HISTORICAL REAL RETURNS IN THE MARKET STOCKS vs. LONG GOVERNMENT
BONDS vs. T-BILLS

Update in Progress

What returns, after deducting inflation, have investors actually made over various holding periods such as 30 years, or ten years? This article shows those returns for stocks (based on the S&P 500 index), bonds (based on 20-year U.S treasury bonds and cash (30-day Treasury bills). We also show the data for balanced portfolios holding a combinations of stocks, bonds and cash. Was the best approach to go 100% stocks or to use a balanced approach?

This is all U.S. data. The data used here was purchased but similar data for Canada or other counties is not readily available even for purchase.

The results here are for one-time investments at the start of 30, 15 or 10 year holding periods. We have other articles that explore the results from making equal annual investments.

The above graph  needs a bit of explaining. Each point on the above graph shows the compounded annual real return (after deducting inflation) from holding each asset class for 30 year periods ended at the end of the year shown on the “X” axis.

For example, the leftmost points on the blue (stocks) line indicates that the average compounded return from holding stocks (the S&P 500 index stocks) for the 30 year period started January 1,1926 and ending December 31, 1955 was about 8.5% while the red (bonds) line shows that holding the U.S. twenty year treasury bond (and selling the bond at the end of each year to purchase the latest 20 year bond to maintain a constant maturity of 20 years) earned about a compounded 2.1% and holding 30-day treasury bills for that 30 year period earned just less than 0.0%. In all cases the returns are after deducting inflation, omit taxes, omit trading costs and assume reinvestment of all dividend and interest income.

Stock (S&P 500 total return index) real returns for 30-year holding periods ranged from a compounded return of a minimum 4.4% per year (which turns a dollar into $3.64 after inflation) to a maximum compounded return of 10.6% (which turs a dolalr into $20.53), with an average of 7.2% ($8.05) across the 69 different 30-year holding periods. These are attractive returns. A 7.2% real return compounded for 30 years increases purchasing power by eight times.

 

XXX

T-Bills which are supposed to be safe are almost a guarantee that your return will at best barely outpace inflation in the long run. Treasury Bills always returned less than a compounded 2% (after inflation) over the 67 different 30 year periods, and often returned less than 0.0% as T-Bills failed to even compensate for inflation. The real T-Bill return for the 67 different 30-year investment periods ranged from minus 1.8% compounded to positive 1.9% with an average of 0.4%. A 0.4% real return compounded for 30 years increases purchasing power by only 13%.

20-year Treasury Bond real returns for 30-year holding periods ranged from a compounded return of minus 2.0% per year to a maximum compounded return of 7.8%, with an average of 1.9% across the 67 different 30-year holding periods.

Treasury bonds have provided unusually high compound average real returns over 4% in the 30-year periods that ended after 2000. These were for time periods that started from 1970 to 1992 and held for 30 years. This was mostly due to the high interest rates that prevailed in the late 1970’s and the 1980’s and also partly due to the huge drop in interest rates over those 30 year periods which provided capital gains in addition to the interest income.

The above graph shows that for the 67 different 30 calendar year rolling investment periods ranging from 1926 through 1955, all the way to 1992 – 2021, real (after inflation) stock returns were higher at the end of 30-year holding periods than 20-year government bonds (Except for the 30 year period started in 1982 and ending 2011 where it was a virtual tie with bonds edging out stocks). In most of the 30-year periods, stock returns were very significantly higher.

Note that the one time that bond returns matched the stock returns, the stocks actually still had a very good return for the 30 years. The bond return was unusually high for the years ending around 2011 because bond interest rates were high at the start of those periods and fell over the periods providing strong interest income as well as capital gains.

Note that stock portfolios that were set up in 1928, just before the massive stock crash of 1929 – 1932, and ending in 1957, still beat bonds – and by a huge amount. And these are for one-time investments at the start of the 30-year period.

Shorter time periods

Stocks held for the 82 different 15 calendar year holding periods mostly did very well with a maximum compounded real return of 15.3% and an average of 6.9%. But it may be sobering to see that there were occasions where stocks (the S&P 500) gave no return over a 15 year period. The lowest return was minus 0.6% for the 15 years ending December 31, 1979. In fact stocks performed so poorly over the 1970’s that Business Week magazine famously declared the Death of Equities as inflation was destroying the stock market. That proved to be spectacularly wrong after the FED managed to slay inflation through the  early 1980’s by choking the economy with massively high interest rates.

The 20-year bond index (the red line) over the 82 rolling 15 year holding periods performed quite poorly over all the periods ending from about 1946 to 1987. But then bonds performed strongly for all the 15 year periods ending after 1987. The highest compounded return was a real return of 9.4% for the 15 years ended December 31, 1996. With this divergent track record it is somewhat meaningless to look at the average. Twenty year U.S. treasury bonds currently yield less than 2% and likely nothing after inflation.

For 15-year holding periods there are a few periods where bonds beat out stocks. Stock portfolios began in the late 20’s (and ending 1940 to 1944) or that began at the end of 1993 through the year 2000 (and ending 2008 to 2016)  did not out-perform long-term government Bonds over the next 15 years.

For 10-year holding periods there are still not very many periods where bonds beat out stocks. However, we do see that in the five 10-year periods ending 2008 through 2012, bonds did beat stocks by a significant amount. The range of real, after inflation, bond returns was relatively large from minus 5% compounded for ten years to over 10% compounded per year. It is apparent that the average return from stocks over many of the 10-year holding periods was significantly higher than the return from bonds. Interestingly, the worst case scenario for stocks was not quite as bad as the worst bond scenario.

Balanced Portfolios

Most investment advice advocates holding a balanced portfolio of stocks, bonds and cash. It is sometimes claimed that due to dollar cost averaging balanced portfolios can provide both higher returns and lower risks. So let’s take a look at the average returns over 30-year periods using balanced portfolios.

The above graph illustrates that over the 67 rolling 30 year periods ending in 1955 through 2021, Balanced portfolios noticeably under-performed 100% stock portfolios in the earlier decades. However for time periods ended in recent decades, the balanced 70% stocks / 30% bonds portfolio (the yellow line) often marginally beat the 100% stock portfolio and never lagged stocks by much.

One thing that stands out here is that holding a constant 25% cash in a balanced portfolio (the purple line) is detrimental. It never beats the 70/30 stocks/bonds portfolio.

The strong performance of the balanced approach in the more recent 30-year holding periods leads many to conclude that this result is to be expected in future. That’s probably not so. Balanced portfolios nearly kept pace with (or even beat) stocks in more recent 30 year periods because of high interest rates in the early years of those periods and becasue of the dramatic drop in interest rates that provided capital gains. Now that interest rates are at historic lows, that situation will almost certainly not occur for 30 year periods that are starting now.

Proponents of Balanced Portfolios often argue that you will only give up a small amount of return and will get lower annual volatility. But note that a $100,000 stock portfolio growing at say 8% (after inflation) grows to $1,006,300 in 30 years, while a Balanced portfolio growing at say 6.0% grows to only $574,300. So, the stock portfolio in this case is worth a hefty 75% more. So much for giving up a “small” amount of return!

Balanced approaches, however may be advantageous for shorter periods, as the following illustrates.

The above graph illustrates exactly what would have happened to an investor following a partly balanced approach of 70% stocks and 30% bonds (the yellow line) or following a more fully balanced 50%, 25%, 25% stocks, bonds and cash (bills) allocation (the purple line). This assumes U.S. data and that stocks are represented by the S&P 500 index stocks, bonds by 20-year U.S. government bonds and cash by 30-day U.S. government Treasury bill investments. This assumes annual re-balancing to maintain the balanced allocation and to maintain the 20-year maturity of the bonds. There is no speculation in this data, only historical reality. Note though that this is for a one-time investment at the start of each 15 year period.

The result is that the partially balanced portfolio significantly under-performs a 100% stock portfolio in many of the 82 different rolling 15 year periods.  The partially balanced approach was superior only for 17 periods which were those that that started in 1926 through 1931 and ending in 1940 through 1945 and as well in the 15 year periods ended 2002 and in 2007 through 2016 and the period ended 2018 (so a lot of recent periods). And the yellow 70/30 portfolio does not trail the 100% stocks portfolio by very much most of the time.

One thing that the graph illustrates is that for 15 year holding periods, all of the asset classes gave poor real returns for the 15 year periods ending approximately 1975 through 1986. And being balanced among three poorly performing asset classes was of no help.

Overall, the graph above provides good support for the notion that a balanced portfolio such as 70% stocks, 30% bonds is a good approach for investment periods of around 15 years.

 

The balanced 70% stocks / 30% bonds portfolio sometimes outperforms the 100% stocks approach over these ten year holding periods – especially in the more recent periods. And it rarely trails the 100% stocks approach by much. The 50% Stocks, 25% bonds, 25% cash portfolio appears to consistently under perform the 70% stocks approach. It would be reasonable to conclude from this graph that the 70% stocks approach is a good approach compared to 100% stocks for ten year holding periods.

Summary

In regards to stocks, this discussion deals only with the performance of the large stocks comprising the S&P 500 index as a group it does not deal with the risks of investing in a non-diversified portfolio of stocks.

For shorter-term investments the stock market is very risky compared to Bonds and short term treasury Bills. The average return from stocks has been consistently higher over long periods but over shorter periods (anything under 10 to 15 years) the results from stocks are hugely uncertain. It would be most unwise indeed to invest money needed next month or next year or even prior to about 10 to 15 years in 100% stocks

As the time horizon lengthens, we reach a point where stock returns are almost (but never quite) certain to exceed Bond and Bill returns – at least based on historical calendar year U.S. results from 1926 through 2021. For time horizons exceeding 15 years it seems quite unlikely that stocks will under perform Bonds and virtually certain that they will out perform Bills. With a 30 year time horizon it seems virtually certain (based on history) that stocks will outperform Bonds. A 100% (diversified) stock portfolio seems virtually certain to outperform, over 30 year periods, portfolios with any portion of the funds allocated to Bonds or Cash. And the case for stocks is all the stronger if you consider that people don’t typically invest a single lump sum for 30 years. Rather they invest on an annual basis which greatly reduces the exposure if one is unlucky enough to run into the odd period where stocks do trail bonds over a 30 year holding period.

This analysis was based on making an initial investment and letting it grow over time.

Of course, if one is capable of expertly timing the markets then it would be possible to beat the 100% stock approach in the long-term by “simply” being in the highest returning asset class each year. This will be attractive perhaps to psychics and clairvoyants. Mere mortals investing for 15 years or longer might wish to consider the 100% stock approach. However, investors that are uncomfortable with short-term volatility should use a balanced approach. And it may be realistic for long-term investors to move some money out of stocks if stock prices are in an obvious bubble.

Virtual certainty is not quite 100% certainty there is always some small chance that Bonds will outperform even in a 30 year time horizon.

You don’t have to agree with my conclusions. You can also study the graphs above and draw your own conclusions.

Self-described long-term investors need to be sure that they really have a long time horizon before they act accordingly. For many investors, there is a chance that they will need to cash out their investments early. This could be caused by illness, job loss, disability, legal problems and other reasons. But, if an investor is virtually certain that they have a very long time horizon then it certainly appears that stocks (based on a U.S. large stock index) are not riskier than bonds, in terms of achieving the highest ending portfolio value.

More Analysis:

The above analysis shows that stocks tend to significantly outperform bonds and balanced portfolios as of the end of a 30-year holding period.

But what about the volatility along the way? And what about for more realistic scenarios like saving so much per year for 30 years rather than just making a one-time deposit and waiting 30 years. And what about retirement scenarios?

We have all of that covered in two related articles:

The first article shows what happened to portfolios for all the possible 30-year savings periods from 1926 to 1955 all the way to 1982 through 2011 invested in either 1. 100% U.S. stocks (S&P 500 index fund in non-taxable account) or 2. Invested 60% in stocks, 35% in corporate bonds and 5% in cash.

The second article shows what happened to one million dollar portfolios for all the possible 30-year retirement periods from 1926 to 1955 all the way to 1982 through 2011 invested in either 1. 100% U.S. stocks (S&P 500 index fund in non-taxable account) or 2. Invested 60% in stocks, 35% in corporate bonds and 5% in cash.

END

Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
Article originally created in June 2001 and last updated November 9, 2021

How Canadians Can Instantly Achieve a Low-Cost Diversified Investment Portfolio Using Exchange Traded Funds

Would you or anyone you know like to establish a prudent diversified investment portfolio using just one low-fee investment? This article explains how. AND the investments recommended have performed wonderfully in recent years as the market rose.

This short article provides a specific portfolio of low-cost Exchange-Traded Funds (ETFs) that can be used to almost instantly create a diversified portfolio. This can solve the problem of how to get started investing or how to achieve a diversified portfolio.

The information will also be useful in reviewing and making adjustments to an existing investment portfolio.

The easiest and most instant way to establish a fully diversified portfolio that includes Canadian, U.S. and global equity (stock) exposure as well safer fixed income investments is to buy a single ETF that provides all of that in just one security. The following table provides the ETF symbols. These are diversified Exchange-Traded Funds that trade on the Toronto Stock Exchange. Similar products are available for U.S. investors of course. And I give symbols for that as well.

The ETFs here, especially the more balanced ones could put some financial advisors out of business since they  provides instant diversification and constant rebalancing at a FAR lower fee. Nevertheless, advisors usually provide additional services and they play an important role in encouraging people to invest and making it easy to do so.

Vanguard and iShares are two ETF providers that that provide Canadian ETFs that consist of a fully diversified and balanced portfolio in a single ETF. In both cases you can vary the Fixed Income component from 0% (which would not be considered balanced) to as high as 60% (Vanguard) or 80% (iShares). Both offer a 40% Fixed Income option which is the traditional “fully balanced” level. The geographic diversification is relatively similar between the two providers. There is no sort of traditional agreed upon ideal geographic diversification and so the level of geographic diversification here may or may not be considered ideal. The biggest difference between the two providers is that iShares does not hedge any currency risk while Vanguard hedges the currency risk on the fixed income portion. Financial theory would suggest that NOT hedging provides better diversification. But that’s a debatable point. Currency fluctuations are a risk but also could benefit the portfolio.

For American investors a 40% fixed income and 60% world-diversified equities Trades as AOR. And a safter 60 /40 version trades as AOM.

The ETF prices below have been updated as of January 12, 2026 but, by nature, they tend to be good choices at any time for diversification.

Name	Symbol	Fee MER	Price & Chart	Canadian Balanced ETF Description
Vanguard Conservative ETF portfolio	VCNS	0.25%	$31.96	40% equities (16% U.S., 12% Canada, 9% rest of developed world, 3% emerging markets). 60% fixed income (35% Canadian, 14% global ex-U.S., 11% U.S.)  For the fixed income portion only, the currency risk is hedged.
Vanguard Balanced ETF Portfolio	VBAL	0.25%	$37.69	60% equities (24% U.S., 18% Canada, 14% rest of developed world, 4% emerging markets), 40% fixed income (24% Canada, 9% Global ex-U.S., 7% U.S.). For the fixed income portion only, the currency risk is hedged.
Vanguard Growth ETF Portfolio	VGRO	0.25%	$44.23	80% equities (32% U.S., 24% Canada, 18% rest of developed world, 6% emerging markets) 20% fixed income (12% Canadian, 5% global ex U.S. 4% U.S.) For the fixed income portion only, the currency risk is hedged.
Note: The equity portion of all of the above three funds is 40% U.S., 30% Canada, 23% rest of developed world, and 7% emerging markets. The fixed income portion is 58% Canadian, 24% global ex-U.S. CAD hedged, and 18% U.S. CAD hedged). The difference between the three funds is simply in the exposure to equity versus fixed income. The Fixed Income component consists of bonds with an average maturity of about 11 years.
Vanguard All-Equity ETF Portfolio	VEQT	0.25%	$55.74	Similar to above but with no allocation to fixed income. Therefore 40% U.S., 30% Canada, 23% rest of developed world, and 7% emerging markets. None of the currency risk is hedged since there is no fixed income portion.
iShares ETFs
iShares Core Conservative Balanced ETF Portfolio	XCNS	0.20%	$25.69	80% Fixed Income (64% Canadian, 16% U.S), 20% Equities (9% U.S., 5% Canada, 5% Europe / Asia, 1% Emerging market.). None of the currency risk is hedged.
iShares Core Balanced ETF Portfolio	XBAL	0.20%	$34.15	59% equities (26% U.S., 15% Canada, 15% Europe/Asia, 3% emerging markets) 41% fixed income (27% broad Canada, 7% short term Canada, 4% U.S. government and 4% U.S. corporate). None of the currency risk is hedged.
iShares Core Growth ETF Portfolio	XGRO	0.20%	$35.94	80% Equities (36% U.S., 20% Canada, 20% Europe/Asia, 4% emerging market) 20% Fixed Income (16% Canada, 4% U.S). None of the currency risk is hedged.
Note: For the above three ETFs the average bond maturity in the fixed income component is approximately ten years.
iShares Core Equity Growth ETF Portfolio	XEQT	0.20%	$41.41	100% Equities (45% U.S., 25% Europe/Asia, 25% Canada, 5% emerging market). None of the currency risk is hedged.

For American investors a 40% fixed income and 60% world-diversified equities Trades as AOR. And a safter 60 /40 version trades as AOM. Click on the links here to find the geographic diversification.

Investing and holding VBAL or XBAL for the long term is not about timing the market but about participating in the markets in a prudent lower stress way over the years.

Click the links in the table above for additional information.

For those who feel that they are ready to construct their own basic investment portfolio using low-cost Exchange-Traded Funds (or make changes to their existing portfolio), rather than just simply use the single symbol approach above, I have put together the following table.

This table is intended for Canadians who have already set up (or will set up) a self-directed investment account. For those who will stick with mutual funds the table may be useful to start a discussion with your advisor who should be able to do something similar with mutual funds.

A new investment portfolio could be very quickly set up using the following table as guidance. The appropriate allocations to each major asset category, the sub-categories and the regions of the world will differ greatly based on individual circumstances. I have provided some rough allocation percentage ranges that might be applicable to a “typical” investor but which may or may not be applicable to your particular circumstances.

The yield figures below have been updated as of January 12, 2026.

Major Asset Class	Sub-class	Country	Toronto Symbol	Fee /MER	January 2026  Yield	Risk	Typical Allocation	Comment
CASH (Interest is fully taxed like wages)	Actual cash in the investment account	Canadian	none	none	About 0% in the big bank self-directed avvounts	no risk	Hold “cash” in deposit accounts and not directly in the investment account. The allocation is normally 5 to 15%	There is no real substitute for cash in terms of lack of volatility and instant access when needed
	Deposit accounts within the investment account	Canadian	Example TDB8150 RBF2010	none	1.8%	no risk
FIXED INCOME (Interest is fully taxed like wages)	Guaranteed Investment Certificates	Canadian	none	none	Currently  about 2.9% for a 1 year term and about 3.0% for a 5 year term. Smaller banks and credit unions may be higher.	very low to no risk	Normally 15 to 50% divided equally between short, medium and long term.	Short-term bonds could be used in place of GICs. But GICs can be a good choice also.
	Short term Bonds 1-5 years	Canadian	VSC	0.11%	3.2% yield to maturity	very low
	Medium Term Bonds	Canadian	VCB	0.19%	3.7% yield to maturity	low
	Long Term Bonds (Average maturity about 23 years)	Canadian	XLB	0.20%	4.5% yield to maturity	medium		Higher risk of loss in value if interest rates rise
EQUITIES (These are generally tax advantaged since the capital gains can largely be deferred and is the taxed at half the full rate applicable to wages)	Canadian Common	Canadian	XIC	0.06% (super low fee)	2.2%	high	10 to 40%	Broad Toronto stock index
	U.S.A. Common	United States	IVV (New York) or XSP hedged to Canadian dollars	0.04% or 0.11%	1.0%	high	5 to 20%	S&P 500, the largest American publicly traded companies
	Rest of Developed  World Common	Rest of World ex North America	VIU or VI hedged to Canadian dollars	0.23%	2.4%	high	0 to 15%	Equities excluding U.S.A and Canada
	Preferred shares (can be very tax efficient in many cases)	Canadian	CPD	0.50% (high fee)	5.0%	medium	0 to 15%	Consider using in taxable accounts in place of some fixed income
	High dividend (can be very tax efficient in many cases)	Canadian	VDY	0.25%	3.5%	medium	0 to 15%
	REIT (Distributions are fully taxed like wages)	Canadian	VRE	0.39%	2.7% This yield seems unusually low for REITS.	medium.	0 to 15%	Consider placing in non taxable accounts

There are hundreds of Exchange-Traded-Funds to choose from. The above table provides a possible basic diversified low-cost Balanced Exchanged Traded Fund portfolio for Canadians. This approach implicitly trusts that markets are efficient and does not reflect any judgement regarding the relative attractiveness of any particular country or asset class or any judgement regarding the timing of when to invest. (And if you invest monthly during your working career, timing is really not an issue.)

I have provided some brief comments on tax efficiency as well. Higher taxed categories could be placed in the TFDSA and RRSP and lower-taxed categories could be favored for taxable accounts.

In a separate article we have a broader list of Canadian ETFs and Global ETFs where we comment on attractiveness of each ETF at the time those articles were updated.

More Information on Getting Started

Before putting together an investment portfolio, you should first know something about where and how to get started investing including having a basic understanding of the main types of investments (“asset classes”) and the different types of advisers and do-it-yourself services. And if you are going to include individual stocks and bonds and Exchange-Traded Funds (instead of or in addition to deposit accounts, Guaranteed Investment Certificates and mutual funds) then you need to have some knowledge of those investments.

We have two articles that cover the basics:

1. Where and How to Invest – Defines the major asset classes, discusses considerations in dividing investments across the major asset classes and across the world, discusses the types of advice available, and discusses active versus passive index investing.

2. How to Get Started Investing in Individual Stocks and ETFs – Discusses how to open a self-directed investment account, explains how investing in stocks differs from investing in mutual funds, explains how much money is needed to get started, and discusses the advice that is available.

This article was originally created on September 27, 2017. Most recently updated and edited January 12, 2026

If you made it this far and are interested and have questions, email me at shawn@investorsfriend.com I’d be glad to help out although ultimately all investments are at your own risk.

And is you got some use out of this reference article, you can consider subscribing to our stock picks and brief daily comments which hundreds of Canadian Investors have found very useful. And we have some content for American investors as well. The cost is just $15 per month or $150 per year but will soon increase to $20 and $200. Existing continuous subscribers NEVER face an increase.

Shawn Allen, CFA, CMA, MBA, P.Eng

President, InvestorFriend Inc.

 

On the occasion of Canada’s 150th birthday I wanted to document my memories of Canada’s 100th birthday and of  Expo ’67.

The 100th birthday of Canada was a VERY big deal. I vividly remember the centennial money with different animals on each coin. A bird on the penny. Without looking it up, I think there was a rabbit on one coin (nickle?) and maybe a leopard on another (the quarter?) I can’t picture what was on the dime and don’t want to disturb my memories by looking it up. (P.S. after sleeping on it, I am pretty sure it was a fish on the dime.) Many many people collected the coins.

This 100th birthday occurring when I was just seven years old really shaped my sense of patriotism and being a Canadian. It was part of the reason that I had to be a Montreal Canadians fan even when the Boston Bruins became the popular team in the early 1970’s.

I attended Expo for a number of days that Summer. We were a family of two parents and five kids ranging in age from 3 to 11. We traveled by car from Cape Breton Nova Scotia to the Expo site pulling a travel trailer ans stayed in a trailer park. Traveling with us, in a separate car, towing their own trailer was my Mother’s sister and her husband with three kids aged about 5 to 10 as well as a grandmother.

I don’t have a lot of memories, but a few are quite vivid. There were two mono-rails to get around the site. I think us kids found the monorails to be a real high-light. One on these went through the American pavilion, the big silver and glass geodesic dome.

I remember it was crowded and we lined up to get into the various county pavilions.

I recall a souvenir shop where some carved wooden flutes were bought for the older boys. My Mother still has some drinking glasses with the centennial logo in her cabinet.

One day my family stopped at some tables and I kept going, following the grandmother’s grey bun of hair. She brought me back to the tables.

There was an amusement park and I recall riding on a giant Ferris Wheel where a whole family could sit in seats that were like bowls. It seems to me that for some reason there was not much of a line up which seems odd.

I clearly remember on our last day we were handed pamphlets about the next World Expo taking place in Japan in 1970. And what I recall is thinking how very far in the future that was!

I was briefly back to the Expo site with my parents and siblings in either 1971 or 1972 and the amusement park remained and I don’t think much else. The America Geodesic dome was still there.

I was again back to the site with my own kids around 2005. We rode the subway out to the site. I was extremely disappointed to see that, as far as I could tell, there was not a single sign in English to indicate I was at the old Expo site. I believe the amusement park was still there. Also I saw the remnants, a concrete floor, from a couple of the old pavilions. The Swedish one I believe.

I also recall that at age seven I thought it might be nice to come back for the 200th centennial a 100 years in the future at my age 107! That is probably extremely unlikely. But if I do make it, perhaps this documentation of my memories will come in handy.

A number of very large mature companies are presently trading at price/earnings (P/E) ratios in the range of  30.

Costco trades at 31 times trailing earnings and Visa at 28 times. This compares to the S&P 500 which is trading at 23 times trailing GAAP earnings and 21 times trailing operating earnings. It also compares to the S&P 500’s historic long-term average trailing GAAP P/E of 16.

Costco and Visa are both exceptionally strong companies with tremendous competitive advantages. It seems a safe bet that both will continue to grow their earnings over the next ten and twenty years.

But the question arises as to whether it makes sense to pay as much as 30 times earnings for the likes of Costco and VISA or other high-quality large mature companies.

An analysis of Costco’s potential returns:

Let’s take a look at the the potential returns that might result from from buying Costco at 31 times earnings and holding it for the longer term.

Costco is unquestionably a wonderful business. Its return on equity has been steady at about 20% for the past four years. It has very significant cost advantages over competitors. Its revenue per share growth in the past ten years has averaged 7.8% annually and earnings per share have grown at an average of 8.7% annually. Costco is in a predictable non-cyclic business. Costco has the ability to continue to add stores internationally. Given its stability and cost advantages it seems reasonable to conclude that Costco will continue to grow and prosper over the years. Nevertheless, its P/E ratio of 31 presents challenges to investors expecting to make an attractive return by buying and holding Costco’s shares. Costco currently pays out a reasonably generous 33% of its earnings but this translates into a dividend yield of only 1.1% because the stock trades at 31 times earnings.

Here are some scenarios:

Imagine that Costco continues to grow earnings per share at 9% annually. In this case, if the P/E remains at 31 then an investor’s return, over any period of time, would be about 10% annually (9% from capital gains and about 1% from dividends). A 10% annual return is very attractive given today’s low inflation and interest rates. An investor can grow quite wealthy over a lifetime based on a 10% return.

However, given that Costco’s P/E seems likely to regress toward the market average in the long term, this 10% compounded annual return is arguably at the very high end of what could be expected from a long-term investment in Costco.

Imagine that the P/E falls to 20 over a twenty year holding period. The decline in the P/E means that the final price will be 35% lower than in the P/E 31 scenario. In this case while the earnings still grew at 9% annually, the 460% gain in earnings becomes only a 261% gain in the stock price. The stock price would only have compounded up at an average of 6.6% annually. The dividend yield would rise to about 1.7% at year twenty (due to the lower price) and the total return would be about 8.0% annually. That is still a good return but not nearly as good as a 10% return when compounded over 20 years. The lesson here is that a significant P/E decline has a fairly substantial impact on the annual return even it occurs over a very long holding period such as 20 years (and this assumes the earnings growth remains unchanged).

And imagine instead that the P/E falls to 20 over a shorter ten year holding period. The ending price would again 35% lower than in the P/E 31 scenario. In this case while the earnings would still grow 9% annually, the stock price would only compound up at an average of 4.3% annually. The dividend yield would rise to about 1.7% at year ten and the total return would be about 5.7% annually. That is not such a bad return but it is far less attractive than a 10% annual return.

And imagine if the P/E fell to the market average of 16 over a ten year period. In that case the 9% annual earnings growth would result in only a 2.0% average compounded increase in the stock price. With the P/E falling by almost half, most of the earnings growth is offset by the P/E decline.

The lesson here is that a significant decline in the P/E ratio over a period of ten years can very significantly lower the achieved return. And, if a P/E decline occurs over a very short period of time it can of course result in a decline in the share price, and a negative return, despite robust earnings growth.

A realistic scenario for a company like Costco is that over say a ten or twenty year period its earnings per share growth will decline from the 9% range to something lower, such as 5%. This would almost certainly be accompanied by a decline in the P/E ratio.

Imagine that the earnings growth averages 6% over the next ten years and that the P/E declines to 18. In this case the earnings would grow by 79% over the ten years. But the P/E decline, in isolation, would lop 42% off the stock price for a total stock price gain of just (1.791 times 18/31 = 1.041) 0.4% per year. In this case the dividend payout ratio might also increase as the growth slowed and so perhaps the total return might be 2.5% per year.

The lesson from all of the above is that a stock like Costco at a P/E of 31 is pricing in a continuation of fairly robust earnings growth. There are a lot of scenarios that would result in only poor to modest returns from Costco going forward. There are some scenarios where an investment in Costco could return about 10% per year for five to ten years. But there are probably no scenarios where Costco could realistically provide an exceptional return such as 15% over the the next ten to twenty years.

My conclusion is that Costco, despite being a wonderful business, (and probably most large mature companies) are not very attractive investments when their P/E is near the 30 level. That is likely no surprise. But the math above demonstrates why this is the case.

When it comes to high PE stocks, it is sobering to realise that a decline in the P/E ratio by one third (say from 30 to 20) would entirely offset a 50% gain in earnings.

END

Shawn Allen

InvestorsFriend Inc.

February 6, 2017

 

 

 

The Jobs Economy versus The Post-Jobs (Jobless) Economy

Once upon a time, there was no such thing as “a job”. And maybe that will be the case in the future as well.

Humans have always had to work hard for a living. But our present economy – and indeed our society – that revolves around the concept of “jobs” is a relatively recent development. And our “jobs economy” may eventually become obsolete. If so, our leaders need to begin thinking about how a post-jobs (jobless) economy and society would work.

For some 2.5 million years humans existed in small groups of hunter-gatherers. It was only about ten thousand years ago, with the agricultural revolution, that humans began to cultivate plants and domesticate animals. This allowed humans to settle in more permanent villages and allowed small towns and cities to develop. Agriculture allowed for a population explosion and also allowed for a hierarchical society with a small pampered elite at the top (the original 1%!). The vast majority of people worked the land, tended animals, and continued to hunt and gather and did not have “jobs” as we use that term today.

The earliest paid “jobs”, were likely in ancient cities including Rome about two thousand years ago and mostly involved working long hours in return for compensation that included and/or purchased nothing more than a basic level of subsistence and survival. At that time and up until perhaps 300 years ago most humans continued to work the land and did not have paid jobs as such.

Today, the great majority of adults expect to have a paid job of some kind for most of their working age years.

Today’s concept of a job – and certainly of a good job – is to work perhaps 40 hours per week in return for compensation that provides much more than a basic subsistence. We expect a job to provide us with much more than the essential food, shelter and clothing. We expect a good job to allow the purchase of a home and a car. We are entitled to a minimum two weeks of vacation but expect more. With good jobs we expect health and retirement benefits. We expect to be able to afford a reasonable amount of entertainment and recreation and travel. We expect a good job to provide us with a reasonable amount of discretionary income. In short, we expect a good job to provide for what would be considered a middle class lifestyle.

Today’s concept of a job – and certainly a good job – is also that it is relatively permanent. A good job is one where (absent quite poor behavior or performance) the employment will most likely continue indefinitely until the employee decides to leave. And a good career is one where the employee is able move to a different employer from time to time to pursue better opportunities or in the event of job loss or a move to a different part of the country.

The precise point in history at which paid “jobs” became the center piece of the economy and the center piece of the lives of the great majority of working-age adults is debatable. But certainly, in the “western world”, this has been the case for at least the past 150 years. Within the last 50 years or so it became normal for both partners in a marriage to work at paid jobs outside the home.

And just how central is their “job” to the lives of most adults in western countries today? Well, it determines their living standard. It largely determines their very identity in society. It often determines their sense of self-worth and happiness. It fills about half of their waking hours. It partly determines their attractiveness to potential mates. In short their job is absolutely central to the lives of most working-age adults.

And the job (if applicable) held by their spouse (if applicable) is also absolutely central to the lives of most adults. And certainly the job(s) held by their parents is central to the lives that different children experience.

In our economy, the great majority of working-age adults strive to prepare for and obtain and hang onto a “good job” or a series of good jobs within a good career. It can be argued that nothing is more central to their lives.

Governments also rely on people having jobs. Income taxes collected on wages are the main source of government revenues. A population with low unemployment rates is also more likely to be a contented and peaceful population.

Businesses are also highly dependent on the existence of the jobs economy. Businesses require workers and they benefit from a stable workforce that is employed for an indefinite period.

The fact that the majority of working age adults have relatively permanent or replaceable jobs is also extremely central to the functioning of our credit economy. Credit (or debt) is very much the grease that allows the economy to go around and to grow. If jobs were not relatively permanent (or were not generally replaceable) it would not be possible to borrow money for a house with a repayment term of 25 years. Almost all personal lending is dependent on the borrower having a job to facilitate repayment of the loan. If most jobs were not expected to be relatively permanent, or at least replaceable, then lenders would not be anywhere near so willing to lend.

