Buffett: Why Stocks Beat Bonds

"Right now bonds should come with a warning label." - Warren Buffett

There's a new column in Fortune Magazine by Warren Buffett well worth reading in its entirety.

In the column, which is an adaptation from his upcoming shareholder letter, Buffett writes about what he describes as the three major categories of investments.

Warren Buffett: Why stocks beat gold and bonds

Here's the first of three categories.

Category I: Currency-Based Investments (money-market funds, bonds, mortgages, deposits etc.)

Buffett makes the point that beta does not measure an investments riskiness. From the article:

"Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power..."

He then says that currency-based investments are often considered safe but they're actually quite dangerous.

"Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur."

...and the U.S. dollar?

It has fallen 86% since 1965 (when Buffett began running Berkshire).

Buffett goes on to make the point that 4.3% interest annually tax-free would be needed from bond investments since 1965 to just maintain purchasing power.

Of course, for most of us, interest is certainly not tax-free.

These days, many are willing to accept a 2% yield on 10-Year U.S. Treasury notes and, somehow for them, that's enough interest income to compensate for the risks.

Now, think of that interest income the same way you'd think about the earnings produced by a good business.

In effect, these investors are paying a price to "earnings" ratio of 50x (inverse of the 2% yield) for an investment that, unlike shares of a good business, has no possibility of any growth in the stream of income.

At 2%, the interest income is likely to prove inadequate when it comes to maintaining purchasing power in the long run. Inadequate compensation considering the risks.

In contrast, it's not hard to find businesses with shares selling at a price to earnings ratio of 12-14x and, in some cases, even less. With the better businesses, there's a more than a reasonable probability they'll produce returns that maintain purchasing power and then some.

As always, the key is buying the shares with an appropriate margin of safety.

Of course, unlike a 10-Year U.S. Treasury note, a business usually pays out only a portion of earnings as an explicit dividend but the part not paid out is obviously no less real.

The question always is how intelligently the part that is not paid out is put to work. As long those retained dollars are consistently put to high return use by management*, the economic value created will increase shareholder value. It should also enhance the capacity for meaningful dividend growth for most businesses.

Good businesses, those with durable competitive advantages, can produce a rising stream of earnings over time yet require only modest incremental capital investment.

The best have pricing power and, as a result, a built in capacity to offset the inevitable degradation of a paper currency.

Despite the relative undesirability of currency-based investments, Buffett still makes the point that it's wise to always have ample liquidity. For Berkshire, that is at least $ 10 billion in something like U.S. Treasury bills though the company generally has much more on hand.

The thinking that fluctuation equates to risk or that shares of a good business bought at a reasonable price relative to value is somehow more risky than currency-based investments is just plain flawed.

Check out the column for Buffett's thoughts on the other two major investment categories.

Adam

* Far from a certainty so better to own businesses run by capable management with sound capital allocation skills. Investors need management that knows when it'd better to return money to shareholders versus the pursuit of low return projects or acquisitions that may be more about expanding the business empire, less about shareholders returns.
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Buffett: Why Stocks Beat Bonds
Buffett: Why Stocks Beat Bonds
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