Warren Buffett’s recent column on Fortune Magazine has a controversial title “Why stocks beat gold and bonds” and caught many eyeballs. But if one read into the article, one would know that Warren Buffett didn’t mean to promote stocks. The phrase he used was “productive assets”.
My personal experience as a writer is that editors are more than willing to change the title of articles for the sake of attracting eyeballs. Although I didn’t see such thing with GuruFocus, I saw a lot of complaint in other places. The article is from Buffett, but the title could probably be cooked up by Fortune’s editors. They know that people like to jump on to this title and start to debate right away. And for a media company, mouse clicks are real money.
In Buffett’s own words:
“My own preference -- and you knew this was coming -- is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola (KO, Financial), IBM (IBM, Financial), and our own See's Candy meet that double-barreled test. Certain other companies -- think of our regulated utilities, for example -- fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.”
Buffett followed the same logic to discuss the three asset classes in his article: bond, gold, and productive assets. He defined “investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power -- after taxes have been paid on nominal gains -- in the future”. There are two buckets to evaluate: the increase (or decrease if unlucky) of the value of the asset, and the annual return the asset generates.
Treasury bonds are safe investment because the federal government guarantees to return all the money back to investors when the bonds mature. In other words, the value of the asset won’t suffer a decrease. Of course investors won’t enjoy any increase either. Treasury bonds also pay interest each year. The problem is that the yield is so low nowadays and could hardly compensate inflation.
Some investors view bonds a safe harbor to park money temporarily during this trying time. They will move the money to offensive assets when time is good. But the catch is that investors receive all their money back only if they hold the bonds to maturity. If they want their money sooner, they can sell the bonds in the market. But remember that price goes the opposite direction of yield. If yield rises, price will drop and investors will suffer a loss. With yield at historical low, what is the chance the yield will drop, or hold steady in the future?
If bond is the north polar, then gold must be the south polar. Gold generates no annual return. Even worse, it may charge investors an annual fee to hold it. Unless an investor buys physical gold and stashes it under mattress, he needs to pay someone else for storage, or pay a fee at 0.4% expense ratio if he buys and holds the popular ETF SPDR Gold Shares (GLD).
What attracts investors is the continuous appreciation of the value of gold. In dollar terms, gold appreciated 160% in the past 5 years, and 270% in the past 10 years. By contrast, the market as represented by the S&P 500 index generated a negative return in the past 5 years, and only less then 20% in the past 10 years.
But why gold kept appreciating? Buffett pointed out that it is because people know they can sell it to others for a better price. It behaves a lot like tulips in the 17th century. People kept buying it because they knew they could sell for a better price. The buying power pressured the price up until the last fool came in and couldn’t find anyone else to buy. The price crashed. In the end, someone got a lot richer and someone lost their shirts. It’s a typical speculative, zero-sum game where the only thing happened was wealth transfer.
To better understand it we need to go one step further to know what support the value of an asset class. To summarize, the value of an asset class is supported by
The third is a common attribute shared by productive assets, Buffett’s favorite. Note that this links the first bucket (value appreciation) to the second bucket (earnings power) we mentioned at the beginning. Think about a piece of farm land. A buyer wants to pay a price for it because the land can produce corns or raise cows until the end of the world. For whatever the price the buyer pays, the buyer is guaranteed to earn the money back in foreseeable future. A piece of real estate is the same.
A better investment in this category is (a portion of) a company generating growing returns. Not only the investor is rewarded by more profit each year, he is able to sell the company for a higher price in the future because five year down the road the company will produce more profit than it does now. Buffett named a couple of companies in his article, IBM (IBM) and Coca-Cola (KO).
It pays to distinguish between stocks and productive assets. Some companies, such as Research In Motion (RIMM), generate diminishing returns. They belong to productive assets but certainly not good ones. As a result, their stock prices --- the value of the asset --- kept falling.
There are also companies whose stocks are purely speculative. For example a bio-tech whose “block-buster” is waiting for FDA’s approval. In this phase, the company generates no sales and no earnings. Thus it produces nothing for the investor. Its stock price is supported by the expectation that its new drug will win FDA’s approval. It is a binary bet for speculators. FDA’s decision determines the zero-sum wealth-transfer between those who long the stock and who short it.