The fact that labour is organized into various specialized jobs in our economy vastly increases the total level of goods and services that are produced. Jobs are central to the production of food, clothing and shelter, and to the provision of healthcare, education and policing. If everyone stopped doing their jobs tomorrow we would immediately face shortages of all goods and services and would soon descend into anarchy.

Our jobs-centered economy produces a prodigious and growing amount of goods and services and real wealth each year. And it is their job that primarily determines the share of the economy’s output that each working adult can receive. A significant portion of the output of the economy is also distributed to the owners of productive land and capital through rent and corporate profits. And a very significant portion is redistributed by government to the elderly and the needy. But for the vast majority of working-age adults, their share of the output of the economy, and therefore their standard of living, is determined by the wages they earn from their job (and/or that of their spouse).

But the question arises: Does our jobs economy, along with the rents and profits to owners of land and businesses combined with income taxes that fund various government payments to individuals, distribute the output of the economy in a reasonably fair manner? Are the wages that various jobs pay inherently fair because they are (supposedly) set in an open competitive market?

Increasingly, those at the bottom and even those near the middle of the wage scale argue that the outputs of the economy are not distributed fairly.

Let’s examine some jobs and consider whether the wages seem to be set in an open competitive manner.

The government worker who is earning $50 to $75 per hour (or $70 to $100 with benefits, and, believe me, there are lots of these jobs on the sunshine lists) tends to believe this is fair compensation set in the open competitive market. But is that really how that government wage was set? Does that government worker get a pay cut when the economy is bad and there is an excess of qualified people around? Is that government worker ever required to sort of rebid for their job in an open competition? Is that wage supported partly because the next level of management wants to be paid even more than that? Is that high wage supported partly because it is not coming out of the pocket of those setting that wage?

Are government wages that make no adjustment for the difference in the cost of living between large cities and smaller towns really set in an open competitive manner?

The dentist who charges fees that amount to $500 or $1000 per hour might be convinced that this price has been set in the open competitive markets. But do people shop around for dental services especially when most patients are covered by benefit plans? Do dentists even post their prices? (In some or most provinces of Canada, dentists are actually prohibited from advertising their prices by their self-regulated professional associations!) Does the dentist profession limit the number of dentists entering dental schools and make it hard for foreign-trained dentists to come in? Does the dental profession discourage or even prohibit competition on price?

Are many wages higher than a competitive level due to union negotiations? Is that a bad thing?

Some employees find themselves subject to relatively brutal competition. Store clerks can’t demand $25 per hour when there are many qualified people willing to work for less. When such people clamor for a $20 per hour minimum wage they often face sanctimonious criticism from people making five times that level whose wages and jobs are not subject to open competition.

The wages of Chief Executive Officers of large companies are set by consultants – paid by the corporation. And are set by comparison to wages of other CEOs in a manner that results in a race to the top. Meanwhile workers on the shop floor are told of the need to compete with lower wage companies in what seems more like a race to the bottom.

Overall, I would conclude that there are many imperfections in the way our current jobs economy sets wages and therefore distributes the output of the economy. An increasingly large proportion of the population believes that the current jobs-based economy is treating them unfairly or excluding them altogether. They may be right.

Are actions warranted to address some of these imperfections? Should income tax rates be more progressive with even higher taxes on the highest incomes and perhaps income tax credits for the lowest wage earners?

And, is the jobs-based economy going to become obsolete in any case?

For hundreds of years, workers have feared that automation would eliminate jobs. But new jobs have appeared to take up the slack. Standards of living rose exponentially for several hundred years due to automation and the specialization of labour.

But now, figures show that on average real wages have not increased for perhaps 20 years or more. Those people with the highest wages have seen their standards of living continue to rise exponentially. Those in the middle and below perceive that their standards of living have stagnated.

For the middle class, good permanent jobs with health and retirement benefits and attractive wages are undeniably harder to find than in many of the decades of the 20th century.

Many highly educated young people find themselves in a “gig economy” in which temporary positions are common and organizations contract with independent workers for short-term engagements. These “gigs” lack the stability and benefits that a traditional “job” provides.

Experts, almost always safely ensconced in good jobs themselves, argue that education and training is the solution. But education and training levels and the years spent in school have continued to increase rapidly and yet a large proportion of young college graduates are unemployed or under-employed or temporarily employed. They even face the indignity and abuse of unpaid internships.

What if artificial intelligence, automation and technology is going to eventually reach the point where essentially all goods and services are produced without any requirement for human labour of either the physical or even the intellectual form? Is it possible that as we head towards such a point that well-paying jobs will become harder and harder to find and eventually become obsolete?

Such a jobless world will produce even more goods and services than today’s system. But how will the output be distributed? What kind of construct could or should replace their job as the thing which gives meaning, definition and stability to people’s lives?

It seems clear it will involve increased levels of government entitlements such as a basic income system paid without the need to work.

We may very well be headed towards this type of post-jobs jobless economy and society. In the western world, people, especially older people, have an ingrained level of contempt for such socialist notions. But technology and automation may be taking us there.

Our thought leaders might be well advised to turn their attention to how such a jobless economy and society would function.

End

Shawn Allen

InvestorsFriend Inc.

December 1, 2016 (with minor edits to August 18, 2025)

P.S. In reviewing this article nine years after it was written I found almost nothing that I needed to change except I added a mention of artificial intelligence. That was certainly not on my radar in 2016. The elite of society had very little sympathy as automation eliminates manufacturing jobs. But it’s going to be a different story as AI eliminates the jobs of vast numbers of lawyers, accountants and other professionals.

 

 

 

 

 

 

 

Money, Money, Money…

We all want money. We all have some understanding of money. But there are a lot of mysteries around exactly how money is created in the economy. You don’t have to look very hard to find people arguing that paper money not backed by gold is a scam and that that our monetary system is destined to collapse into hyper inflation at some point. All money is debt they warn.

This article attempts provide some answers, and some reassurance, regarding money.

What is Paper Money and how is it created

What is electronic money and how is it created

 

What are the historical origins of “money” and what exactly is “money”?

Money is most often said to have originated as a convenient medium of exchange arising out of barter economies. However, historical research has not been able to find evidence that such a barter society ever existed. Instead, it seems that primitive societies were based primarily on sharing and gifting and not barter.

Conventional theory holds that money is a thing – a commodity chosen to serve as a medium of exchange to facilitate the swapping of goods and services. It is also commonly supposed that credit and debts were “invented” sometime after the invention and use of money.

In reality, the essence of money is to keep track of debts.

Rather than barter, the first commercial exchanges may have been in the form of debt as when one “cave man” said to another. “Your hunt today was most successfull, while mine yielded nothing. Lend me two of those rabbits you caught and I will replace it with three when my hunt is successful tomorrow”.

Money has long been said to posses three characteristics

 

A medium of excanhe

A store of value

A unit of measure

It may be the last that is the most important.

Money is a special type of credit or debt. Monetary exchange is the clearing or settling of debt.

paper currency money is tokens that represent an underlying credit relationship.

Conventional wisdom is that credit is the lending out of the money commodity.

 

 

 

 

I like Defined Benefit Pension Plans. I have one. I wish everyone could have one. They have many advantages.

But, I have reluctantly come to the conclusion that they suffer from a major flaw.

To understand the major flaw of defined benefit pension plans, consider the following scenario.

Imagine that you own a successful and growing business that now has 100 employees, with an average age of 30, earning an average of $50,000 each. You have just finished another year of record profits and growth. You announce to the employees that you are willing to fund a pension plan by contributing 10% of wages over and above their $50,000 average wage.

You and the employees now set out to discuss the benefits of the pension and how the plan should work.

The employees want to know how much the pension might pay out. You calculate that if the money can earn a real return of 2% and based on 35 years service from age 30 to 65, the pot of money for such an employee will amount to $255,000 at age 65 and will fund a pension of $12,800 per year until age 90. And, that is in real 2016 dollars. And you emphasise that a 2% real return can be pretty much locked in with safe investments so the employees will be able to count on the funds growing enough to support that $12,800 per year pension.

Still, the employees are not too impressed. They ask what return could be expected from a more typical balanced investment approach with about 60% of the investments going into equity stocks. You reply that an expected real return of 4% would be reasonable but is not guaranteed. You inform the employees that at that return they could expect to fund a pension of $23,600 per year after age 65 and lasting until age 90. But, you point out that this is only an expectation and that if the real return varies much from 4.0% on average over the 60 years until they are age 90 then the pension amount that the money can fund could be far lower or far higher than $23,600.

The employees decide that they really like the expected $23,600 pension amount from the balanced portfolio a lot more than the $12,800 from the safe fixed income investments.

The employees then ask if you the employer could guarantee them the $23,600. That way, they could access the higher returns associated with equity investments but they would not face any risk. You laugh and say, no, you are asking for the far higher returns of equities but you don’t want to take any of the risk. You want guarantees like you were 100% invested in government bonds and at the same time you want the higher returns expected from equities.

The employees say, yes, that is how Defined Benefit plan pensions work. The pension is based on the expected return from a balanced investment pool consisting usually of about 60% in equities. But the pension amount is guaranteed.

You realise at that point that the typical Defined Benefit pension plan is deeply flawed in that the pensioners are being guaranteed amounts based on the expected return from risky investments without taking any of the risk. If the employer pays all of the contributions then the employer takes all the risk. If the contributions are split between the employer and the employees, which is often the case, then the active employees and the employer share the risk of inadequate returns. If the returns are lower than expected then the contributions must rise. Once an employee is retired on a defined benefit pension then they face no further risk as long as the pension plan remains solvent. Pensioners on a defined benefit pension plan are never expected to face a decline in their pension even if the plan’s returns are lower than expected.

Defined Benefit plans have many good features. But placing all the risk with the employer is too onerous. Sharing the risks between the employer and the active employees has also turned out to be too generous to the pensioners. Defined Benefit plans that share some of the risk with pensioners are more realistic.

I have addressed the feature of a more realistic and sustainable pension plan in a separate article.

End

Shawn Allen

September 18, 2016

 

 

 

 

Banks make money by taking in deposits and then lending out the deposits at a higher rate of interest. The gross profit or “spread” on such lending is relatively small such as 2 to 3%. After accounting for all of its costs a bank often makes a net profit on each dollar loaned out of about 1% per year.

This 1% return on assets is then typically increased to a return on share owner equity of 10 to 20% through the use of leverage. Banks typically have common equity of only 5 to 10% of their assets. In the simplest cases the assets consist almost entirely of loans receivable. Share owner money funds only 5 to 10% of the loans. The remaining 90 to 95% of the money loaned out is funded largely by deposits from the banks customers and to a small degree by bank preferred share and debt investors. I explain this and how banks make money in more detail in a related article.

Leveraging an investment 10 to 20 times, as banks do, could be very dangerous and could easily result in a total loss of the equity investment or even losses well beyond the equity investment. Banks are able to operate with very high leverage because they are very careful about how they lend out their money. Much of their lending is insured residential mortgage lending where government guarantees protect the bank against loan losses. The remaining lending often has security pledged against the loan. In addition, banks carefully consider the credit rating and the earnings level and stability of each borrower. Also, the most that bank common share owners can lose is their total equity investment. Any losses beyond that would be suffered by preferred share investors, debt investors, government deposit guarantee funds and uninsured depositors.

The question arises as to whether an individual investor could emulate a bank by borrowing money at a low rate and investing the money into a relatively safe asset that pays a higher interest rate. This article explores that question.

Many individuals have access to a secured line of credit at an interest rate in the range of 3.2%. Investment margin accounts are available for use at 3.0%. Mortgage money can be borrowed on a five-year variable rate basis at 2.0% or a three year fixed rate at 2.14% or a five year fixed rate at 2.42%. These interest rates are applicable as I write this article but are subject to change.

Meanwhile, there are many  securities that pay cash yields that are higher than these borrowing costs which results in a positive “spread” that can be accessed by investors. For example, bank perpetual preferred shares yield 5.0 to 5.5%

Consider the option of taking out a five-year fixed rate mortgage at 2.42% and investing in a bank perpetual preferred share at about 5.4%. The spread would be about 3.0%. With such a small spread it takes a large investment to result in a meaningful annual cash flow. For example, if you had the equity available, a $400,000 mortgage could be used in this manner to generate $12,000 per year or $1000 per month.

While $12,000 per year is nothing to sneeze at, it does not strike me as sufficient incentive for taking out such a very large mortgage. Also there would be a risk that the bank preferred shares would decline in value and not recover. The $12,000 would be about $10,720 after tax based on Ontario tax rates for someone with a $100,000 taxable income. Strangely enough, the $12,000 would increase to $13,490 after tax in Ontario for a taxable income of $50,000. This is because the tax credit on the interest would exceed the tax paid on the dividends due to the very low tax rate on eligible dividends that applies at lower levels of taxable income.

It would be safer to undertake this spread strategy with a bond investment it it were feasible to do so. A high-grade bond of say 5 years or less duration could be counted on to mature at a set amount to repay the loan. Unfortunately, such corporate bonds generally yield under 3.0% (except for riskier issues) and therefore offer little to no spread over available borrowing costs. For example, there is a Bank of Nova Scotia bond that matures in five years that yields only 2.1% based on the ask yield at TD Direct.

It may be possible to find reasonably safe dividend yields as high as 7.0%. In this case our spread over the five-year fixed mortgage rises to 4.6%. A $400,000 mortgage could then generate a more motivating net cash flow of $18,400 per year before tax. In Ontario, with a $100,000 taxable income this would be about $16,440 after tax. Keep in mind that this amount of dividends would add substantially to taxable income.

Perhaps at spreads of 4.0% and higher this borrowing-to-invest strategy may be worthy of consideration for some investors. However, this would not come without risks. Any investment that is yielding in the range of 7% or more is risky. It can drop in value. It could perhaps even become worthless. The dividend could be cut or eliminated. The debt meanwhile would still exist. Spreading the investment over several securities would reduce the risk but not eliminate it.

Even if the investment works out as planned the investor has used up some or most of their borrowing capacity. That borrowing capacity would not be available for other needs or better investment opportunities that might arise.

On of the problems with borrowing to invest is that mortgages and most lines of credit require more than an interest-only payment.

Using a margin account for some or all of borrowing can be convenient because the payments will be interest-only and the payments will be deducted automatically by the bank. Keep in mind that margin debt is usually personally guaranteed. Even if the investments became worthless you would still owe the margin loan. And margin loan principle has to be partially repaid immediately if the securities have been fully margined and then drop in value.

Rather than borrow and invest at a yield spread like a bank does another strategy would be to borrow and invest in bank common shares.

Royal Bank has a dividend of 4.2%. That’s enough to cover the borrowing interest costs with a little left over. And due to the Bank’s profitability, driven by the Bank’s high leverage, the share price is likely to increase over the years. But a share price increase is in no way guaranteed. Under certain senearios there could be major losses on the bank shares and the dividend could be cut or eliminated.

Borrowing to invest is risky. It’s certainly not something that everyone should consider. But for some investors it is worth considering. A 3 or 4% yield on your own money may not be exciting, but as banks are well aware, earning 3 or 4% on someone else’s money is another matter.

Another possibility when it comes to banks is to simply invest in their shares without leverage. This is far less risky and is likely to work out satisfactorily over the years.

END

Shawn Allen

InvestorsFriend Inc.

November 30, 2015

 

Capital allocation here refers to how a company’s management invests the funds they raise from investors and that they acquire through earnings.

Warren Buffett has often written about the crucial importance of capital allocation skills.

For example, in his “owners manual” for owners of Berkshire Hathaway shares he indicates that investors should assess management’s skill in that regard and he notes that capital allocation and the care and feeding of key managers is what he mainly attends to in managing Berkshire.

Buffett pointed out that even for large long-established companies each new CEO should be skilled at capital allocation. In his 1987 letter he pointed out the perhaps surprising fact that that “After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.” (10% growth compounded for ten years increases capital to 259% of the original amount and the 159% gain is 61% of the resulting total.)

In his 2010 letter, Buffett explained that calculating the intrinsic value of Berkshire involved an examination of its assets and earnings. In regards to capital allocation he then stated:

There is a third, more subjective, element to an intrinsic value calculation that can be either positive or negative: the efficacy with which retained earnings will be deployed in the future. We, as well as many other businesses, are likely to retain earnings over the next decade that will equal, or even exceed, the capital we presently employ. Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills.

This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.

Given the importance of capital allocation skills, the InvestorsFriend analysis process for each company specifically comments on management’s apparent skills in capital allocation.

The four main categories of capital allocation or use of cash generated are: 1. To invest in the company’s assets to grow or maintain the business; 2. To use to make a corporate acquisition to grow the business; 3. To pay a dividend or; 4. To repurchase shares.

When it comes to choosing how to spend money within the existing business, almost all companies will undertake an analysis of the return on capital and will choose projects which appear to have the best return. However, few companies will explicitly compare that option to the alternative of repurchasing shares.

If capital was used to repurchase shares we comment, in each of our reports, on whether or not that appears to have been a wise use of funds. (It has turned out to be unwise if the share price has subsequently declined by a material amount).

We consider whether capital additions made to maintain or expand the business appear to have been wise.

We consider whether the company has made wise decisions if it has made acquisitions. Purchasing businesses that provide poor returns is unwise and even purchasing wonderful businesses can be unwise if the purchase price was too high.

The payment of dividends is not always wise if there were better uses for the money, or particularly if the payment is effectively being made from borrowed funds, and we consider if the dividend policy was rational.

In conclusion, the capital allocation skills of management can be the most important factor in determining the long term returns of a company. Before investing, it is important to consider if the management of the company has displayed good skills in allocating its capital.

END

Shawn Allen

InvestorsFriend Inc.

November 30, 2015 (edited on December 1, 2015)

 

 

Banking Profits and Bank Capital Requirements

Many of us own shares of banks and it’s pretty safe to say that all of us are bank customers. Let’s take a look at how a bank makes money by lending money.

The following is a simplified balance sheet for a small bank that takes in deposits and makes loans.

Assets ($ millions)	Liabilities and Equity ($ millions)
Cash on hand   $40	Customer Deposits  $900
Government T-bills and Bonds (this is money loaned to the government)   $200	Bonds Issued Capital $20
Loans & Mortgages owed by Customers  $760	Preferred Shares  Capital $10
	Share Holders’ Common Equity Capital  $70
Total Assets  $1000	Total Liabilities & Equity   $1000

The bank, of course, makes money by loaning out money.

It’s also strange but true that it is bank lending that creates the deposits in the first place. That’s not relevant to the discussion here but is explained in our article about money creation.

Let’s think about how, for example, the bank can make money lending out mortgage money. Today, the going rate on a Canadian mortgage is under 2.0%.

Despite such low lending rates, banks often manage to make more like a 14% return on their share holders’ equity capital. They do this through leverage.

The bank illustrated above has $1000 million dollars of interest-earning assets and yet its share owners have only invested $70 million dollars of equity capital. This bank is not primary lending out its own share owners’ money. Instead, it is primarily loaning out its depositors’ money as well as a small mount of money it raised by issuing bonds and by issuing preferred shares. In the example here, the bank has leveraged the investment of its common share owners by 1000 / 70 or 14.3 times.

A key fact that allows banks to make high returns while lending mortgage money at just 2.0% or even less is the fact that they currently pay little or nothing on much of their deposits. In addition, most of their mortgage lending results in zero loan losses because most mortgages are insured against default by a government mortgage default insurance company or program. And, the customer and not the bank pays the insurance premium through an upfront fee added to the mortgage amount.

Banks are able to attract deposit money while paying little or no interest on the deposits for reasons that include the fact that every adult and every corporation requires one or more bank accounts. The great majority of economic activity by consumers takes place by transferring money from a consumer’s bank account to the bank account of some corporation or other. Much of this occurs electronically. Banks can attract deposits at low rates because it is convenient end even necessary for consumers and businesses to hold money in bank accounts. It’s also safe since most bank deposits are insured against bank failures by a government Deposit Insurance Corporation.

It’s easy to see that if you can take in money that is not your own at 0% and lend it out at even just 2.0%, then a lot of money can be made. The difference between the lending rate and the amount paid on deposits is known as the “spread” or Net Interest Margin (NIM) and in this case it is 2.0% minus 0%, or 2.0%. In this scenario, the bank’s gross profit would be limited mostly by its ability to attract and keep deposits and to find credit-worthy customers willing to borrow money.

In this government-insured mortgage lending business the bank’s leverage is more than the 14.3 times mentioned just above. In fact, bank regulations allow very high, even unlimited leverage, on government-insured mortgage loans. There are also regulations regarding the overall leverage of the bank. The same rules and very high or even unlimited leverage apply to investing in government debt (which is effectively lending to government) and which typically earns the bank far less than even 2.0%.

Banks also have the ability to earn a higher spread, or Net Interest Margin, by lending for things such as automobiles or for credit card purchases or by lending to businesses. However, there is no default insurance available for lending other than for residential mortgage lending. For these loans the bank faces default risk. Typically, some small percentage of borrowers will default on their loans. Even after collection efforts and seizing any collateral, banks usually face some small percentage of loan losses on their non-insured lending.

In this non-insured type of lending a prudent bank management will not allow the leverage to get too high. And bank regulations also limit the leverage. See below for a real-life  example of the allowed leverage for Canadian Western Bank.

Bank capital (leverage) regulations are designed to protect depositors’ money. The extent that a bank can leverage its owners’ capital by lending out depositor’s money is regulated and also depends on the types of assets, such as loans, in which the bank invests its customers’ deposits and its owners’ capital. The assets are risk-weighted. Some assets including some government insured mortgages and some government debt are considered risk-free and are weighted at a factor of zero. Some other assets are weighted at figures considerably higher than 1.

Bank capital or leverage regulations usually prevent banks from engaging in risks (loans, investments and leverage) that could threaten their ability to protect depositors’ money. Normally the risk to preferred share and bond investors is also very low. The risk that a bank will become insolvent causing a loss of share owner capital is generally very low but is not zero. And bank capital regulations certainly do not prevent banks from incurring losses in certain years or from generating inadequate profits over a period of years.

If a bank runs into financial trouble it is common share owners who should expect to incur losses. Only in the event that common shareholders are “wiped out” in a bank failure should bond and preferred share investors expect to incur a loss in that situation. If the financial troubles were so severe that all investor capital was “wiped out” then depositor money could also be lost, except that government deposit guarantee programs would protect most depositors up to certain limits. Bank capital leverage and risk-weighted asset rules are designed such that severe financial distress and failure for banks should not occur. But the rules cannot totally protect against all scenarios. Also, even while bankruptcies of banks may be rare, the market value of bank common shares and also (to a lesser extent) preferred shares and bank debt can fluctuate greatly in the market.

So, banks make money for their share owners by highly leveraging their common equity capital. But the leverage is limited by prudency and by regulation.

The manner in which each dollar of equity capital is leveraged and loaned out determines the banks gross profitability before considering its losses to bad loans and its operating costs. As a hypothetical example, a dollar loaned on an insured mortgage loan with a spread of 2.0% leveraged 20 times results in a higher gross profit on equity (40% before internal costs and income taxes) than a business loan with a spread of 3.0% leveraged ten times (30% before loan losses, operating costs and income tax).

The above discussion is meant to illustrate some of the workings of how a pure lending bank makes money. Large banks have non-lending operations including wealth management and assisting large companies to issue bonds and stocks. Those operations are not included in the simple example above.  It is meant to be a simplified explanation of the overall manner in which banks leverage owners’ equity capital to (usually) make high returns on equity for their owners. And many of us are those owners or can become owners.

END

October 25, 2015 (with minor edits to December 13, 2020)

Shawn C. Allen, CFA
President, InvestorsFriend Inc.

A real life example:

Below are some facts and figures from Canadian Western Bank as of its October 31, 2020 year end. CWB is largely a pure lending bank although it also has some wealth management and Trust operations.

CWB paid an average of 1.9% on its deposits in 2020. It’s average interest rate on loans was 3.8% for personal loans and 4.8% for commercial loans. Its overall average interest rate on loans was 4.6%. This leads to a net interest margin of 2.7%. Overall when accounting for its cash and securities assets and accounting for its equity capital upon which it does not pay interest, CWB’s overall net interest margin was 2.45%. Note that the great majority of its personal loans are mortgages and are categorized as Alternative mortgages and are not the type of mortgages that have rates below 2%.

CWB had physical cash and non-interest bearing deposits in other financial institutions of $114 million. This amounts to just 0.4% of its total deposits. Since this includes deposits with other financial institutions, it’s interesting to consider what a very tiny percentage indeed of customer deposits exist as physical cash in the bank’s various vaults. CWB earns no interest on this cash and is therefore incented to minimize it.

In addition it had $254 million of interest bearing deposits with other financial institutions for a total of $368 million of total cash resources. This amounted to only 1.3% of total deposits. Clearly, CWB is confident that only a very tiny portion of its customers’ deposits will be withdrawn in the very near term. But just in case there was ever a large outflow of deposits CWB also has an additional $3,225 million invested in highly liquid bonds that can be converted almost instantly to cash. This amounted to 11.8% of deposits. The total cash and liquid assets amounted to 13.2% of total deposits.

Banks strive to make double digit ROEs on loans and assets that mostly earn low single-digit returns. They do this through leverage. That is, they try to make loans with or buy bonds with a maximum amount of depositor money and a minimum amount of their own investor’s equity and bond capital. The result is that they treat their owners’ capital as a scarce resource. In order to protect depositors, bank regulators set some limits on the minimum amount of owner capital that the banks must invest in various categories of loans and other bonds and assets on their balance sheet.

Canadian Western Bank is subject to having a minimum overall common equity ratio of 7.0% of risk-weighted assets and total owner capital (including bonds and preferred shares issued by CWB) of 10.5%.

The fact that assets are risk-weighted is very important as the following demonstrates.

Most of CWB’s bonds that are issued by Canada or the provinces are rated at 0% risk. A modest portion of CWB’s residential mortgages (presumably fully insured by CMHC or equivalent) are also rated at 0% risk. CWB can issue these mortgages and purchase these bonds and fund them strictly with depositor money without using up any of their own owner’s capital. The bond assets likely earn no more than 1.5% and the highest quality mortgages may only earn about 2% (especially after paying broker commissions on origination) but if they can be funded entirely by the lowest cost deposits then CWB can still earn a positive spread. And there would be very little administrative or other costs associated with investing in the government bonds.

Most of CWB’s residential mortgages are risk-rated at 35%. This means that CWB must effectively fund these with a minimum of 7% x 0.35 = 2.45% common equity and 10.5% x 0.35 = 3.675% total owner’s capital with the rest funded by deposits. In this way a 1% spread over the cost of deposits can be leveraged up to a 1%/0.0245 = 41% return on common equity – before the cost of bad loans and all administrative and other non-interest costs and taxes.

About 80% of CWB’s loans are commercial as opposed to personal loans and these represent about 60% of CWB’s assets and are risk-rated at 100%. That means that CWB must fund these loans with a minimum of 7% common equity and 10.5% total capital and the remaining 89.5% can be funded with deposits. If CWB wants to make say a 21% return on equity on these loans before the cost of bad loans and before administrative costs and all other non-interest costs and taxes then it must charge 3.0% more than its costs of deposits.

The above illustrates why banks must charge higher interest rates to commercial borrowers. It’s because the risks are higher and therefore less leverage is appropriate and allowed.

InvestorsFriend Inc.

December 13, 2020

 

formInvestorsFriend’s Canadian Business Hall of Shame

The following are some companies that I am metaphorically inducting into a “Hall of Shame”. These are companies that I judge to have been exceedingly poorly managed and which deserve some “recognition” in that respect.

TransAlta Corporation

Here is a link to TransAlta’s stock price chart going back as far as Yahoo Finance has the data.

As I write this on July 11, 2015, TransAlta’s stock price is $9.44 which is the lowest price on the chart. The oldest data on the chart is January 1995 when TransAlta traded at $13.63. It subsequently rose to about $24 in 1999. It fell to about $14 in early 2000. It then quickly rose to almost $30 in 2001 but then slid back to about $16 in the Summer of 2004. It then rose steadily for four years reaching its all time high of about $37 in August 2008. In the seven years since then it has fallen all the way back under $10.

When a stock has managed to fall 30% over a 20 year period, that would seem to call into question the ability of its management.

TransAlta is a utility company headquartered in Calgary Alberta. In 1995 its assets were mostly in regulated power generation, transmission and distribution. 86% of its assets were in Canada while 14% were invested in New Zealand, Australia and South America.

Subsequently, TransAlta appears to have made poor decisions in capital allocation.

In the year 2000 TransAlta opted not to participate in an auction to buy 20 year contracts on the output of Alberta electric generation plants as Alberta deregulated electricity generation. The companies that did participate in the auction have made excellent returns on those investments.

Also in the year 2000, TranAlta sold its Alberta regulated distribution assets to an American utility. Several years later these same assets were purchased by Fortis Inc. of Newfoundland and have subsequently provided excellent returns and growth for Fortis.

In 2002, TransAlta sold its regulated electric transmission assets to AltaLink which enjoyed years of strong returns and growth and then sold the assets to Berkshire Hathaway in late 2014 at a large gain.

TransAlta apparently invested the proceeds mostly into unregulated generation assets in Argentina, Australia, New Zealand, the United States and Mexico. Given the stock price performance, it does not appear that much of that was wise.

Partly mitigating the terrible share price performance over the past twenty years is the fact that TransAlta has paid a quarterly dividend . The dividend of 98 cents per share per year was increased to $1.00 per share and to as high as $1.16 per share. However it was cut to 72 cents per share in early 2014.

In my view, this dividend mitigates but in no way makes up for the terrible share price performance.

It seems remarkable that this poor performance was achieved by an Alberta-headquartered utility in the past twenty years, a period over which the Alberta economy has done extremely well.

To my knowledge, TransAlta’s share owners did not receive any proceeds from various asset sales such as special dividends or shares in any entities that were “spun-off”.

Many other Alberta utilities including TransCanada, Canadian Utilities Ltd, Enbridge and AltaGas have done very well over this period of time.

My conclusion is that TransAlta’s poor performance indicates poor management. In my view, its Board of directors have also performed very poorly by not ensuring that competent management was in place. Share owners are also to blame to some degree for not voting in new directors.

Since this is a Management Hall of Shame, it seems appropriate to “recognize” the CEOs of TransAlta over this period of time.

Steve Snyder was  the President and CEO of TransAlta Corporation for a 15 year term from 1996 to 2011. During that 15 year period the share price started at about $15 and finished at about $21. Steve Snyder presided over many of the capital allocation decisions that have apparently worked out so badly. Long-time employee Dawn Farrell was named CEO in January 2012. So, far she does not appear to have been able to correct the situation and the stock price has fallen by over 50% during her tenure.

In summary, I believe that TransAlta and its top management and Board members over these last twenty years are well qualified to be “recognized” in my Canadian Business Hall of Shame.

Shawn Allen, President of InvestorsFriend Inc. July 11, 2015

Additional companies to be added over time. (Spots are reserved for Bombardier and for Barrick Gold in particular.)

 

Just How Successful has Warren Buffett been with Berkshire Hathaway?
It’s difficult to grasp the sheer magnitude of Warren Buffett’s success in growing the value of Berkshire Hathaway. The returns, on a per share basis, over the last 50 years, have compounded up to numbers that are so far outside the normal range of experience and expectation as to almost defy comprehension.

In the 50.25 years since October 1, 1964, Warren Buffett has increased Berkshire Hathaway’s book value per share from $19.46 to $146,186. This is an absolutely staggering gain of 751,113%. Amazingly, this represents a compounded return of “only” about 19.4% per year.  This is probably the best result world-wide over 50 years for any company that started out with any significant assets. Berkshire was already a fairly large company when Buffett took it over in 1965. It then had book equity of $22 million and 2,300 employees.  

Berkshire’s market price per share has risen even faster than its book value and has risen over one million percent in these 50 years. A $1000 investment in early 1965 would be worth over $15 million today.

Return on Equity and the impact of retaining all earnings instead of paying out a portion of earnings as a dividend each year

Berkshire’s annual return on equity (counting capital gains as earnings) is approximately equal to its average compounded increase in book value per share of approximately 19.4% per year over these 50 years. This is the case for Berkshire because there were no dividends (save, ironically enough, one thin dime per share paid out in 1967) and because there was only a minor issuance of shares (in association with certain merger and purchase transactions), and then not at very high multiples of book value. Issuing shares at a high multiple of book value increases the book value per share in a manner unrelated to earnings or return on equity. This was not the case to any material extent at Berkshire which has never even traded at a particularly high multiple of book value. The increase in Berkshire’s book value per share came almost entirely from earnings.

It’s one thing for a company earn an ROE of almost 20% in any given year. It’s another thing for a company to manage to earn an average ROE of almost 20% for 50 years or even for several decades. But it’s unique and stunning for Berkshire to have compounded its equity per share at almost 20% for 50 years.

Most companies that earn double digit ROEs dividend out a large part of their earnings annually or use the earnings to buy back their own stock. If they were to retain all of these earnings they would quickly run out of lucrative double digit ROE projects to invest the retained earnings in and their ROE would quickly decline.

