At the 2000 Berkshire Hathaway (BRK.A, BRK.B) shareholder meeting, Charlie Munger and Warren Buffett were asked about the potential impact of changes in demographics on the expected future performance of equity ownership. Here’s what they said (edited for clarity and brevity):
Munger: “Well, generally, you can say that stocks are valued in two different ways. One, they’re valued much the way wheat is valued, in terms of its perceived practical utility to the user of the wheat. And there’s a second way that stocks are valued, which is the way Rembrandts are valued. And to some extent, Rembrandts are valued high, because in the past, they’ve gone up in price. And once you get a lot of Rembrandt element into the stock market, and you fuel the stock market with massive retirement system purchases, you can get stocks selling at very high prices by past historical standards. And that can go on for a long, long time. That’s what makes life so interesting. It isn’t at all clear how it’s going to work out. It isn’t even clear what the level of interest rates is going to be. Nobody in this room ever expects to see 3% interest rates continue for a long time again. But that could happen. That would have an enormous effect on the price of equities. You live in a world where you can’t really predict these macroeconomic changes.”
Buffett: “You can argue that increases in savings will drive down the returns on capital. The more capital around, the lower the returns will be on capital. But I don’t think it will help you make any decisions about businesses over your lifetime by thinking about matters like that. We’re a little biased on that. But you’ll find all kinds of guys that will tell you, I mean, that’s what books are written about. Because everybody likes predictions.”
The question is logical. And it's one I've seen repeated in various forms over the years. The coming tsunami of baby boomers or millennials (as an example) often leads to predictions about what the impact will be on certain companies, industries or even the broader stock market. As Buffett noted, you can find plenty of books out there predicting what these developments will mean for investors in the years and decades to come.
Read more here:
The Importance of Proper Incentives
But as Buffett discussed in his testimony to the Financial Crisis Inquiry Commission (FCIC) in 2010, it’s in these kinds of situations where a seemingly sound idea can be pushed to extremes:
“My former boss Ben Graham made an observation 50 or so years ago that really stuck in my mind and now I’ve seen elements of it. He said you can get in a whole lot more trouble in investing with a sound premise than with a false premise. If you have some premise that the moon is made of green cheese or something, you know, it’s ridiculous on its face. If you come up with a premise that common stocks have done better than bonds and I wrote about this in a Fortune article in 2001. Because it was, there was a famous little book in 1924 by Edgar Lawrence Smith that made a study of common stocks versus bonds. He started out with the idea that bonds would over-perform during deflation and common stocks would over-perform during inflation. He went back and studied a whole bunch of periods and, lo and behold, his original hypothesis was wrong. He found that common stocks always over-performed. And he started to think about it and why was that. Well it was because there was a retained earnings factor. The dividend you got on stocks was the same as the yield on bonds and on top of that you had retained earnings. So they over-performed. That became the underlying bulwark for the 1929 bubble. People thought stocks were starting to be wonderful and they forgot the limitations of the original premise which was that if stocks were yielding the same as bonds that they had this going for them. So, after a while the original premise which becomes sort of the impetus for what later turns out to be a bubble is forgotten and the price action takes over.”
The demographics thesis – or really any broad industry growth thesis – often falls into this same trap. In addition to the fact that they can often be overstated, they are also missing part of the equation. I know this well because I learned this the hard way in my early days as an investor. One of the first companies I ever invested in was a solar panel manufacturer. I did so for a simple reason: Solar had secular tailwinds and was likely to be a growth industry for decades to come. But what I missed was that growth for an industry does not necessarily translate to economic success for any individual company – or even all of the companies – within that industry.
Looking back further, we’ve witnessed similar results in other industries like automobile manufacturing, airlines and railroads (some of those industries have since changed, with improved economics). More recently, we’ve seen similar phenomena in 3D printing, wearables, meal kits and (possibly) plant-based meat substitutes.People assume that growth for the industry will ultimately lead to economic success for the companies within it. But that isn't a given. History has clearly shown that in many instances the benefits have largely accrued to customers (or other places within the value chain), not the shareholders. Eventually, capital will show up and compete away attractive economics without the presence of sustainable competitive advantages.
Conclusion
While a tailwind of industry growth may be beneficial to an investment, it should never be the sole consideration. I’ll let Buffett have the last word:
“I think [Michael Porter] talks about durable or sustainable competitive advantages as being the core of any business. And I can tell you that that is exactly the way we think. If you are evaluating a business, the number one question you want to ask yourself is whether the competitive advantage have been made stronger and more durable; that’s more important than the P&L for a given year. And that is the key to investing. If you can spot that, particularly if you can spot it when others don’t spot it so well, you will do very well. And we focus on that… What we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle. And in essence, that’s what business is all about.”
Disclosure: Long Berkshire Hathaway.
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