Buffett's 10% Hurdle

Implications of the guru's hurdle rule

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Nov 08, 2019
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Towards the end of the afternoon session of the 2003 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholder meeting, Patrick Wolff asked Warren Buffett (TradesPortfolio) and Charlie Munger (TradesPortfolio) the following question:

"In the annual report you say explicitly that you look for a 10 percent pretax return on equity, in looking at common stocks. How do you adjust that required rate of return across periods of time? For example, when interest rates are higher. Do you look for a different equity premium return over different period of time?"

Buffett answered this way:

"The question on opportunity costs and the 10 percent we mention. That’s the figure we quit on. We don’t want to buy equities where our real expectancy is below 10 percent. That’s true whether short rates are 6 percent or whether short rates are 1 percent. We just feel that it would get very sloppy to start dipping below that. We feel also that we will get opportunities that are at least that level, and perhaps substantially above. I will bet you that a lot of years in the future, we will be able to find equities that you understand, or we understand, and that have the probability of returns at 10 percent or greater."

Munger added:

"In the last analysis, everything we do comes back to opportunity cost. But it, to some considerable extent – we are guessing at our future opportunity cost. Warren is basically saying that he’s guessing that he’ll have opportunities in due course to put out money at pretty attractive rates of return, and therefore, he’s not going to waste a lot of firepower now at lower returns. But that’s an opportunity cost calculation. And if interest rates were to more or less permanently settle at 1 percent or something like that, and Warren were to appraise his notions of future opportunity cost, he would change the numbers."

Fast-forward to 2017, somebody asked the following question: “At what rate has Berkshire compounded intrinsic value over the last 10 years? And at what rate, including your explanation for it please, do you think intrinsic value can be compounded over the next 10 years?”

Buffett thusly answered:

"Intrinsic value can only be calculated in retrospect. But the intrinsic value pure definition would be the cash to be generated between now and judgment Day, discounted at an interest rate that seems appropriate at the time. And that’s varied enormously over a 30 or 40-year period.

If you pick out 10 years, and you’re back to May of 2007, we had some unpleasant things coming up. But I would say that we’ve probably compounded it at about 10 percent.

And I think that’s going to be tough to achieve, in fact almost impossible to achieve, if we continued in this interest rate environment.

That’s the number one. If you asked me to give the answer to the question, if I could only pick one statistic to ask you about the future before I gave the answer, I would not ask you about GDP growth. I would not ask you about who was going to be president. I would ask you what the interest rate is going to be over the next 20 years on average, the 10-year or whatever you wanted to do.

And if you assume our present interest rate structure is likely to be the average over 10 or 20 years, then I would say it’d be very difficult to get to 10 percent.

On the other hand, if I were to pick with a whole range of probabilities on interest rates, I would say that that rate might be — it might be somewhat aspirational. And it might well — it might be doable.

I do not think it’s easy to predict the course of interest rates at all. And unfortunately, predicting that is embedded in giving a good answer to you. I would say the chances of getting a terrible result in Berkshire are probably as low as about anything you can find. Chance of getting a sensational result are also about as low as anything you can find. So my best guess would be in the 10 percent range, but that assumes somewhat higher interest rates — not dramatically higher — but somewhat higher interest rates in the next 10 or 20 years than we’ve experienced in the last seven years."

There are a few interesting messages from the above:

  1. A 10% pre-tax rate of return is a filter Buffett and Munger use, just like the four general filters they use in evaluating an investment. It’s a mental short cut to filter out companies that might sound interesting but are not worth their time. This is different from a low price-earnings ratio / low price-book ratio approach, where opportunity cost is missing.
  2. In 2003, while Buffett was saying the 10% hurdle would be the same whether the short rates are 6% or 1%, Munger actually pointed out that there might be a chance that interest rates may settle permanently at 1%, in which case Buffett should reappraise his opportunity cost. Munger’s words turned out to be prescient.
  3. From 2007 to 2017, Berkshire has only compounded its intrinsic value at about 10% a year, a subpar performance that has caused Wedgewood Partner’s David Rolfe (Trades, Portfolio) to decide to part ways with Berkshire. Buffett did reappraise the situation and admits that the combination of size and low interest rates makes 10% almost impossible to achieve.

At the end of the third quarter, $128 billion in cash and cash equivalents are sitting on Berkshire’s balance sheet. It’s an astonishing amount of dry powder. I would imagine it’s hard for Buffett to accept anything less than 10% pre-tax return even in this low rates environment, so he might very well be patiently waiting for big opportunities to come. The important question we need to ask is whether a less than 10% rate of return is acceptable for existing Berkshire shareholders. For Wedgewood’s Rolfe, the answer is no. And for Bill Ackman (Trades, Portfolio), the answer is yes. I don’t think there is a right or wrong answer here. It depends on your own opportunity cost.

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