Consider the following examples:

• If a company matched Berkshire’s 19.4% ROE for 50 years but paid out half the earnings as a dividend and if the investor could only earn 10% by reinvesting the dividends received in other stocks, that investor would have compounded her money at “only” 13.6%. In that case the investment would have grown by 58,587% in 50 years. That would be phenomenal, but still far short of Berkshire’s book value per share gain of 751,113%. And the company itself would have grown its book value per share by “only” 10,141%
  
• Even if Berkshire had paid a dividend of just 30% of earnings each year, and if investors had earned an average of 10% when they reinvested their dividends on their own, their gain would have been 133,691%. Again, phenomenal but far short of 743,783%. And Berkshire’s book value per share would have increased by “only” 58,123%.
• If all of Berkshire’s earnings had been paid out as dividends each year and if the investors earned an average of 10% by reinvesting those dividends elsewhere then those investors would have seen gains of 22,580% in 50 years. In this case Berkshire’s wonderful 19.4% ROE would have remained applicable only to its original 1964 equity level of $19.46 per share. 

Buffett’s success with Berkshire was achieved in part by earning (counting capital gains) an average of almost 20% on equity for 50 years. But the real key was the fact that all earnings were retained and that Buffett somehow found ways to earn that average 19.4% ROE despite the fact that the capital with which he was working was growing at an average of 19.4% annually which is nothing short of explosive exponential growth. The retaining of all earnings combined with the 19.4% ROE allowed the original capital per share  to continue to compound at an average of 19.4% for 50 years. It seems likely, that no other company that started with over $20 million in equity has ever managed to compound that equity on per share basis at 19.4% for 50 years. 

In his 2012 letter, Buffett himself explained that paying out a dividend would have greatly hurt Berkshire’s investors.

Berkshire’s high ROE was not primarily due to leverage.

One way to generate an ROE of 20% would be with massive leverage. With financial leverage the assets become significantly larger than the equity. Banks, for example, typically leverage their equity  at least 10 times. Before the 2008 financial crisis many large U.S. banks were leveraged about 20 times. With 20 times leverage a 1% return on assets translates into a 20% ROE.

Some sources have attributed Berkshire’s success to leverage. But the facts say otherwise. 

One academic paper claimed that leverage was a major contributor to Berkshire’s success. But then it noted that the leverage had averaged 1.6 to 1. The problem with that claim is that 1.6 to 1 is not a high leverage level for a typical operating business. It implies equity of 62.5% of assets which  would not be high leverage for most companies and is in fact unusually low leverage for a publicly traded company heavily involved in the insurance business. Allstate, for example had shareholder equity of just 17% of assets at the end of 2013. That is leverage of 5.9 to 1. In Canada, one of the largest property insurance companies is Intact Financial and it had equity of just 25% of assets at the end of 2013, resulting in leverage of 4.0 to 1. The academics attempted to explain Buffett’s success in comparison to un-leveraged stock funds. But they did not compare his returns with Berkshire to other corporations. They also did not address the income tax disadvantage that Buffett faced when investing in stocks through a corporation rather than through a partnership or mutual fund.

Berkshire does leverage its equity. But it has used far less leverage than most publicly traded insurance companies and its leverage is not high even compared to most non-financial companies.

Suggestions that Buffett’s success with Berkshire has been due to an unusually high level of leverage simply do not stand up to scrutiny. 

Berkshire’s high ROE was boosted by its unusually low cost for the modest leverage that it did employ.

The normal way to achieve leverage is through debt. But debt costs money for interest payments. For much of the time that Buffett has controlled Berkshire, interest rates on even high quality corporate debt were high. If Berkshire had used long-term debt for leverage it would have had to pay interest rates of 8% or even well into double digits in many years. 

However, as demonstrated below, Berkshire used little or no debt in its insurance and investing operation. (It did use debt in its small lending operation and in recent years in its utility and railroad businesses.) Berkshire’s two main sources of financial leverage were insurance “float” and deferred income taxes.

Insurance “float” was a large and low-cost form of leverage for Berkshire over most of the last 50 years. Float represents money ear-marked for future insurance claim payments that meanwhile can be invested. In 2013, for example, Berkshire made an underwriting profit on insurance that amounted to 4% of its float. This meant that the float, in 2013, was effectively a form of leverage with a cost equivalent to a negative 4% interest rate. Most insurance companies face a positive cost of float. Berkshire has had a negative “cost” of float in more years than not.

In addition, Berkshire used deferred income taxes as an interest-free form of leveraging. Berkshire had an unusually large amount of deferred income taxes over much of the past 50 years. This was due in large part to the fact that it maintained large unrealized gain positions in many stocks. 

The lower-than-debt cost of leverage provided by float and deferred income taxes boosted Berkshire’s ROE by an average of perhaps 2% per year. That may not seem like a lot but consider that money compounding at 19.4% for 50 years grows to an amount that is more than double the amount that money compounding at 17.4% grows to – 133% higher to be precise. Such is the power of compounding. A little higher rate of compounding goes a very long way when you talking about 50 years.

Berkshire achieved a high return on assets

In the absence of high leverage, the way to achieve a high return on equity is to achieve a high return on assets. It is therefore clear that Buffett and Berkshire Hathaway achieved a relatively high return on assets compared to most companies and that its return on assets was far higher than that of most insurance companies (which had far lower ROEs despite their much higher leverage).

The nature of Berkshire’s activities and assets and how they were funded

Berkshire’s core activity since shortly after Buffett took control in 1965 has been to operate a property and casualty insurance operation which invests in stocks, bonds and non-insurance subsidiary businesses with these assets and  investments funded by, in order of importance: common equity, insurance float, accounts payable, “other” which includes deferred taxes, and a very modest amount of debt.

This operation differed from most other insurance companies in at least three major ways:

1. Financial leverage (including debt and insurance float) was and is unusually low and the common equity ratio unusually high.

2. Investments were and are concentrated in equities and even the ownership of entire businesses rather than in bonds.

3. The insurance operation was and is unusually profitable (or had unusually small losses) even before considering profits from investments.

To illustrate, here is a simplified view of Berkshire Hathaway’s Insurance and investment assets, on a percentage basis and how they were financed as at the end of 2013. This excludes the railroad and utilities segments as well as the finance segment. Those two excluded segments do use a lot of debt leverage. The rail and utility sectors are more recent additions to Berkshire and are excluded because they do not reflect its core insurance and investing operation. The finance sector is excluded because it also does not reflect the core operation and is, in any case, quite small.

 

	A very high level of equity (which is composed largely of retained earnings)
	Very little debt
	A significant but not over-whelming level of insurance float liabilities
	The famously high allocation to cash
	Only a modest level of investments in fixed maturity investments (bonds).
	A very high level of investments in equities
	Substantial investments in subsidiary non-insurance operating businesses including purchased goodwill of these businesses and of the insurance businesses.

The oldest balance sheet available on Berkshire’s web site is from 1995. The following is the full consolidated balance sheet from the end of 1995 on a percentage basis:

 

Berkshire Hathaway — Year End 1995
Assets			Liabilities and Owners Equity
Cash and cash equivalents	9%		Insurance liabilities (float)	14%
Investments – fixed maturity	5%		Accounts Payable and other	4%
Investments – equities	73%		Finance business debt	2%
Finance Assets	3%		Other debt	4%
Business assets including goodwill	9%		Deferred Income Tax	17%
			Owner’s Equity	59%
Total	100%		Total	100%

Back in 1995, the liability side of the balance sheet was supported 59% by equity, similar to 2013. Insurance float was a smaller percentage of the liabilities and deferred taxes supported 17% of the assets. Debt was very low, similar to 2013. On the asset side of the balance sheet, there was a significant allocation to cash. The allocation to fixed maturity investments (bonds) was quite low. Almost three quarters of the assets were invested in equities. (In part this is because the equities were marked to market while business assets were not.) The percentage of assets devoted to subsidiary businesses and goodwill were much lower than in 2013.

Summary

To be concise; Buffett entered the insurance business and achieved negative cost float through wise management and discipline and invested the float extremely wisely in high returning stocks and businesses and retained all earnings to grow the insurance, investment and business assets.

Additional Details and Keys to Warren Buffett’s Success:

The material above documented the level of success achieved and has demonstrated that it was achieved by earning unusually high returns on assets accompanied by some use of unusually low-cost insurance float and zero-cost deferred tax leverage and by a very modest amount of debt leverage. The sections below provide a number of factors which further explain Buffett’s extraordinary success with Berkshire Hathaway.

Setting a growth per share goal and sticking to it

From the start, Buffett’s goal was to grow the per share  intrinsic value of Berkshire Hathaway at a rate well above the average annual returns of the S&P 500. As an approximate but imperfect measure of this he used the growth in Berkshire’s book value per share. He has never wavered from this goal and this measuring stick. 

Relentlessly doing what was good for shareholders

Buffett always acted according to what was good and rational for shareholders. Investments that would reduce reported earnings temporarily were pursued if they made sense in the longer term. A dividend would have been popular but was not introduced because it would ultimately diminish shareholder wealth.  Growth was never pursued for the sake of growth if it would hurt shareholder wealth.

Retaining all earnings

As documented above, Berkshire’s phenomenal growth in value per share would have been severely reduced if it had paid out even a modest dividend over the years. By retaining all earnings and by continuing to find investments that would earn an average of almost 20% per year, Buffett accomplished the compounding of his starting book value per share at almost 20% per year as of 2014. If all of the earnings were not retained then the original book value per share would not have compounded at anything close to 20% even with the near 20% average ROE achieved at Berkshire.

A high level of equity and low debt and ample cash in the insurance companies allowed investing in equities

Most insurance companies invest primarily in bonds rather than equities.  This reduces the risk of earnings volatility but also reduces long-term returns. Buffett very much targeted equities. By initially funding his insurance companies with high levels of equity and little or no debt and by then retaining all or substantially all insurance and investment earnings within the insurance companies he always had equity levels that were multiples larger than the minimums required by insurance regulators. It appears that debt was totally avoided in the insurance operations. The modest debt shown in the balance sheets above is likely associated with its non-insurance subsidiaries and (in the 1995 balance sheet) its finance operations. 

Since financial risk amplifies the risks associated with assets, the lower level of financial leverage or financial risk allowed higher risks on the investment side including a heavy allocation to equities.  

By maintaining a high cash level Buffett was never forced to sell investments at inopportune times in order to fund, for example, an unexpectedly high level of insurance payouts. The maintenances of ample cash also likely contributed to the ability to take higher risks  with the remaining assets.

Equities are perceived by regulators as higher risk, though Buffett did not see his stock selections as risky.

Finding High Return Investments for the retained earnings 

A huge part of Buffett’s success with Berkshire was in continually finding equities and businesses, to invest retained earnings in, that provided high returns. If Buffett had retained all of Berkshire’s earnings but invested in assets that resulted in returns on equity of 10% rather than in the order of 20% then the growth in Berkshire’s book value per share would have been about 11,739% after 50 years or (astoundingly) just 1.6% of the actual 743,783% that has been achieved. Continuously finding additional ways to average about 20% returns on equity despite an equity level that was compounding up at that average rate per share was a huge and necessary component of Berkshire’s success.

Those “ways” included investing extremely selectively in high quality companies whether through the stock market or by purchasing them outright. There were  also superior investments in bonds and arbitrage positions over the years. The following contributed to accumulation of high-return assets.

Superior Stock Picking –

It is well-recognized that Buffett exhibited superior stock picks skills. Somewhat bizarrely, the academics mentioned above “explained” this by noting that he favored low-risk, high-quality companies. This appears to “explain” away his stock picking skill by noting that he “merely” picked the type of stocks that tend to do the best. Buffett has noted that at Charlie Munger’s urging he focused on businesses with exceptional brand strength. He bought wonderful businesses at fair (or better) prices rather than fair businesses at wonderful prices.

Superior Business Acquisition Strategies

It is clear that Buffett made many extremely successful business acquisitions. The focus was on buying the best businesses with the best predictable long-term growth prospects.

Rarely Issuing Shares for Acquisitions

Buffett has explained that, given that Berkshire itself was growing its net worth per share rapidly it was rarely ever the case that the shares were under-valued in the market. It almost always made sense to acquire for cash rather than shares. Berkshire’s growth per share would have been much lower if the share count had been allowed to increase more than the modest amount that it did.

Superior Business Management

Through some combination of choosing the best managers and providing the right working environment and incentives and rewards (both financial and emotional – as in public praise), Buffett was able to get extraordinary performance out of most of his subsidiary companies most of the time.

Becoming the Buyer of Choice

At some point, based on his reputation and way of doing things, Buffett and Berkshire became the “buyer of choice” for many large and successful family-controlled businesses. This led to some excellent acquisitions more or less falling into his lap and led to good prices for those acquisitions.

Achieving profit on insurance operations

Buffett has often explained how most insurance companies do not make an operating or underwriting profit on their insurance operations before considering the profit on investments. In contrast, Berkshire managed to make a profit most years on its insurance operations even before considering the profits from investing the insurance float.

The use of Insurance float and deferred taxes to fund assets

Buffett has explained that using insurance float to fund investment assets can be very beneficial but only if the insurance companies operate with a cost of float that is lower than the cost of using debt. Most insurance companies lose money on their insurance operations but make a profit overall by investing their insurance float. Most insurance companies face a high cost of float, usually not consistently lower, if any, than the cost of debt. Buffett and Berkshire however have managed to achieve a cost of float that has been below zero on average. This meant that the leverage that was provided by float, while it was not a large amount of leverage came at a “cost” less than zero. This boosted the return on assets by lowering the cost of funding the assets.

Another advantage of funding assets with float rather than debt was that float did not have a maturity date. As long as the insurance operations were growing the float would grow. Insurance claims would be paid out each year but the incoming premiums, after operating expenses, would usually exceed the payments and the float would grow.

Deferred income taxes represented mostly the income tax that would be due if the stock investments which had appreciated greatly in value were sold.  This is not a legal liability until and unless the shares are sold and the capital gain realized. This source of funding has no interest rate cost. In addition, this source of funding would tend to grow over the years as Berkshire grew and as Buffett tended not to sell and not to realize gains on his largest equity positions.

Together, float and deferred taxes provided a low or even negative cost way to leverage the equity return by allowing assets to be larger than equity. Again, however, Buffett’s use of leverage was modest in comparison to other insurance companies.  The advantage was in the low cost of this leverage.

Discipline and patience

It is difficult to do justice in describing the level of discipline and patience that Buffett exercised. At times he severely curtailed the level of business in his insurance operations when he judged market insurance rates to be too low. He studied hundreds of investment opportunities each year but had the discipline to select only those very few that were the very best he could find. In the 1970’s he had the patience and discipline to buy a very large position in GEICO only after its price had fallen some 95%. This was despite the fact that he had known and admired the company for two decades prior to that. He always had the discipline to restrict his investments to fit a strict criteria which excluded many industries.

Focus

Buffett exhibited a laser-like focus on his goal of increasing the value of Berkshire on a per share basis.

Ignoring the Stock Price

Buffett focused on growing the value per share and the earnings per share. He let the stock price basically take care of itself.

Speed

Buffett has taken pride over the years in describing the extreme speed at which he was able to make deals and acquire companies. In each annual letter he has stated that he can provide a preliminary indication of his interest in a potential acquisition, “customarily within five minutes”.

Buffett also used speed in his huge reinsurance operation. He has described how the top manager of that business is able to give a same-day commitment on an insurance contract in the hundreds of millions of dollars. He indicated that no other reinsurance company operates at close to that speed.

Keeping it Lean

Head office staff was remarkably lean at about  11 to 14 for many years. In recent years it has “bloated” up to around 24. The extremely lean head office staff meant that there were fewer distractions from managing staff. It also set a great example of frugality that no-doubt influenced the managers of his subsidiary companies.

Running a Highly Concentrated Equity Portfolio

One certainly cannot beat the stock market averages by holding a diversified portfolio that mimics the market. Finding  a handful of stocks that beat the market substantially allowed Buffett to beat the market. A concentrated portfolio in no way guarantees beating the market. But mimicking the market with a widely diversified portfolio would have precluded beating the market by any material amount.

Time Management

Buffett has described how he set up his operation in a way that allowed him to spend most of his time on the all-important functions of finding the best investments. As Berkshire grew, it would have been natural to have spent most of his time on administration and management. Buffett did not allow that to happen. His letter indicate the ability also to drop everything and focus immediately on an acquisition or other matter of great importance whenever that was required. 

Placing Trust in managers and giving them full authority and autonomy

Buffett has described how he placed the utmost trust in the management of his various subsidiaries. He ceded full control and autonomy  over operations to these managers. It seem clear that the managers responded to this trust by working very hard to earn it. This was also part of his strategy of freeing up his own time to focus on the investment process.

Providing managers with appropriate financial incentives

Managers were given simple and relevant financial incentives. Their pay was linked tightly to achieving a higher than normal return on the capital that they worked with. 

Heaping public praise and encouragement on his best managers

Buffett has always used his annual letter to heap extremely lavish praise on his top managers. It has got to be very motivating for managers to be praised in such a widely-read public letter.

Keeping tabs on his companies and investments

While managers are left alone to run “their” subsidiary businesses, they must file frequent detailed reports to Buffett. These reports focus on weekly and daily sales volumes and on costs. The reports allowed Buffett to keep close tabs on operations and profitability.

Rationality

Buffett was constantly aware of the mathematics of making returns. He always focused on making rational decisions. He never priced his insurance below a reasonable level just because others were doing it. He never did anything simply because others were doing it . He always acted in ways that he thought to be rational.

Investing in businesses as well as securities

Owning businesses outright provided some tax advantages as compared to owning stocks and earning returns through dividends. Buffett also found that at some times businesses were the better bargain and at other time stocks in the market were the better bargain. Being willing to choose from the two options assisted in the maximization of return on assets. He also chose bonds when those were the best option. And there was no fixed allocation to bonds and equities. The allocations changed depending on the relative attractiveness of each category at any point in time.

Separating the Insurance Business Into Two Parts

In each insurance operation he made management responsible for the underwriting profit and the growth of float and gave them no responsibility for the investment process. He expected his insurance managers to achieve an under-writing profit or at least a lower-than-average cost of float with no reliance on investment returns. By taking the management of investments out of their hands he assured that their attention was 100% focused on under writing profitability and profitable growth.

Controlling large capital expenditures at the top

Berkshire’s conglomerate nature allowed excess capital generated in one business to be used to grow another. By controlling the bigger capital expenditure decisions from the top, Buffett insured that mangers did not pour capital into their particular business when better opportunities were available elsewhere in Berkshire including by investing in stocks or bonds.

Confidence

Buffett always had a huge amount of confidence in his own analysis. The fact that his approach was unconventional or unpopular never bothered him.

The ability to transfer earnings of subsidiary companies to other companies tax free

When Berkshire received dividends and interest from marketable securities there was income tax to pay. However, dividends from one subsidiary could be received and invested in another subsidiary without incurring income tax.

Wise consideration of income tax

Buffett has said that minimizing income tax was never the primary goal. But he certainly did defer income taxes and structure transactions in tax efficient ways when it made sense to do so. However, it should be noted that he was by no means aggressive in avoiding income tax. For example, unlike (as I understand it) most insurance companies he did not set up captive reinsurance operations located in tax havens to flow profits to those low-tax jurisdictions. I have never seen any commentator give Berkshire or Buffett credit for that.

Toughness

Warren Buffett’s son Howard has said that people don’t understand just how tough Warren Buffett is. He did not like to do it, but he fired managers when he had to. He is an extremely tough negotiator. He tends to name a price and stick with it.

An immense will to win and be the best

Buffett has always displayed an enormous will to win. He made sure to measure how his companies stacked up. For example, he knew that Nebraska Furniture Mart had the highest single store sales in the U.S. and he was very proud of it. He has noted several times when his two pipelines ended up at the very top of the customer satisfaction rankings for pipelines. He is proud of the high returns his companies make and is proud when they can offer the lowest prices and still make the highest profits. Buffett has won many things. One was a Pulitzer prize for his tiny Sun newspaper, in the early 1970’s, for an article he suggested and helped write. He is a famously skilled and competitive Bridge player. You just don’t win as often and as big as Buffett has without having an enormous will to win.

A photographic memory

It’s my observation that Buffett has a photographic memory. I have witnessed him pull detailed facts and figures out of the air in answering hundreds of random questions.  He has described how he had basically memorized Benjamin’s Graham’s book Security Analysis and knew the book better than Graham when he was taking classes from Graham. 

Loyalty

Buffett has displayed great loyalty to his oldest friends and associates. Carol Loomis, for example has been editing his annual letter since 1977 and was a friend before that. He was enormously loyal to Katherine Graham at the Washington Post. He calls long-time business associate and Berkshire Board member and later former CEO of Capital Cities (which Berkshire owned a huge and hugely profitable  stake in), Tom Murphy, “overall the greatest business manager I’ve ever met”. He has frequently done business repeatedly with the same executives. When he has gained great trust and has great admiration for someone he very rationally chooses to continue to do business and associate with that person.

A total lack of pandering to Wall Street

Buffett has never played the Wall Street game of attempting to meet or beat the earnings expectations of analysts. He considers that a waste of time and considers that it would offer an unfair information advantage to analysts. Berkshire may be alone among S&P 500 companies in not doing quarterly or even annual analyst conference calls. This avoids a distraction and a demand on his time.

Constantly Reading, Learning and Thinking

Buffett has said that he often read 500 pages per day. He reads widely. He reads or goes through five newspapers per day. When he was young he studied every page of the Standard and Poors and Moodys summary reports on companies. His partner, Charlie Munger calls him a learning machine.

Unique Mathematical Analysis Abilities

Buffett has said that he posses “certain mathematical gifts”. He can calculate in his head what others need a computer to calculate. He has an ability to take a few numbers and relate them in uniquely insightful,  useful and memorable ways. For example, he related the number of households being formed to the number of houses being built before during and after the U.S. housing bust. He calculated that all the gold in  the world would form a cube only about 68 feet per side which he said could rest comfortably inside a baseball infield. He then noted that the market value of this imaginary gold cube was equal to 16 Exxon Mobils, all the cropland in the United States plus a trillion dollars. These kind of simple but powerful relationships give him a unique and fast insight into many things.

Consistency

Although he has learned and adapted over the years, Buffett has also been remarkably consistent. In 2013 he included in the annual report a letter about pensions that he had written in 1975. Presumably his opinions had not changed. Reading his earliest letters (from the late 50’s and the 1960’s) one can see that his most basic views have not changed.

Conclusion

All of the above explains how Warren Buffett was able achieve such staggering growth per share at Berkshire. It’s interesting that while he has hundreds of thousands of fans so few people have truly tried to emulate his methods. Business schools rarely teach his methods. Other CEOs rarely seem to copy him. You now have the information you need to do so.

END

Shawn Allen, CFA, CMA. MBA, P.Eng.

February, 2015 (latest edit March 1, 2015)

 

How Warren Buffett Achieved Such Phenomenal Success with Berkshire Hathaway

Just How Successful has Warren Buffett been with Berkshire Hathaway?

It’s difficult to grasp the sheer magnitude of Warren Buffett’s success in growing the value of Berkshire Hathaway. The returns, on a per share basis, over the last 50 years, have compounded up to numbers that are so far outside the normal range of experience and expectation as to almost defy comprehension.

In his 50 years of controlling Berkshire Hathaway, Warren Buffett has increased its book value per share from $19.46 to $144,565 as of September 30, 2014. This is an absolutely staggering gain of 742,783%. Amazingly, this represents a compounded return of “only” about 19.5% per year. This is probably the best result world-wide over 50 years for any company that started out with any significant assets. Berkshire was already a fairly large company when Buffett took over. At the start of fiscal 1965 it had book equity of $22 million and had 2,300 employees.

Berkshire’s market price per share has risen even faster than its book value and has risen over one million percent in these 50 years. A $1000 investment in early 1965 would be worth over $15 million today.

Return on Equity and the impact of retaining all earnings instead of paying out a portion of earnings as a dividend each year

Berkshire’s annual return on equity (counting after-tax realised capital gains as earnings) has also averaged approximately 19.5% over these 50 years. This is the case for Berkshire because there were no dividends (save, ironically enough, one thin dime per share paid out in 1967) and because there was only a minor issuance of shares (in association with certain merger and purchase transactions), and those issuances were not at very high multiples of book value.

It’s one thing for a company to earn an ROE of almost 20% in any given year. It’s another thing for a company to manage to earn an average ROE of almost 20% for 50 years or even for several decades. But it’s unique and stunning for Berkshire to have compounded its equity per share at almost 20% for 50 years.

Most companies that earn double digit ROEs dividend out a large part of their earnings annually or use the earnings to buy back their own stock. If they were to retain all of these earnings they would quickly run out of lucrative double digit ROE projects to invest the retained earnings in and their ROE would quickly decline.

If a company matched Berkshire’s 19.5% ROE for 50 years but paid out half the earnings as a dividend and if the investor could only earn 10% by reinvesting the dividends received in other stocks, that investor would have compounded her money at “only” 13.6%. In that case the investment would have grown by 59,608% in 50 years. That would be phenomenal, but still far short of Berkshire’s book value per share gain of 742,783%. And the company itself would have grown its book value per share by “only” 10,377%

Even if Berkshire had paid a dividend of just 30% of earnings each year, and if investors had earned an average of 10% when they reinvested their dividends on their own, their gain would have been 137,365%. Again, phenomenal but far short of 742,783%. And Berkshire’s book value per share would have increased by “only” 59,944%.

If all of Berkshire’s earnings had been paid out as dividends each year and if the investors earned an average of 10% by reinvesting those dividends elsewhere then those investors would have seen gains of 22,696% in 50 years. In this case Berkshire’s wonderful 19.5% ROE would have remained applicable only to its original 1965 equity level of $19.46 per share.

Buffett’s success with Berkshire was achieved in part by earning (counting after-tax realised capital gains) an average of almost 20% on equity for 50 years. But the real key was the fact that all earnings were retained and that Buffett somehow found ways to earn that average 19.5% ROE despite the fact that the capital with which he was working was growing at an average of 19.5% annually which is nothing short of explosive exponential growth. The retaining of all earnings combined with the 19.5% ROE allowed the original capital per share to continue to compound at an average of 19.5% for 50 years. It seems likely, that no other company that started with over $20 million in equity has ever managed to compound that equity on a per share basis at 19.5% for 50 years.

Berkshire’s high ROE was not primarily due to leverage.

One way to generate an ROE of 20% would be with massive leverage. With financial leverage the assets become significantly larger than the equity. Banks, for example, typically leverage their equity at least 10 times. Before the 2008 financial crisis many large banks were leveraged about 20 times. With 20 times leverage a 1% return on assets translates into a 20% ROE.

Some sources have attributed Berkshire’s success to leverage. But the facts say otherwise.

One academic paper claimed that leverage was a major contributor to Berkshire’s success. But then it noted that the leverage had averaged 1.6 to 1. The problem with that claim is that 1.6 to 1 is not a high leverage level for a typical operating business. It implies equity of 62.5% of assets which would not be high leverage for most companies and is in fact unusually low leverage for a publicly traded company heavily involved in the insurance business. Allstate, for example, had shareholder equity of just 17% of assets at the end of 2013. That is leverage of 5.9 to 1. In Canada, one of the largest property insurance companies is Intact Financial and it had equity of just 25% of assets at the end of 2013, resulting in leverage of 4.0 to 1. The academics attempt to explain Buffett’s success in comparison to un-leveraged stock funds. But they don’t compare his returns with Berkshire to other corporations. They also do not address the income tax disadvantage that Buffett faced when investing in stocks through a corporation rather than through a partnership or mutual fund.

Berkshire does leverage its equity. But it has used far less leverage than most publicly traded insurance companies and its leverage is not high even compared to most non-financial companies.

Suggestions that Buffett’s success with Berkshire has been due to an unusually high level of leverage simply do not stand up to scrutiny.

Berkshire’s high ROE was boosted by its unusually low cost for the modest leverage that it did employ.

The normal way to achieve leverage is through debt. But debt costs money for interest payments. For much of the time that Buffett has controlled Berkshire, interest rates on even high quality corporate debt were high. If Berkshire had used long-term debt for leverage it would have had to pay interest rates of 8% or even well into double digits in many years.

However, as demonstrated below, Berkshire used little or no debt in its insurance and investing operation. (It did use debt in its small lending operation and in recent years in its utility and railroad businesses.) Berkshire’s two main sources of financial leverage were insurance “float” and deferred income taxes.

Insurance “float” was a large and low-cost form of leverage for Berkshire over most of the last 50 years. Float represents money ear-marked for future insurance claim payments that meanwhile can be invested. In 2013, for example, Berkshire made an underwriting profit on insurance that amounted to 4% of its float. This meant that the float, in 2013, was effectively a form of leverage with a cost equivalent to a negative 4% interest rate. Most insurance companies face a positive cost of float. Berkshire has had a negative “cost” of float in more years than not.

In addition, Berkshire used deferred income taxes as an interest-free form of leveraging. Berkshire had an unusually large amount of deferred income taxes over much of the past 50 years. This was due in large part to the fact that it maintained large unrealized gain positions in many stocks.

The lower-than-debt cost of leverage provided by float and deferred income taxes boosted Berkshire’s ROE by an average of perhaps 2% per year. That may not seem like a lot but consider that money compounding at 19.5% for 50 years grows to an amount that is more than double the amount that money compounding at 17.5% grows to – 133% higher to be precise. Such is the power of compounding. A little higher rate of compounding goes a very long way when you talking about 50 years.

Berkshire achieved a high return on assets

In the absence of high leverage, the way to achieve a high return on equity is to achieve a high return on assets. It is therefore clear that Buffett and Berkshire Hathaway achieved a relatively high return on assets compared to most companies and that its return on assets was far higher than that of most insurance companies (which had far lower ROEs despite the use of high leverage).

The nature of Berkshire’s activities and assets and how they were funded

Berkshire’s core activity since shortly after Buffett took control in 1965 has been to operate a property and casualty insurance operation which invests in stocks, bonds and non-insurance subsidiary businesses with these assets and investments funded by, in order of importance, common equity, insurance float, accounts payable and other including deferred taxes, and a very modest amount of debt.

This operation differed from most other insurance companies in at least three major ways:

1. Financial leverage (including debt and insurance float) was and is unusually low and the common equity ratio unusually high.
2. Investments were and are concentrated in equities and even the ownership of entire businesses rather than in bonds.
3. The insurance operation was and is unusually profitable (or had unusually small losses) even before considering profits from investments.

To illustrate, here is a simplified view of Berkshire Hathaway’s Insurance and investment assets, on a percentage basis and how they were financed as at the end of 2013. This excludes the railroad and utilities segments as well as the finance segment. Those two excluded segments do use a lot of debt leverage. The rail and utility sectors are more recent additions to Berkshire and are excluded because they do not reflect its core insurance and investing operation. The finance sector is excluded because it also does not reflect the core operation and is, in any case, quite small.

Berkshire Hathaway Insurance and Other Segment — Year End 2013
Assets		Liabilities and Owners Equity
Cash and cash equivalents	14%	Insurance liabilities(float)	28%
Investments – fixed maturity	9%	Accounts Payable and other	7%
Investments – equities and other	45%	Debt	4%
Business assets including goodwill	33%	Owner’s Equity	61%
Total	100%	Total	100%

Some notable characteristics of this condensed balance sheet include:

• A very high level of equity (which is composed largely of retained earnings)
• Very little debt
• A significant but not over-whelming level of insurance float liabilities
• The famously high allocation to cash
• Only a modest level of investments in fixed maturity investments(bonds).
• A very high level of investments in equities
• Substantial investments in subsidiary non-insurance operating businesses including purchased goodwill of these businesses and of the insurance businesses.

The oldest balance sheet that I have available is from 1995. The following is the full consolidated balance sheet from the end of 1995 on a percentage basis:

Berkshire Hathaway for the Year End 1995
Assets		Liabilities and Owners Equity
Cash and cash equivalents	9%	Insurance liabilities(float)	14%
Investments – fixed maturity	5%	Accounts Payable and other	4%
Investments – equities and other	73%	Finance business debt	2%
Finance Assets	3%	Other Debt	4%
Business assets including goodwill	9%	Deffered Income Tax	17%
		Owner’s Equity	59%
Total	100%	Total	100%

Back in 1995, the liability side of the balance sheet was supported 59% by equity, similar to 2013. Insurance float was a smaller percentage of the liabilities and deferred taxes supported 17% of the assets. Debt was very low, similar to 2013. On the asset side of the balance sheet, there was a significant allocation to cash. The allocation to fixed maturity investments (bonds) was quite low. Almost three quarters of the assets were invested in equities. (In part this is because the equities were marked to market while business assets were not.) The percentage of assets devoted to subsidiary businesses and goodwill were much lower than in 2013.

Keys to Warren Buffett’s Success:

The material above documented the level of success achieved and has demonstrated that it was achieved by earning unusually high returns on assets accompanied by some use of unusually low-cost insurance float and zero-cost deferred tax leverage and by a very modest amount of debt leverage. The sections below provide a number of factors which further explain Buffett’s extraordinary success with Berkshire Hathaway.

Setting a growth per share goal and sticking to it

From the start, Buffett’s goal was to grow the per share value of Berkshire Hathaway at a rate well above the average annual returns of the S&P 500. As an approximate but imperfect measure of this he used the growth in Berkshire’s book value per share. He has never wavered from this goal and this measuring stick.

Retaining all earnings

As documented above, Berkshire’s phenomenal growth in value per share would have been severely reduced if it had paid out even a modest dividend over the years. By retaining all earnings and by continuing to find investments that would earn an average of almost 20% per year, Buffett accomplished the compounding of his starting book value per share at almost 20% per year as of 2014. If all of the earnings were not retained then the original book value per share would not have compounded at anything close to 20% even with the near 20% average ROE achieved at Berkshire.