The right message conveyed by Buffett’s article is to pick and hold stocks of good companies over bonds and gold. The message is certainly not in the title.
My personal experience as a writer is that editors are more than willing to change the title of articles for the sake of attracting eyeballs. Although I didn’t see such thing with GuruFocus, I saw a lot of complaint in other places. The article is from Buffett, but the title could probably be cooked up by Fortune’s editors. They know that people like to jump on to this title and start to debate right away. And for a media company, mouse clicks are real money.
In Buffett’s own words:
“My own preference -- and you knew this was coming -- is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola (KO, Financial), IBM (IBM, Financial), and our own See's Candy meet that double-barreled test. Certain other companies -- think of our regulated utilities, for example -- fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.”
Buffett followed the same logic to discuss the three asset classes in his article: bond, gold, and productive assets. He defined “investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power -- after taxes have been paid on nominal gains -- in the future”. There are two buckets to evaluate: the increase (or decrease if unlucky) of the value of the asset, and the annual return the asset generates.
Treasury bonds are safe investment because the federal government guarantees to return all the money back to investors when the bonds mature. In other words, the value of the asset won’t suffer a decrease. Of course investors won’t enjoy any increase either. Treasury bonds also pay interest each year. The problem is that the yield is so low nowadays and could hardly compensate inflation.
Some investors view bonds a safe harbor to park money temporarily during this trying time. They will move the money to offensive assets when time is good. But the catch is that investors receive all their money back only if they hold the bonds to maturity. If they want their money sooner, they can sell the bonds in the market. But remember that price goes the opposite direction of yield. If yield rises, price will drop and investors will suffer a loss. With yield at historical low, what is the chance the yield will drop, or hold steady in the future?
If bond is the north polar, then gold must be the south polar. Gold generates no annual return. Even worse, it may charge investors an annual fee to hold it. Unless an investor buys physical gold and stashes it under mattress, he needs to pay someone else for storage, or pay a fee at 0.4% expense ratio if he buys and holds the popular ETF SPDR Gold Shares (GLD).
What attracts investors is the continuous appreciation of the value of gold. In dollar terms, gold appreciated 160% in the past 5 years, and 270% in the past 10 years. By contrast, the market as represented by the S&P 500 index generated a negative return in the past 5 years, and only less then 20% in the past 10 years.
But why gold kept appreciating? Buffett pointed out that it is because people know they can sell it to others for a better price. It behaves a lot like tulips in the 17th century. People kept buying it because they knew they could sell for a better price. The buying power pressured the price up until the last fool came in and couldn’t find anyone else to buy. The price crashed. In the end, someone got a lot richer and someone lost their shirts. It’s a typical speculative, zero-sum game where the only thing happened was wealth transfer.
To better understand it we need to go one step further to know what support the value of an asset class. To summarize, the value of an asset class is supported by
- Warranty from the government or debt issuers
- Speculation that others will buy for a better price
- Its earnings power to generate (a growing) annual return
The third is a common attribute shared by productive assets, Buffett’s favorite. Note that this links the first bucket (value appreciation) to the second bucket (earnings power) we mentioned at the beginning. Think about a piece of farm land. A buyer wants to pay a price for it because the land can produce corns or raise cows until the end of the world. For whatever the price the buyer pays, the buyer is guaranteed to earn the money back in foreseeable future. A piece of real estate is the same.
A better investment in this category is (a portion of) a company generating growing returns. Not only the investor is rewarded by more profit each year, he is able to sell the company for a higher price in the future because five year down the road the company will produce more profit than it does now. Buffett named a couple of companies in his article, IBM (IBM) and Coca-Cola (KO).
It pays to distinguish between stocks and productive assets. Some companies, such as Research In Motion (RIMM), generate diminishing returns. They belong to productive assets but certainly not good ones. As a result, their stock prices --- the value of the asset --- kept falling.
There are also companies whose stocks are purely speculative. For example a bio-tech whose “block-buster” is waiting for FDA’s approval. In this phase, the company generates no sales and no earnings. Thus it produces nothing for the investor. Its stock price is supported by the expectation that its new drug will win FDA’s approval. It is a binary bet for speculators. FDA’s decision determines the zero-sum wealth-transfer between those who long the stock and who short it.
The right message conveyed by Buffett’s article is to pick and hold stocks of good companies over bonds and gold. The message is certainly not in the title.
