1997: Is the S&P 500's return on equity sustainable?

AUDIENCE MEMBER: Mr. Buffett, Mr. Munger, my name John Shane (PH). I’m from Nashville, Tennessee.

You touched on the subject of return on equity in response to a different question. I wonder whether you might be willing to elaborate along the following line.

Right now, the Standard & Poor’s 500, in aggregate, have a return on equity of about 22 percent. The average over the decades for corporate America has been more like 12 or 13 percent.

How did we get to this point of extraordinary profitability? And how likely do you think we are, over the next ten or 15 years, to revert back to the mean of the low teens?

WARREN BUFFETT: Well, I would say is, I never thought it would happen. So I start out with the fact that if you’d listened to me, you’d have been dead wrong, in terms of what the return on equity in 1996 or 1995, 1997 would be.

It does not seem to me that 22 percent returns on equity are sustainable in a world where the long-term interest rate is 7 percent, and where the capability of saving large amounts in the economy, you know, are quite dramatic.

You would just think that there would be some sort of leveling effect between 7 and the 22 you named, that as savings got directed within the economy and as the competitive forces operate that we’ve been taught will operate over time, would come into play.

But, you know, I’ve been wrong on that subject. And that’s why I say these levels are not unjustified if those kinds of returns can be made.

Because let’s just say that you had a 22 percent perpetual bond. And you had the ability — and let’s say that a quarter of that — a third of that coupon — would be paid out. So you got a bond with a 22 percent coupon and, say, 7 percent is paid out, being the dividend payout on the S&P, we’ll say. And the other 15 percent is reinvested in more 22 percent bonds with similar characteristics.

Now, what’s that instrument worth on a present-value basis in a 7 percent world? It’s worth a lot of money.

In fact, it’s worth so much money that it becomes a mathematical fallacy at some point, because when the compound rate becomes higher than the discount rate, you get into infinite numbers, which are — or you get into infinity.

And that’s a number — that’s the concept we like to think about around Berkshire — (laughs) — we haven’t figured out how to attain it.

There’s a book called “The Petersburg Paradox” — there’s an article called “The Petersburg Paradox and the Growth Stock Fallacy.” I think that’s the name of it, by a fellow named, I think, David Durand, written about 25 years ago. And it gets into this bit where the growth rate is higher than the discount rate. And it shouldn’t work for an extended period of time. But it’s sure fun while it’s going on.

Charlie?

CHARLIE MUNGER: Yeah. I think a couple of things contributed to this phenomenon that we so carefully mispredicted.

Number one, it became very fashionable for corporations to buy in shares. And I think that we helped, in a very small way, bring on that enlightenment. And I think that was a plus, in terms of rational corporate decision making.

The other thing that happened is that the anti-trust administration got way more lenient in allowing people to buy competitors.

And I think those two factors helped raise returns on capital in the United States.

But that can’t — you wouldn’t think that can go on forever. And what 15 percent per annum compounded will do is grow way faster than the economy can grow, way faster than aggregate profits can grow, over a long pull. So, sooner or later, something has to happen. I don’t think we’ve reached a new order of things where the laws of mathematics are somehow repealed.

WARREN BUFFETT: If real output in this country grows at, say, 3 percent a year — or real GDP grows at 3 percent a year — and the capitalized value of industry in the country grows at 10 percent a year, at some point you get into mathematical absurdities, I mean, at the low inflation rates.

You know, you can’t have it — if we have an economy that’s seven or eight trillion now in GDP and seven or eight trillion in equity valuation, that may or may not make sense. But if you have one that’s 15 billion in GDP and 75 billion in equity valuation — 75 trillion in equity valuation — you know, you get to things that don’t — can’t make any sense.

So if you get these differential rates of growth among items that have some relationship, however tenuous, or at least non-specific in the short run, it doesn’t work after a while. And, you know, nobody wants to think about that. They don’t want to think about their own death. But I mean, it doesn’t go away just because you don’t want to think about it.

And we haven’t gotten to any point like that. But you can project out numbers. And they just won’t make any sense after a while.

CHARLIE MUNGER: Yeah. Corporate profits can’t be 200 percent of GNP.

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: Indeed, they can’t be 50 percent of GNP. So these high rates of compounding just go automatically into absurdity.

WARREN BUFFETT: Yeah. They really can’t be 20 percent of GDP or some number like that. So if — and if you start saying you can’t have a multiple of more, you get differential rates. And they just simply — you leave the tracks after a while.

CHARLIE MUNGER: And all you people should be aware of this because all the people who are professional sellers of investment advice and brokerage service, et cetera, et cetera, have an immense vested interest in believing that things that can’t be true are true. (Laughter)

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: And not only that, they’ve been selected in a Darwinian process to have formidable sales skills and large energy. (Laughter)

And this is dangerous to the rest of us. (Laughter)

WARREN BUFFETT: Yeah. Well, you’ve been selected to be the recipients of their advice. (Laughs)

CHARLIE MUNGER: Right.

Furthermore, they figure out who we are and come in about 6 o’clock in the evening. (Buffett laughs)