esting 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. More succinctly, investing is forgoing consumption now in
order to have the ability to consume more at a later date.
From our definition there flows an important corollary: The
riskiness of an investment is
not measured by beta (a Wall
Street term encompassing volatility and often used in measuring
risk) but rather by the probability -- the
reasoned
probability -- of that investment causing its owner a loss of
purchasing power over his contemplated holding period. Assets can
fluctuate greatly in price and not be risky as long as they are
reasonably certain to deliver increased purchasing power over their
holding period. And as we will see, a nonfluctuating asset can be
laden with risk.
Investment possibilities are both many and varied. There are three
major categories, however, and it's important to understand the
characteristics of each. So let's survey the field.
Investments that are denominated in a given currency include
money-market funds, bonds, mortgages, bank deposits, and other
instruments. Most of these currency-based investments are thought
of as 'safe.' In truth they are among the most dangerous of assets.
Their beta may be zero, but their risk is huge.
Over the past century these instruments have destroyed the
purchasing power of
investors
in many countries, even as these holders continued to receive
timely payments of interest and principal. This ugly result,
moreover, will forever recur. Governments determine the ultimate
value of money, and systemic forces will sometimes cause them to
gravitate to policies that produce inflation. From time to time
such policies spin out of control.
Even in the U.S., where the
wish for a stable currency is strong, the dollar has fallen a
staggering 86% in value since 1965, when I took over management of
Berkshire. It takes no less than $7 today to buy what $1 did at
that time. Consequently, a tax-free institution would have needed
4.3% interest annually from bond investments over that period to
simply maintain its purchasing power. Its managers would have been
kidding themselves if they thought of
any portion of that
interest as 'income.'
For taxpaying investors like you and me, the picture has been far
worse. During the same 47-year period, continuous rolling of U.S.
Treasury bills produced 5.7% annually. That sounds satisfactory.
But if an individual investor paid personal income taxes at a rate
averaging 25%, this 5.7% return would have yielded
nothing
in the way of real income. This investor's visible income tax would
have stripped him of 1.4 points of the stated yield, and the
invisible inflation tax would have devoured the remaining 4.3
points. It's noteworthy that the implicit inflation 'tax' was more
than triple the explicit income tax that our investor probably
thought of as his main burden. 'In God We Trust' may be imprinted
on our currency, but the hand that activates our government's
printing press has been all too human.
High interest rates, of course, can compensate purchasers for the
inflation risk they face with currency-based investments -- and
indeed, rates in the early 1980s did that job nicely.
Current rates, however, do not come close to offsetting the
purchasing-power risk that investors assume. Right now bonds should
come with a warning label.
Warren Buffett: Your pick for Businessperson of the Year
Under today's conditions, therefore, I do not like currency-based
investments. Even so, Berkshire holds significant amounts of them,
primarily of the short-term variety. At Berkshire the need for
ample liquidity occupies center stage and will
never be
slighted, however inadequate rates may be. Accommodating this need,
we primarily hold
U.S.
Treasury bills, the only investment that can be counted on for
liquidity under the most chaotic of economic conditions. Our
working level for liquidity is $20 billion; $10 billion is our
absolute minimum.
Beyond the requirements that liquidity and regulators impose on us,
we will purchase currency-related securities only if they offer the
possibility of unusual gain -- either because a particular credit
is mispriced, as can occur in periodic junk-bond debacles, or
because rates rise to a level that offers the possibility of
realizing substantial capital gains on high-grade bonds when rates
fall. Though we've exploited both opportunities in the past -- and
may do so again -- we are now 180 degrees removed from such
prospects. Today, a wry comment that Wall Streeter Shelby Cullom
Davis made long ago seems apt: 'Bonds promoted as offering
risk-free returns are now priced to deliver return-free
risk.'
The second major category of investments involves assets that will
never produce anything, but that are purchased in the buyer's hope
that someone else -- who also knows that the assets will be forever
unproductive -- will pay more for them in the future. Tulips, of
all things, briefly became a favorite of such buyers in the 17th
century.
This type of investment requires an expanding pool of buyers, who,
in turn, are enticed because they believe the buying pool will
expand still further. Owners are
not inspired by what the
asset itself can produce -- it will remain lifeless forever -- but
rather by the belief that others will desire it even more avidly in
the future.
The major asset in this
category is gold, currently
a huge favorite of investors who fear almost all other assets,
especially paper money (of whose value, as noted, they are right to
be fearful). Gold, however, has two significant shortcomings, being
neither of much use nor procreative. True, gold has some industrial
and decorative utility, but the demand for these purposes is both
limited and incapable of soaking up new production. Meanwhile, if
you own one ounce of gold for an eternity, you will still own one
ounce at its end.
