticated utility maintains -
perhaps increases - the quarterly dividend and then asks shareholders (either old or new) to
mail back the money. In other words, the company issues new stock. This procedure diverts
massive amounts of capital to the tax collector and substantial sums to underwriters.
Everyone, however, seems to remain in spirits (particularly the underwriters).

Encouraged by such success, some utilities have devised a further shortcut. In this case, the
company declares the dividend, the shareholder pays the tax, and - presto - more shares are
issued. No cash changes hands, although the spoilsport as always, persists in treating the
transaction as if it had. AT&T, for example, instituted a dividend-reinvestment program in
1973. This company, in fairness, must be described as very stockholder-minded, and its
adoption of this program, considering the folkways of finance, must he regarded as totally
understandable. But the substance of the program is out of Alice in Wonderland.

In 1976, AT&T paid $2.3 billion in cash dividends to about 2.9 million owners of its
common stock. At the end of the year, 648,000 holders (up from 601,000 the previous year)
reinvested $432 million (up from $327 million) in additional shares supplied directly by the
company. Just for fun, let's assume that all AT&T shareholders ultimately sign up for this
program. In that case, no cash at all would be mailed to shareholders - just as when Con Ed
passed a dividend. However, each of the 2.9 million owners would be notified that he should
pay income taxes on his share of the retained earnings that had that year been called a
"dividend." Assuming that "dividends" totaled $2.3 billion, as in 1976, and that shareholders
paid an average tax of 30 percent on these, they would end up, courtesy of this marvelous
plan, paying nearly $700 million to the IRS. Imagine the joy of shareholders, in such
circumstances, if the directors were then to double the dividend.

Except in tax-advantaged accounts, dividends have pretty much the same inefficiency
today. That's a point Buffett made in his 2012 Shareholder Letter. There are a few
dividend favorites mentioned frequently on this site which in broad outline resemble
those utility companies in the 1970s. I won't name names. I wrote an article about couple
of them last year and the comments made me wonder if I needed a bodyguard when I left
the house. You can check on your own dividend stocks easily on the SA site by looking for
the Dividend heading beneath the stock chart. That's the easy way. To go into more depth,
look at Financials And Cash Flow, as well as the number for Payout percentage. You
should check five or ten years of earnings and free cash flow growth per share and
compare to dividend growth. It makes me think of the Satchel Paige line, "Don't look

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back, something might be gaining on you." If the dividend is increasing much faster than
the earnings, and the company shows no top line growth, you should give your investment
some serious thought.

Even if the numbers look fine, dividends have the same problems they had in the 1970s
except that inflation doesn't take as large a final cut - just 2%. You should at least
endeavor to keep your dividend payers in a tax-advantaged account. For heaven's sake,
though, don't you want your equity investments to do what they are uniquely able to do?

This year, if you own shares in Berkshire, Buffett arranged a much better deal for you. As
of the end of October he had bought back over $18 billion of Berkshire shares. When you
see the positive impact of these buybacks it will seem like a conjuring trick. Taking
surplus cash off the books reduces equity capital, effectively right-sizing Berkshire as a
whole and increasing return on equity in a way that begins to reveal Berkshire's true
profitability. Taking shares off the books increases the value of every remaining share. No
cash flow is lost. Best of all, those who want a payout of the sort that usually comes with a
dividend can manufacture one for themselves on very favorable terms. Those like me who
would prefer to leave their money inside Berkshire to continue compounding do not have
to take any action. I have written on this subject a number of times, as in this recent
article, under the heading Addition By Subtraction, so I will not go into detail here,
except for this list which shows what an $18 billion dollar buyback looks like from a few
perspectives:

1. Assuming an average buyback price of $205 Buffett appears to have bought back
about 3.72% of Berkshire's market cap so far in 2020.
2. Continuing shareholders owned 96.28% of $37 billion in cash flow, or $35.62 billion
before the buyback.
3. Continuing shareholders own 100% of $37 billion in cash flow, or $37 billion after
the buyback.
4. Continuing investors are thus 3.87% better off after the buyback.
5. That's the equivalent of a dividend yield of 3.87%. Continuing investors can sell
enough stock to equal that 3.87% yield without having their percentage of
ownership decline from what it was before the buybacks.
6. Departing investors get the market price for their shares which may be a bit more
than they would have received without the underlying bid.
7. Book value drops by $18 billion.
8. Return on book value goes up just as it would have if Buffett had paid cash for an
$18 billion acquisition. As of Q3 ROE is up from 8.45% in 2019 to 8.83%.
9. Book value becomes less important as a criterion for value.