A high level of equity and low debt and ample cash in the insurance companies allowed investing in equities

Most insurance companies invest primarily in bonds rather than equities. This reduces risk but also reduces return. Buffett very much targeted equities. By initially funding his insurance companies with high levels of equity and little or no debt and by then retaining all or substantially all insurance and investment earnings within the insurance companies he always had equity levels that were multiples larger than the minimums required by insurance regulators. It appears that debt was totally avoided in the insurance operations. The modest debt shown in the balance sheets above is likely associated with its non-insurance subsidiaries and, in the 1995 example, its finance operations.

Since financial risk amplifies the risks associated with assets, the lower level of financial leverage or financial risk allowed higher risks on the investment side including a heavy allocation to equities.

By maintaining a high cash level Buffett was never forced to sell investments at inopportune times in order to fund, for example, an unexpectedly high level of insurance payouts. The maintenances of ample cash also likely contributed to the ability to take higher risks with the remaining assets.

Equities are perceived by regulators as higher risk, though Buffett did not see his stock selections as risky.

Finding High Return Investments for the retained earnings

A huge part of Buffett’s success with Berkshire was in finding equities and businesses to invest in that provided high returns. If Buffett had retained all of Berkshire’s earnings but invested in assets that resulted in returns on equity of 10% rather than in the order of 20% then the growth in Berkshire’s book value per share would have been about 11,739% after 50 years or (amazingly enough) just 1.6% of the actual 742,783% that has been achieved. Continuously finding additional ways to average about 20% returns on equity despite an equity level that was compounding up at that average rate per share was a huge and necessary component of Berkshire’s success.

Those “ways” included investing extremely selectively in high quality companies whether through the stock market or by purchasing them outright. It also included many superior investments in bonds and arbitrage positions over the years.

Superior Stock Picking

It is well-recognized that Buffett exhibited superior stock picks skills. Somewhat bizarrely, the academics mentioned above “explained” this by noting that he favored low-risk, high-quality companies. This appears to “explain” away his stock picking skill by noting that he merely picked the type of stocks that tend to do the best.

Superior Business Acquisition Strategies

It is clear that Buffett made many extremely successful business acquisitions. He bought the right type of businesses, which usually came with the right kind of top manager and he did not over-pay. He avoided bidding wars.

Superior Business Management and motivation of managers

Through some combination of choosing the best managers and providing the right working environment and incentives and rewards (both financial and emotional – as in praise), Buffett was able to get extraordinary performance out of most of his subsidiary companies most of the time. I addressed this in detail in an article about Buffett’s management and motivation skills.

Becoming the Buyer of Choice

At some point, based on his reputation and way of doing things, Buffett and Berkshire became the “buyer of choice” for many large and successful family-controlled businesses. This led to some excellent acquisitions more or less falling into his lap and led to good prices for those acquisitions.

Achieved profit on insurance operations

Buffett has often explained how most insurance companies do not make an operating or underwriting profit on their insurance operations before considering the profit on investments. In contrast, Berkshire managed to make a profit most years on its insurance operations even before considering the profits from investing the insurance float.

The use of Insurance float and deferred taxes to fund assets

Buffett has explained that using insurance float to fund investment assets can be very beneficial but only if the insurance companies operate with a cost of float that is lower than the cost of using debt. Most insurance companies lose money on their insurance operations but make a profit overall by investing their insurance float. Most insurance companies face a high cost of float, usually not consistently lower, if any, than the cost of debt. Buffett and Berkshire however have managed to achieve a cost of float that has been below zero on average. This meant that the leverage that was provided by float, while it was not a large amount of leverage came at a “cost” less than zero. This boosted the return on assets by lowering the cost of funding the assets.

Another advantage of funding assets with float rather than debt was that float did not have a maturity date. As long as the insurance operations were growing the float would grow. Insurance claims would be paid out each year but the incoming premiums, after operating expenses, would usually exceed the payments and the float would grow.

Deferred income taxes represented mostly the income tax that would be due if the stock investments which had appreciated greatly in value were sold. This is not a legal liability until and unless the shares are sold and the capital gain realized. This source of funding has no interest rate cost. In addition this source of funding would tend to grow over the years as Berkshire grew and as Buffett tended not to sell and not to realize gains on his largest equity positions.

Together, float and deferred taxes provided a low or even negative cost way to leverage the equity return by allowing assets to be larger than equity. Again, however, Buffett’s use of leverage was modest in comparison to other insurance companies. The advantage was in the low cost of this leverage.

Discipline and patience

It is difficult to do justice in describing the level of discipline and patience that Buffett exercised. At times he severely curtailed the level of business in his insurance operations when he judged market insurance rates to be too low. He studied hundreds of investment opportunities each year but had the discipline to select only those very few that were the very best he could find. In the 1970’s he had the patience and discipline to buy a very large position in GEICO only after its price had fallen some 95%. This was despite the fact that he had known and admired the company for two decades prior to that. He always had the discipline to restrict his investments to fit a strict criteria which excluded many industries.

Focus

Buffett exhibited a laser-like focus on his goal of increasing the value of Berkshire on a per share basis.

Speed

Buffett has taken pride over the years in describing the extreme speed at which he was able to make deals and acquire companies. In each annual letter he has stated that he can provide a preliminary indication of his interest in a potential acquisition, “customarily within five minutes”.

Buffett also used speed in his huge reinsurance operation. He has described how the top manager of that business is able to give a same-day commitment on an insurance contract in the hundreds of millions of dollars. He indicated that no other reinsurance company operates at close to that speed.

Keeping it Lean

Head office staff was remarkably lean at about 11 to 14 for many years. In recent years it has “bloated” up to around 24. The extremely lean head office staff meant that there were fewer distractions from managing staff. It also set a great example of frugality that no-doubt influenced the managers of his subsidiary companies.

Running a Highly Concentrated Equity Portfolio

One certainly cannot beat the stock market averages by holding a diversified portfolio that mimics the market. Finding a handful of stocks that beat the market substantially allowed Buffett to beat the market. A concentrated portfolio in no way guarantees beating the market. But mimicking the market with a widely diversified portfolio would have precluded beating the market by any material amount.

Time Management

Buffett has described how he set up his operation in a way that allowed him to spend most of his time on the all-important functions of finding the best investments. As Berkshire grew, it would have been natural to have spent most of his time on administration and management. Buffett did not allow that to happen. His letters indicate the ability to drop everything and focus immediately on an acquisition or other matter of great importance whenever that was required.

Placing Trust in managers and giving them full authority and autonomy

Buffett has described how he placed the utmost trust in the management of his various subsidiaries. He ceded full control and autonomy over operations to these managers. It seems clear that the managers responded to this trust by working very hard to earn it. This was also part of his strategy of freeing up his own time to focus on the investment process.

Providing managers with appropriate financial incentives

Managers were given simple and relevant financial incentives. Their pay was linked tightly to achieving a higher than normal return on the capital that they worked with.

Heaping public praise and encouragement on his best managers

Buffett has always used his annual letter to heap extremely lavish praise on his top managers. It has got to be very motivating for managers to be praised in such a widely-read public letter.

Keeping tabs on his companies and investments

While managers are left alone to run “their” subsidiary businesses, they must file frequent detailed reports to Buffett. These reports focus on weekly and daily sales volumes and on costs. The reports allowed Buffett to keep close tabs on operations and profitability.

Rationality

Buffett was constantly aware of the mathematics of making returns. He always focused on making rational decisions. He never priced his insurance below a reasonable level just because others were doing it. He never did anything simply because others were doing it . He always acted in ways that he thought to be rational.

Investing in businesses as well as securities

Owning businesses outright provided some tax advantages as compared to owning stocks and earning returns through dividends. Buffett also found that at some times businesses were the better bargain and at other time stocks in the market were the better bargain. Being willing to choose from the two options assisted in the maximization of return on assets. He also chose bonds when those were the best option. And there was no fixed allocation to bonds and equities. The allocations changed depending on the relative attractiveness of each category at any point in time.

Separating the Insurance Business Into Two Parts

In each insurance operation he made management responsible for the underwriting profit and the growth of float and gave them no responsibility for the investment process. He expected his insurance managers to achieve an under-writing profit or at least a lower-than-average cost of float with no reliance on investment returns. By taking the management of investments out of their hands he assured that their attention was 100% focused on under writing profitability and profitable growth.

Controlling large capital expenditures at the top

Berkshire’s conglomerate nature allowed excess capital generated in one business to be used to grow another. By controlling the bigger capital expenditure decisions from the top, Buffett insured that mangers did not pour capital into their particular business when better opportunities were available elsewhere in Berkshire including by investing in stocks.

Confidence

Buffet always had a huge amount of confidence in his own analysis. The fact that his approach was unconventional or unpopular never bothered him.

The ability to transfer earnings of subsidiary companies to other companies tax free

When Berkshire received dividends and interest from marketable securities there was income tax to pay. However, dividends from one subsidiary could be received and invested in another subsidiary without incurring income tax.

Wise consideration of income tax

Buffett has said that minimizing income tax was never the primary goal. But he certainly did defer income taxes and structure transactions in tax efficient ways when it made sense to do so. However, it should be noted that he was by no means aggressive in avoiding income tax. For example, unlike (as I understand it) most insurance companies he did not set up captive reinsurance operations located in tax havens to flow profits to those low-tax jurisdictions. I have never seen any commentator give Berkshire and Buffett credit for that.

Toughness

Warren Buffett’s son Howard has said that people don’t understand just how tough Warren Buffett is. He did not like to do it, but he fired managers when he had to. He is an extremely tough negotiator. He tends to name a price and stick with it.

An immense will to win and be the best

Buffett has always displayed an enormous will to win. He made sure to measure how his companies stacked up. For example, he knew that Nebraska Furniture Mart had the highest single store sales in the U.S. and he was very proud of it. He has noted several times when his two pipelines ended up at the very top of the customer satisfaction rankings for pipelines. He is proud of the high returns his companies make and is proud when they can offer the lowest prices. Buffett has won many things. One was a Pulitzer prize for his tiny Sun newspaper, in the early 1970’s, for an article he suggested and helped write. He is a famously skilled and competitive Bridge player. You just don’t win as often and as big as Buffett has without having an enormous will to win.

A photographic memory

It’s my observation that Buffett has a photographic memory. I have witnessed him pull detailed facts and figures out of the air in answering hundreds of random questions. He has described how he had basically memorized Benjamin’s Graham’s book Security Analysis and knew the book better than Graham when he was taking classes from Graham.

Loyalty

Buffett has displayed great loyalty to his oldest friends and associates. Carol Loomis, for example has been editing his annual letter since 1977 and was a friend before that. He was enormously loyal to Katherine Graham at the Washington Post. He has frequently done business repeatedly with the same executives. When he has gained great trust and has great admiration for someone he very rationally chooses to continue to do business and associate with that person.

A total lack of pandering to Wall Street

Buffett has never played the Wall Street game of attempting to meet or beat the earnings expectations of analysts. He considers that a waste of time and considers that it would offer an unfair information advantage to analysts. Berkshire may be alone among S&P 500 companies in not doing quarterly or even annual analyst conference calls. This avoids a distraction and a demand on his time.

Constantly Reading, Learning and Thinking

Buffett has said that he reads 500 pages per day. He reads widely. He reads or goes through five newspapers per day. When he was young he studied every page of the Standard and Poors and Moodys summary reports on companies. His partner, Charlie Munger calls him a learning machine.

Unique Analysis Abilities

I have often witnessed Buffett’s ability to take a few numbers and relate them in uniquely insightful, useful and memorable ways. For example, he related the number of households being formed to the number of houses being built before during and after the U.S. housing bust. He calculated that all the gold in the world would form a cube only about 68 feet per side which he said could rest comfortably inside a baseball infield. He then noted that the market value of this imaginary gold cube was equal to 16 Exxon Mobils, all the cropland in the United States plus a trillion dollars. These kind of simple but powerful relationships give him a unique and fast insight into many things.

Consistency

Although he has learned and adapted over the years, Buffett has also been remarkably consistent. In 2013 he included in the annual report a letter about pensions that he had written in 1975. Presumably his opinions had not changed. Reading his earliest letters one can see that his most basic views have not changed.

Conclusion

All of the above explains how he was able achieve such staggering growth per share at Berkshire. It’s interesting that while he has hundreds of thousands of fans so few people have truly tried to emulate his methods.

END

Shawn Allen, CFA, CMA. MBA, P.Eng.
February 3, 2015 (with minor edits to October 15, 2017)

The eternal question for investors is: How and where should they invest their money?

For example, how should they divide their investments between equities, fixed income, and cash? Regarding stocks, should they focus on dividend stocks? Should they invest strictly in their home country or should they diversify internationally? Where can they find trustworthy advice? How much risk is appropriate? Can stock picking and frequent trading beat buy and hold index investing?

To fully answer all of these questions would likely require a thick book and perhaps a book customized for each individual. Nevertheless I can offer some brief basic guidance on these questions.

To lay the groundwork, let’s start with a few basic definitions. My definitions may or may not precisely match textbook definitions but are intended to provide an accurate and basic understanding.

Definitions:

Equities represent ownership shares in corporations. Investors can directly purchase shares in individual corporations whose shares trade on various stock exchanges around the world. Another way to invest in equities is through equity mutual funds. Equity mutual funds purchase shares in a relatively large number of companies and then sell units of the fund to investors. This can provide a convenient way to invest in a broadly diversified fashion without having to buy shares in many individual companies. However not all equity mutual funds are broadly diversified. Many of them target only very specific types of companies. Others target, for example, only European companies, or even, as an extreme example, only small companies in South Africa. Equity mutual funds charge fees ranging from about 1% to about 3% annually. The annual fees are taken out of the fund and investors may not be aware of them. These fees go to the fund managers and a portion usually goes to the individual investment advisors who encourage their clients to purchase a particular mutual fund. There are some mutual funds that strictly emulate a broad index such as the S&P 500 index and which do not pay fees to advisors and which therefore have much lower annual fees. A third way to invest in equities is to purchase exchange traded funds (ETFs). These usually have (much) lower annual fees than mutual funds. Like mutual funds there are ETFs that emulate broad market indexes and also ETFs that invest strictly in extremely specific companies such as only in mining companies in Australia.

Fixed Income refers to investments that “promise” to return a fixed amount of dollars per year and which usually also return the original investment at a known future date. Two broad categories of fixed income are government and non-government (corporate). Another way to categorize fixed income investments would be those issued in the currency of your home country versus those issued in other (foreign) currencies. Yet another way to categorize fixed income is short-term versus medium- and long-term. Common types of fixed income investments include individual corporate and government bonds, bond mutual founds, bond ETFs and bank guaranteed certificates of deposit (GICs). Fees apply for bond mutual funds and bond ETFs. Not all promises associated with fixed income investment are created equal. Government bonds of “first world” countries are usually considered risk free in terms of delivering the promised cash flows. The risk associated with corporate bonds depends on the current and future financial strength of the corporation and ranges from extremely low risk to extremely high risk in terms of delivering the promised cash flows. The risk associated with bond mutual funds and bond ETFs depends on the underlying investments they hold.

In addition to the risks associated with delivering the promised cash flows, many fixed income investments also subject investors to the risk of price declines. These can be associated with changes in interest rates and changes in the credit worthiness of the issuer.

Cash refers to investments in cash deposit accounts or in near-cash investments such as a 30-day government treasury bills (government bonds of less than one year maturity are usually referred to as treasury bills). Money market mutual funds are also usually considered to be classified as “cash”. Short-term corporate “commercial paper” is effectively a very short term loan to a corporation and may be considered to be “cash”. In general, an investment should only be considered to be “cash” if it can be converted to actual cash on very short notice and if it is virtually risk-free. Investors hold cash in investment accounts for various reasons such as to provide stability to a portfolio, for upcoming spending needs, or to provide the ability to make investments if an attractive opportunity arises.

The Asset Allocation Decision

The division of your investments between the three broad categories of equities, fixed income and cash is referred to as the asset allocation decision. The appropriate allocations differ greatly for different individuals. In rare cases it might be appropriate to hold 100% of the the investments (assets) in cash. This might be the case if the investments are shortly going to be spent to buy a house for example. In the case of a young person just starting out investing and who who is prepared to accept volatility a 100% allocation to equities could be appropriate. For an elderly person who is relying on the income stream from the investments and who also has a very low emotional tolerance for risk it may not be appropriate to include any allocation to equities.

Equities are generally expected to provide the highest return in the long run but can be extremely volatile in the short term. For example, a 50% decline in the value of even a very diversified index such as the S&P 500 may be rare but is never out of the question. 10% declines occur frequently enough that they should really not even be newsworthy. Individual stocks can fall to zero in the event of bankruptcy.

Fixed Income is generally expected to provide a lower long-term return than equities while being less volatile. However, long-term fixed income investments can decline precipitously in value if interest rates soar. But, such a decline will usually be recovered by the time the investment matures. Also an individual corporate fixed income investment can fall to zero in the event of bankruptcy of the issuing corporation.

Often, fixed income investments will not fall at the same time as a decline in equities and this provides diversification and stability to a portfolio. But sometimes both equities and fixed income investments can fall at the same time.

Cash, often provides just a modest return. But it also remains perfectly stable in monetary value and therefore provides stability to portfolios. An allocation to cash also makes available cash for spending or to quickly make investments if an attractive opportunity arises.

It is risk tolerance that has the largest impact on an appropriate asset allocation. A higher risk tolerance argues for a higher allocation to equities. Risk tolerance is often thought of as purely a matter of emotion and temperament. However, I would divide risk tolerance into financial risk capacity and emotional risk tolerance. A person with a very secure job, an employed spouse, a company pension plan and a paid-for house and who is some years from retirement has a high financial risk capacity in regards to their retirement investments. And this is true no matter what their emotional tolerance for risk. Emotional risk tolerance refers to how one feels about and reacts to losses in the market. It is not a good idea to be heavily weighted to equities if your reaction to a stock market decline is likely to be to sell the equities. It is my belief that many people can and do learn to increase their emotional tolerance to risk over time as they gain experience. It is also true however that people often over estimate their ability to be calm during market corrections. That is, they have a high emotional tolerance for market declines until it actually happens and then suddenly they realize they actually have very little emotional risk tolerance.

One of the main factors that influences financial risk capacity is the length of time before any or all of the money is needed for spending. A longer investment time horizon increases the financial (though not necessarily the emotional) tolerance for short-term volatility in the portfolio and therefore allows a higher allocation to equities. Age is often used as a proxy for the time horizon but it is not always an accurate proxy. Most elderly people would be considered to have a short investment time horizon. However, a wealthy person of age 95 who has a large portfolio that is intended to be left for a foundation to make charitable donations for decades to come actually has a very long investment time horizon.

The fact that investors’ financial and emotional risk capacities and tolerances can vary widely and that they are not easy to identify is why registered investment advisors are required to explore and document these matters for each individual client.

Advisor Based or Do-it-Yourself Investing?

Almost all beginning investors and even most experienced investors need and appreciate help with their investments and will choose to use some type of advisor. There are those that will argue that all financial advisors are basically unneeded parasites sucking fees from client accounts and not adding any value. They are wrong. In fact, many investors would never even have got started investing if some advisor had not encouraged them to do so or at least facilitated the process.

The following are some of the main types of financial advisors:

Mutual Fund Advisors – This includes junior investment advisors at bank branches, and advisors from InvestorsGroup (there may be other large outfits like this but I can’t think of any), it also includes many independent mutual fund advisors. These advisors are typically licensed only to sell mutual funds and cannot put your investments into individual stocks or ETFs. This category would also include various independent insurance brokers and financial planners who are licensed to sell mutual funds. These advisors usually have access to software that will assist in the asset allocation decision. They can usually provide financial plans. These advisors are often the best choice for beginning investors who will usually start out with a small amount and add to that monthly or annually. The fees may be relatively high as a percentage of assets but tend to be low in terms of absolute dollars paid because the portfolios tend to be smaller. In some cases it is reasonable to remain with these advisors even as the portfolio grows large especially if a reduction in the fee percentage applies.

Advisors Licensed to Sell Stocks – Full service brokers and some senior bank advisors are licensed to invest clients in individuals stocks and, importantly, ETFs. These advisors are more suited to those with larger portfolios and could lead to lower fees.

Portfolio Managers – These advisors are licensed to make discretionary trades in a client’s account. They may charge a 0.75% to 1.5% flat fee and then basically take care of everything and just report to each client periodically how things are going. They will typically accept only those with large portfolios.

Fee-Only Advisors. – These are relatively rare. These are independent licensed advisors who will complete a financial plan for you and or will meet periodically with clients on a flat fee basis. They will not invest money for clients but provide advise only.

Do-it-yourself investors, as the term implies, basically do not rely on advice. These investors use a discount broker (there are many choices and all of the large banks offer a discount broker service). These investors can easily access stocks, ETFs bonds and mutual funds through their discount broker. They are on their own as far as developing a financial plan and determining an asset allocation and deciding which investments to make. However, they may also get be able to get a financial plan and a suggested asset allocation free from a bank financial advisor. Do it yourself investors typically source investment ideas from many places including reading the financial news, watching financial television shows, and/or subscribing to various investment newsletters and magazines. Ultimately they are on their own as to the individual investments selected. This can be a good approach for some people. Others however may unfortunately ultimately end up feeling that in acting as as their own advisor, they have a fool for a client.

Country and Regional Allocations

Some investors will choose to invest in companies (and in fixed income and cash) strictly in their own country. Others will include one or even many other countries. Most Canadians will invest part of their funds in United States companies and some invest globally.

Investing outside of your own country provides diversification of the performance because in any given year the stock markets of various countries perform differently. And in general it is not the same countries that out perform each year. It also can provide diversification of investment choices. This is true for Canadians because the Canadian stock market is lacking in certain segments such as large consumer product brand name companies and is lacking in, for example, large pharmaceutical companies. It can also provide the opportunity to invest in high growth countries such as China or in emerging markets.

Investing outside of your own country also necessarily introduces currency risk (although for mutual fund and ETF investors it is often possible to choose funds which hedge away the currency risk). Accepting currency risk may be beneficial if the currency of your home country tends to fall relative to foreign currencies over time.

Canadian investors often have a natural hedge when it comes to U.S. currency investments since most will at some point wish to spend time and money in the U.S.

Most investors achieve country diversification through broad mutual funds and ETFs rather than by attempting to select individual stocks in foreign countries.

In regards to fixed income it is generally not important to diversify by country. The main reason to do so would be if one suspected that the currency of the home country was going to fall relative to foreign currencies.

Index investing versus selecting individual stocks or specialized mutual funds and ETFs

All investors, including those invested strictly in mutual funds, should consider whether they wish to be passive index investors or instead wish to skew their investments towards certain segments of the market or (except for mutual fund and ETF investors) to certain individual stocks and bonds. Skewing your investments away from the broad indexes is known as active investing. Many investors have made this choice without really thinking about it or their advisors have made the choice for them.

By “index” I refer to broad indexes such as the S&P 500, the Toronto stock exchange index or a world equity index. These equity indexes measure the average return from investing in the stock market of a particular country, a region of the world or even of the entire world. There are also indexes that measure the average performance of fixed income investors in a particular country or the world. When I refer to investors beating the indexes, I refer to an investor’s return being better than a strategy of passively investing in broad indexes with the same asset and regional allocations. Anyone attempting to beat the indexes is by definition, to some degree, an active investor.

In thinking about this choice between passive and active investing consider the following:

It is a mathematical fact that the average passive index investor will make the same return (before fees) as the average active investor. This is so because the index is by definition the average of all investors, and if passive investors earn the index amount then, on average, so must the remaining investors, the active investors. Since active investing involves higher fees, the average active investor will under perform the average passive index investor. And this is true over every time period – every minute, every day and every decade.

It is also a mathematical fact that the top achieving individual investors over every time period will always be active investors. There are always some people beating the index. Equally, however, there are always some active investors trailing the index. Most active investors will tend to beat the index some years and trail it other years. On average, active investors experience more volatility in their portfolios than do passive index investors. There is some debate as to whether anyone ever beats the index in the long term except by luck. I happen to be of the view that some people can beat the index in the long run through skill in market timing and skill in selecting (and selling) individual investments. However, I do recognize that it is difficult to do and that only a small percentage of active investors will succeed in beating the indexes over the long term.

Beating the index, if it can be done, is very rewarding in the long term. Consider that $100,000 compounded at 7% for 35 years grows to just under $1.1 million. But at 10% it would grow to $2.8 million.

My conclusion based on the two mathematical facts above is that most people should choose to be passive index investors. This will lower their investment fees and reduce the volatility of their portfolios. Only those who are convinced that they have the personal skill and knowledge, or the access to superior advice, that results in a rational expectation of beating the market indexes over the long term should consider deviating much if at all from a strategy of passive index investing.

It is true that investing in individual stocks is simply more interesting and exciting than passive index investing. There can be a certain psychological joy or benefit in, for example, owning shares in some of the businesses where you shop or that you hear about in the news. For that reason many investors may decide to allocate a certain small proportion of their portfolio to active investing even if they have no good reason to expect to beat the indexes.

Dividend versus non-dividend stocks

Some investors elect to favor or even to invest exclusively in dividend paying companies. Investors should be aware that this is implicitly an active strategy that attempts to beat the equity index.

In some cases, this is done because investors believe that capital gains on stocks are somewhat arbitrary and do not represent “real” returns. In fact the stocks of profitable companies tend to rise, albeit very irregularly, over time as they retain and invest part or all of their earnings for growth.

These dividend-stock-only investors should also keep in mind that even dividend paying stocks can fluctuate greatly in value. The fact that a stock paid a 3% dividend will provide cold comfort if it declines by 50%.

Dividends provide cash for withdrawals. But a non-dividend paying stock can also be sold at any time to provide cash.

Dividend paying stocks have their place. But investors should be cautious about avoiding all non-dividends paying stocks simply on the basis of incorrect but common statements such as “only dividend returns are real”.

Conclusion

This article has provided general information about how and where to invest. For those do-it-yourself investors that are looking for individual investment ideas, (despite my indication that beating the indexes is difficult) we have a service that rates selected Canadian and U.S. stocks and some Canadian fixed income choices as Buys or Sells and provides our full and detailed reasons behind the ratings, Click the link for more information about this product.

END

January 12, 2015 (with minor edits to September 26, 2017 and additional very minor edits on September 3, 2024)

Shawn Allen, President

InvestorsFriend Inc.

Are Long Term Bonds a Good Investment Now? (Late November 2024)

Yes, long term bonds are arguably a good investment now. The yield on a 20-year U.S. treasury bond has risen from lows of well under 2% in 2020 to a recent 4.5%. That’s arguably a reasonable return on an asset that is risk-free in nominal dollars if held to maturity. And it’s quite possible that this bond will offer capital gains in the short term.

There three reasons that investors might be attracted to long-term government bonds:

1. For the secure and fixed annual interest. (And today’s rates are arguably reasonable although not highly attractive.)
2. For potential short term capital gains as interest rates fall. (And that’s possible but by no means assured at this time.)
3. For the the interest plus the certainty of the eventual return of capital in nominal dollars .

At this time investors could buy long-term government bonds in the hopes for a short term capital gain and failing that (and there could be a capital loss) the bond could be held for the interest and safe in the knowledge that it will eventually mature at par value. Note that interest income is best suited for non-taxable accounts.

Long-term bonds proved to be excellent investments most years all the way from 1980 to 2019 as interest rates fell steadily. Bonds offered what turned out to be attractive interest plus capital gains. But they were terrible investment in 2020 and 2021 because their yields were then so low and because long-term interest rates subsequently rose causing capital value losses on bond holdings. Now that long-term bond interest yields are higher and generally expected to decline, long term bonds may once again be a good investment.

A long term government bond, even though it will mature at precisely its issue price can be surprisingly volatile over its life.

Consider a 20-year U.S. treasury bond issued at $1000 at today’s 4.5% yield. If interest rates drop to 3.5% after one year, the bond is then worth $1137 for a capital gain of 13.7% and that’s in addition to the 4.5% interest received. But it’s a certainty that over its remaining 19 year life the capital gain will reverse and the bond will mature at $1000. And if interest rates instead rise to 5.5% in the year after the purchase then the bond would be worth only $884 for a temporary  capital loss of 11.6%. With this kind of volatility in a fixed income investment that will mature with no capital gain or loss, it can be difficult to interpret the performance of long-term bonds.

Looking at past performance, long-term (20-year) bonds purchased from about 1980 to the year 2000, and held until they ultimately matured at par turned out to be very good to good investments strictly because their interest rate yields turned out to be attractive in relation to subsequent inflation. An investment in an index fund that continuously sells and buys bonds to maintain a 20-year maturity did even better because it was capturing capital gains most years as interest rates continued to decline.

Long-term (20-year) bonds purchased from 2012 to 2019, and which are not yet near maturity, had, as of 2020, provided very good returns in spite of their low yields (under 3% in most cases). Capital gains had greatly boosted their returns. But those capital gains were subsequently wiped out as interest rates recently rose significantly. As of their ultimate maturity those bonds will have provided poor returns strictly because of their low yields at the date of issuance.

The analysis here is based on U.S. data for stocks (S&P 500 index) and bonds (20-year U.S. government treasury bonds) from 1926 through October 2024. The data source is a well-known reference book called “Stocks, Bonds, Bills and Inflation”. The formerly annual reference book has sadly been discontinued. But, as a Chartered Financial Analyst, I have access to the updated data.

Zero-coupon or Strip Bonds

It is important to understand that the return on a long-term zero-coupon government bond that will be held to maturity is precisely known at the purchase date.

To analyze historic bond returns or expected future bond returns it is best to start with the simplest type of bond which is a bond that only pays off at maturity. These are called zero-coupon bonds because there are no annual interest payments. Bond interest is sometimes referred to as coupon payments since bonds used to have detachable physical interest “coupons” attached. Zero-coupon bonds are also known as “strip bonds” because they can be created by “stripping” the interest payments or notional “coupons” from regular bonds. Zero-coupon twenty-year bonds, for example, represent a lump sum to be received in 20 years. The lack of annual interest payments simplifies the analysis. Long-term zero-coupon bonds are purchased at a large discount to their face value and the interest is effectively received all at once when the bond eventually matures at its much higher face value.

From 1980 to 2020, long-term zero-coupon bonds provided excellent returns. A zero-coupon twenty-year U.S. government bond purchased in 1982 and held to maturity in 2002 ultimately returned precisely its initial yield which was about 14%. A zero-coupon twenty-year U.S. government bond purchased in December 2000 and held to maturity in December 2020 returned precisely its initial yield which was about 5.6%.

Regular bonds, in contrast, pay annual annual or semi-annual interest. A regular bond issued in 1982 and paying 14% annually ended up returning something less than 14% over its life since the annual interest payments (of $140 per $1000 bond) would have been reinvested each year at prevailing interest rates that turned out to be below 14%.

A new zero-coupon twenty-year U.S. government bond purchased today and held to its maturity in November 2044 will return precisely its initial yield which is currently about 4.5%. A regular 20-year bond paying annual interest will return something different than  a 4.5% yield over its life depending on the future interest rates that the annual interest payments can be re-invested at.

Historic one-year annual return of long-term bonds.

Despite the fact that they will mature at par, long-term bonds returns on an annual basis are quite volatile due to their temporary capital gains and losses as interest rates change over the life of a bond.

The above chart shows the return on a new 20-year zero-coupon bond purchased at the start of each year. Returns were very high in many of the years from 1982 to 2020 as interest rates fell most years. In 2022 there was a significant loss on such a bond as interest rates rose sharply.

Historic results for all 20 calendar year holding periods

The following graph shows the rolling 20-year returns from a 20-year bond index fund for all 20 (calendar) year periods ending 1945 through 2024 – note that 2024 uses data through October. (So a series of 20-year periods beginning at the start of each year from 1926 through 2005.) Note that a 20-year bond index fund would sell the bonds annually (for a capital gain or loss) and reinvest in new 20 year bonds in order to maintain a constant approximate 20 year maturity. The graph also includes what the 20-year bond interest rate was at the start of those periods. We also already know the interest rate at the start of the 20 year periods that will end in 2025 through 2044. And we graph that because the returns from the bond index are likely to track that beginning interest rate fairly closely.

 

To interpret this graph, we can start from the left side. An investment in a 20-year U.S. government bond index at the start of 1926 and held until the of 1945 provided a compounded return of 4.7% over the 20 years.

Prospective long -term bond investors should be aware of the low bond returns for all the 20 year periods stated in the 1940’s and ended in the 1960’s.

In the 20 year periods that ended in 2001 through 2020, investing in a 20-year U.S. bond index fund would have provided a return that was very similar to and occasionally higher than the return from stocks over the same 20 years.

It seems quite likely that when the returns from holding stocks for 20 years starting at the beginning of all the years from 2002 through to 2022 (and ending 2021 through 2041) are ultimately known, we will likely see the return from the 20-year bond index fund track down because the starting bond yields were so much lower. And then for 20-year bond investments started at the beginning of 2023 or 2024 and ending 2042 and 2043, we will see the bond returns recover to above 4%.

Why did 20-year long-term government bonds provide unexpectedly good returns for most investment periods starting since about 1982?

Several years ago investors were pointing out that a long term investment in U.S. treasury bonds had provided returns similar to the S&P 500 for 20 -year periods ending 2001 to 2020 and at far less risk. However that was a situation that was destined to end.

Long-term government bonds can provide good returns for two possible reasons. But one of the reasons is always only temporary.

The first and most important reason why a long term bond may provide a good return is that the initial interest rate paid by the bond turns out to be an attractive rate over the life of the bond.