What motivates most gold purchasers is their belief that the ranks
of the fearful will grow. During the past decade that belief has
proved correct. Beyond that, the rising price has on its own
generated additional buying enthusiasm, attracting purchasers who
see the rise as validating an investment thesis. As 'bandwagon'
investors join any party, they create their own truth --
for a
while.
Over the past 15 years, both
Internet
stocks and
houses
have demonstrated the extraordinary excesses that can be created by
combining an initially sensible thesis with well-publicized rising
prices. In these bubbles, an army of originally skeptical investors
succumbed to the 'proof ' delivered by the market, and the pool of
buyers -- for a time -- expanded sufficiently to keep the bandwagon
rolling. But bubbles blown large enough inevitably pop. And then
the old proverb is confirmed once again: 'What the wise man does in
the beginning, the fool does in the end.'
Today the world's gold stock is about 170,000 metric tons. If all
of this gold were melded together, it would form a cube of about 68
feet per side. (Picture it fitting comfortably within a baseball
infield.) At $1,750 per ounce -- gold's price as I write this --
its value would be about $9.6 trillion. Call this cube pile
A.
Let's now create a pile B costing an equal amount. For that, we
could buy
all U.S. cropland (400 million acres with output
of about $200 billion annually), plus 16 Exxon Mobils (the world's
most profitable company, one earning more than $40 billion
annually). After these purchases, we would have about $1 trillion
left over for walking-around money (no sense feeling strapped after
this buying binge). Can you imagine an investor with $9.6 trillion
selecting pile A over pile B?
Beyond the staggering
valuation given the existing stock of gold, current prices make
today's annual production of gold command about $160 billion.
Buyers -- whether jewelry and industrial users, frightened
individuals, or speculators -- must continually absorb this
additional supply to merely maintain an equilibrium at present
prices.
A century from now the 400 million acres of farmland will have
produced staggering amounts of corn, wheat, cotton, and other crops
-- and will continue to produce that valuable bounty, whatever the
currency may be. Exxon Mobil (
XOM) will
probably have delivered trillions of dollars in dividends to its
owners and will also hold assets worth many more trillions (and,
remember, you get
16 Exxons). The 170,000 tons of gold
will be unchanged in size and still incapable of producing
anything. You can fondle the cube, but it will not respond.
Admittedly, when people a century from now are fearful, it's likely
many
will
still rush to gold. I'm confident, however, that the $9.6
trillion current valuation of pile A will compound over the century
at a rate far inferior to that achieved by pile B.
Our first two categories enjoy maximum popularity at peaks of fear:
Terror over economic collapse drives individuals to currency-based
assets, most particularly U.S. obligations, and fear of currency
collapse fosters movement to sterile assets
such as gold. We heard 'cash is king' in late 2008, just when
cash should have been deployed rather than held. Similarly, we
heard 'cash is trash' in the early 1980s just when fixed-dollar
investments were at their most attractive level in memory. On those
occasions, investors who required a supportive crowd paid dearly
for that comfort.
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),
IBM
(
IBM),
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.
Whether the currency a century from now is based on gold,
seashells, shark teeth, or a piece of paper (as today), people will
be willing to exchange a couple of minutes of their daily labor for
a Coca-Cola or some See's peanut brittle. In the future the U.S.
population will move more goods, consume more food, and require
more living space than it does now. People will forever exchange
what they produce for what others produce.
Our country's businesses will continue to efficiently deliver goods
and services wanted by our citizens. Metaphorically, these
commercial 'cows' will live for centuries and give ever greater
quantities of 'milk' to boot. Their value will be determined not by
the medium of exchange but rather by their capacity to deliver
milk. Proceeds from the sale of the milk will compound for the
owners of the cows, just as they did during the 20th century when
the Dow increased from 66 to 11,497 (and paid loads of dividends as
well).
Berkshire's goal will be to increase its ownership of first-class
businesses. Our first choice will be to own them in their entirety
-- but we will also be owners by way of holding sizable amounts of
marketable stocks. I believe that over any extended period of time
this category of investing will prove to be the runaway winner
among the three we've examined. More important, it will be
by
far the safest.
This article is from the February 27, 2012 issue of
Fortune.
Posted in:
Berkshire
Hathaway,
Berkshire Hathaway shareholder letter,
bonds,
gold,
investing,
stocks,
Warren
Buffett
FORTUNE -- Investing is often
described as the process of laying out money now in the expectation
of receiving more money in the future. At Berkshire Hathaway
(BRKA) we take
a more demanding approach, defining inv 