So look at item #5 and give yourself as much of a yield as you want up to 3.87%, perhaps
more if buybacks continued through the end of the year. Then hope that the ratio of price
to business value remains in an area enabling buybacks in the future.

What Worked During Inflation Works During Deflation

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Buffett was an early discoverer of the virtues of a capital-lite company. Over the years he
has presented several appreciations of See's Candy, which he bought for $25 million in
1972. With only $15 million additional capital, he has received cash flow before taxes of
$2 billion, 8000 per cent on his original investment. See's became the template for a
major Buffett approach - investing mainly in high quality publicly traded companies with
outstanding brands and moats which could increase volume with very little extra capital
expenditure and raise prices with very little loss of unit volume.

This was exactly the formula Buffett suggested for a company which could prosper in
inflationary times, but as it turned out, his most successful application of the model was
building a large position in Coca-Cola (KO) in the disinflationary 1980s. The principles
formed in the inflationary 1970s clearly worked equally well in a disinflationary
environment. Compounding capital was compounding capital. Buffett's model works well
in both environments because its central principle is actually strong return on capital,
period. This is the central thing and is independent of external events such as inflation
and deflation.

The only problem eventually presented by the capital-lite model is that it soon becomes
difficult to find places to reinvest surplus cash flow. Chaining up outstanding new
investments one after the other is every bit as difficult as you might imagine. A partial
solution involved buying whole companies which could compound capital inside
Berkshire as subsidiaries. Buffett's favorites were regulated capital-intensive businesses
like utilities for which the regulatory authorities required capital expenditures but
virtually guaranteed a solid return as the capital expenditures were added to the base for
rate increases. This approach provided a vehicle for internal reinvestment at a good rate,
but it could not use up the entirety of Berkshire's cash flow. Meanwhile the level of
surplus cash within Berkshire passed the $100 billion mark, about 20% of market cap.

By the time of the February 2017 release of Berkshire's Annual Report and Shareholder
Letter Buffett had come to realize the necessity to develop his own working model of the
terms the market presented in a low-inflation low-rate era. In his follow-up interview with
Becky Quick on CNBC, you could hear him weighing the two sides of an argument:

Buffett: Well... I've been talking this way for quite a while, ever since the fall of 2008. I was
a little early on that actually. But I don't think you could time it. And we are not in a bubble
territory or anything of the sort. Now, if interest rates were 7 or 8 percent, then these prices
would look exceptionally high. But you have to measure, you know, you measure everything
against - interest rates, basically, and interest rates act like gravity on valuation. So when
interest rates were 15 percent in 1982 they'd pull down the value of any asset. So, what's the
sense of buying a farm on a 4 percent yield basis if you can get 15 percent in governments?
But measured against interest rates, stocks actually are on the cheap side compared to
historic valuations. But the risk always is, is that - that interest rates go up a lot, and that
brings stocks down. But I would say this, if the ten-year stays at 230, and they would stay
there for ten years, you would regret very much not having bought stocks now."

Three months later, during the Q and A portion of the 2017 Annual Meeting he had
focused specifically on Berkshire's cash hoard:

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 At a point, the burden of proof really shifts to us, big time. There's no way I can come back
here three years from now and tell you that we hold US $150 billion or so in cash."

It's approaching four years since the two above statements. Far from rising above 2.3 per
cent rates have actually fallen below 1% on the 10-year Treasury and the Fed has issued a
virtual guarantee that rates will remain quite low for quite a while. Most areas of the stock
market are quite expensive. Does that mean you should stop buying stocks? Buffett's
actions clearly say no. It is clear that his doubts expressed in 2017 have resolved into a
point of view which still reflects his view of equities and the "equity coupon" from his 1977
article. His purchase of Apple (AAPL), begun by one of his lieutenants in 2016 and
ramped up over more than two years, has been his largest single investment. It is
exemplary of his model of the world which says to own strong brands with the kind of
internal compounding which continues to make stocks the only game in town.

