Buffett – Stocks Can’t Outperform Businesses Indefinitely

When I finished The Snowball: Warren Buffett and the Business of Life I immediately downloaded all of the Berkshire Hathaway annual shareholder letters.  If you are new to Buffett (beyond reading what other’s think he is thinking on investment sites) I would recommend reading the two books in this order as it gives you an idea as to what is going on in his life.  Currently, I am re-reading The Snowball and am enjoying it even more the second time around now with the knowledge of those letters.

As part of this series I have already written about:

In Buffett’s 1986 Letter there is a section with a few concentrated thoughts that really really caught my attention.  The main point seems to be that the value of a stock versus the the earnings of the underlying business (a subject which highlights my shortcoming in being unable to stomach an investment in an unprofitable company).

Stocks Can only outperform Businesses for So Long

As you’ll see in a moment the actual crux of what caught my attention are just a few tiny sentences within a much larger picture.  Notwithstanding, I think it is reflective of where our market is today, and I hope to read this post back in a few years to remind myself.

During 1986, our insurance companies purchased about $700 million of tax-exempt bonds, most having a maturity of 8 to 12 years. You might think that this commitment indicates a considerable enthusiasm for such bonds. unfortunately, that’s not so: at best, the bonds are mediocre investments. They simply seemed the least objectionable alternative at the time we bought them, and still seem so. (Currently liking neither stocks nor bonds, I find myself the polar opposite of Mae West as she declared: “I like only two kinds of men – foreign and domestic.”)

We must, of necessity, hold marketable securities in our insurance companies and, as money comes in, we have only five directions to go: (1) long-term common stock investments; (2) long-term fixed-income securities; (3) medium-term fixed-income securities; (4) short-term cash equivalents; and (5) short-term arbitrage commitments.

Common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value – stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests. This statement in no way translates into a stock market prediction: we have no idea – and never have had – whether the market is going to go up, down, or sideways in the near- or intermediate term future.

What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

As this is written, little fear is visible in Wall Street. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely.Indeed, because of the heavy transaction and investment management costs they bear, stockholders as a whole and over the long term must inevitably underperform the companies they own. If American business, in aggregate, earns about 12% on equity annually, investors must end up earning significantly less. Bull markets can obscure mathematical laws, but they cannot repeal them.

Emphasis Added.  Since each one of the emphasized sentences can be an investment course unto themselves I will only add a few short thoughts.

This statement in no way translates into a stock market prediction: we have no idea – and never have had – whether the market is going to go up, down, or sideways in the near- or intermediate term future

This sentiment is often repeated throughout the letters.  I think a small part of it has to do with Buffett being modest, however, for the most part his stock or business “bets” are based on a holding period of forever.

Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful

How many times is this repeated the media?  Interesting to re-read it as the broad market hits new highs almost weekly!

Unfortunately, however, stocks can’t outperform businesses indefinitely.Indeed, because of the heavy transaction and investment management costs they bear, stockholders as a whole and over the long term must inevitably underperform the companies they own.

Really makes you wonder if the crazy P/Es that are out there today are truly reflective of possible future growth prospects.

4 Responses to Buffett – Stocks Can’t Outperform Businesses Indefinitely

  1. I have been stcking mostly to Market index ETFs. Who knows where the market is heading, but if you are not in, you lose. Statistics show you are better off buying at regular intervals than trying to time it.

    • Dollar cost averaging is so important. Even more so when you are looking at the 10, 20 or 30+ year time horizon. As far as the market index, I think that is way to go for most people who have zero interest in the research part of it all.

  2. Definitely high stock prices in this new normal economy. It can all be corrected with some bad media coverage for the high PE ratio companies. Buffett is smart because his track record is proof itself, that he knows how to pick the winners.

    • Not sure I believe that high stock prices are the new norm. Rather, I would say we are set for some type of wake up call in the markets.

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