NOVEMBER 22, 1999

FORTUNE

The most celebrated of investors says stocks can't possibly meet the public's expectations. As for the Internet? He notes how few people got rich from two other transforming industries, auto and aviation.

Mr. Buffett on the
Stock Market

l¥wren Buff'etl. chaimwn of Berkshire Hatha~t~ay, almost never talks publicly abolllthe generallel'e! of stock prices- neither in

his famed amw.al report norm Berkshire~· thronged annual meetings nor in the rare speeches Ire gi11es. But in the past few nwnlhs, on four occasions, Buj}'ell did step up to that .whject, laying out his opinions. in ways both analytical and crcatiFe, about the long-tam future for stocks. FORTUNE's Carol
Loornis heard lhe last of those talks, gi1•en in September to a group ojBuffett's jiiends (of whom site is one). and also watchul a videotape ofthe first speech, given in July at Allen &
Co. 's Sun Valley, Idaho. bash for business leaders. From those

extemporaneous talks (the first made with the Dow Jones indu.\·trial rlverage at 1 J./9.J), Loomis distilled the following account of what Buff wid. Buffett re1•iewed if and weighed in with ett some clarifications.

nvestors in stocks these days arc expecting far too much, and I'm going to explain why. T hat wil l inevitably set me to talking about the genera l stock market, a subject I' m usua lly unwilling to discuss. But I want to make one thing clear going in: Though I will be talki ng about the level of the ma rket , I will not be predicting its next moves. At
Berkshi re we focus almost exclusively on the valuations of individual companies, looking only to a very lim ited extent at the valuation of the overall market. Even the n, valuing the market has nothing to do wit h where it's going to go next week or

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next month or next year, a line of thought we never get into. T he

fac t is that markets behave in ways, somet imes for a very lo ng stretch, that are no t linked to value . Sooner or later, though, val ue counts. So what I am going to be saying-assuming it's correct-will have implications for the long-term results to be realized by American stockholders.
Let's start by defining "investing." The definition is simple

but often forgotten: Investing is laying o ut money now to get more money back in the fut ure- more money in real terms, after taking inflation into account.

Now, to get some h istorical perspective, let's look back at the
34 years before this one-a nd here we are going to see analmost Biblical kind of symmetry, in the sense o f lean years and

fat years-to observe what happened in the stock market. Take, to begin with, the first 1 years o f the period, from the end of
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1964 th rough 1981. Here's what took place in that interval:

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DOW JONES INDUSTRIAL AVERAGE
Dec. 3 1, 1964: 874. 12
Dec. 31 , 1981: 875.00

Now I'm known as a long-term investor and a patient guy, but that is not my idea of a big move.
And here's a major and ve ry op posite fact: During that same
17 years, the GDP of the U.S.- that is, the business being done in this country-almost quintupled, rising by 370% . Or, if we look at another measure, the sales of the FORTUNE 500 (a changing mix of compan ies, of course) more than sextupled.
And yet the Dow went exactly nowhere.
To understand why that happened, we need first to look at one of the two important variables that affect investment re sults: interest rates. These act on financial valuations the way gravity acts on matter: T he higher the rate, t he greater the downward pull. T hat's because the rates of return that investors need from any kind o r investment are directly tied to t he riskfree rate that t hey can earn from government securities. So if the government rate rises, t he prices of all other investments must adjust downward, to a level that brings their expected rates of ret urn into line. Conversely, if government interest rates fa ll, the move pushes the prices of all other investments upward. The basic proposition is this: W hat an investor should pay today for a dollar to be received tomorrow can only be de-

termined by first looking at the risk-free interest rate.
Consequently, every time t he risk-free rate moves by one basis point- by 0.01o/o--the value of every investment in the country changes. People can see this easily in the case of bonds, whose value is normally affected o nly by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the

effect of interest rate changes is usually obscured. Nonetheless, the effect- like the invisible pull of gravity- is constantly there.
In the 1964-81 period, there was a tremendous increase in the rates on long-te rm government bonds, which moved from

just over 4% at year-end 1964 to more than 15% by late 1981.
That rise in rates had a huge depressing effect on the value o f all investments, but t he one we noticed, of course, was the price of equit ies. So there-in that tripling of the gravitational pull of interest rates-lies the major explanation o f why tremendo us growth in the econo my wa accompanied by a stock market go ing nowhere.