There is actually a current article (available here) by Robert J. Shiller, Laurence Black,
and Farouk Jivra entitled "Making Sense of Sky-High Stock Prices" which may closely
reflect the thought process by which Buffett developed a rationale for investing in the
current market. That's the Shiller of "Irrational Exuberance," by the way, who has often
been characterized as a perma-bear, which makes the article all the more interesting. The
approach bears some resemblance to Ed Yardeni's famous Fed Model, but with a
modification which makes it more applicable in a deflationary era. The authors present a
concept they call Excess CAPE Yield, or ECY. Here's an excerpt from the Shiller et al
argument:

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 The cyclically adjusted price-to-earnings (CAPE) ratio, which captures the ratio of the real
(inflation-adjusted) share price to the ten-year average of real earnings per share, appears to
forecast real long-term stock-market returns well in five influential world regions. When the
CAPE ratio is high, long-term returns tend to be low over the next 10 years, and vice versa.
Since the COVID-19 shock, CAPE ratios have mostly recovered to their pre-pandemic
levels.

For example, the U.S. CAPE ratio in November 2020 was 33, exceeding its level prior to the
start of the COVID-19 pandemic… In fact, it is now back to the same level as the high of 33
in January 2018. There are only two other periods when the CAPE ratio in the U.S. was
above 30: the late 1920s and the early 2000s.

Market observers have noted the potential role of low interest rates in pushing up CAPE
ratios. In traditional financial theory, interest rates are a key component of valuation models.
When interest rates fall, the discount rate used in these models decreases and the price of the
equity asset should appreciate, assuming all other model inputs stay constant. So, interest-
rate cuts by central banks may be used to justify higher equity prices and CAPE ratios...To
capture these effects and compare investments in stocks versus bonds, we developed the
ECY, which considers both equity valuation and interest-rate levels. To calculate the ECY,
we simply invert the CAPE ratio to get a yield and then subtract the 10-year real interest
rate.

This measure is somewhat like the equity market premium and is a useful way to consider
the interplay of long-term valuations and interest rates. A higher measure indicates that
equities are more attractive. The ECY in the U.S., for example, is 4%, derived from a CAPE
yield of 3% and then subtracting a 10-year real interest rate of -1.0% (adjusted using the
preceding 10 years’ average inflation rate of 2%).

(Author's Note: I too blinked the first time I read the above paragraph, but remembered that
the negative of a negative number is positive.)

The only other time ECYs were this high using our global data was in the early 1980s. That
period was characterized by depressed equities with cheap valuations, high interest rates,
and high inflation. CAPE ratios for the five regions were in the low teens back then,
compared with levels in the twenties and thirties now. These conditions are almost the
opposite of what we see today: expensive equities and exceptionally low real interest rates."

That early 1980s period is pretty much the era which Buffett's 1977 inflation article
addressed. I don't pretend to any particular insight into Buffett's private thoughts, but
listening to his inner debate in the quotes above from 2017 and then observing his actions
suggests that his thinking is similar to that of Shiller and his co-authors. Buffett is of
course much less formal and theoretical, and more practical and intuitive.

The important point is that the Shiller model for returns in times of low inflation and low
rates ties together the present moment and the early 1980s just as Buffett did in his 2017
Becky Quick interview. The 1980s and 2010s are diametrically opposed market situations
which, however, share the same uniquely high rate of return for stocks over bonds. That

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differential between the expected return of stocks and bonds is what we generally call the
risk premium, accounting for the fact that stocks offer superior returns but with greater
volatility and risk.

The one shared element in 1977 and 2021 is the importance of internal return - return on
equity capital. Regardless of the external forces which afflict the economy from time to
time, the return on equity capital of a superior company does its work of compounding
value inside a wall that separates it from the variety of external forces which leave their
imprint on the economy and the markets. Because of that compounding, it is almost
always a good time to buy well-chosen stocks. It is now a good time to buy a relatively
cheap Berkshire Hathaway.

Disclosure: I am/we are long BRK.B. I wrote this article myself, and it expresses my
own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I
have no business relationship with any company whose stock is mentioned in this article.

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