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2005: Will higher commodity prices squeeze corporate profits?
AUDIENCE MEMBER: Good morning, gentlemen. My name is Matt Sauer (PH) and I’m from Durham, North Carolina.
Many businesses are reporting rising costs and surcharges on such inputs as fuel, metals, and wood. They are often unable to pass along these costs to their consumers.
If commodities stabilize at price levels above those of the past decade, will corporate margins be compromised into the future?
WARREN BUFFETT: Well, it’s a great question. I would say that that would depend very much on the industry you’re talking about.
But, in our carpet business [Shaw Industries], for example, we’ve just been hit time after time, as I mentioned in the annual report, with raw material increases, because there’s a big petroleum derivative factor there.
And we have lagged in terms of being able to put through those increases to our customers, simply because we want to protect the Nebraska Furniture Marts, or those that have ordered, for a reasonable period of time. And that squeezed margins in carpet.
We use lots of natural gas at Johns Manville, use lots of natural gas at Acme Brick, and that’s tended to squeeze margins some.
I think, over time — I think there has been a lot more inflation in these basic materials. Steel has been off the chart.
I think, over time the businesses with strong competitive positions manage to pass through increases in raw material costs, just as they passed through increases in labor costs.
But you get these temporary situations where, sometimes, the costs are increasing faster.
I don’t think — I don’t think the American industry — I mean, a higher cost for oil, when we import 10 million barrels a day or more of oil, if we’re paying $20-or-so more per barrel than we were a year or two ago, that’s $200 million a day, is a tax, but it’s more of a tax on the American consumer, probably, than on American business. The American business will probably be able to pass through most of those raw material cost increases.
It is worth pointing out that corporate profits, as a percentage of GDP, are right at the all-time high, leaving out a few aberrational periods.
And I would — you know, if I had to bet on the direction of corporate profits, as a percentage of GDP, over the next five years, I would bet they would go down somewhat. But that’s because they’re right at this very high level.
Interestingly enough, while corporate profits, as a percentage of GDP, are at this very high level, corporate taxes, as a percentage of total taxes raised in America, are very close to an all-time low.
So, American businesses managed to pull off a situation where they’re making extremely good profits and paying a very small percentage of the total tax bill, as measured in this country historically.
And I’m not sure whether that could, or should, or will continue, but it’s a very, very favorable period right now for corporate America.
But that’s nothing to get bullish about, because you might expect something of a reversion to the mean.
CHARLIE MUNGER: Well, I can’t add to that but I can restate it.
It’s hard to know just which companies can pass through the increases in costs that come from higher commodity prices. And it’s also important to know.
WARREN BUFFETT: We like buying businesses where we feel that there’s some untapped pricing power.
We haven’t been able to do much of that lately. But back in 1972, when we bought See’s Candy, I think it was either — was it $1.95 a pound?
CHARLIE MUNGER: Something like that.
WARREN BUFFETT: Yeah. And they were selling 16 million pounds of candy a year, making four million pretax, with about 25 million purchase price, which I would have very foolishly refused to budge on, and in history have cost us a lot of money.
But one of the questions we asked ourselves, and we thought the answer was obvious, was, you know, if we raised the price 10 cents a pound, would sales fall off a cliff?
And of course, the answer, in our view at least, was that no, there was some untapped pricing power in the product.
And it’s not a great business when you have to have a prayer session before you raise your prices a penny. I mean, you were in a tough business then.
And I would say you can almost measure the strength of a business over time by the agony they go through in determining whether a price increase can be sustained.
And frankly, a good example of that is the newspaper business right now. Because 30 years ago, when the — whatever the local daily would be had an absolute lock on the economics of the community, because it had the megaphone through which merchants had to talk if they were going to get their message across to their audience — at that time, rate increases, both circulation and advertising, were something that were almost a big yawn to most publishers.
They did it annually. They did not worry about the fact that Sears or Walmart or Penney’s or whomever would pull their advertising. They did not worry that people would drop their subscriptions to the paper.
And they went merrily along, increasing prices, and they increased them when newsprint went up and they increased them when newsprint went down, and it worked.
And you got these very fat profit margins. And it looked like about as strong a business as you can imagine.
Now publishers find themselves in a position where they agonize over rate increases, both in advertising and in circulation, because they’re worried about driving away advertisers into other media.
And they’re worried about people, when they get a 20 cent increase, you know, per month, or whatever it may be, in their circulation prices, deciding, well, I think I’ll just drop it. And when they drop it they don’t usually take it up again.
So, that world has changed. And you could recognize the change in that world, simply, if you could get inside the mind of the publisher, in terms of how they felt about price increases.
You can learn a lot about — you learn a lot about the durability of the economics of a business by observing the behavior of — the price behavior.
I mean, you’re seeing that — talk about the beer business. Beer has moved up in price every year, but there have been some rollbacks in certain areas in the last year, which means that, you know, it’s getting a little bit more difficult to increase prices, even though they increase them at rates below inflation.
And those are not — that’s not a good economic sign.
CHARLIE MUNGER: I have nothing to add to that.