As I wrote a few days ago, Warren Buffett (Trades, Portfolio) published his latest annual letter for shareholders of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) over the weekend. On Monday, as has become his custom, he appeared on CNBC to discuss some of the main points of his letter. As someone who finds financial history of great interest (as all investors should), this particular part of the interview stood out to me.
Lessons from history
In his letter, Buffett talked about a man named Edgar Lawrence Smith, an economist who in 1924 published a book called "Common Stocks as Long Term Investments." Smith set out to prove that bonds were superior to stocks, but while carrying out his research, he found that he had it exactly backward - it turned out that stocks had historically outperformed bonds over the long term because the issuing companies reinvest their profits back into themselves, thus benefiting from compound interest. This may seem obvious to you and me today, but at the time it was apparently a revelation.
Incidentally, I’ve mentioned previously how striking it is that in Graham and Dodd’s "Security Analysis," the authors express a consistent preference for bonds over common stocks. In the past, I’ve chalked that up to the fact that securities used to be less well-regulated than they are today, so the idea of buying an instrument that could end up yielding nothing (if the issuing company turned out to be fraudulent) seemed a lot more risky.
Combine this with the fact that at the time Graham and Dodd were writing, many people still probably believed stocks would return more than bonds - particularly those who had lost money in the recent 1929 stock market crash - and it’s easy to see why they felt this way.
Of course, Buffett’s Berkshire Hathaway does not pay dividends, choosing instead to reinvest all profits back into its subsidiary businesses. Clearly the Oracle of Omaha took Smith’s recommendations to heart.
A good idea?
During the interview, Buffett was asked whether this strong argument for stocks over bonds could have led to the manic bull run of the late 1920s. He said:
“My old boss Ben Graham told me very early on: 'You can get into more trouble with a good idea than a bad idea,' because the good idea works. It’s a good idea to buy a home, for example. And then people go crazy sometimes. A good idea works and it works and it works. Stocks work out better than bonds most of the time. And after a while, people forgot that there were some other limiting conditions.”
So when Smith was writing his book, stocks were yielding roughly the same as bonds in percentage terms. When more people started buying these equities, however, the price started to rise, and consequently the yield fell. So this is the main takeaway: price matters, and nothing is ever so good that it is a buy at any price, nor so bad that it can’t be good value at a low enough one.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Seth Klarman: First, Don't Lose Money
- Warren Buffett and the Problem of Executive Compensation, Pt. 2​
- Warren Buffett and the Problem of Executive Compensation, Pt. 1
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