T hen. in the early 1980s, the situation reversed itself. Y u will o re member Paul Volcker com ing in as chairman of the Fed and remember also how un popular he was. Butt he heroic things he did-his taking a two-by-fou r to the econo my and breaking the back of inflation--{;llused the interest rate trend to reverse, with some rather spectacular results. Le t's say you put $1 million into the 14% 30-year U. S. bond issued Nov. 16, 1981, and reinvested the coupons. That is, every time you got an interest payment, yo u used it to buy more of that same bond . A t the end of 1998, wit h long-term gove rnments by then selling at 5 %, you would have had $8, 18 1,219 and wou ld have earned an annu al return of more than 13%.
That 13% annua l return is better than stocks have done in a great many 17-year periods in history- in most 17-ycar periods, in fact. It was a helluva result, and from none ot her than a stodgy bo nd.
The power o f interest rates had the effect of pushing up equi ties as well, t hough ot her things that we will get to pushed additio nally. And so here's what equ ities did in t hat same 17 years:
If you'd invested $ 1 million in the Dow o n Nov. 16, 198 1, and re invested all dividends, you'd have had $ 19,720, 112 on Dec. 31 ,
1998. A nd your annual retu rn wo uld have been 19% .
T he increase in equity values since 1981 beats anyth ing you can find in history. This increase even surpasses what you would have realized if yo u'd bough t stocks in 1932, at their Depression bo ttom-on its lowest day, July 8, 1932, the Dow closed at

41.22-and held them for 17 yea rs.
The second thi ng bearing on stock prices d uring this 17 years was after-tax corporate profits, which th is chart Iabove! displays as a percentage of GOP. In effect, what this cha rt tells you is what portion o f the GOP ended up every year with the shareho lders o f A merican business.
The chart, as you will see, starts in 1
929. I'm qu ite fond of 1929, since that"s when it all began for me. My dad was a stock sales-

man at the time, and after the C rash came, in the fall , he was

a fraid to call anyone-all those people who'd been burned. So he just stayed home in the afternoons. And there wasn't television then . Soooo .. . I was conceived on or about Nov. 30, 1929
(and bo rn nine months later, on Aug. 30, 1930), and I've forever had a kind o f warm feeling about the Crash.
As you can see, corporate profit s as a percentage of GOP peaked in 1929, and then they ta nked. The left-ha nd side of the chart, in fact, is filled with aberrations: not on ly the Depressio n but also a wartime profits boom-sedated by the excess-profits tax- and a nother boom after the war. But from 1951 on, the percentage settled down prcn y much to a 4% to 6.5% range .
By 198 1, though, the trend was headed towa rd the bottom of that band, a nd in 1982 profits tumbled to 3.5%. So al tha! point investors were lo oking at two strong negatives: Profits were sub-par and int erest rates were sky-high.
A nd as is so typical , investors projected out into the future what they we re seeing. T hat 's their unshakable habit: looking into the rear-view mirror instead of through the windshield.
W hat they were observing, looking backward, made them very discouraged abou t the country. They were projecting high interest rates, they were projecting low profits, and they were therefore valuing the Dow at a level that was the same as 17 years earlier, even though G OP had nearly quintupled.
Now, what hap pened in the 17 years begin ning wit h 1982?
O ne th ing that did n't happen was comparable growth in G OP:
In this second 17-ycar period, GOP less than tripled. But interest rates began their descent, and after the Volcker effect wore off. profi ts began to climb-no t steadily, but nonetheless wit h real power. You can sec the profit trend in the chart , which shows that by the late 1990s, after-tax profits as a percent of
G OP were ru nning close to 6%, which is on the upper part o f the " no rmalcy" band. And at the end of 1998, lo ng-term gov-

ernment interest rates had made their way down to t hat 5%.
These dramatic changes in the two fund amentals that matter most to investors explain much, though not all, of the more

than tenfold rise in equity prices-the Dow went from 875 to
9. 181- during t his 17-year period. What was at work also, o f course, was market psycho logy. Once a bull market gets under way, and once you reach the point where everybody has made money no matter what system he or she followed, a crowd is at-

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T H E MARKET tracted into the game that is responding not to interest rates offset here is that the companies are just about as husy issu ing and profits but si mply to the fact that it seems a mistake to be new stock, both through primary offerings and those ever preout of stocks. In effect, these people superimpose a n !-can 't- sent stock options. m iss-the-party factor on top of the fundamental factors that
So I come back to my postulat ion of 5% growth in G OP and drive the market. Like Pavlov's dog, these " investors" learn rem ind you that it is a limiting factor in the returns you're gothat when the bell rings-in this case, the one that opens the ing to get: You canno t expect to forever realize a 12% annua l
New York Stock Exchange at 9:30 A.M.-t hey get fed. Through increase -much less 22%- in the valuation of American busithis daily reinforcement, they become convinced that there is a ness if its profitability is growing only at 5% . The inescapable fact is that the value of an asset, whatever its character, can not
God and that He wan ts them to get rich.
Today, sta ring fixedly back at the road they just traveled, over the long term grow faster than its earnings do. most investors have rosy expectations. A Paine Webber and
Now, maybe you'd like to argue a different case. Fair enough.
Gallup Organizat ion sur vey released in July shows that the But give me your assumptions. If you think the A merican publeast experienced investors-those who have invested for less lic is going to make 12% a year in stocks, I think you have to say, than five years-expect annual returns over the next ten years for example, "Well, that's because I expect GOP to grow at 10% of22.6 %. Even those who have invested for more than 20 years a year,