20-year U.S. bonds issued in 1982 at 14% provided an excellent return (of precisely 14% annually for zero-coupon bonds and about 11% for regular bonds due to the reinvestment of annual interest payments at lower interest rates) if held through to their maturity in 2002 solely because that 14% was, in retrospect, a good return. Had we had hyper-inflation (as some feared at the time) then 14% might not have been a poor return. But the 1982 (zero-coupon) bond provided a 14% return simply because that was what it paid. And we now know, in retrospect, that this was a good return over the 20 years from 1982 to 2002.

The second but temporary reason that bonds can provide a good return also came (temporarily) into play for the 1982 bond.

In 1983 the market interest rate on 20-year government bonds dropped to about 11% (from 14% in 1982). This provided a significant (23%!) but temporary boost in the market value of the 1982 bond. The 1982 bond would have traded at a premium over much of its life as long-term interest rates declined significantly over the years. But in 2002 the bond matured at exactly its par value. The capital gain on the value of the 1982 bond was temporary and eventually the bond value declined to precisely its initial par value.

Over its full life the 14% return on the 14% 1982 zero coupon government bond was entirely driven by its contractual 14% interest rate. The decline in interest rates initially boosted its value but that was only a temporary impact. The fact that interest rates on 20-year bonds in 2002 had declined to 5.9% had no impact at all on the ultimate return at maturity in 2002 provided by the 1982 bond.

The situation for a 20-year bond index fund that continually sells bonds annually and buys new 20 year bonds to maintain a constant maturity of approximately 20 years is somewhat different. The capital gain in a falling rate environment would persist until some time after rates reversed and moved higher.

Bond Temporary Capital Appreciation

The temporary nature of market value gains on long-term government bonds is illustrated in the next graph which shows an index of the capital appreciation value of a 20-year government bonds index fund since 1926.

The blue line, plotted on the left scale, shows the capital appreciation on an index of 20-year U.S. government bonds starting at 1.00 at the start of 1926. The index had risen slightly above 1.0 by the end of 1926, the first point on the graph. The index then rose significantly to 1.40 in the mid 1940’s. This meant that an investment permanently maintained in 20 year government bonds through annual rollovers to new 20 year bonds and originally made in 1926 had appreciated in capital value by 40%. This excludes the value of the annual interest payments. This 40% is significant but keep in mind that it was built up over 20 years and therefore amounted to an average compounded amount of 1.7% per year.

This 40% capital value increase was driven by long-term interest rates (shown on the red line plotted on the right scale) dropping from 4% at the start of 1926 down to 2.0% in the mid 1940’s. But this capital appreciation value gain eventually evaporated as the index returned to 1.0 when interest rates returned to 4% around 1959. And the bond capital value index slumped to about 0.50 in 1982 as long-term interest rates rose to 14%. This meant that the capital portion (which totally excludes the interest payments) of an investment in long-term government bonds made in 1926 (or at anytime the capital value line was at 1.0) was worth only about 50% of the initial invested amount! The index then rose steadily all the way back to (not coincidently) about 1.40 as interest rates recently declined all the way back close to about the the 2% level of 1926 and the mid 1940’s. And the index has peaked at about 1.75 at the end of 2020 as the interest rate on a 20-year bond fell below 2.0% and a record low. The Capital appreciation index then plummeted as interest rates rose sharply in 2022 but the index remains above 1.0.

The red line, plotted on the right scale also shows the initial interest rate which is also the return that would have been made by those investing in and holding to maturity a 20-year zero coupon bond in each year from 1926 to 2020. An investor in 1932 would have made 4%. An investor  in the 1940’s would have made barely over 2%, An investor at the peak in the early 80’s would have made 14% and today’s (November 28, 2024) investor in a 20-year zero coupon U.S. government bond held to maturity will, of a certainty, make a compounded annual return of 4.5% to maturity in 2044. Regular bonds are not zero coupon and therefore investors in regular bonds would have experienced somewhat different returns by reinvesting the annual interest payments. And investors in a 20-year bond index fund make a return generally quite similar to the starting interest rate as illustrated in other graphs further above.

What Return can we now expect from 20-year bonds?

A 20-year U.S. zero-coupon government bond purchased today should be expected, over its full life, to return its current yield of about 4.5% per year. If 20-year interest rates soon decline then the bond will provide a temporary gain in market value. If interest rates increase it will suffer a temporary loss in market value. But over its life this bond will return only and precisely its promised yield to maturity of 4.5%.

Should we invest in long-term government bonds?

The data appears to suggest that the answer is no. Not unless you are satisfied with an expected return on the order of 1.8% for 20-year government bonds. And long-term higher rated corporate bonds also will return no more than about 2.8% if held to maturity, since that is their approximate current yield. However, if you wish to speculate and bet that interest rates will fall then in that case a 20-year bond could be used to make that speculative bet. In that case you would be planning or hoping to sell the bond for a capital gain in the relatively short term.

END

Shawn Allen, President

InvestorsFriend Inc.

November 28, 2024

The original version of this article was written in 2012 when 20-year U.S. bond interest rates were 2.4%. As of today following the advice of that article to avoid long-term bonds at that time would have worked out well. And an update in February 2021 when the yield was 1.8% was correct in saying to avoid long-term bonds at that time.

 

Warren Buffett is acknowledged as one of the very best stock investors ever.

It should go without saying that every investor from beginner to seasoned expert can benefit by closely reading and studying Warren Buffett’s thoughts on how to pick stocks.

As an investor can you really afford not to study how Warren Buffett picks stocks?

The great man unfortunately has not written an investment book. But he has written extensively in annual letters to his shareholders and in a number of published articles. And many books have been written about Warren Buffett. The best insight to his methods comes from reading his own words. A number of the books written about him quote his own words extensively.

Here is how Warren Buffett described in his February 29, 2008 letter to shareholders what he looks for in a company to buy.

In Warren Buffett’s own words:

Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stock market purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

A truly great business must have an enduring moat that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business castle that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with Roman Candles, companies whose moats proved illusory and were soon crossed.

Our criterion of enduring causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s creative destruction is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

So there you have how Warren Buffett picks stocks in his own words.

More recently in his 2013 letter to shareholders, warren Buffett said:

When Charlie and I buy stocks – which we think of as small portions of businesses – our analysis is very similar to that which we use in buying entire businesses. We first have to decide whether we can sensibly estimate an earnings range for five years out, or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings – which is usually the case – we simply move on to other prospects. In the 54 years we have worked together, we have never foregone an attractive purchase because of the macro or political environment, or the views of other people. In fact, these subjects never come up when we make decisions. 

It’s vital, however, that we recognize the perimeter of our circle of competence and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a desire to be where the action is.

In that 2013 letter, Buffett provided additional thoughts about investing, see pages 17 to 20.

Earlier he had described buying common stocks this way in his 1987 letter:
See http://www.berkshirehathaway.com/letters/1987.html

Whenever Charlie and I buy common stocks for Berkshire… we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on [our subsidiary companies that do not trade on the stock exchange]. Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.

….

In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.

Charlie and I let our marketable equities tell us by their operating results – not by their daily, or even yearly, price quotations – whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben [Graham] said: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which a business’s success is recognized, furthermore, is not that important as long as the company’s intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such a case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.

We need to emphasize, however, that we do not sell holdings just because they have appreciated or because we have held them for a long time. (Of Wall Street maxims the most foolish may be “You can’t go broke taking a profit.”) We are quite content to hold any security indefinitely, so long as the prospective return on equity capital of the underlying business is satisfactory, management is competent and honest, and the market does not overvalue the business.

…

We really don’t see many fundamental differences between the purchase of a controlled business and the purchase of marketable holdings such as [GEICO, The Washington Post & Capital Cities / ABC]. In each case we try to buy into businesses with favorable long-term economics. Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price. Charlie and I have found that making silk purses out of silk is the best that we can do; with sow’s ears, we fail.

…

In making both control purchases and stock purchases, we try to buy not only good businesses, but ones run by high-grade, talented and likeable managers.

Many commentators, however, have drawn an incorrect conclusion upon observing recent events: They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor – small or large – so long as he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times.

In his 1996 annual letter, Buffett described the education that was needed to invest successfully and explained what knowledge was not needed:

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.

In his 1997 annual letter, Buffett described how to think about market prices:

If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

You can read all of Warren Buffett’s annual letters to shareholders back to 1977 at www.berkshirehathaway.com

END

Shawn C. Allen
Last Updated: October 28, 2014 (with minor additional edits to October 15, 2017)

IS THE S&P 500 (“S&P”) INDEX FAIRLY VALUED AT THIS TIME?

(This article is dated September 8, 2004, for a current version, click here)

This question can be answered by looking at the current level of earnings and dividends of the S&P stocks, projecting the future rate of earnings and dividend growth and by considering the minimum return required by investors. Analysts, including myself, often apply valuation techniques to individual stocks. It is actually far easier to apply these calculations to a stock index since an index constitutes a portfolio and therefore eliminates most of the random noise of unexpected events through diversification. The index remains vulnerable to changes in interest rates and to growth in the economy but is largely insulated from the numerous random events that can impact an individual stock.

As of  August 31, 2004, the S&P index was at 1104 and had a Price Earnings Ratio (“P/E”) of 19.7 based on trailing earnings and 18.73 based on projected 2004 earnings and had a Dividend yield of 1.80%. (Source:http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS). I will focus on S&P’s projected level of 18.73 based on estimated 2004 calendar year earnings.

The S&P 500 represents a portfolio of 500 stocks. For each $1104 (the index value)   purchased, the underlying companies in the portfolio are therefore currently projected to earn $1104/18.73 = $59 in 2004 and pay a dividend of $1104 * 0.0180 = $19.90 in 2004.

When we Buy the S&P index, we can therefore think of it as being an investment or “stock” that (as of August 31, 2004) costs $1104 and currently earns $59 per year and pays a current dividend of $19.90 per year. It is worth thinking about whether or not this “stock” is a good investment at or around its recent level of $1104.

We know that the S&P index was at 1104 on August 31, 2004. We can estimate what the S&P “should” have been trading at based on the value of its current earnings and dividends and the projected growth in those earnings and dividends. This intrinsic value approach calculates the value of the projected earnings and dividends for a ten year period and then assumes that the index is sold at a projected future P/E.

In addition to the beginning earnings and dividend level, three additional factors are required to calculate the fair value at which the S&P should be trading at. These are, 1. The forecast average compound growth rate in earnings and dividends over the next ten years. 2. The forecast P/E ratio at which the S&P index will be trading in ten years time. 3. The estimated rate of return required by investors.

The S&P portfolio average earnings should grow at a rate close to the growth rate of the U.S. economy in nominal (after inflation) terms. I believe a prudent estimate for this growth rate is  4% to 6% and I would focus on 5%.

The average P/E for the S&P 500 since 1935 is 15.6. However the Justifiable P/E changes with earnings expectations and the market’s required return on equities. I have conservatively calculated that the current Justifiable P/E is in the range of only 12.5 to 14.3, even with today’s low interest rates. This conservative calculation of the justifiable P/E assumes that, on average, the S&P 500 companies will only earn, on new investments,  the 7 to 8% minimum ROEs required by investors in today’s low-interest rate environment. If companies can earn more than ROE required by investors, then it is possible to justify a P/E in the 16 range. The more optimistic we are about the level of the P/E in ten years time, the higher is the justifiable fair value level of the S&P index today.

I would estimate that a minimum (pre-tax) return required by stock investors is in the range of 7% to 9%. The higher return required by investors then the lower the price or level that investors should be willing to pay for the index today, all else being equal.

The following table calculates the value that the S&P should be trading at given prudent assumptions about earnings growth, the P/E ratio that will exist in ten years and the rate of return that investors require.

S&P Forecast Current Annual Earnings	S&P Current Annual Dividends	Earnings and Dividend Growth forecast	P/E forecast in 10 years	Resulting S&P in 10 years	Required Return	Resulting S&P Fair Value Today
59	20	4%	14	1,222	7%	792
59	20	4%	16	1,396	7%	880
59	20	4%	18	1,571	7%	969
59	20	4%	14	1,222	9%	671
59	20	4%	16	1,396	9%	745
59	20	4%	18	1,571	9%	818
59	20	5%	14	1,344	7%	863
59	20	5%	16	1,537	7%	961
59	20	5%	18	1,729	7%	1,058
59	20	5%	14	1,344	9%	731
59	20	5%	16	1,537	9%	812
59	20	5%	18	1,729	9%	893
59	20	6%	14	1,478	7%	940
59	20	6%	16	1,689	7%	1,048
59	20	6%	18	1,900	7%	1,155
59	20	6%	14	1,478	9%	795
59	20	6%	16	1,689	9%	885
59	20	6%	18	1,900	9%	974

Conclusions

By changing the expected earnings growth rate, the return required by the investor and the assumed P/E ratio that will apply in ten years I can calculate that today’s S&P index should be anywhere from 671 to 1155.

My own fair-value estimate is highlighted in yellow and is 961. This assumes that investors require a minimum 7% return, that the S&P earnings and dividend will grow at 5%  (3% GDP growth plus 2% inflation) and that the long run S&P P/E is 16. Higher S&P index values are implicitly assuming that earnings growth will exceed 5% annually, that the justifiable long-run P/E exceeds 16, and/or that investors require less than a 7% (pre-tax) return.

Since the S&P is currently about 1104, I conclude that it is likely overvalued.

The table illustrates quite a wide range for a reasonable fair value of the S&P. Investors should be sobered by the fact that if investors require a 9% rate of return and if the earnings only grow at 5% (say 3% GDP plus 2% inflation) and if the S&P commands a P/E of only 14 in ten years then the fair value of the S&P today is calculated as only 731, which is 34% below the current value!

(Note the high light on the above paragraph was added only in August 2009, just to point out that this article in the past did indicate that the S&P could be considered high)

Most investors would probably not admit to being happy with a 7% return, but the level of the S&P suggests that investors have bid stocks up to the point where no more than 7% is a realistic long-term return. However the return should be higher than 7 to 8% if earnings growth is significantly higher than my assumed 5%.

My overall conclusion is that at its current level of about 1104, the S&P is probably somewhat overvalued and priced to return no more than about 7% annually.

However, given the current relatively optimistic outlook for earnings I would rate the S&P as a Hold rather than a Sell.

It is impossible to predict where the S&P 500 index will go in the next year. But it is relatively easy to calculate whether or not it is currently overvalued based on reasonable growth expectations. Caution is warranted because the S&P can sometimes spend years in an over-valued or an under-valued-state. But ultimately, as we have recently seen, valuation does correct itself.

The good news is that although the S&P is no screaming bargain, it is currently at a better price in relation to trailing year earnings than it has been since 1997. The last time that the S&P 500 P/E was below 20 was in early 1997.

Readers should see also a similar article on the Dow Jones Industrial Average which paints a more optimistic picture. See IS THE DOW JONES INDUSTRIAL AVERAGE (“DJIA”) INDEX OVERVALUED?

Shawn C. Allen,
Editor
InvestorsFriend.com

DOES THE S&P 500 P/E RATIO AND INDEX VALUE REPRESENT A GOOD INVESTMENT AT THIS TIME? (June 1, 2008)

(For the latest version of this article, click here)

Should you believe those who claim that stocks are cheap because (they claim) the P/E ratio on the S&P 500 index is low at 12.9? But wait a minute, they are not talking about the actual P/E of 23.2 based on actual achieved earnings in the last 12 months. Many analysts will point out that the actual trailing P/E of 23.2 is distorted upwards by “unusual” and “one-time” write offs at the likes of General Motors and at many big financial institutions. These optimistic analysts prefer to focus on “operating earnings” which ignores one-time items. (But the funny thing is over 500 stocks we will always have some one-time items, and they always seem to be negative in the aggregate, and can we really ignore these?). Optimistic analysts will also point out that stock valuation depends on future earnings and direct us to the forecast operating earnings in 2009.

The forecast operating earnings for 2009 on a “bottom up” basis adding up the forecast for the 500 companies results in an attractive looking P/E of 12.9. But on a “top-down” basis the forecast operating earnings for 2009 result in a much less attractive P/E of 18.4. Meanwhile the forecast for actual reported GAAP earnings in 2009 results in a P/E of 20.4, which is not attractive.

I believe it is very dangerous to focus on the the optimistic operating earnings figure for 2009 resulting in the attractive looking P/E of 12.9. I believe it is irresponsible and misleading to state that the S&P 500 P/E is 12.9 without pointing out that this is based on forecast 2009 operating earnings and is not based on actual achieved historical GAAP earnings. Based on the forecast GAAP P/E of 20.4 times forecast 2009 earnings, the S&P 500 index is clearly expensive and does not appear to represent good value at this time.

Below we delve into this issue in more detail.

The attractiveness of the S&P 500 index level can be judged by looking at the current level of earnings and dividends of the S&P 500 index stocks, projecting the future rate of earnings and dividend growth and by considering the minimum return required by investors. Analysts often apply valuation techniques to individual stocks. It is actually far easier to apply these calculations to a stock index since an index constitutes a portfolio and therefore eliminates most of the random noise of unexpected events through diversification. The index remains vulnerable to changes in interest rates and to growth in the economy but is usually largely insulated from the numerous random events that can impact an individual stock.

As of  June 1, 2008, the S&P 500 index was at 1400 and had a Price Earnings Ratio (“P/E”) of 23.2 based on actual trailing reported earnings and a current Dividend yield of 2.07%. The trailing P/E based on operating earnings (eliminates unusual one-time items) was 18.2.  The forward S&P 500 P/E ratio based on projected reported GAAP earnings in the next 12 months was 19.9. Source: http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS. The forward P/E based on forecast operating earnings in the next 12 months (eliminates unusual one-time items) is much more attractive at 14.4.

Given that projected earnings tend to be optimistic, I normally prefer to use the actual trailing P/E. At this point in time both the trailing and forward P/Es based on actual and forecast reported earnings have been driven higher due to an extremely large unusual loss at General Motors and another at Sprint Nextel and numerous large losses at financial institutions. Normally I would use the actual trailing P/E. In this case the the unusual losses were very large and so I will use the average of the trailing actual P/E and the trailing operating P/E. This creates an adjusted trailing P/E of 20.7. (At this time the P/E ratio is less meaningful than normal due to the large difference between the actual earnings and the operating earnings.)

The S&P 500 index represents a portfolio of 500 stocks. For each $1400 (the index value) purchased, the underlying companies in the portfolio have earned $1400/20.7 = $68 (this is based on our adjusted trailing P/E ratio of 20.7)  in the last 12 months (to March 31, 2008) and currently pays an annualized dividend of $1400 * 0.0207 = $29.

When we Buy the S&P 500 index, we can therefore think of it as being an investment or “stock” that (as of June 1, 2008) costs $1400 and currently earns $68 per year and pays a current dividend of $29 per year. It is worth thinking about whether or not this “stock” is a good investment at or around its recent level of $1400.

We know that the S&P 500 index was at 1400 on June 1, 2008. We can estimate what the S&P theoretically “should” have been trading at based on the value of its current earnings and dividends and the projected growth in those earnings and dividends. This intrinsic value approach calculates the value of the projected earnings and dividends for a ten year period and then assumes that the index is sold at some projected future P/E ratio.

In addition to the beginning earnings and dividend level, three additional factors are required to calculate the fair value at which the S&P 500 should be trading at. These are, 1. The forecast average annual growth rate in earnings and dividends over the next ten years. 2. The forecast P/E ratio at which the S&P index will be trading in ten years time. 3. The estimated rate of return required by investors.

The S&P 500 portfolio average earnings should (in the longer term) grow at a rate close to the growth rate of the U.S. economy in nominal (after inflation) terms. I believe a prudent estimate for this growth rate is  4% to 6% and I would focus on 5%.  We have articles that both explain why (quoting Warren Buffett) and also demonstrate that earnings tend to grow at about the same rate as nominal GDP growth in the long run.

The average for the S&P 500 P/E ratio since 1935 is 15.6. But the average since 1988 has been 23.15. However the Justifiable P/E changes with earnings expectations and the market’s required return on equities. I have conservatively calculated that the current Justifiable P/E is in the range of only 12.5 to 14.3, even with today’s low interest rates. However, I have given some weight to the much higher historical figure since 1988.

I would estimate that a minimum (pre-tax) return required by stock investors is in the range of 7% to 9%. The higher return required by investors then the lower the price or level that investors should be willing to pay for the index today, all else being equal.

The following table calculates the value that the S&P 500  will be  at in ten years given various forecasts for the earnings growth and given various scenarios for the forecast P/E ratio that will apply at that time. The last column of the table then shows the fair or present value that we should be willing to pay today for the cash flows that would result from ten years of dividends plus the assumed cash from selling the index in ten years time. The present value is calculated based on various scenarios for the required return or discount rate.

S&P 500 Current Annual Earnings	S&P 500 Current Annual Dividends	Earnings and Dividend Growth forecast	S&P 500 P/E forecast in 10 years	Resulting S&P 500 in 10 years	Required Return	Resulting S&P 500 Fair Value Today
68	29	4%	14	1,402	7%	961
68	29	4%	16	1,602	7%	1,063
68	29	4%	18	1,802	7%	1,165
68	29	4%	14	1,402	9%	818
68	29	4%	16	1,602	9%	903
68	29	4%	18	1,802	9%	987
68	29	5%	14	1,542	7%	1,046
68	29	5%	16	1,763	7%	1,158
68	29	5%	18	1,983	7%	1,270
68	29	5%	14	1,542	9%	889
68	29	5%	16	1,763	9%	982
68	29	5%	18	1,983	9%	1,075
68	29	6%	14	1,696	7%	1,137
68	29	6%	16	1,938	7%	1,260
68	29	6%	18	2,180	7%	1,384
68	29	6%	14	1,696	9%	966
68	29	6%	16	1,938	9%	1,068
68	29	6%	18	2,180	9%	1,170

Conclusions

By changing the expected earnings growth rate, the return required by the investor and the assumed P/E ratio that will apply in ten years I can calculate that today’s S&P 500 index should be anywhere from 818 (assumes market P/E falls to 14, earnings grow at only 4% annually and equity investors require an expectation of making 9%) to 1,384 (assumes terminal market P/E of18, earnings grow at 6% and investors only require an expectation of earning 7% on equities).

My own fair-value estimate is highlighted in yellow and is 1158. This assumes that investors require only a minimum 7% expected return, that the S&P earnings and dividend will grow at 5%  (3% GDP growth plus 2% inflation) and that the long run S&P 500 P/E ratio is 16. Higher S&P 500 index values are implicitly assuming that earnings growth will exceed 5% annually, that the justifiable long-run P/E exceeds 16, and/or that investors require less than a 7% (pre-tax) return.

Since the S&P 500 index is currently  about 1400, I conclude that it appears to be about 20% over-valued.

The table illustrates quite a wide range for a reasonable fair value of the S&P 500. Investors should be sobered by the fact that if investors require a 9% rate of return and if the earnings only grow at 5% (say 3% GDP plus 2% inflation) and if the S&P commands a P/E of only 14 in ten years then the fair value of the S&P today is calculated as only 818, which is a sickening 42% below the current value!

(Note the high light on the above paragraph was added August 2009, just to point out that this article in the past did indicate that the S&P could be considered high)

Most investors would probably not admit to being happy with a 7% return, but the level of the S&P suggests that investors have bid stocks up to the point where probably no more than about 7% is a realistic long-term return. This is attractive compared to the recent 10-year U.S. government bond yield of about 4.1%.

My overall conclusion is that at its current level of about 1400, the S&P 500 index is perhaps 20% overvalued and will result in a return expected to be in the 5% range in the long-term. Buying the S&P 500 index today should be expected (but certainly not guaranteed) to result in an average return of about 5% per year if held for the next 10 years.  The expected standard deviation around this expected 5% is also large so that the actual return over the next 10 years might be expected to fall within a range of say 3% to 7% per year with some chance of being outside that range. And in any given year, the return could certainly be negative.

If we expect the trailing S&P 500 P/E ratio to trend back from 20.7 to 16.0 over ten years (a 23% reduction, or 2.3% per year) then the amount we we should expect to earn by investing in the S&P 500 index is equal to our earnings growth assumption plus the dividend yield less a reduction of about 2.3% per year for the P/E regression. Thus with a 5% earnings growth assumption, plus 2.1% for dividends less the 2.3% for P/E regression we could expect to earn about 4.8% per year.

I note that the reported S&P 500 P/E ratio was well above 20 for most of the last 8 years. Either the earnings were distorted (downward) or the index was overvalued. Hindsight suggests that the index was overvalued for much of the period from 1997 to 2003.

It is impossible to predict where the S&P 500 index will go in the next year. But it is relatively easy to calculate whether or not it is currently overvalued based on reasonable growth expectations and a reasonable expectation around the P/E ratio. Caution is warranted because the S&P 500 can sometimes spend years in an over-valued or an under-valued-state. But ultimately, as we have seen in the early 2000’s crash, valuation does correct itself.

Readers should see also a similar article on the Dow Jones Industrial Average.

Shawn C. Allen, CFA, CMA, MBA, P.Eng.

President, InvestorsFriend Inc.

Updated June 1, 2008

I first applied this analysis to the S&P 500 index on September 8, 2004. At that time (3.5 years ago) I concluded the index was probably somewhat overvalued at 1104 and priced to return no more than 7% per year on average (actually since the analysis indicated the S&P 500 index was over-valued, the analysis at that time indicated the S&P 500 was priced to return less than the required 7% per year) was. With a current index level of 1400 it has returned an annualized average (but very lumpy) capital gain of 7.0% per year plus a dividend of about 1.8% for a total return of 8.8% which is somewhat higher than expected. Earnings growth until recently was significantly higher than the expected 5%. However with the recent earnings declines the earnings growth has now averaged only 4.1% per year.  The better-than-expected return is explained by the fact that the P/E ratio (now at 20.7) did not decline to 16 as expected. (Actually the P/E ratio did decline to about 16 but has now risen as earnings evaporate). Earnings growth tends to match the growth in nominal GDP over the long-run.

The Difference between Saving and Investing

The Returns from Saving versus Investing  (Understanding where the returns from savings and investing come from)

IS THE S&P 500 INDEX A GOOD INVESTMENT AT THIS TIME?

This is a lengthy and detailed article but the first few paragraphs give you to conclusions.

What Return Can You Reasonably Expect From Investing today in the S&P 500 Index?

This article is your One-Stop Page to Understand The S&P 500 Earnings and Dividend Yield and how these relate to The Fair Value of The S&P 500 Index.

This article (which draws on Warren Buffett’s teachings¹) provides:

1. Calculations of the current  fair value of the S&P 500 index based on several scenarios
2. The Expected next 10-year average Return per Year from the S&P 500 based on earnings growth and terminal P/E Assumptions.
3. The S&P 500 index  P/E ratio (based on trailing and forward earnings)
4. Earnings and earnings yield on the S&P 500 index (GAAP, operating and forward earnings)
5. Dividend Yield on the S&P 500 index
6. A link to the source for all the S&P 500 data on the the Standard and Poors web site
7. The Exchange Traded Fund (ETF) symbols to use to invest in the S&P 500 index

Mathematically, the Fair Value of the S&P 500 Index can be calculated based on just four things: the return that investors require, the current earnings and dividend level, the expected growth in earnings and dividends, and the probable P/E ratio that the index can be expected to be sold for at the end of a reasonable holding period of say 10 years.

This article provides a range of values depending on the scenario chosen. I believe that the analysis indicates that the fair value for the S&P 500 Index is about 5,745 as a point estimate. And so it appears to be over-valued at its recent value of 6843. My assumption for this estimate is that the S&P normalized earnings and dividend will grow at about 7.0% per year (which might be ambitious on top of all the recent earnings growth) and sell at a P/E of 20 in ten years (which is somewhat above its long-term average P/E of 17.9 but is below the 30 year average of 24.2) and that investors require a minimum expected return of 7.0%.

You can compare my fair value estimate of 5475 to the current S&P 500 level which is available here.

This analysis is as of February 17, 2026. However the calculated fair value of the S&P 500 index is not affected by the precise date of the analysis and my fair value estimate of 5745 will not change until at least after the next set of actual and/or forecast quarterly earnings numbers becomes available, and even then will not change much. As of February 17, 2026, the S&P 500 index at 6,843 appeared to me to be over-valued at 19% above my point estimate of fair value and based on a long-term investment and based on reasonable assumptions.

To be notified when we next update this article, simply join the list for our free investment newsletter. The sign-up link is at the top of every page on this site. If you don’t find our newsletter valuable, every issue provides a link to get off of our email list.

ANALYSIS

A quick indication of whether or not the S&P 500 index is fairly valued can be provided by simply looking at its trailing and forward P/E ratio.  As of  February 17, 2026, the S&P 500 was at 6843 and had a 2025 trailing year actual reported earnings P/E ratio of 27.5 and a forward P/E ratio (based on expected GAAP earnings in the next four quarters to September 30, 2025) of 24.1.

The trailing P/E of 27.5 is 53% higher than the historical average trailing year P/E ratio of 18 and it’s 20% above the 30 year average of 23. The forward P/E of 24.1 is 34% higher than the historical average trailing year P/E ratio of 18 and is 5% above the 30 year trailing P/E average. Note that analyst forward earnings estimates are usually considered to be biased high.

Overall, the quick indication is that the S&P 500 index is probably somewhat or even significantly over-valued,  at this time at 6,843 However this might be jumping to conclusions. We have to consider whether the forecast earnings level on the index is a reasonable estimate and at a sustainable level and what the outlook is.

This article explores the question of the estimated fair value of the S&P 500 index in much more detail below.

Importantly, an analysis of the fair value of the S&P 500 index will not likely provide a short-term indicator of market direction but it should provide a long-term indicator of the expected return from investing in the S&P 500 index at this time.

The attractiveness of the S&P 500 index level can be judged by looking at the current level of earnings and dividends of the S&P 500 index stocks, projecting the future rate of earnings and dividend growth and by considering the minimum return required by investors. Analysts often apply valuation techniques to individual stocks. It is  actually far easier to apply these calculations to a stock index since an index constitutes a portfolio and therefore its diversification eliminates much or most of the random noise of unexpected events that affect individual companies. Still, many challenges remain in applying this analysis and its results, while providing some indication for the long-term, can offer no insight for the short-term. The index remains vulnerable to changes in interest rates and the growth rate of the economy but is usually largely insulated from the numerous random events that can impact an individual stock.

It is perhaps worth noting that top 5 stocks in the S&P 500 represent 26% of its value and the top 10 represent 35%. This concentration could make the index less predictable.

What is the Earnings and P/E ratio on the S&P 500 index right now? (February 17, 2026 with the index at 6843)?

Data from Standards and Poors itself provides no less than four quite different answers to the above question based on different views of the earnings on the S&P 500 index.

S&P 500 Index Earnings Type	Annual Earnings on Index	P/E Ratio at S&P index 6843	Earnings Yield (Not dividend yield!)
Actual latest year (trailing four quarters to December 31, 2025) GAAP earnings (as reported to February 17, 2026)	$249	27.5	3.6%
Latest year “operating” earnings (removes certain “unusual” items)	$265	25.8	3.9%
Forecast forward GAAP earnings for the next year (2026 estimates summed by individual company)	$284	24.1	4.2%
Forecast forward operating earnings for the next year ( 2026 estimates summed by individual company)	$307	22.3	4.5%
For Comparison here are the S&P 500 Actual GAAP Earnings in prior years:	Earnings	Historical Year End P/E	Historical Earnings Yield
2024 Actual GAAP Earnings, S&P ended at 5882	$210.17	28.0	3.6%
2023 Actual GAAP Earnings, S&P ended at 4770	$192.43	24.8	4.0%
2022 Actual GAAP Earnings, S&P ended at 3840	$172.75	22.2	4.5%
2021 Actual GAAP Earnings, S&P ended at 4766	$197.87	24.1	4.2%
2020 Actual GAAP Earnings, S&P ended at 3756	$94.13	39.9 (Anomalous low earnings – pandemic)	2.5%
2019 Actual GAAP Earnings, S&P ended at 3231	$139.47	23.2	4.3%
2018 Actual GAAP Earnings, S&P ended at 2507	$132.39	18.9	5.3%
2017 Actual GAAP Earnings, S&P ended at 2674	$109.88	24.3	4.1%
2016 Actual GAAP Earnings, S&P ended at 2239	$94.55	23.7	4.2%
2015 Actual GAAP Earnings, S&P ended at 2044	$86.53	23.6	4.2%
2014 Actual GAAP Earnings, S&P ended at 2059	$102.31	20.5	4.9%
2013 Actual GAAP Earnings, S&P ended at 1848	$100.20	18.4	5.4%
2012 Actual GAAP Earnings, S&P ended at 1426	$86.51	16.5	6.1%
2011 Actual GAAP Earnings, S&P ended at 1258	$86.95	14.5	6.9%
2010 Actual GAAP Earnings, S&P ended at 1258	$77.35	16.3	6.1%
2009 Actual GAAP Earnings, S&P ended at 1115	$50.97	21.9	4.6%
2008 Actual GAAP Earnings, S&P ended at 903	$14.88	60.7 (anomalous low earnings – financial crisis)	1.6%
2007 Actual GAAP Earnings, S&P ended at 1468	$66.18	22.2	4.5%
2006 Actual GAAP Earnings, S&P ended at 1418	$81.51	17.4	5.7%
2005 Actual GAAP Earnings, S&P ended at  1248	$69.93	17.8	5.6%
2004 Actual GAAP Earnings, S&P ended at 1212	$58.55	20.7	4.8%
2003 Actual GAAP Earnings, S&P ended at 1112	$48.74	22.8	4.4%
2002 Actual GAAP Earnings, S&P ended at 880	$27.59	31.9	3.1%
2001 Actual GAAP Earnings, S&P ended at 1148	$24.69	46.1 (anomalous low earnings – tech wreck)	2.2%
2000 Actual GAAP Earnings, S&P ended at 1320	$50.00	26.4	3.8%
1999 Actual GAAP Earnings, S&P ended at 1469	$48.17	30.5	3.3%
1998 Actual GAAP Earnings, S&P ended at 1229	$37.71	32.6	3.1%

When you ask the “simple” question of “what is the earnings on the S&P 500 index?” or “what is its P/E ratio?” you are given a number of quite different answers. We can help you better understand the different answers.

