2001: What does Buffett think about the recent inventory write-offs at large companies?
AUDIENCE MEMBER: My name is Charlie Sink (PH). I’m from North Carolina.
Mr. Buffett, your article last year in Fortune Magazine was excellent.
I’m thinking — well, I’m wondering what your thoughts are on American business profit margins and return on equity in the future. I also would like your thoughts about the — some businesses today with their huge inventory write-offs, what your thoughts about those are.
WARREN BUFFETT: Yeah, well, in that article I talked about the unlikelihood of corporate profits in the United States getting much larger than 6 percent of GDP. And historically, the band has been between 4 and 6 percent. And we’ve been up at 6 percent recently.
So, unless you think that profits, as a part of the whole country’s economic output, are going to become a bigger slice of the pie — and bear in mind, they can only become a bigger slice of the pie if other slices get diminished to some extent, and you’re talking about personal income and items like that.
So, I think it’s perfectly rational and reasonable that in a capitalistic society the corporate profits are something like 6 percent of GDP.
That does not strike me as outlandish in either direction. It attracts massive amounts of capital, because returns on equity will be very good if you earn that sort of money.
And on the other hand, I think it would be very difficult in the society to get where they’d be 10 percent or 12 percent, or something of the sort because it just — it would look like an unfair division of the pie to the populace.
So, I don’t see any reason for corporate profits — they’re going to be down in the near future as a percentage of GDP from recently, but then they’ll go back up at some point. So I think 10 years from now, you’ll be looking at a very similar picture.
Now, if that’s your assumption and you’re already capitalizing those profits at a pretty good multiple, then you have to say that you have to come to the conclusion that the value of American business will grow at a relationship that’s not much greater than the growth in GDP.
And most of you would estimate that probably to be, you know, maybe 5 percent a year, if you expect a couple percent a year of inflation.
So, I wouldn’t change my thoughts about the profitability of American business over time. And I wouldn’t change my thoughts much about the relationship of stock prices over time to those profits. So, I — you know, I would come down very similarly.
Now, interestingly enough, some of those same relationships prevailed decades ago, but you were buying stocks that were yielding you perhaps 5 percent or something like that, so that you were getting 5 percent in your pocket, plus that growth as you went along.
And of course, now if you buy stocks you get 1 1/2 percent, if you’re the American public, before the frictional cost. So that the same rate of growth produces a way smaller aggregate return. And some —
You know, I think stocks are a perfectly decent way to make 6 or 7 percent a year over the next 15 or 20 years. But I think anybody that expects to make 15 percent per year, or expects their broker or investment advisor to make that kind of money, is living in a dream world.
And it’s particularly interesting to me that back when the prospects for stocks were far better — I even wrote something about this in the late ’70s — pension funds were using investment rate assumptions that were often in the 6 percent or thereabout range.
And now when the prospects are way poorer, most pension funds are using — building into their calculations — returns of 9 percent or better on investments. I don’t know how they’re going to get 9 percent or better on investments.
But I also know that they change the investment assumption down, it will change the charge to earnings substantially. And they don’t want to do that.
So, they continue to use investment assumptions which I think are quite unrealistic. And with companies with a big pension component in their financial situation, and therefore in their income statement, that can be quite significant.
It will be interesting to me to see whether in the next couple years where pension funds are experiencing significant shortfalls from their assumptions, how quickly they change the assumptions.
And the consulting firms are not pushing them to do that at all. It’s very interesting. The consulting firms are telling them what they want to hear, which is hardly news to any of us. But it’s what’s taking place.
The second question about inventory write-offs. You know, that gets into the category entirely of big-bath charges, which are the tendencies of management, when some bad news is coming along, to try and put all the bad news that’s happened into a single quarter or a single year —and even to put the bad news that they are worried about happening in the future into that year.
And it’s — it leads to real deception in accounting. The SEC has tried to get quite tough on that, but my experience has been that managements that want to do it usually can find some ways to do it.
And managements, frequently, are more conscious of what numbers they want to report than they are of what has actually transpired in a given quarter or a given year.
CHARLIE MUNGER: Yeah, pension fund accounting is drifting into scandal by making these unreasonable investment assumptions. It’s — evidently, it’s part of the human condition that people extrapolate the recent past.
And so, since returns from common stocks have been high for quite a long period, they extrapolate that they will continue to be very high into the future. And that creates a lot of reported earnings, in terms of pension benefits, that aren’t available in cash and are likely not to be available at all.
And this is not a good idea, and it’s interesting how few corporate managements have just responded like Sam Goldwyn: “Include me out.”
You’d think more people would just say, “This is a scummy way to keep the books, and I will not participate.” Instead, everybody just drifts along with the tide, assisted by all these wonderful consultants.
WARREN BUFFETT: Yeah, I don’t think — I don’t know of any case in the United States right now, and I’m sure there are some, but except for the pension funds that we take over, I don’t know of any case where people are reducing their assumed investment return.
Now you’d think if interest rates drifted down several percentage points that that might affect what you would think would be earned with money. It certainly is to bond holders or to us with float or something of the sort.
But most major corporations, I believe, are using an investment return assumption of 9 percent or higher. And that’s with long-term governments below 6 percent, you know, and maybe high-grade corporates at 7.
They don’t know how to get it in the bond market. They don’t know how to get it in the mortgage market. I don’t think they know how to get it in the stock market. But it would cause their earnings to go down if they change their investment assumption.
And, like I say, I don’t know of a major company that’s thinking about it. And I don’t know of a major actuarial consultant that’s suggesting it to the managements. It just — they’d rather not think about it.
CHARLIE MUNGER: The way they’re doing things would be like living right on an earthquake fault that was building up stress every year and projecting that the longer it’s been without an earthquake the less likely an earthquake is to occur.
That is a dumb way to write earthquake insurance. (Laughter)
And the current practice is a dumb way to do pension fund planning and accounting.
WARREN BUFFETT: If you talk —
CHARLIE MUNGER: Dumb and improper.
WARREN BUFFETT: If you talk to a management or board of directors about that, you get absolutely no place.
CHARLIE MUNGER: No, they — their eyes would glaze over before the hostility came. (Laughter)