1998: Are rising ROEs sustainable at U.S. banks?

AUDIENCE MEMBER: Yes. Good morning, Mr. Buffett, Mr. Munger. My name is Patrick Rown (PH) from Charlotte, North Carolina.

And I’ve watched returns on equity for the banking sector in the U.S. go up a good bit over the last few years. And returns on tangible equity for some of the major banks that have led to consolidation have gone up a good bit more. Leads me to wonder whether these returns are sustainable over the near-term or the longer-term, five, 10 years out.

WARREN BUFFETT: Well, that’s the $64 question, because the returns on equity — and particularly tangible equity, as the gentleman mentioned — and particularly tangible equity in the banking sector, even — those returns have hit numbers that are unprecedented. And then the question is, if they’re unprecedented, are they unsustainable?

Charlie and I would probably think the — we would certainly prefer — we would not base our actions on the premise that they are sustainable. Twenty percent-plus returns on tangible equity — or on book equity — and much higher returns on tangible equity. In the banking field, you have a number of enterprises that on tangible equity are getting up close to the 30 percent range.

Now, can a system where the GDP in real terms is growing, maybe, 3 percent — where in nominal terms this grows 4 to 5 percent — can businesses consistently earn 20 percent on equity?

They certainly can if they retain most of their earnings, because you would have corporate profits rising as a percentage of GDP, to the point that would get ludicrous.

So under those conditions, you’d either have to have huge payouts — either by repurchases of shares or by dividends or by takeovers, actually — that would keep the level of capital reasonably consistent among industry, because you couldn’t sustain — let’s just say every company retained all of its earnings and they earned 20 percent on equity — you could not have corporate profits growing at 20 percent as a part of the economy year after year.

This has been a better world than we foresaw, in terms of returns, so we’ve been wrong before. And we’re not making a prediction now, but we would not want to buy things on the basis that these returns would be sustained.

We told you last year, if these returns are sustained and interest rates stayed at these levels or fell lower, that stock prices, in aggregate, are justified. And we still believe that.

But those are two big ifs. And a particularly big if, in my view, is the one about returns on equity and on tangible assets. It goes against — it certainly goes against classic economic theory to believe that they can be sustained.

Charlie, how do you feel about it?

CHARLIE MUNGER: Well, I think a lot of the increase in return on equity has been caused by the increasing popularly of Jack Welch’s idea that if you can’t be a leader in a line of business, get out of it.

And if you have fewer people in the business, why, returns on equity can go up.

Then it’s got more and more popular to buy in shares, even at very high prices per share. And if you keep the equity low enough by buying shares back, why, you could make return on equity whatever you want.

It would be that, to some extent, a slow revolution in corporate attitudes.

But Warren is right. You can’t have massive accumulations of earnings that are retained and keep earning these rates of return on them.

WARREN BUFFETT: An interesting question is to think about, if you had 500 Jack Welches and they were running the Fortune — they’re cloned — and they were running all of the Fortune 500 companies, would returns on equity for American business be higher or lower than they are presently?

I mean if you have 500 sensational competitors, they can all be rational, but that doesn’t — and they will be. And they’ll be smart and they’ll keep trying to do all the right things. But there’s a self-neutralizing effect, just like having 500 expert chess players or 500 expert bridge players. You still have a lot of losers if they get together and play in a tournament.

So it’s not at all clear that if all American management were dramatically better, leaving out the competition against foreign enterprises, that returns on equity would be a lot better. They might very well drive things down.

That’s what, to some extent, can easily happen in securities markets. It’s way better to be in securities markets if you have a hundred IQ and everybody else operating has an 80, than if you have 140 and all the rest of them also have 140.

So the secret of life is weak competition, you know. (Laughter)

Somebody said, “How do you beat Bobby Fischer?” You play him in any game except chess, well — (Laughter)

That’s how you beat Jack Welch. You play him in any game except business, although he’s a very good golfer, I want to — (laughs) — point out.

He shot a 69 a few months ago when I saw him at a very tough course. Jack manages to play 70 or 80 rounds of golf a year, and come in sub-par occasionally, while still doing what he does at GE. He’s a great manager. But 500 Jack Welches, I’m not at all sure would make stocks more valuable in this country.