Most analysts focus on the forecast year (called forward) “operating” earnings scenario, summed by individual company which is usually the highest earnings number and lowest P/E forecast. I find that to be overly aggressive as it ignores all unusual losses. (Surely on a group of 500 companies a certain amount of so-called “unusual” losses is to be expected every year and should not be ignored?)

As of February 17, 2026, the S&P 500 index was at 6843 and had a trailing Price Earnings Ratio (“P/E”) of 27.5 (note that the long-term historical average is 18 but the 30 year average is higher at 23) based on actual trailing reported earnings and had a current dividend yield of 1.17%  The trailing P/E based on the past 12 months reported  operating earnings (eliminates unusual one-time items) was 25.8.  The forward S&P 500 P/E ratio based on projected reported actual accounting GAAP earnings was at 24.1 (based on an expected increase in earnings of 15%). The forward P/E based on a forecast or forward operating earnings (eliminates all forecast unusual company-specific one-time items) was at 22.3 (based on the weighted sum of individual company forecasts). The forecast calls for an increase in operating earnings of 16%. This seems like an ambitious forecast of earnings growth on top of all the recent increases but maybe the magnificent seven can provide that.

Most analysts might focus on forecast operating earnings for the index (P/E of 22.3) as the best estimate since it eliminates company-specific unusual gains and losses and is future oriented.

Given that projected earnings tend to be optimistic and also ignore all “unusual” losses, I normally prefer to simply use the actual trailing P/E, or equivalently the actual trailing GAAP earnings level.  This figure is $246, for a P/E of 27.5. It is important to understand that this starting earnings level is a very major determinant in my calculation of the fair value of the S&P 500 index and that it can be a difficult number to estimate if the actual trailing earnings is not judged to be at a “normal” level. At this time, the trailing year earnings are somewhat above the trend line (see graph below). For that reason, it might be best to use something a little lower and closer to the trend line of earnings. But I also note that analysts expect reported earnings to grow to $284 in the next year. I will use the actual trailing year earnings of $246 as my starting point. It’s not totally clear if the earnings are above the trendline. Earnings are a higher percent of GDP. But perhaps it is reasonable that the 500 largest companies become a larger portion of the stock market and the economy.

The S&P 500 index represents a portfolio of 500 stocks. For each $6843 (the index value)  purchased, the underlying companies in the portfolio were recently earning about $246 per year and currently paying an annualized dividend of about $80 (1.17%).

When we buy the S&P 500 index, we can therefore think of it as being an investment that (as of February 17, 2026) costs $6843 and currently earns about $246 per year and pays a current dividend of $80 (1.17%) per year. It’s worth thinking about whether or not this portfolio of businesses is a good investment at or around its recent level of $6843.

We know that the S&P 500 index was at 6,843 on February 17, 2026. We can estimate what the S&P theoretically “should” be trading at based on the value of its current earnings and dividends and the projected growth in those earnings and dividends. This intrinsic value approach calculates the value of the projected earnings and dividends for a ten year period and then assumes that the index is sold at some projected future P/E ratio.

In addition to the beginning earnings and dividend level, three additional factors are required to calculate the fair value at which the S&P 500 should be trading at. These are, 1. The forecast average annual growth rate in earnings and dividends over the next ten years. 2. The forecast P/E ratio at which the S&P index will be trading in ten years time. 3. The estimated rate of return required by investors.

The S&P 500 portfolio average earnings arguably should (in the longer term) grow at a rate close to the growth rate of the U.S. economy in nominal (including longer-term expected inflation) terms. I believe a prudent estimate for this nominal earnings long-term growth rate is no higher than 6% to 8% and I would focus on about 7.0%. This 6% to 8% earnings and and nominal GDP growth could occur with real GDP growth of about 4% (which may be ambitious) and inflation of 2% to 4%. We have a short article that both explains why (quoting Warren Buffett) and also demonstrates that historically the S&P 500 earnings have tended to grow at about the same rate as nominal GDP growth in the long run.

Is my assumption of S&P 500 earnings growth of only 6 to 8% and nominal GDP growth of 6 to 8% too low? Afterall, The S&P earnings growth rate since 2015 has been 11.1% compounded annually. But that  has been unusually high. The S&P 500 earnings growth rate since 2013 has been 7.8%, since 1990 has been 7.2%, since 1980 – 6.1%, since 1960 – 7.07%. So, no, my 6 to 8% growth assumption is not too low by historical standards. Possibly growth in the next 10 years will be more like 10% annually driven by new technologies, lower income taxes and and/or less competition. This is just the earnings growth which drives the S&P 500 index level. I have also accounted for dividends which do add to the total return.

The following graph illustrates that the S&P 500 earnings have trended up at about the same rate as GDP growth over the long-term, although certainly with substantial volatility around the trend in individual years and over short periods of years.

This graph also clearly illustrates that the U.S. GDP (In nominal dollars, not inflation adjusted dollars)  has trended up steadily and has never failed to grow over say a three year period, except in the case of the 1930’s depression.

Note that we use a logarithmic scale on this chart. Logarithmic scales should always be used, on data that grows over time, when the time period is more than about 30 years because otherwise the lines will rise up exponentially (will “hockey stick”). A constant percentage historic growth rate plots as a straight line on a logarithmic chart. Note also that the left and right scales are consistent in that each rises exactly 10,000 fold from bottom to top and each point on the right GDP scale is exactly 100 times higher than the corresponding point on the left S&P earnings scale. Many analysts improperly present data with inconsistent scales.

The S&P 500 earnings (the red line) plunged with the financial crisis in 2007 and 2008 after reaching a peak in 2006. This graph shows that there is volatility in the relationship of S&P earnings to GDP. Earnings recovered as of 2011 and have grown VERY strongly since then with the exception of the pandemic in 2020. The Trump Income tax cut of 2018 has boosted earnings since then.

The GDP figure is showing a small dip in 2009 with a full recovery by 2010 and then continued growth until the minor decline with the pandemic in 2020.  The pandemic decline has been followed by strong growth in U.S. GDP since 2020. Note that the GDP figures here are in nominal dollars, whereas reports of GDP growth percentages almost always refer to real, inflation-adjusted dollars.

Having determined and discussed the earnings level on the S&P 500 index we also need to make an assumption about the P/E level that is likely to apply to the index in the longer term.

The average for the S&P 500 P/E ratio since 1949 is 17.8 (this eliminates from the average any P/E greater than 50 which only occurred in 2008 when the earnings plunged to abnormally low levels). The average (again eliminating the outlier 60.7 of 2008) in the past 30 years has been 23.3. The Justifiable P/E changes with earnings expectations and the market’s required return on equities.

The linked article states “I have conservatively calculated that the current Justifiable P/E is about 14.3 assuming that with today’s low interest rates investors require about a 7% expected return and assuming that competition will drive available returns down to the required 7% level.” The article also indicates that if companies can deliver in perpetuity an 8% ROE when investors only require 7% (perhaps due to a lack of corporate competition) then a P/E of 21.4 can be justified but we considered that to violate equilibrium conditions.   However, it does appear that companies have been able to earn ROEs higher than the required return and to do so consistently which does justify a higher P/E.  The long-run P/E range used in our table below is 17 to 23. I had historically used a lower range such as 15 to 19 but the persistently high P/E levels arguably support a higher range

I would estimate that a minimum (pre-tax) expected return required by stock investors (given today’s interest rates -which are expected to moderate somewhat) is in the range of 6% to 8%. The higher return required by investors then the lower the price or level that investors should be willing to pay for the index today, all else being equal.

The following table calculates the value that the S&P 500  will be  at in ten years given various forecasts for the earnings growth and given various scenarios for the forecast P/E ratio that will apply at that time. The second last column of the table then shows the fair or present value that we should be willing to pay today for the cash flows that would result from ten years of dividends plus the assumed cash from selling the index in ten years time. The present value is calculated based on various scenarios for the required return or discount rate.

The last column in the table indicates the average annual return that would be made if the S&P 500 is purchased at its recent level of 4559 and if earnings and dividends grow at the indicated rate and the index trades at the indicated P/E ratio in ten years time.

S&P 500 Current Annual Earnings Estimate	S&P 500 Current Annual Dividends	Earnings and Dividend Growth forecast	S&P 500 P/E forecast in 10 years	Resulting S&P 500 index in 10 years	Required Return	Resulting S&P 500 index Fair Value Today	Resulting Fair P/E today	Return per Year Buying at S&P 6843
$             246	$              80	6.0%	17	7,489	6%	4,982	20.3	2.5%
$             246	$              80	6.0%	20	8,811	6%	5,720	23.3	4.0%
$             246	$              80	6.0%	23	10,133	6%	6,458	26.3	5.4%
$             246	$              80	6.0%	17	7,489	8%	4,192	17.0	2.5%
$             246	$              80	6.0%	20	8,811	8%	4,804	19.5	4.0%
$             246	$              80	6.0%	23	10,133	8%	5,416	22.0	5.4%
$             246	$              80	7.0%	17	8,227	6%	5,463	22.1	3.4%
$             246	$              80	7.0%	20	9,678	6%	6,247	25.4	5.0%
$             246	$              80	7.0%	23	11,130	6%	7,058	28.7	6.3%
$             246	$              80	7.0%	17	8,227	8%	4,571	18.6	3.4%
$             246	$              80	7.0%	20	9,678	8%	5,243	21.3	5.0%
$             246	$              80	7.0%	23	11,130	8%	5,916	24.0	6.3%
$             246	$              80	8.0%	17	9,029	6%	5,929	24.1	4.4%
$             246	$              80	8.0%	20	10,622	6%	6,819	27.7	6.0%
$             246	$              80	8.0%	23	12,215	6%	7,709	31.3	7.3%
$             246	$              80	8.0%	17	9,029	8%	4,982	20.3	4.4%
$             246	$              80	8.0%	20	10,622	8%	5,720	23.3	6.0%
$             246	$              80	8.0%	23	12,215	8%	6,458	26.3	7.3%

Conclusions

Given the current trailing-year earnings level of $246 and the current dividend of $80, a range of expected earnings growth rates, the return required by investors and the assumed P/E ratio that will apply in ten years I can calculate that today’s S&P 500 index should be anywhere from as low as 4192 (assumes that our starting adjusted earnings level of $246 is reflective of a normalized starting point, that the market P/E falls to 17, earnings grow at 6% annually and equity investors require an expectation of making 8%) to as high as 7709 (assumes our starting adjusted trailing year earnings level of $246 is reasonable, a terminal market P/E of 23 will apply in ten years, earnings will grow at 6% per year and investors only require an expectation of earning 6% on equities).

My own fair-value point estimate is 5745. It’s based on the average of the two bolded rows. This assumes that equity investors require a minimum 7.0% expected return, that the S&P earnings and dividend will grow at 7.0% and that the long run S&P 500 P/E ratio is 20.  Higher S&P 500  index values are implicitly assuming that the current normalized starting earnings level is higher than $246,  or, more likely, that earnings growth will exceed 7.0% annually, that the justifiable long-run P/E exceeds 20, and/or that investors require less than a 7.0% (pre-tax) return. Or some combination of these factors.

My range of investor required expected returns of 6% to 8%, although low by historic standards, is attractive compared to the recent 10-year U.S. government bond yield of about 4.1%. It also represents an attractive real return of 4% to 6% after an expected 2% to 3% long-term inflation rate. But the long-term inflation rate that investors should expect is currently quite uncertain.

The last column in the table shows that under the indicated assumptions, if money is invested today in the S&P 500 and held for ten years and if the earnings and dividends grow at the rate indicated and the P/E ratio in ten years is as indicated then the average returns per year would range from 2.5% to 7.3% per year. With the 10-year treasury bond currently yielding about 4.1% these estimated returns are mostly not attractive. Of course the earnings growth on the S&P 500 could be lower than an average 6% per year and the terminal P/E ratio could be lower than 17, in which cases a lower (and negative) return could result. It’s also possible that the P/E ratio will remain above 23 and/or that earnings will grow faster than 8% per year.

One can always come up with losing scenarios, or winning scenarios but based on historical earnings growth and P/E ratios it would appear that over this next ten year holding period, the S&P 500 is not very likely to provide attractive returns.

The overall conclusion is that a fair value of the S&P 500 index based on its  trailing GAAP earnings is probably about 5745 as a point estimate. Since this is based on many assumptions it should be taken as a rough indication and certainly not as an exact determination.

My point estimate (the average of the two bolded rows) is that the S&P 500 in ten years will be at about 9,678 (assumes 7.0% annual earnings growth from $246 and a final P/E ratio of 20). Buying the S&P 500 index when it is at about 6843 (the level when this article was written) would, on that basis, be expected (but certainly not guaranteed) to result in a forecast return of about 5.0% per year if held for the next 10 years.  The expected standard deviation around this expected 5.0% is also large so that the actual return over the next 10 years might be expected to fall within a range of about 0% to 10% per year with some chance of being outside that range. And that return includes dividends and is before trading costs and personal taxes. And in any given year, the return will range wildly and should most definitely be expected to be negative in some years.

It is impossible to predict where the S&P 500 index will go in the next year. But it is possible to estimate its fair value and therefore whether or not it is currently over-valued based on reasonable growth expectations and a reasonable expectation around the initial earnings (or equivalently the  initial P/E level) and around the terminal P/E ratio. Caution is warranted because the S&P 500 can sometimes spend years in an over-valued or an under-valued-state. But ultimately, as we have seen in the early 2000’s crash, and the crash of 2008 and early 2009, valuation does correct itself.  (And sometimes over-corrects to the downside such as we saw in March of 2020).

You can easily invest in the S&P 500 index by buying the ishares S&P 500 index Exchange Traded Fund under symbol IVV on the New York Stock Exchange. And if you are really bullish you can buy the double bull Proshares Ultra S&P 500 symbol SSO. Or if you are bearish there is the single bear ETF, Proshares short S&P 500 symbol SH, or the double bear Proshares Ultrashort S&P 500 symbol SDS. Be cautious and understand what you are buying.

Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.

Updated February 17, 2026

Past Results from this Analysis.

Before placing any weight on the analysis above, you may be interested to review a summary of the fair values that we calculated in the past and whether or not our long-term analysis provided any hint of the 2008 market crash (Arguably the June 1, 2008 analysis provided some hint, especially for investors that felt that a 9% return was required for which we indicated a fair value of the S&P 500 index was 982 in that case and the index was sitting at 1400).

Keep in mind that with the past analysis we also provided a range of valuations and readers were free to select a different fair valuation from our table above.

The table below shows that our analysis appears to have mostly been too conservative.  The ONLY time our analysis saw the S&P 500 as under-valued was near its major low in the Spring of 2009. And indeed, over the following ten years an investor buying the S&P 500 made an abnormally high return (a 13.7% compounded annual gain not counting dividends!).

In general, based on where the S&P 500 is today, this past analysis now looks like it has been too cautious. It usually found the market to be over-valued when in fact investing at the dates indicated  for the ten-year period or, if ten years has not passed, until today (February 17, 2026) has provided a decent return in almost all  cases. Investing and holding at the dates shown from 2004 through 2007 provided, over the following ten years acceptable but unspectacular returns. Investing and holding at any of the dates since 2009 has provided very good returns – except for November  10, 2021.

Date of prior calculations	S&P Level at that Date	Fair Value we Calculated	Market appeared:	10 Year or to date Average Capital Gain Per Year (annualized)	Our apparent performance as of February 17, ’26 with the Index at 6843, or after ten years
13-Oct-24	5815		Significantly Over-valued	12.8%	Wrong, too conservative
26-Nov-23	4559	4234	moderately over-valued	20.0%	Wrong, too conservative
27-Nov-22	4026	3872	about fair-valued	17.9%	Wrong, too conservative
10-Nov-21	4674	3788	over-valued	9.3%	Wrong, too conservative
20-Jan-21	3848	2828	over-valued	12.0%	Wrong, too conservative
24-Nov-18	2633	2241	over-valued	14.1%	Wrong, too conservative
25-Mar-18	2588	2078	over-valued	13.1%	Wrong, too conservative
26-Nov-17	2602	1871	over-valued	12.5%	Wrong, too conservative
02-Mar-17	2382	1692	over-valued	12.5%	Wrong, too conservative
12-Mar-16	2022	1539	over-valued	13.0%	Wrong, too conservative
24-Mar-15	2100	1820	over-valued	11.4%	Wrong, too conservative
05-Apr-14	1865	1676	over-valued	10.7%	Wrong, too conservative
14-Nov-13	1791	1513	over-valued	9.6%	Wrong, too conservative
18-May-13	1667	1396	over-valued	9.7%	Wrong, too conservative
24-Feb-13	1557	1396	over-valued	9.8%	Wrong, too conservative
08-Sep-12	1438	1387	about fair-valued	10.8%	Wrong, too conservative
25-Feb-12	1366	1340	about fair-valued	12.1%	Wrong, too conservative
25-Aug-11	1159	1188	about fair-valued	14.5%	Wrong, too conservative
26-Feb-11	1320	1165	over-valued	11.2%	Wrong, too conservative
15-May-10	1136	944	over-valued	9.6%	Wrong, too conservative
05-Aug-09	1003	886	over-valued	11.0%	Wrong, too conservative
20-Feb-09	770	896	under-valued	13.7%	It appears we were correct, the index was very much under-valued on Feb 20, 2009
05-Oct-08	1099	991	over-valued	10.1%	It appears we were wrong the market has delivered a good ten-year  return to those buying in October 2008
01-Jun-08	1400	1158	over-valued	6.9%	It appears that we were moderately too conservative
25-Mar-08	1358	1221	over-valued	6.7%	It appears that we were moderately too conservative
10-Feb-08	1331	1388	about fair-valued	7.0%	It appears that we were correct
19-Aug-07	1446	1373	over-valued	5.3%	correct given that investors likely expected 6% from capital gains
10-Feb-07	1438	1295	over-valued	4.8%	correct given that investors likely expected 6% from capital gains
09-Sep-06	1299	1189	over-valued	5.3%	correct given that investors likely expected 6% from capital gains
07-Apr-06	1295	1215	over-valued	4.8%	correct given that investors likely expected 6% from capital gains
28-Feb-05	1191	925	over-valued	5.9%	It appears that we were moderately too conservative
04-Sep-04	1104	961	over-valued	6.1%	It appears that we were moderately too conservative

 

This analysis attempts to look forward ten years. That’s always difficult to do and subject to much error. The oldest analysis is our September 2004 analysis. At that time we were projecting that the S&P 500 index in September 2014 would be at 1,537 based on a P/E of 16 and that its earnings would grow 5% per year from $59 to $96 and that the dividend would grow from $20 to $33. The projection was intended to be reasonably conservative. The index ended September 2014 at 1,972 which was 28% higher than our projection. The earnings at about $100 turned out be reasonably close while the dividend was then running about 21% higher than predicted. The P/E ratio at 19.5 was 22% higher than our base projection of 16 and higher than the top end of our projection which was a P/E of 18. If the P/E was at the long-term average of about 16 then our S&P 500 projection would have been quite close.

The only time the analysis suggested the market was under-valued on the dates we updated was February 20, 2009 and that turned out to be correct.

1. See Warren Buffett in Fortune Magazine, November 22, 1999, and  his updated article of December 10, 2001. The same linking of stock index growth to GDP (or GNP) was made in Buffett’s October 9, 1969 letter to his partners.

IS THE TORONTO COMPOSITE S&P/TSX INDEX (TSX index) FAIRLY VALUED AT THIS TIME?

Note: This article is out of date and we cannot update it because our source for the Toronto Stock Exchange Index P/E and therefore earnings is no longer included in Statistics Canada CANSIM 176-0047. We know of no reliable free or low-cost source for the actual earnings on the Toronto Stock index. 

This short article (which draws on Warren Buffett’s teachings¹) provides:

1. Calculations of the current fair value of the Toronto TSX stock exchangeindex based on several scenarios
2. The Expected next 10-year average Return per Year from the Toronto TSX stock exchange based on earnings growth and terminal P/E Assumptions.
3. The Toronto TSX stock exchange index P/E ratio
4. Earnings and earnings yield on the Toronto TSX stock exchange index 
5. Dividend Yield on the Toronto TSX stock exchange index
6. The Exchange Traded Fund (ETF) symbols to use to invest in this Toronto TSX stock exchange index

This article concludes that:

A fair level of the Toronto Stock exchange index,  based on our estimate of its normalized trailing earnings level, is about 13,980. You can compare that to its current level.

However, the past earnings level of the TSX index has been extremely volatile. This makes it very difficult to estimate the trailing normalized earnings level. For that reason, there is a great deal of uncertainty in our estimate at this time.

At its November 29, 2016 level of 15,008, the Toronto Stock Exchange index was probably moderately over valued and priced to return about 5% annually based on a ten year holding period. The range around the estimated 5% average over 10 years is large and it could feasibly instead average  2% to 8% per year. In any given year the return could certainly be negative. In fact, it can be expected to be negative in some years.

This conclusion is heavily dependent on assuming that our normalised adjusted trailing earnings figure for the index is correct. (Which, due to the nature of the TSX is a questionable assumption).

Calculating a Fair Level of the Toronto Stock Index

The question of the fair value of the Toronto TSX stock exchange index can be explored mathematically by looking at the current consolidated total level of earnings and dividends of the stocks that make up the S&P/TSX  index, projecting the future rate of earnings and dividend growth and then considering the minimum return required by investors.

Analysts often apply such valuation calculation techniques to individual stocks. It is (usually) actually far easier to apply these calculations to a stock index since an index constitutes a portfolio which eliminates most of the random noise of unexpected events through diversification. Still, many challenges remain in applying this analysis and its results while providing some indication for the long-term and offer no insight for the short-term. The index remains vulnerable to changes in interest rates and to growth in the economy but is somewhat insulated from the numerous random events that can impact an individual stock. And, keep in mind that the TSX index is heavily concentrated in financials (35%), energy (21%), and materials (12%) and therefore it is not as easy to predict as would be a more fully diversified market index.

As of  November 29, 2016, the Toronto Stock Exchange composite index was at 15,008 and had an ostensibly very unattractive Price Earnings Ratio (“P/E”) of 59 based on actual trailing earnings as reported by Statistics Canada. The P/E based on our normalized view of earnings was also unattractive 23. The dividend yield was 2.82%. We will focus on the adjusted or normalized P/E of 23. This P/E is somewhat above the historical average. Therefore, the quick indication is that the S&P/TSX index is moderately over-valued at this time at 15,008. Below, we provide further analysis.

Based on its reported index value and P/E the earnings on the Toronto stock exchange in the last year (based on the latest available quarterly reports) were just $255. It is important that before starting the analysis we be satisfied that this is a representative level of earnings from which to forecast the future. We want to avoid using an earnings figure that is affected up or down by large unusually events or that is from the bottom of a recession or the top of the economic cycle. Unfortunately, based on the table below it is very difficult indeed to arrive at a representative earnings level. There is no apparent trend to the earnings. The ten year average level is $639. Allowing for some growth we will use $650. But this may be generous given the current $255 level and given lower oil prices.

Historic S&P/TSX  Figures:

Year End	Trailing Earnings $	P/E	Earnings Yield %
2015	366	35.5	2.8%
2014	608	24.1	4.1
2013	443	30.8	3.2
2012	671	18.5	5.4
2011	839	14.2	7.0
2010	682	19.7	5.1
2009	377	31.1	3.2
2008	832	10.8	9.3
2007	751	18.4	5.4
2006	818	15.8	6.3
2005	565	19.9	5.0
2004	503	18.4	5.4
2003	417	19.7	5.1
2002	152	42.4	2.4
2001	negative	n.a.	n.a.
2000	388	23.0	4.3

The above P/E data is directly from Statistics Canada CANSIM Table 176-0047 and the earnings were calculated from the Statistics Canada data.

The above table shows that the total reported earnings on the the Toronto Stock Exchange composite index which represents a portfolio of 247 companies. For each $15,008 (the index value) purchased, the underlying companies in the portfolio, in the last year earned  $650 (estimated normalised trailing level) and currently pays a dividend of $15,008* 0.0282 = $423 per year.

When we buy the TSX Composite index, we can therefore think of it as being an investment or “stock” that (as of November 29, 2016) cost $15,008 per share and currently earns $650 per year (estimated normalized trailing earnings) and pays a dividend of $423 per year. It is worth thinking about whether or not this “stock” is a good investment at or around its recent level of 15,008.

We know that the Toronto Stock Exchange index was at 15,008 on November 29, 2016, 2015. We can estimate what the TSX “should” have been trading at based on the value of its current (albeit estimated normalized) earnings and dividends and the projected growth in those earnings and dividends. This intrinsic value approach calculates the value of the projected earnings and dividends for a ten year period and then assumes that the index is sold at a projected future P/E.

In addition to the beginning earnings and dividend level,three additional factors are required to calculate the fair value at which the Toronto Stock Exchange index should be trading at. These are, 1. The forecast average annual growth rate in earnings and dividends over the next ten years (using an assumed ten year holding period for analysis purposes). 2. The forecast P/E ratio at which the TSX  index will be trading in ten years time . 3. The estimated rate of return required by investors.

The TSX  portfolio average earnings should (in the long run) grow at a rate close to the growth rate of the Canadian economy in nominal (after inflation) terms.I believe a prudent estimate for this growth rate is  3% to 5% and I would focus on 4%.

The average P/E for the Dow Jones Industrial average since 1950 is just over 15. (This is based on year-end data and excludes 1982 when the P/Ewent over 100 and a couple of other years where the P/E spiked due to abnormally low earnings – I don’t have the average for the TSX). However the Justifiable P/E changes (fairly dramatically) with earnings expectations and the market’s required return on equities.

I have conservatively calculated that the current Justifiable P/E- for the overall market – is in the range of about 14.3 to 16.7, with today’s low interest rates and a required return of 7%. This conservative calculation of the justifiable P/E assumes that, on average, the TSX companies will earn, on new investments,  the assumed 7% minimum ROEs required by investors (or for the higher end of the range will earn slightly more at 8%). If companies can sustainably earn significantly more than ROE required by investors, then it is possible to justify a P/E in the 20 range. The more optimistic we are about the level of the P/E in ten years time, the higher is the justifiable fair value level of the TSX  index today.

The following table calculates the value that the TSX index  will be  at in ten years given various forecasts for the earnings growth and given various scenarios for the forecast P/E ratio that will apply at that time. The second last column of the table then shows the fair or present value that we should be willing to pay today for the cash flows that would result fromten years of dividends plus the assumed cash from selling the index in ten years time. The present or fair value is calculated based on various scenarios for the required return or discount rate. The last column shows the return expected based on our assumptions.

 

TSX Composite Current Annual Earnings	TSX Current  Dividend	Earnings and Dividend Growth	TSX P/E forecast in 10 years	Resulting TSX Composite in 10 years	Required Return	TSX Composite Fair Value Today
650	423	3%	13	11,356	6%	9,966
650	423	3%	15	13,103	6%	10,941
650	423	3%	17	14,850	6%	11,917
650	423	3%	13	11,356	7%	9,224
650	423	3%	15	13,103	7%	10,112
650	423	3%	17	14,850	7%	11,000
650	423	6%	13	15,133	6%	12,680
650	423	6%	15	17,461	6%	13,980
650	423	6%	17	19,789	6%	15,280
650	423	6%	13	15,133	7%	11,711
650	423	6%	15	17,461	7%	12,895
650	423	6%	17	19,789	7%	14,078
650	423	9%	13	20,004	6%	16,118
650	423	9%	15	23,082	6%	17,836
650	423	9%	17	26,159	6%	19,555
650	423	9%	13	20,004	7%	14,859
650	423	9%	15	23,082	7%	16,424
650	423	9%	17	26,159	7%	17,988

Conclusions

By changing the expected earnings growth rate, the return required by the investor and the assumed P/E ratio that will apply in ten years I can calculate that today’s TSX  index should be anywhere from 9,224  to 19,555.

My own fair-value estimate is from the row highlighted in yellow and is 13,980. This assumes that investors require a minimum 6.0% return, that the Toronto Stock Exchange earnings (estimated to be $650 as of now on a normalised basis) and dividend will grow at an average of 6.0%  per year for the next ten years and that the long run TSX  P/E is 15.  My projected P/E of 15 is based on the long run average of about 15.0 and is consistent with the theoretical sustainable level of 14.3 to 16.7, noted above. Higher TSX index values are implicitly assuming that earnings growth will exceed 4% annually, that the justifiable long-run P/E exceeds 15, and/or that investors require less than a 6.5% (pre-tax) return.

Since the Toronto Stock Exchange index is at 15,008, as of November 29, 2016, I conclude that it appears to have been about 7% over-valued compared to my fair value estimate as of that date.

My required return of 6.0% is lower than historic equity returns but still very attractive compared today’s 10 year Canadian government bond yield of just 1.5%.

At its current level (as of November 29, 2016) of 15,008 the Toronto Stock Exchange index was probably moderately over valued and priced to return about 5% annually based on a ten year holding period.  The range around the estimated 5% average over 10-years is large and it could feasibly instead average  2% to 8% per year. We should expect the return to be negative in some years.

However, the extremely volatile nature of the TSX earnings makes it very hard to judge the value of this index.

It is impossible to predict where the Toronto Stock Exchange index  will go in the next year. But it is possible to calculate whether or not it is currently fairly-valued based on reasonable growth expectations and based on the assumption that we have a reasonable starting point for the earnings. Currently, the TSX index seems moderately under-valued. Caution is warranted in interpreting the numbers because the TSX earnings are volatile and can sometimes spend years in an over-valued or an under-valued-state. But ultimately, valuation does correct itself.

You can easily invest in the Toronto Stock Exchange index index by buying the ishares S&P/TSX Capped Composite Index under the symbol XIC on the Toronto Stock Exchange. There is also an index of the largest 60 shares in the Toronto Index, the ishares S&P/TSX 60 Index Fund trading under symbol XIU. And if you are really bullish you can buy the double bull as Horizons BetaPro S&P/TSX 60 Bull under symbol HXU. Or, if you are bearish, there is the single bear ETF Horizons BetaPro S&P/TSX 60 Inverse under symbol HIX, or the double bear Horizons BetaPro S&P/TSX 60 Bear under symbol HXD. Be cautious and understand what you are buying.

Readers should see also a similar analysis of the S&P 500 index and the Dow Jones Industrial Average

Shawn C. Allen CFA, CMA, MBA, P.Eng.
President, InvestorsFriend inc.

Updated November 29, 2016.

Here are past results from this analysis from our records:

Date of prior calculations	TSX/S&P Level at that Date	Fair Value we Calculated	Valuation of TSX	Average Capital Gain Per Year	Apparent Performance as of November 29, 20165 with the Index at 15,008 (and note that this was meant to be a long-term tool not short-term)
17-Sep-15	13787	15139	under-valued	7.3%	In the (very) early going. It appears we were correct.
03-Jun-14	14735	14226	about fair-valued	0.7%	In the (very) early going. It appears we were too optimistic.
11-May-13	12,589	12,630	about fair-valued	5.1%	In the  early going. It appears we were about correct.
17-Mar-12	12,497	13,216	under-valued	4.0%	It appears we were too optimistic.
28-Sep-11	11,585	11,838	about fair-valued	5.1%	It appears we were correct that the TSX was fairly valued.
11-Mar-11	13,674	11,369	over-valued	1.6%	It appears we were correct
29-May-10	11,671	11,637	about fair-valued	3.9%	It appears our fair value was about correct, the capital gain has been adequate, although barely so
21-Dec-09	11,555	11,565	about fair-valued	3.8%	It appears our fair value was about correct, the capital gain has been adequate, although barely so
11-Nov-08	9,065	12,369	under-valued	6.5%	It appears we were correct, the market was under-valued, a good investment
10-Feb-08	12,989	13,027	about fair-valued	1.7%	It appears we were wrong, our fair value was too high
08-Sep-07	13,651	12,585	over-valued	1.0%	It appears we were correct it was over-valued, but the overvaluation was much worse than we calculated
09-Sep-06	11,870	12,476	about fair-valued	2.3%	It appears we were wrong, our fair value was too high
07-Dec-05	11,131	10,261	over-valued	2.8%	It appears we were correct, but the over-valuation was worse than we calculated
26-Jan-02	7,659	5,986	over-valued	4.6%	It appears we were correct in that the capital gain has been less than investors would have “required” at that time.
06-Jul-01	7,594	6,014	over-valued	4.5%	It appears we were correct in that the capital gain has been less than investors would have “required” at that time.

1. See Warren Buffett in Fortune Magazine, November 22, 1999, and  his updated article of December 10, 2001. The same linking of stock index growth to GDP (or GNP) was made in Buffett’s October 9, 1969 letter to his partners.

