2001: Are historically high ROEs driven by accounting shenanigans or fundamentals?
AUDIENCE MEMBER: John Golob from Kansas City.
I have a follow-up question to your comments about how financial statements can be distorted by making over-optimistic assumptions about returns for the pension portfolio.
If you believe accounting statements, as published in annual reports, returns on equity for U.S. businesses are amazingly high — higher than in Europe, higher than they’ve been historically, higher than Japan.
Are these highs, do you think, completely attributable to accounting shenanigans? Or are there any fundamental reasons in addition that might make returns in the U.S. higher than in Europe or higher than they’ve been historically?
WARREN BUFFETT: Well, I would say that they certainly — to the extent that American returns have been higher than those around the world, at least in developed countries, I would say that they are not solely due at all to accounting shenanigans.
I think that the absence of honest accounting for option costs and — has been a factor. But American business has done very well, excluding — very well — excluding any accounting activities that Charlie and I might differ with.
You know, I’m no expert on exactly what returns have been around the world in developed countries, but my impression definitely is that American business is well above averaged — average — for the developed world, in terms of profitability.
And, you know, I don’t have the answers as to why that’s occurred. I think that American business, and I think the whole American system, has reflected more of a meritocracy than exists in many countries.
And I think that a meritocracy works best. I think — and I think that mobility between classes, which is the flip side of a meritocracy, you know, does tend to get the Jack Welches into positions of — whether they run a General Electric or an Andy Grove or an Intel or, you know, go with Sam Walton at Walmart.
I think if you’d taken those same individuals and dropped them down in most countries, they would’ve done very well. But I don’t think they would’ve done quite as well as here. And I think that what they have done well has spilled over, in a big way, to benefit the American economy.
So I would not lay it all on the accounting shenanigans.
And the pension funds accounting, that applies very heavily at some companies. And, of course, most newer companies don’t have pensions.
Companies that have started in the last 20 or 30 years are much more inclined to have various kinds of profit sharing or 401(k)s.
The older industries that took on pensions spurred, to a great degree, I think, by World War II, when you got excess profits taxes that ran to 90 percent. And there was a huge incentive to start pension plans and fund them heavily because the government, in effect, was funding 90 percent of your pension obligation.
So there was a great boon — boom period in the inauguration of pension funds. And, of course, that meant steel and auto and all of those big industries of that time.
CHARLIE MUNGER: Yeah. It isn’t so much accounting shenanigans as it is deliberate financial practice. Take General Electric.
There’s been a deliberate increase in financial leverage, which was made possible by the wonderful and deserved reputation. There’s been a deliberate increase in repurchase of stock, which General Electric has done even when they’re paying huge multiples of book value.
That sort of thing does wonders for returns on equity as reported, as does the process of writing off everything in sight and various extraordinary charges, removing the burden of past costs from future earnings.
You put all those things together, and American returns on equity are higher partly because the management has deliberately set out to paint the company as unusually efficient in its use of capital, meaning that it earns a high return on shareholders’ equity.
Think of how high we could drive our return on equity at Berkshire. I mean, we could make it almost any number you want if we just used enough leverage.
WARREN BUFFETT: Yeah, we could run it with no (inaudible).
CHARLIE MUNGER: We could run Berkshire with no equity. And then people could say, “Gosh, these guys have finally learned how to manage the damn thing.” (Laughter)
It’s not been an objective around here to reduce the equity to zero. But at other places, in order to make the reported return on equity good, they deliberately pound on the net worth as much as they can.
WARREN BUFFETT: Yeah. The questioner may have seen — if you look at the S&P figures of the last 15 years, they report them both before special charges and after special charges. And there’s been a very significant difference between those two figures.
American business likes to frequently write off things and say that doesn’t count. And, of course, that takes the equity down. And it actually frequently benefits future earnings because you remove costs that would otherwise hit the income statement in future years.
CHARLIE MUNGER: The truth of the matter is you have — part of this is shrewd and correct management of the companies’ financial structure and operations. And part of it can drift into gamesmanship.