Dow Jones Industrial Average Valuation Analysis

This page (which draws on Warren Buffett’s teachings¹) provides:

1. The Dow Jones Industrial Average  P/E ratio (based on trailing and forward earnings)
2. The expected next-10-year average return per year from the Dow Jones industrial Average based on earnings growth and ending P/E Assumptions
3. Earnings on the Dow Jones Industrial Average (GAAP and forward earnings)
4. Dividend yield on the Dow Jones Industrial Average
5. A link to the current P/E, earnings and dividend information on the the Dow Jones web site
6. Calculations of the fair value of the Dow Jones Industrial Average based on several scenarios
7. Complete and transparent data on exactly how our analysis has performed in the 18 occasions over 15 years that we have now provided this analysis.

The overall conclusion is that a fair level for the Dow would be 19,297 (as a point estimate) and that at its current level (as of April 16, 2017) of 20,453 the Dow Jones Industrial Average is about 6% over-valued which is not much above fairly valued.

Mathematically, the Fair Value of the Dow Jones Industrial Average depends on (only)  four things: i) the return that investors require, ii) the current earnings and dividend level, iii) the expected growth rate in earnings and dividends, and iv) the  expected P/E ratio at which it could be sold at the end of a reasonable holding period of say 10 years.

This article provides a range of values depending on the scenario chosen.

This analysis is for the DOW as of April 16, 2017. However, the calculated fair value of the Dow Jones Industrial Average (DJIA) is not affected by the precise date of the analysis and our fair value  estimates will not change before the next set of quarterly earnings numbers becomes available for the DJIA. And even then, the fair value is not likely to change much.

To be notified when we next update this article, simply join the list for our (approximately) monthly free investment newsletter. If you don’t find our newsletter valuable, every issue indicates how to get off our list.

A quick indication of whether or not the Dow Jones Industrial Average is fairly valued is to look at its P/E ratio. At this time the P/E ratio (based on actual reported earnings in the past year) of the DJIA index is 20.0. This is somewhat unattractively high compared to the historical average of about 16. Therefore the quick indication is that the DJIA index was somewhat over-valued as at April 16, 2017 at 20,453. This article explores the fair value of the DJIA in much more detail below.

Importantly, an analysis of the fair value of the Dow Jones Industrial Average (DJIA) will not provide a short-term prediction of market direction but it should provide a rough indicator of the fair value of the DJIA and a long-term prediction of the expected average annual return from investing in the DJIA at this time.

The attractiveness of the current DJIA level can be judged by looking at the current level of its earnings and dividends, making a reasonable forecast of the future rate of earnings and dividend growth and by considering the minimum expected return required by investors. Analysts often apply this valuation technique to individual stocks.

It is actually far easier or more logical to apply these calculations to a stock index since an index constitutes a portfolio. A portfolio automatically eliminates much (and usually most) of the random noise of unexpected events at individual companies through diversification. Still, many challenges remain in applying this analysis and therefore its results while providing some indication for the long-term can offer no real insight for the short-term. A broad index like the DJIA remains vulnerable to changes in interest rates and to uncertain growth (or shrinkage) in the economy but is usually largely insulated from the numerous random events that can impact an individual stock.

Current and Historical Dow Jones Industrial Average Earnings and P/E Ratio

What is the Earnings and P/E ratio of the Dow Jones Industrial Average right now? (April 16, 2017 with the index at 20,453)

Current and historical data from the Dow Jones company are as follows:

Note: the data in the following table, including the historical earnings and P/E ratios, is reasonably accurate but should not be taken as exact since I was unable to find an ideal data source for the DOW’s historical earnings. This data was derived from data on the Dow Jones web site at various historical points in time, but that data was subject to later updates. For example, trailing earnings reported early in a new year would not reflect the final GAAP earnings for the prior year.

DJIA Earnings Type	Annual Earnings on Dow Industrials	P/E Ratio at DOW 20,453	Earnings Yield (1/(P/E))
Actual latest year (trailing four quarters) GAAP earnings	$1017	20.1	5.0%
Forecast forward GAAP earnings for the next year (next four quarters)	$1196	17.0	5.9%
For Comparison here are the DJIA earnings and closing index level in prior years:	Annual Earnings on Dow Industrials (Typically based on Q3 trailing earnings)	Historical GAAP P/E	Historical Earnings Yield
2016 GAAP Earnings at 19,763	$1017	19.4	5.1%
2015 GAAP Earnings at 17,425	$1040	16.8	6.0%
2014 GAAP Earnings at 17,823	$1110	16.1	6.2%
2013 GAAP Earnings at 16,577	$1045	15.9	6.3%
2012 GAAP Earnings at 13,104	$925	14.2	7.1%
2011 GAAP Earnings at 12,218	$724	17.9	5.6%
2010 GAAP Earnings at 11,578	$831	13.9	7.2%
2009 GAAP Earnings at 10,428	$624	16.7	6.0%
2008 GAAP Earnings at  8,776	$661	13.3	7.5%
2007 GAAP Earnings at 13,265	$831	16.0	6.3%
2006 GAAP Earnings at 12,463	$720	17.3	5.8%
2005 GAAP Earnings at10,718	$476	22.5	4.4%
2004 GAAP Earnings at 10,783	$592	18.2	5.6%

Note that our historical DOW earnings data were mostly derived from Dow data sheets from December each year or early in each new year which earnings were subject to updating based on Q4 earnings and so should not be taken to be the precise calendar year earnings.

Note that the forecast calls for the Dow Jones Industrial Average earnings to rise 18% in the next year! Generally such forecasts are optimistic.

Normalized DOW Earnings

In order to calculate a fair value of the Dow Jones Industrial Average, it is necessary to start with its current trailing earnings level and to then consider whether this current earnings level is reasonably “representative” of “normal” expected economic conditions and has not been materially affected upwards or downwards by usual items.

The following graph provides additional insight into the representative or normalized level of the DJIA earnings.

Note that we use a logarithmic scale on this chart. Logarithmic scales should always be used for data that grows over time when the time period is more than about 30 years because otherwise the lines will rise up exponentially. A straight line on a logarithmic chart represents a constant percentage per year growth. Note also, that the right and left hand scales are consistent, both rise 10,000 fold.

The above chart shows that the annual earnings on the DOW have trended up with the U.S. GDP although at a slightly lower rate than GDP since the early 1930’s and with substantial volatility around the trend. The DOW earnings in 2016 are running at a somewhat higher percentage of GDP than in more recent decades. Possibly this is explained by the fact that the DOW companies are international companies and/or by the changing composition of the DOW companies. With slightly negative earnings growth in the past few years, it may be that the 2016 earnings was somewhat below the trend line.

The next chart presents the same data but starting in 1986 so that we can more closely examine the graph over more recent years.

Note that the GDP figures here are in nominal dollars, to be consistent with the earnings on the Dow, whereas most reports of GDP growth refer to real, inflation adjusted dollars.

This chart shows that while U.S. GDP rose fairly steadily since 1986, the DOW earnings growth rose faster but in an irregular fashion dipping with recessions. Based on this graph, the earnings of 2016 may be slightly below the trend line.

Given that the Dow earnings in 2016 appear to be somewhat below the trend line and given that, as noted above, the forecast is for earnings growth of 18% in the next year, we will use the average of the 2016 earnings and the forecast 2017 earnings as our normalized or on trend level for 2016. This amounts to $1106. On that basis the current P/E level is 18.5.

Valuation Analysis

The Dow Jones Industrial Average represents a portfolio of 30 stocks. For each $20,453 (the current index value) purchased, the underlying companies in the portfolio earned, on a normalised GAAP basis, $1,106 in the past reported four quarters and currently pay a dividend of $506 per year.

When we buy the Dow Jones Industrial Average index, we can therefore think of it as being an investment or “stock” or (better yet) “business”, that (as of April 16, 2017) costs $20,453 per share and currently earns $1,106 per year and pays a dividend of $506 per year or 2.47%. It is worth thinking about whether or not this “stock” is a good investment at or around its recent level of $20,453.

We know that the Dow Jones Industrial Average index was at 20,453 on April 16, 2017. We can estimate what the DJIA “should” have been trading at (or is worth) based on the value of its current earnings and dividends and the projected growth in those earnings and dividends. This intrinsic value approach calculates the present value of the cash dividends for a ten year period and assuming that the index is sold for cash at a projected future P/E.

In addition to the beginning earnings and dividend level, three additional factors are required to calculate the fair value at which the DJIA should be trading at. These are, 1. The forecast average annual growth rate in earnings and dividends over the next (say) ten years. 2. The forecast P/E ratio at which the DJIA index will be trading in ten years time (an assumed ten year holding period for analysis purposes). 3. The estimated minimum expected rate of return required by investors. (This required return is used to discount future cash received amounts to today’s present value).

Warren Buffett has argued that over the longer term, the Dow Jones Industrial Average portfolio average earnings should grow at a rate close to the growth rate of the U.S. economy in nominal (not adjusted down to remove inflation) terms. I believe a prudent estimate for this growth rate is normally 4% to 6% and I would normally focus on 5%. This 5% can also be thought of as 3% real GDP growth and 2% for inflation). Currently there is a lot of uncertainty as to both expected real GDP growth and the inflation level. Some expect deflation while others expect inflation. Overall a 5% earnings growth assumption does not seem unreasonable but is certainly subject to much uncertainty.

The average P/E for the Dow Jones Industrial average since 1929 has been 15.7 (Uses year-end data and excludes years when the P/E was abnormally high due to near-zero earnings and not due to optimism (The 1933 P/E of 47.3, 1982 P/E of 114.4,and the 1991 P/E of 64.3 are all excluded as outliers, which lowers our historical P/E estimate). The historical median P/E was 16.1.

However, the Justifiable P/E changes with earnings expectations and the market’s required return on equities.

The linked article states “I have conservatively calculated that the current Justifiable P/E is about 14.3 assuming that with today’s low interest rates investors require about a 7% expected return and assuming that competition will drive available returns down to the required 7% level.” The article also indicates that if companies can deliver in perpetuity an 8% ROE when investors only require 7% (perhaps due to a lack of corporate competition) then a P/E of 21.4 can be justified but we considered that to violate equilibrium conditions.   However, it does appear that companies have been able to earn ROEs higher than the required return and to do so consistently which does justify a higher P/E.  The long-run P/E range used in our table below is 15 to 19. I have focused on a P/E level of 17, just above the long run average of 16. Given today’s low interest rates 17 may be conservative. An argument could be made to assume a higher P/E such as 19.

I would estimate that a minimum (pre-tax) expected return required by stock investors (given today’s historically low interest rates) is in the range of 6% to 7%. The higher return required by investors then the lower the price or level that investors should be willing to pay for the index today, all else being equal.

The following table calculates the value that the Dow Jones Industrial Average  will be at in ten years given various forecasts for the earnings growth and given various scenarios for the forecast P/E ratio that will apply at that time. The table then shows the fair or present value that we should be willing to pay today for the cash flows that would result from receiving each of the ten years of dividends plus the assumed cash from selling the index in ten years time (at the amount in the column titled “Resulting DJIA in 10 years”). The cash flows are converted to a “present value” calculated using the amount in the “Required Return” column. The present value is calculated based on various scenarios (as shown) for the required return or discount rate applied to each earnings growth and ending P/E scenario.

Earnings	Dividend	Growth	Terminal P/E	Resulting DJIA in 10 years	Required Return	DJIA Fair Value Today	Implied Fair P/E today	Return per Year at 20,453
1,106	506	3%	15	22,296	6%	16,785	15.2	3.7%
1,106	506	3%	17	25,268	6%	18,445	16.7	4.8%
1,106	506	3%	19	28,241	6%	20,105	18.2	5.8%
1,106	506	3%	15	22,296	7%	15,462	14.0	3.7%
1,106	506	3%	17	25,268	7%	16,973	15.3	4.8%
1,106	506	3%	19	28,241	7%	18,484	16.7	5.8%
1,106	506	4%	15	24,557	6%	18,276	16.5	4.7%
1,106	506	4%	17	27,832	6%	20,105	18.2	5.8%
1,106	506	4%	19	31,106	6%	21,933	19.8	6.8%
1,106	506	4%	15	24,557	7%	16,825	15.2	4.7%
1,106	506	4%	17	27,832	7%	18,490	16.7	5.8%
1,106	506	4%	19	31,106	7%	20,154	18.2	6.8%
1,106	506	5%	15	27,023	6%	19,894	18.0	5.7%
1,106	506	5%	17	30,626	6%	21,906	19.8	6.8%
1,106	506	5%	19	34,230	6%	23,918	21.6	7.9%
1,106	506	5%	15	27,023	7%	18,305	16.6	5.7%
1,106	506	5%	17	30,626	7%	20,137	18.2	6.8%
1,106	506	5%	19	34,230	7%	21,969	19.9	7.9%

Valuation Conclusions and Observations

By changing the expected earnings growth rate, the return required by investors and the assumed P/E ratio that will apply in ten years I can calculate that today’s DJIA index should be anywhere from  16,785  (we would earn an average a return of 3.7% per year, buying today at 20,453 under these assumptions) to 23,918 (we would expect to earn an average 7.9% per year, buying today at 20,453 under those assumptions). A reasonable scenario may be average of the two highlighted rows with 4% earnings growth per year, a 6.5% (average of 6% and 7% in the two rows) required rate of return and a final P/E ratio of 17 in ten years and a fair DOW level of 19,297 and an expected return of 5.8% per year on average if bought at today’s 20,453. However, other scenarios are certainly plausible as well.

Note however that all estimates assume the $1,106 actual trailing GAAP earnings is the current representative normalized earnings on the DOW.

Since the Dow Jones Industrial Average is currently at 20,453, I conclude that it is likely about 6% overvalued as a point estimate.The table illustrates quite a wide range for a reasonable fair value of the Dow Jones Industrial Average.

Some investors might not admit to being happy with a 6.5% expected long-term return from stocks, but 7% seems highly attractive compared to a current 10 year U.S. government bond yield of just 2.3%.

Note also that the Price to book ratio of the Dow Jones Industrial Average is 3.56. The DJIA companies have therefore achieved a return on ending equity of about 17.5% in the past year based on ROE = P/B divided by P/E.

Another way to calculate the expected return on the Dow Jones Industrial Average index is by using the dividend growth model. This assumes that the dividend will grow at the rate of the ROE on retained earnings times the proportion of earnings that are retained.  The dividend payout ratio calculated from the dividend and earnings in the table above is $506/$1106 = 46%. That means the earnings retention ratio is 54%. If the DJIA companies could continue to make the same ROE of 17.5% on their existing equity plus on retained earnings then the dividend would grow at 54% of that or 9.4% annually, assuming the same earnings pay-out ratio. Adding the current dividend yield of 2.5% would then suggest an expected return of about 11.9%, assuming the P/E was unchanged. However, an 17.5% ROE on future as well as past retained earnings seems quite optimistic. If we use a 10% ROE on new investments (of future retained earnings) the expected return on this basis is about 7.9% (5.4% plus 2.5%). And this assumes that the P/E remains constant at 18.5.

The overall conclusion is that a fair level for the Dow would be 19,297 (as a point estimate) and that at its current level (as of April 16, 2017) of 20,453 the Dow Jones Industrial Average is about 6% over-valued which is not much above fairly valued.

It is impossible to predict where the DJIA will go in the next year. But it is relatively easy to calculate whether or not it is currently significantly under- or over-valued based on reasonable growth expectations and a reasonable projection for the P/E ratio and a reasonable assessment of investors’ minimum required rate of return. Caution is warranted because the DJIA can sometimes spend years in an over-valued or an under-valued-state. But ultimately, as we saw in the early 2000’s, and in 2008, valuation does correct itself, and often over-corrects as well.

You can easily invest in the Dow Jones Industrial Average Index index by buying the ticker symbol DIA on New York, the SPDR Dow Jones Industrial Average Exchange Traded Fund.

Readers can also see our similar analysis of the S&P 500 index and of the Toronto Stock Exchange Index

Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend inc.

Last updated April 16, 2017

This is an update of an analysis I first did of the DJIA dated February 8, 2002 Click to check out what the analysis was indicating way back then. The table below shows how this analysis has performed in the past. The assessment of past performance assumes that today’s level of the DOW at 20,453 at April 16, 2017 is a fair value of the DOW today. The results are mixed. Our fair value of the DOW estimates in the earlier years were too optimistic. This analysis did not “warn” that the market was over-valued entering 2008.  In recent years it appears to be working better perhaps due to enhancements to our analysis and to better consideration of whether the beginning earnings needed to be normalized or not and due to a correction to the long-run average P/E ratio. Since late 2008, this analysis has in most cases suggested that the DOW was undervalued and in fact returns since each of the analysis dates beginning in the Fall of 2008 to late 2015 have been quite good.

Date of prior calculations	DJIA Level	Fair Value we Calculated	We Indicated Market appears:	Average Capital Gain Per Year (Annualized)	Apparent Performance as of April 16, 2017 with Index at 20,453
December 12, 2015	17,265	17,546	about fair-valued	13.4%	It appears we too cautious
March 31, 2014	16,458	17,249	about fair-valued	7.4%	It appears we were correct
May 18, 2013	15,354	14,853	about fair-valued	7.6%	It appears we were correct
January 12, 2013	13,488	14,165	about fair-valued	10.3%	It appears we were correct
March 4, 2012	12,978	15,072	under-valued	9.3%	It appears we were correct
March 6, 2011	12,170	11,997	about fair-valued	8.9%	It appears we were correct
September 11, 2010	10,463	11,779	under-valued	10.7%	It appears we were correct
May 29, 2010	10,137	10,975	under-valued	10.7%	It appears we were correct
October 11, 2009	9,865	11,026	under-valued	10.2%	It appears we were correct
April 4, 2009	8,018	9,146	under-valued	12.4%	It appears we were correct
December 6, 2008	8,635	10,317	under-valued	10.9%	It appears we were correct
November 6, 2008	8,696	10,506	under-valued	10.7%	It appears we were correct
June 8, 2008	12,182	12,931	under-valued	6.0%	We now appear too optimistic as the $803 earnings from June 2008 declined before finally recovering. In hindsight, we should have considered whether earnings were above the trend line. The trend line was not part of the analysis at that time.
September 8, 2007	13,113	13,214	about fair-valued	4.7%	We were too optimistic as we did not project a sharp earnings decline.
September 15, 2006	12,446	12,009	about fair-valued	4.8%	We were too optimistic,  the earnings, then at $720 did not grow as expected.
May 31, 2005	10,467	10,912	about fair-valued	5.8%	We were too optimistic,  the earnings, then at $661 did not grow as expected.
November 30, 2004	10,428	10,716	about fair-valued	5.6%	We were too optimistic,  the earnings did not grow as expected.
February 8, 2002	9,744	9,820	about fair-valued	5.0%	See below

Regarding the earliest estimate just above. In hind-sight, and based on the 15 years that have now passed we were moderately optimistic. Earnings, then at $485 did not grow at the then expected 7% (but they have grown at 5.6% in the 15 years since then) and our assumed terminal P/E at 18 subsequently seemed somewhat high although as of today it does not look too high. But we did recognize that our fair value of 9,820 in 2002 might be too high and we stated at that time: “Investors should be sobered by the fact that if investors require a 9% rate of return and if the earnings only grow at 5% (say 3% GDP plus 2% inflation) and if the DOW commands a P/E of only 15 in ten years then the fair value of the DOW is calculated as only 5898. So conservative but not really gloomy forecasts of earnings, required return level, and P/E result in a fair value of the DOW at only 5898. Gulp!”

1. See Warren Buffett in Fortune Magazine, November 22, 1999, and  his updated article of December 10, 2001. The same linking of stock index growth to GDP (or GNP) was made in Buffett’s October 9, 1969 letter to his partners.

Stocks, Bonds, Bills and Inflation and Gold  – Asset Class Performance – updated through October 14, 2023

This article shows you the long-term historic after-inflation performance and returns of the five major asset classes of U.S. stocks, U.S. long-term (20-year) government bonds, U.S. Treasury bills, Gold and  cash (the U.S. dollar). The results are truly enlightening and amazing. The results are based on U.S. data from the start of 1926 through October 14, 2023. The data source (other than for Gold) is a well-known reference book called “Stocks, Bonds, Bills and Inflation” 2022 edition. The book is published annually and is available through Wiley. The figures for 2023 were added from other sources as of October 14.

Note that most analysis of historic returns that you have seen is often flawed in that it is based on “nominal” returns before inflation. The graphs and figures below are based on “real” returns after inflation. That is, this analysis shows the real increase in actual purchasing power generated by each investment asset class – and the decrease in the purchasing power of cash.

The first graph below shows the long-term real (after inflation) returns on large capital U.S. stocks (The S&P 500 index of stocks), long term U.S. Treasury bonds (20 years), U.S. Treasury Bills (30-day cash investments), the real value of a U.S. dollar after inflation and Gold. The return is illustrated by showing the inflation-adjusted growth over the years of each $1.00 invested in each asset at the end of 1925.

Note that the investment in 20-year U.S. government bonds does not buy and hold a 20 year bond to its maturity. Rather, it starts with a 20-year bond and sells that bond at the end of each year and reinvests in a new 20 year bond in order to keep the maturity constant at 20 years. In that sense it is a 20-year bond index investment.

Isn’t that amazing? In real-dollar terms (adjusted for inflation), large U.S. stocks have absolutely clobbered long-term government bonds, short-term cash investments, Gold, and the dollar itself in terms of total growth or return. There is just no comparison! Each dollar invested in large stocks at the end of 1925 was worth $749 in real (inflation-adjusted) purchasing power 98 years later at October 14, 2023. Yes, that is an increase of 749 times the real spending power after inflation!. An astounding gain of 74,800% even after accounting for inflation!

Compared to large stocks, the other asset class values after (almost) 98 years are, comparatively, so low that they barely show up on the graph. (We’ll fix that below.) $1.00 constantly invested in long-term (20-year) U.S. government treasury bonds for those same 98 years was worth $7.03 (after inflation) as of October 14, 2023. $1.00 constantly invested in one month T-Bills since 1926 was worth just $1.33 in real dollars after inflation. $1.00 invested in Gold for the same 98 years was worth $5.35. $1.00 left literally in cash (such as under the proverbial mattress) and not invested at all is now worth what just 5.7 cents bought in 1926, due to the ravages of 98 years of inflation.

Remember, all these figures are after adjusting for inflation (and so the above figures are the growth in real purchasing power) and assume reinvestment of all dividends or interest received and also assume tax-free and no-fee investment accounts. After tax, the growth would be less dramatic but would be even more in favor of stocks versus bonds given the lower tax rates on both capital gains and dividends. However since the Gold held for the 98 years would attract no taxes (unless assumed sold at the end of the period) and no transaction fees, it would improve relative to stocks if income taxes were taken into account.

This means that if your ancestor had foregone just 1 case of beer at the end of 1925 and invested the money, assuming it were possible, in a tax-free account, in the S&P index of large stocks (and reinvested all dividends and rebalanced to stay with the index over the years, and ignoring transaction costs), then you, as heir, as at October 14, 2023, could go out and buy 1 case of beer and still have money enough left to buy 748 more cases! This is truly amazing and is really a case where you can in fact have your cake and eat it too, if you just delay eating the cake and instead invest the money for a long time. Later I will show that there are some pretty good returns over 20 year periods, so you don’t have to actually invest for 98 years! (which is a long time to wait for either a drink or a piece of cake).

This amazing out-performance of stocks (which beat long-term government bonds by a factor of $749/$7.03 or a staggering 107 to 1, in the 98 years) has occurred in spite of the two huge stock crashes that have occurred since the year 2000, not to mention the stock crash of the great depression. The S&P 500 stocks also clobbered Gold by a factor of $749/$5.35 or a withering 140 to 1.

The continuous investment in one-month T-Bills at $1.33 has just barely kept ahead of inflation. And a dollar kept literally in cash as in a safe deposit box or under a mattress still is the same dollar but it now buys only what 5.7 cents would have bought in 1926. Cash in a safe deposit box is a wasting asset, over longer periods of time, in the presence of inflation.

The above graph which has a normal linear (arithmetic) scale does a great job of showing the huge difference in the ending portfolio values but unfortunately is horribly distorted in four ways.  First, the results from the earlier years are not really visible. Second, it looks like the percentage rate of growth for stocks was increasing toward infinity until 1999 and also again from about 2011 to 2021. Third, on this graph it looks like the early 2000’s stock crash and the 2022 decline were the biggest market crashes ever – which they were not.  Fourth, the very strong performance of government bonds and Gold in some recent years is obscured and is not even visible.

A logarithmic scale solves these problems because a constant percentage growth appears as approximately a straight line and the percentage gains in the earlier years are much more visible. Also the large gains in Gold and long-term government bonds in more recent years will become visible. Unfortunately a logarithmic scale tends to somewhat obscure the huge differences in the ending values. When viewing a growing data series it is essential to to view it with a logarithmic scale in order to properly understand the trend and the volatility over time. A regular linear arithmetic scale is useful for showing the total growth achieved in the end but horribly distorts the trend and the level of volatility across time. The longer the time period and the higher the average annual percentage growth, the worse the distortion.

The same data presented in the above graph is presented below with a logarithmic scale.

In this graph (with the same data as above) you now have to look more closely to realize the amazing extent to which large stocks (the S&P 500) outperformed Treasury bonds, T-bills, Gold and the dollar itself over the (almost) 98 year period. But only this logarithmic scale allows you to properly view the trend and volatility over the years.

A constant slope on this logarithmic graph represents an approximately constant annual percentage growth. By the nature of logarithmic graphs, a dip or gain on this graph of a certain height represents the same percentage change whether it happened in the 1920’s or the 2000’s. Any dip or gain visible on this graph is actually large since a logarithmic scale tends to make even large percentage changes look small.

This graph reveals that large cap stocks (the blue line) were much more volatile than bonds, particularly  from 1926 – 1932, the mid 70’s and in the first decade of the 2000’s. Again, remember that the graphs show real returns, adjusted for inflation. It is interesting that the big stock market crash in 1987 is not apparent on this graph. The reason for that is the fact that the graph here shows only year-end figures. The big crash in 1987 was actually an event that happened within the year as stocks soared until October that year and then crashed. On a calendar year basis U.S. large cap stocks were actually up slightly in 1987. Similarly, the pandemic panic of Spring 2020 is not visible since it was largely recovered from by the end of that year.

The Graphs below take the data above and break it out into 20 year periods and reveal some very interesting insights into asset performance in different periods. Note that the scales below are linear (as opposed to logarithmic) and that all the scales go to $8.00 (A 700% gain, from the $1.00 starting point). A linear scale is acceptable here given the relatively short time period. By using the same scale it is easier to visually compare the performance across the different 20 year periods.

Long Treasury Bonds (the red line)  look like the place to be in the 1926 – 1945 period. Stocks beat out Bonds in the end but it was a rough ride indeed. The stock index returned 291% after inflation in the 20 year period while the Treasury bond index returned 148% and Treasury bills eked out 22%. Gold gained 78% in real terms. The gain in Gold was due to a U.S. devaluation of the dollar from 1/20th of an ounce of Gold to 1/35th of an ounce of Gold in 1934. A paper dollar in a safe or under a mattress gained in value during the depression due to deflation and ended up losing just 1.5% in purchasing power over these 20 years. (And that was despite the devaluation of the U.S. dollar in terms of Gold which apparently had no impact on inflation inside the United States).

Notice that the dollar exactly tracked Gold (or was it vice versa?) until 1934 which was when the U.S. government forced citizens to turn in their Gold for $20.67 per ounce (so called expropriation, but they did pay for the Gold, but the former Gold holders lost out on the appreciation in Gold that came soon after it was “expropriated” and then the government effectively devalued the dollar by redeeming U.S. $35.00 dollars from foreign banks in exchange for one ounce of Gold as opposed to the former $20.67. ($1000 therefore that used to “buy” 48.4 ounces of Gold would then buy only 28.6 ounces due to the devaluation of the U.S. dollar in terms of Gold). The value of a dollar fell sharply relative to Gold in 1934 but then precisely parallels gold for the remainder the period shown in this graph.

The (relatively) unique thing about this time period was the huge stock valuation bubble in the late 20’s followed by a bursting in late 1929, which was then exacerbated by poor government policies that led to the Great Depression. Note that the full extent of the stock bubble and devastating crash is not visible in this graph because it uses only year-end, rather than daily data.

Wow, 1946 – 1965, what an incredible run for stocks!, while bonds and T-Bills and Gold all  failed to even keep up with inflation. The dollar itself fell in real value due to inflation. It’s interesting to note that stocks would be considered to be much more risky, because they increased in a volatile fashion while bonds were pretty flat and went nowhere. But if this is what people call risk, I’ll take it! The stock index returned a whopping 664%, after inflation, while the long bond index investment lost about 21% and even so-called risk-free Treasury bills lost 16% after inflation, over the 20 years. Gold lost 46% in real terms and the dollar itself lost a similar 43%. Gold was tied to the dollar because the U.S. government would (for foreign governments) redeem dollars for Gold at a fixed $35 per ounce, hence the similar loss.

Whenever you look at long term data that shows the huge margin by which stocks have beaten bonds, it is wise to remember that a huge chunk of that came from the 16 years after 1948.

During this period there was moderate inflation, in contrast to the deflationary 1930’s. Long-term bond rates did not appear to reflect an expectation of even moderate inflation. Stocks were able to keep up with inflation, (in fact far out-paced inflation) while long term bonds got hammered due to unanticipated inflation.  The post war years also saw unprecedented gains in productivity and the birth of the consumer society. This benefited stocks, hugely.

The 1966 to 1985 period included an incredible run for Gold from 1972 to 1980. But, ouch!, this was an ugly time to be an investor in stocks and bonds. Note that the scale extends to $8.00 so that the graph can be easily and properly compared to the 1946-1965 graph above. These were the really big inflation years and both stocks and bonds as well as treasury bills had a very hard time keeping up with high inflation. The dollar itself lost an ugly 71% in real purchasing power mostly due to the famously high inflation of the 1970s. It does not look like much, but stocks returned a total real portfolio gain of  53% over the 20 years while long bonds lost 7% and Treasury bills made 20%. Both stocks and bonds were volatile and both had periods where they dropped about 50%. T-bills were looking good with low volatility and reasonable returns compared to the other assets.

But Gold, was the place to be. It continued to track the dollar until President Nixon took the dollar off of the Gold standard in 1971 and then Gold soared in dollar terms. From 1972 to 1980, Gold did a LOT more than keep up with inflation. At its peak it had risen about 500% in real buying power terms even after adjusting for the big inflation.

Next we look at the period from the end of 1985 through the end of 2005.

$1.00 invested in large stocks at the end of 1985 was worth $5.29 at the end of 2005 for a gain of 429% in real after-inflation terms. This was in spite of the stock crash of the early 2000’s. The gain in stocks from 1985 to 1999 was similar to the gains from 1948 to 1965. The 20-year investment of $1.00 in long-term bonds grew to $3.15 (215% gain) and for T-Bills grew to $1.36 (36% gain). Gold did not quite hold its purchasing power and was down 13% in these 20 years. $1.00 invested in gold at the start of 1986 had fallen to an inflation-adjusted 54 cents at the end of 2000 but then roared back to 87 cents at the end of 2005. The purchasing power of a cash dollar fell by 44%.

A very distinctive thing about the period of 1986 through 2005 was a huge drop in interest rates. This provided a huge boost to bond returns. It also contributed to higher P/E multiples being justified for stocks, which boosted stock returns. Another relatively unique thing about that period was the huge stock valuation bubble of the late 90’s which then deflated and then partially recovered.

In order to cover the 20 years ended in 2023, our next graph will over-lap the last two years of the one above.

In the 20 years from the end of 2003 / start of the year 2004 through October 14, 2023, Gold initially clobbered stocks but in the end stocks prevailed. 20-year Treasury Bonds had done very well over this period until they got clobbered with the higher interest rates and inflation in 2022.

$1.00 invested in large stocks (the S&P 500 index)  for the 20 years since the start of 2004 (end of 2003) was worth $3.37, (a 237% gain) in real terms after inflation, as of October 14, 2023. For an investment constantly rolled over each year in 20-year long-term government bonds the figure was $1.19 and for monthly Treasury bills $0.78. Gold surged from 2004 to 2012 and $1.00 invested in gold peaked at $3.20 and ended the 20 year period at $2.73. The purchasing power of a cash dollar declined 41% in these 20 years to 59 cents due to inflation.

A distinctive thing about the period of 2004 through 2021 was a huge drop in interest rates until the end of 2021. This provided a huge boost to bond returns. It also contributed to higher P/E multiples being justified for stocks, which boosted stock returns. This period included crisis of 2007 / 2008 which was followed by huge gains in stocks after 2009. This period also saw the emergence of the digital economy and the huge valuations of certain companies in that sector. The last two years of this period included a huge increase in interest rates which pushed stock values lowered and really hammered the value of long-term government bonds.

The above graphs demonstrate that the market looks very different in different time periods and it is therefore very dangerous to make assumptions about the relative performance of stocks and bonds in the next 20 years.

Conclusions and Summary

By studying these graphs, you can draw your own conclusions about the relative past returns and risks of Stocks, Bonds, T-Bills and Gold. And you can see the decline in purchasing power that occurs with actual cash held in a safe or in a mattress for 20 year periods.

Note that these total return indexes ignore taxes (effectively assumes a non-taxable account) and also ignore trading costs.

Stocks (the S&P 500) out-performed 20-year government Bonds and T-bills and Gold by an absolutely staggering amount over the last 98 years. Stocks therefore also did a far superior job of protecting against inflation over the full 98 year period.

Stocks even out-performed over the 20 years from 1926 through 1945, in spite of the depression and crash of 1929-1932. Bonds also did reasonably well. T-Bills were basically the after inflation equivalent of stuffing cash under the mattress. Gold did reasonably well over the full 96 year period but was highly volatile in terms of purchasing power. Actual cash in a mattress basically rotted away due to high inflation in some decades.

For the 20 years from 1946 to 1965, stocks were far superior. Long-term bonds and T-Bills imitated mattresses (but did protect against inflation, although not fully). The dollar itself and Gold which was tied to the dollar both lost almost half of their purchasing power.

The 20 years from 1966 through 1985 were ugly all around (unless one held Gold). Stocks came out slightly ahead of bonds. Gold had very large returns as it was de-coupled from the U.S. dollar and as Americans were again allowed to own it.

During the 20 years ended 2005, Stocks did very well but with high volatility, Bonds did unusually well compared to stocks and with a lot less volatility. T-Bills continued to only slightly out-perform inflation. Gold slightly trailed inflation.

In the 20 years ended 2023 (based on October 14 2023 data) stocks did very well and Gold was also strong while long-term government bonds did very well until they declined noticeably in the last two years of this period.

A major learning from the above graphs is that the markets look very different in different time periods. It would be foolish indeed to base your investment decisions solely on the results from the last 20 years or so. Those two decades were unique due to a combination of lower inflation and dramatically declining interest rates (until recently) as well as the maturing of the digital economy.

The above data and graphs focus on just five 20-year investment periods beginning at the end of 1925, 1945, 1965, 1985, and 2003. Given the significant differences in the performance of stocks, versus bonds or T-bills and Gold over those different periods, it is also very useful to look at the comparison over all the possible 10 to 30 year holding periods beginning each year since the end of 1925. My related article does this by graphing the average annual returns over all those possible holding periods and also attempts to answer the question of whether stocks are really riskier than bonds.

Originally written Summer 2001 and updated annually and last updated October 14, 2023

Shawn Allen, CFA, CMA, MBA, P.Eng.

President, InvestorsFriend Inc.

 

Key Points and Extracts from Warren Buffett’s Letters 1957 – 1983

I am sorry but this article had to be removed due to copyright concerns.

However, you can access the all the letters from our Links tab, just choose links from the menu at the left of each page on this site and on our Links page choose here and then choose Warren Buffett’s Annual letters.

Opportunities in Thinly Traded Shares

“Thinly traded shares” are shares of companies that trade a low volume of shares per day. In extreme cases the share may trade only a few times per month and the daily average could be in the range of 100 shares and the average daily value of the trade could be in the range of one thousand dollars or less. Of course there is a continuum of what is considered thinly traded. Any share which does not have an average daily trade value of at least $10,000 would be considered thinly traded by most investors. Meanwhile a large institutional trader might consider any stock that is not trading one million dollars in value on an average day to be thinly traded.

While some investors would like to be famous for their trading prowess, after the fact – no investor wants to attract notice when they are actually trading. When you buy a stock you want your order to be small in relation to the daily average traded amount, so that your trade does not drive up the market price. Once you own shares in a company it is always preferable to be able to sell those shares at the recent market price without driving down the price.

If a retail investor wants to invest $5000 in a company this will not be a problem if the company is trading say $100,000 in value per day. But it could be a problem if the company only trades an average $2000 per day. In that case the existence of the retailers order to buy could be enough to drive up the price of the shares.

Thinly traded shares present an opportunity for the astute retail investor who is willing to be patient in both buying and selling and who is willing to put up with price volatility.

While there is an opportunity there are also reasons to be cautious with thinly traded shares as explained in our related article.

I think an opportunity exists for retail investors because there is and can be essentially no analyst coverage on very thinly traded shares.

Institutional investors would likely ignore anything that is not trading perhaps $100,000 per day or more (usually much more) because it would be too thinly traded for the purposes of large institutional investors. But such a stock might not be too thin for a given individual small retail investor. Meanwhile analysts cannot cover the stock because if a number of their clients tried to buy, that would drive up the price. No legitimate analyst would want to recommend a thinly traded stock and then see it rise in price only because his or her own clients bought the stock. In that case there would be no one to sell to and the stock might quickly collapse.

In the past I have had a smaller following of investors who were looking at my stock picks. As I now have more subscribers I have recently removed a few thinly traded stocks from my list because I did not want to get into a situation where my analysis might drive the price up. I can still certainly cover stocks that are somewhat thinly traded by institutional standards, but I will not be covering extremely thinly traded shares.

The bottom line is that it seems very likely that bargains could exist from time to time among thinly traded shares. Therefore such shares would be a good place for an individual retail investor to hunt for a bargain if he or she has the ability to do their own analysis of the earnings and the value of the company.

Shawn Allen
InvestorsFriend Inc.

Net income seems like a very straightforward concept. Ideally, we should be able to rely on the accounting net income figure as the best measure of the financial performance of a company.

It is very important to understand:

• Which portion of reported earning represents one-time items?
• Which portion of a companies reported earnings are likely to be on-going
• How expense estimates have affected the earnings
• How accounting rules have affected the earnings
• That net income applicable to common shares is lower than net income if preferred dividends are paid
• What are the “real” normalized earnings?

The following are examples of things that cause the net income to not be “real” because it is based on estimates and accounting rules:

• In capital-intensive industries, the accounting depreciation expense can over or under estimate the true decline (or rise) in the value of fixed assets by a very wide margin. If the depreciation expense is too low the company will likely eventually realise a loss when it eventually disposes of or retires a major fixed asset. Conversely some assets may be appreciating in value and the associated depreciation expense is not a “real” expense.
• Mining and exploration companies are allowed to capitalize exploration costs rather than expensing them in the period incurred. When they do this, the net income can be grossly over-stated if it eventually turns out that the mine or well is not an economic find. In particular, the “true” net income of small exploration companies may be much less than reported.
• Some companies capitalize various development and customer acquisition costs that are expected to provide future benefits. Such intangible assets sometimes end up not providing the hoped for future benefits. In those cases the net income will have been over-stated.
• Manufacturing companies capitalize the expenses incurred in creating inventory. In some cases the inventory may end up being sold for much less than the anticipated price. In those cases the net income would be over-stated in the period the inventory was created.
• Most research and development costs are required to be expensed as incurred. But these “expenses” are actually designed to be investments that will yield benefits in future years. This required practice is conservative and tends to cause net-income to be understated. This factor seems to be causing an under-statement in earnings of many computer software related companies, including Nortel.
• When a corporation purchases another company it often pays a premium over book value, which creates an intangible asset called “goodwill”. The purchaser is then required to amortise this intangible asset. It can be argued that this expense causes net income to be under-stated if the true value of the intangible “goodwill” is not actually declining.
• Income tax can be artificially low due to one-time tax deductions that are not sustainable in future years. We calculate the apparent tax rate to check for this. A calculated income tax rate lower than about 35% is probably unsustainable.

The following are examples of one-time impacts on reported earnings:

• Whenever a company disposes of a major asset there will be a gain or loss on disposal as the cash proceeds will inevitably differ from the book value of the asset. These one-time gains and losses can easily be larger than the net income in a normal year. The same affect occurs when company “writes-down” the value of a major asset to recognise that the asset is now worth less than its carrying value.
• Companies sometimes take one-time restructuring charges in association with severance payments to employees in a “down-sizing” or cost reduction operation.
• Net income will not be representative if the company suffered a major production problem or strike during the year.

In our analysis of companies we attempt to deal with the problem of unrepresentative net income by basing our calculations on up to 5 different views of net income. We look at net income for the last two fiscal years, for the latest four quarters, for the latest fiscal year adjusted for unusual items and/or adjusted to reverse the expensing of goodwill amortization and of R&D “expenses” and sometimes the forecast net income for the next fiscal year. By calculating the P/E based on all of these views of net income we get a sense of what the “representative” P/E is. This helps us to determine a representative P/E ratio and net income level and will prevent us from being fooled by an artificially low P/E ratio and high net income.

In calculating the intrinsic value of shares based on forecast future earnings we use the latest 4 quarters of earnings adjusted for unusual items and/or accounting items as the starting point.

The issue of expense estimates affecting earnings is more difficult to adjust for. In our analysis we deal with this issue by examining the accounting methods. We note any concerns under “accounting issues”.

Calculating a representative or normalized level of current net income is easiest when the net income is level or is trending up at a steady level.The most difficult case is when net income is volatile and when there appear to be several unusual items affecting net income.

A few companies provide investors with supplemental information that indicates a normal level of net income, adjusted for unusual gains and losses. This is very useful and we wish all companies would do so.

It should go without saying that increases in net income are meaningless if the number of shares has also increased proportionately. Investors should always focus on net income per share (and after dilution for stock options) in evaluating growth in net income.

If preferred dividends are present, then investors should focus on net income applicable to common shares and not “net income” as such. Some companies discuss their performance in terms of net income, when they should be discussing the net income applicable to common shares. We consider that to be bad practice.

In conclusion, our advice is this: Never assume that the actual net income or the resulting P/E ratio is representative. Always work with net income and P/E figures that are adjusted for unusual items. Consider calculating what the net income would be if R and D expenses were capitalized and if the goodwill amortization expense is removed. Calculate net income after adjusting for any capitalized items that may not create tangible assets. Attempt to adjust net income if depreciation seems too low or too high. If the P/E ratio at first appears to be too good to be true,…… it probably is.

Shawn Allen, CFA, CMA, MBA, P.Eng.

President, InvestorsFriend Inc.

In the short term gains on a stock may seem unrelated to the underlying profits (earnings) of the company. After all, companies only report earnings four times per year and yet stock prices gyrate up and down by the hour and sometimes change by a large percentage without any earnings or any other news from the company.

One of our articles explains in detail that all gains in the stock market can be divided into two sources: 1. gains made at the expense of other stock market investors and 2. gains made from the underlying company selling goods and services to customers at a profit.

Over the entire life of a company, 100% of the aggregate returns (or losses) to the entire aggregate population of investors must come from the profits or losses of the company itself. Gains and losses made by investors trading shares amongst themselves must cancel out to zero.

In the short term there can be big gains made by trading astutely.
In the long-run stock returns are driven by the earnings of the underlying company.
Imagine a stock that has returned a compounded average of 10% per year for ten years years.

Here are some ways that this could happen.

1. The stock paid no dividend and the P/E ratio has remained constant. In this case the entire return has come from an increase in the stock price. The stock price must have risen 159% over the ten years, for example from $10 to $25.90 ($10 times 1.10 to the tenth power is $25.90). With no dividend and with no change in the P/E ratio, the annual return on the stock is precisely equal to the growth in the earnings each year. All of the return is clearly provided by earnings which come from selling products and services to customers.

2. The stock paid no dividend but the P/E ratio rose by 25% (say from 10 to 12.5). If the P/E ratio rises 25% then that is of course a gain or return of 25%. If this occurs over ten years then this is 2.2565% per year (1.022565 to the tenth power is 1.25). In this case the return due to earnings gain must be 2.59/1.25 equals 2.072 times or 107% or 7.557% per year. Starting with a $10.00 stock earning $1.00, the earnings would rise to $2.072 per year which at the 25% higher P/E of 12.5 results in a stock price of $25.90.

3. The stock paid out a 5% dividend yield and the P/E remained constant. In this case 5% of the return would come from the dividend and the earning would need to grow at 5%. The $1.00
earnings would grow to $1.63. The remaining return would come from the dividend to total 10% per year.

4. The stock paid out all of its earnings as a dividend and the P/E remained constant. In this case the stock price may have remained constant and therefore the earnings may have remained constant and all of the 10% return would have come from a constant 10% dividend yield.

5. The stock paid no dividend and the earnings remained constant. In this case the P/E must have risen 159%, or an average of 10% per year. That seems an unlikely scenario. A P/E ratio
would rarely rise much with flat earnings and no dividend. It could happen though if there was reason to expect large profits in the future.

In order for any company to provide a very attractive long-term return such as 10% per year for 10 years, it is almost imperative that the company have earnings (rare exceptions exist where the big profits are expected to come in the future but have not yet materialized). In addition, in most cases the earnings must grow at a strong rate for this to happen. In lieu of earnings growth, a very high dividend coupled with relatively flat earnings could achieve the 10% per year return. Generally one could say that a company that is to provide strong returns in the long term must deliver growth or dividends or some acceptable combination of both. In order to achieve a 10% long-term return at a constant P/E level the dividend yield plus the growth in earnings per share must total to approximately 10%.

END

Shawn C. Allen, CFA, CMA, MBA,
P. Eng.President, InvestorsFriend Inc.

Almost any Professional Financial Planner that you approach will advise you to divide your assets into three major categories or “asset classes”.

These three major asset classes are stocks, bonds and cash.

Stocks represent a share of ownership in a business. Stocks may or may not pay regular dividends.

Bonds represent a loan from yourself to a business. The business pays you a fixed regular interest payment and then repays the loan to you in a lump sum after from 2 to 30 years (or occasionally longer) depending on the maturity of the bond.

Cash includes bank accounts and other guaranteed investments with maturities within one year. You usually receive interest on your money.

It is generally acknowledged and expected that stocks will have the highest long term rate of return but that the return will be quite volatile or risky from year to year and that in fact it will not be at all unusual to suffer a negative return in any given year. Bonds are expected to offer a lower long term return than stocks but with a much reduced volatility (which is considered to be synonymous with risk). Cash investments are expected to have the lowest long term return but your return is known at the time you invest and therefore cash is considered to be essentially risk free (In this case assume that the cash is invested in government guaranteed bank account or securities which have no default risk).

Modern Portfolio theory indicates and most Financial Planners advise that by allocating a proportion of your assets to each of the three classes, and by widely diversifying within the bond and stock categories, you can achieve an optimum balance between risk and return.

In general the youngest investors may be advised to allocate as much as 75% of their assets to stocks while the oldest investors may be advised to allocate no more than 25% of their assets to stocks.

Before You accept any of this advise, I think it is prudent to examine the following questions:

How does inflation affect Returns?

What risk should you be concerned about?

What are the historic returns and volatilities of stocks, bonds and Cash?

Is there a trade-off between risk and return?

If stocks have the highest return should you put 100% into stocks?

When you have these answers then you will be in a better position to allocate your assets between the major asset classes of stocks, bonds, and cash in an intelligent manner.

For answers to these questions refer to Historic Asset Returns for Stocks, Bonds and Bills and Are Stocks Really Riskier Than Bonds? The graphs and information presented in those articles are truly enlightening.

Disclosure Checklist for Companies

The following is a checklist of Disclosure items for companies. All of these items are things that will help investors to analyse and understand the company. Those companies that respect individual shareholders tend to provide most of these items.

It is assumed that all companies provide at least the minimum level of disclosure that is required by law and GAAP. For very small companies that may be acceptable. However, larger companies that respect their shareholders will go well beyond that level and provide supplemental disclosure including the following. Unfortunately, few such companies exist.

INCOME STATEMENT DISCLOSURE
Current Outlook and progress		When reporting earnings a company should always comment on the how the current quarter, already underway, is proceeding. Whenever sales or profits are tracking higher or lower than expected, a company should issue a press release. This will insure that all investors become aware at the same time.
Average Shares Outstanding	ü	Many companies neglect to provide the average number of shares in the period. This is particularly true for quarterly reports.
Diluted Shares Outstanding	ü	Average diluted shares should be provided in all quarterly and annual reports.
Net Income to Common	ü	A few companies with preferred share dividends fail to deduct preferred dividends to show the net income applicable to common shares
Adjusted net income		The net income adjusted for unusual gains losses, amortization of goodwill and other unusual or non-recurring items, net of income tax impacts, should be provided. Usually the adjusted net income is a more representative figure than the unadjusted net income.
Unrealized gains on investments	ü	If a company has an investment in shares of another company that is carried at the lower of book or market value, the company should discuss and disclose any unrealized gains on those shares. In a few cases such unrealized gains can be very substantial.
Dividend	ü	The dividend per share should be mentioned in every quarterly or annual report.
CASH FLOW STATEMENT
Cash Flow	ü	Show a subtotal of the cash flow from operations, before changes in working capital amounts. (Effectively this is the cash flow from operations before changes in net short term non-interest bearing investments in inventories, accounts receivable less cash owed to suppliers). Only a few companies fail to do this.
	ü
Free Cash Flow		Cash flow is net income plus depreciation plus other non cash gains and losses. The Cash Flow is available for re-investment in the business, paying down debt, or paying dividends. Free Cash Flow is Cash Flow minus capital investments that are needed to sustain the business at its current level. For example a large Cash Flow that results from a large depreciation expense is not of much use if all of the Cash Flow has to be spent to replace the depreciated and deteriorated equipment, just to stay in business. Free cash flow is a better measure of the net cash available for investment to expand the business, pay down debt or pay dividends. Free Cash Flow should be reported and discussed. Almost no companies do this.
	ü
Maintenance Capital Spending		Related to free cash flow, it is essential that companies separate capital spending into two categories: 1. maintenance spending to replace worn out assets, 2. new spending to accommodate growth. Very few companies provide this essential break-out.
Dividends	ü	Dividends on preferred shares should always be shown separate from dividends on common shares
ANNUAL REPORT
Summary of Quarterly Reports in the Annual Report	ü	The annual report should always provide a summary of the quarterly reports. This should include a figure for adjusted net income.
Historical summary	ü	As an analyst I find that this is the area that companies most often fail to provide enough basic information. The summary should be for at least the last six years. Companies often fail to provide the average number of shares outstanding (both basic and diluted) each year. Also they usually fail to provide the adjusted earnings. If the company believes that adjusted earnings are the most representative, then it is essential and logical that these be provided in the historical summary.
Competitive Landscape	ü	Companies should always discuss the major industry(s) that they compete in and disclose their market share and who the major competitors are. The outlook for the industry in terms of both growth and profitability should be discussed. companies should indicate what their competitive advantage (if any) is.
Segmented Earnings	ü	Where segmented revenues and earnings are provided, the assets and ideally the equity in each segment should be provided.
Schedule of Fixed Assets		Companies should provide a summary of their major fixed assets. Where real estate or other marketable assets are involved, the summary should indicate the original cost of the assets, the depreciation, the additional investment in the assets, the age of the assets, the current market value and the property tax assessment value.
LIQUIDITY AND FINANCIAL STRENGTH
Bond Rating		Only a few companies provide their bond ratings. The Bond Rating is an important independent assessment of the credit worthiness and financial strength of the organization. It should be disclosed.
STOCK OPTION COMPENSATION
Stock Option Value	ü	When disclosing the number of options issued to executives in the annual meeting proxy circular, companies should include the estimated value of the options calculated in accordance with the black-scholes formula. I understand that some U.S companies are required to disclose this. It is only logical that the value of the options be disclosed so that investors can make some judgment regarding the salary level. I no of no Canadian company which is voluntarily providing this vital information.
INSIDER TRADING
Insider Trading	ü	Companies should make a much greater effort to distribute insider trading reports by posting them to their Web Sites or as periodic press releases. I know of no company that does this.
OUTLOOK
Next year’s earnings	ü	Companies should provide, each quarter, an estimate of net and adjusted earnings per share for the next rolling 4 quarters. Companies are in a much better position to forecast their earnings than are analysts (who in most cases are probably fed the estimate by management in any event).
Long range earnings growth	ü	The company should forecast its earnings growth for the next 5 or 10 years and discuss, at a high level, how it will be achieved.

How to Pick Winning Stocks

This article explains how you can implement a successful analytical method for more consistently picking out winners in the stock market. If you currently pick your own individual stocks for investment, then I believe that my suggested methodology will likely increase your investment returns while reducing risks. You will also become much more comfortable with your investment portfolio since you will understand exactly why you own each company and will know how its stock price relates to your estimate of its actual value per share.

Does this system work?

Absolutely, it has worked for me, here is a summary of my Performance since I first began applying this method in June 1999 through December 31, 2006.

The cumulative result of investing $10,000 in the strong buys at the start of 2000, and switching to the new strong buys at the start of 2001 and again at the start of 2002 etc is that the $10,000 would have grown to $52,033 for over a 400% cumulative gain! This compares to a gain of about only 53% on the TSX Composite over that period. My own money was not invested strictly in the Strong Buys and each $10,000 that I invested grow to $30,679 for a gain of 207% or almost four times the 53% gain on the market index.

The system that I use and recommend relies on many of the same fundamental principals that are used by legendary investor Warren Buffett. The Canadian Shareowner Association and the National Association of Investment Clubs (U.S.) also use somewhat similar systems. The system is also grounded in fundamental finance theory.

What is the system?

The system is to buy Great companies at bargain prices. That is, buy shares that are selling at a price significantly below their estimated “true” value AND which have certain vital characteristics including, most importantly, ethical rational management and a competitive advantage in the marketplace.
The “trick” of course is to figure out how to confidently estimate the “true” value of the shares as opposed to the market price. It turns out that the instructions for doing this have been laid out by Benjamin Graham, Warren Buffett, certain advanced finance texts and a few other sources. Although proven to work, this method remains amazingly under utilized for several reasons. It contradicts the efficient market hypothesis, it requires a fair amount of diligence, it requires patience and very few companies truly pass muster with this method which (to my understanding) leaves most stock analysts unable to use the method since it would reject buying the shares of most of the clients of investment banks. Therefore this method can be the little used secret weapon for independent investors.

The “true” value of a share can be easily calculated given the following inputs:

• the starting “normalized” or sustainable earnings per share
• the assumed growth in earnings per share and in the dividend
• the initial dividend pay-out ratio
• the assumed steady state P/E ratio at which the shares will sell in (say) ten years
• an assumed discount rate (minimum acceptable rate of return)

The first box below describes in detail how this calculation of the intrinsic value per share can be made.
The process of finding an initial adjusted earnings figure is described in detail in the second box below.
After completing the steps in the boxes we have a conservative and a more optimistic estimate of the value per share. Note that the optimistic estimate should not be wildly optimistic, we want to leave some room for the company to out-perform our projection. This intrinsic value per share provides an estimate of the value that we might be willing to pay per share. We would only buy the shares if the current price as below our estimate of intrinsic value. Ideally, it would be below even our more conservative estimate of value.

We also ideally want to buy companies that are not only bargains, but that are also great quality companies in other ways.

The following are Vital Qualitative Characteristics to analyse:

• Industry attractiveness, intensity of competition
• future outlook
• quality, integrity and rationality of the management.

The industry attractiveness and intensity of competition can be judged by looking at the five forces of competition identified by Michael Porter of Harvard University. He believes that an attractive industry is one that does not suffer from intensive price competition. The five factors that determine the level of price competition are:
Barriers to entry – if new competitors can easily come in, there will be more intense competition. Such things as patents, special knowledge, product differentiation and brand loyalty create barriers to entry. For commodity products there are no barriers to entry.
Powerful Suppliers – Such as strong unions or other strong suppliers can effectively compete with a company and usurp all the available profit in the industry.
Powerful Customers – Sometimes there are only a few large customers and they may control access to the ultimate consumer and can usurp most of the profit for themselves. Wal-Mart could be an example.

Substitute Products – Some products have other substitutes which limits a company’s ability to extract high profits.
Competitor Response – Some industries simply seem to fall into a habit of being more interested in getting market share than in making profits. This occurs most often where fixed costs are high and where competitors for one reason or another fail to act together to keep prices higher.
The quality of management can be judged to a degree by the past history of the company and to an extent by the level of candor and disclosure in the annual report. I consider grossly excessive executive competition to be a strong negative indicator in this regard.

A number of other factors can also be looked at to provide further comfort.
The book value per share should be calculated and compared to the share price. Usually shares do sell for well above book value but an extreme value is cause for caution. For example a share selling at ten times its book value may signal a stock that is possibly significantly over-valued. In looking at book value it is important to analyse the nature of the assets in which the equity is invested. If the assets are largely financial in nature, then the book value is more reliable. If the assets are represented by specialized industrial equipment then you should place less reliance on book value. If the assets consist primarily of purchased goodwill or of capitalized development or exploration costs then I recommend placing little or no reliance at all on the book value.
The Balance Sheet should be examined to see if the company has enough equity and cash to continue in operation. This is very important for emerging technology, bio-technology or other companies that have not yet reached a profitability stage. If they are about to run out of cash then bankruptcy becomes a concern notwithstanding that their technology may have great potential.
In attempting to identify Great companies available at bargain prices, Warren Buffett reportedly uses a screen consisting of a number of tenets. My understanding is that he requires the company to pass each and every one of his tenets or he does not invest. In brief his tenets are:
Simplicity – It must be easy to understand the product or service of the company and how it makes money.
History of profit – Profits must be historic and proven not just potential
Strong outlook – There must be reason to believe that the company can earn above average rate of return. This requires a competitive advantage, barriers to entry, limited price competition. This effectively rules out commodity producers.
Ethical Rational Management – Management must be acting rationaly and in shareholder interest and be trustworthy.
Strong Return on Equity – He will not assume, much less pay for, high future returns unless the company is already achieving this. He believes that a high ROE is the key to retaining earnings and growing shareholder wealth.
High Profit on Sales – It is possible to achieve high ROEs with low profits on sales (given enough volume) but Warren requires high profits on sales.
Low Debt Levels – Higher debt levels create a leverage that can lead to higher profits but Warren requires high profits without excessive debt levels.
Selling at a discount – Warren will not buy a share that is selling at a price that is above his calculation of its intrinsic value. (But interestingly, he will continue to hold such shares even though that seems inconsistent.
As discussed in the opening paragraphs of this Article, after over five years years of using and refining this method, I have found that it is remarkably adept at predicting winners. In the past, I have not required my Strong Buys to pass all of Buffett’s tenet’s but more recently I am moving more in that direction, in most cases.
A consistent application of this methodology requires an investor to set up a spreadsheet to enter income and balance sheet data from each company and to calculate key ratios and the intrinsic value per share after first adjusting the net income as discussed in the box. It also requires consideration of the outlook for the company based on the quality of its management, its strategies and its environment.

In conclusion I urge those investors who are interested in picking individual stocks for investment to use this method, which will allow you to invest with much more confidence and will likely lead to much more consistent results. Alternatively, investors can seek out those analysts such as myself who apply this type of fundamental analysis.

Shawn Allen, Editor, June 2, 2001, with updates to December 31, 2006

Calculating the Present Value per Share of all Future Earnings The prospect of calculating the present value per share of all future earnings sounds daunting or even impossible. The calculation is actually quite easy (that is, for those who are familiar with time value of money calculations) and while it is subject to error useful approximations can be made, at least for some stocks. Essentially, the process consists of forecasting the earnings level and growth for the next ten years. After ten years it is assumed that the stock will be sold at a conservative Price / Earnings (“P/E”) ratio such as 12 or 15. Cutting the analysis off at ten years nicely eliminates the impossible task of predicting earnings into the infinite future. Using this method, the present value of the stock is then the present value of the calculated amount that that the stock will be sold for in ten years plus the present value of any dividends that will be received. For example, if a stock presently earns $2.00 per share and earnings are expected to grow at an average of 15% per year then in ten years time the earnings are expected to be $2.00 times (1.15)10 . This equals $2.00 x 4.0456 = $8.09. So the company is expected to be earning $8.09 per share in ten years time. If we assume that we can sell the stock at a conservative P/E ratio of say 15 in ten years, then we will receive 15 x $8.09 = $121.35 for the share at that time. Using a 10% required rate of return, $121.35 to be received in 10 years is worth $121.35 / (1.10)10= $121.35 / 2.594 = $46.78. That is, if you pay $46.78 for the share today and sell it for $121.35 in ten years, you will have earned 10% compounded annually on your money. So, if you expect that the earnings will grow at 15% then you now know the stock is worth about $47, If the stock is selling in the market at substantially less than $47 then you would expect to earn more than 10% by investing at that lower price. Conversely, if the stock were trading in the market at more than $47 than you would conclude that the stock was not a good investment since you would expect to earn less than a 10% annual return. If the above stock pays a dividend then you add the present value of the dividend stream to the $46.78. For example, if the prior year’s dividend was $1.00 per share and the dividend is expected to grow at 15% per year then the present value of that amount can be calculated as $1.15/1.10 + ($1.00×1.152)/(1.10)2 + ($1.00×1.153)/(1.10)3 …  + (1.00×1.1510)/(1.10)10 = $12.87. In that case the calculated present or intrinsic value of the share is $12.87 + $46.78 = $59.65. To account for the fact that some companies are riskier than others, investors can assume a lower growth rate (to be on the safe side) or can use a higher discount (required return) rate in the present value calculation. I believe that investors rarely make these kind of calculations. Furthermore, most advisors and brokers do not make these kinds of calculations. Therefore those investors who are capable of and willing to make such calculations should gain an advantage over the majority of investors who are not making or relying on those calculations. The intrinsic value calculation requires just 4 basic inputs. 1. The initial earnings and dividend per share; 2.The expected earnings per share growth rate; 3. The required return or “discount” interest rate; 4. The P/E ratio at which the stock is assumed to be sold after ten years. More information on setting each of the four inputs is provided below. The initial earnings per share is simply the current adjusted earnings divided by the diluted weighted average number of shares outstanding. Average diluted shares are higher than the actual average number of shares outstanding to account for the net dilution from stock options and convertible bonds. The diluted average number of shares can be determined from information provided on the income statement. The calculation should be based on adjusted earnings, rather than actual earnings, as discussed in the other box. Calculating an expected growth rate for earnings is very challenging. But, an investor can consider the nature of the business and the competitive environment of each industry to make a more informed judgment regarding earnings growth. In predicting the earnings growth it is very useful to calculate and graph past earnings growth rates. Since earnings can often be impacted by a variety of one-time gains and losses you should also graph the adjusted or normalized earnings per share to reveal the under-lying growth trend. If the historic earnings and sales graph shows a very erratic pattern, as is often the case, then it may not be possible to forecast future earnings. (In which case you really can’t apply this intrinsic value method to judge the true value of that stock.) If however, the company has shown a reasonably consistent pattern of earnings then an initial assumption might be that the historic growth rate will continue. However, it is advisable to also consider the environment in which the company operates in order to attempt to discover if it is likely that the company’s past trend is no longer applicable. The current state of the economy is also a factor, although we should remember that this is a ten year projection and we should not be overly influenced by the current state of the economy, since that will change. The return on equity can provide an estimate of the sustainable growth rate. In theory, the sustainable growth rate is equal the return on equity rate multiplied by the percentage of earnings that are retained (not paid out as dividends). In this case, it is important to use the adjusted or normalized earnings to calculate the return on equity and to consider whether or not the return on equity level is sustainable for the next ten years. In some cases management provides an outlook for the longer term growth in earnings per share. Since the growth rate over the next ten years is inherently uncertain, the calculation should be done twice, once with a relatively conservative growth rate and once with a more optimistic growth rate. It is important to avoid the use of a wildly optimistic growth rate since doing so would result in a calculated intrinsic value per share that assumes that the wildly optimistic growth will occur. If you paid a price that assumed all that wildly optimistic growth would occur, you would essentially have a stock that had little or no up-side left and plenty of down-side risk. The required rate of return can be set at a standard level. It consists of the return available from risk free bonds plus some risk premium. In theory the risk premium could change with every company. In practice I estimate the return on bonds as about 6% and add 4% for a risk premium to arrive at a 10% required return or discount rate. I then adjust for risk by being more or less conservative in my growth assumptions in step 2 above. Finally, estimate the P/E ratio at which the stock can be sold after the ten year holding period. Today’s high growth, high P/E stock cannot be assumed to grow rapidly forever. To be conservative, assume that ten years out the growth rate will have slowed to a more normal level and that therefore the stock will be selling at a relatively normal P/E between 12 and 25. In most cases you should assume a P/E of about 12 for a conservative calculation. Repeat the calculation with a P/E of about 15 for a more optimistic scenario. In unusual cases you could assume a P/E as low as about 8 or as high as 20. If you assume a P/E that is too high, you leave yourself with little up-side risk and plenty of down-side risk. So after all of that, for the more predictable companies, you will have arrived at a conservative and a more optimistic calculation of the present or intrinsic value per share. If the earnings do not seem sufficiently predictable then it is appropriate to decide not to make the calculation or alternatively to assume a very conservative growth rate. A variation of the above method is to use an assumed 5 year holding period rather than 10 years.

Analysis of Adjusted Net Income Net income is the most important consideration in valuing a stock. There is often a tendency to trust and use the reported net income as is. In reality you usually have to correct for any unusual gains and losses that distorted the net income. The following are items that often may distort net income.One-time gains and losses – A company may have a substantial gain or loss on the sale of land or equipment. Or a company may take a one-time charge for restructuring or some very unusual item such as a strike or other disruption. These items should be reversed in attempting to calculate the future income since they are not expected to recur. Unusual income tax rate – Some companies pay very little in income tax expenses due to past tax losses. This is a temporary phenomenon and should be adjusted for. Calculate the effective tax rate of each company and then investigate the reasons if the tax rate is much different than the expected statutory rate (about 45%) for large companies. Capitalized exploration expenses – Mining and oil exploration companies are allowed to capitalize exploration costs even for “dry holes”. For this reason, it may be appropriate to be very skeptical of the net income of such companies. In fact such companies typically do not lend themselves to this type of analysis since their earnings are often inherently unpredictable. R & D expense – Under U.S. GAAP all R & D costs are expensed while in Canada all research costs are expensed while development costs are capitalized. In either case the result of this conservative accounting can be an “artificial” lowering of net income. If it is believed that the research will create future value then it seems appropriate to add back at least a portion of the expensed R&D or recalculate income as if R&D were amortized over say 5 years. Depreciation – Consideration should be given to the level of the depreciation expense versus the likely true deterioration (or possibly appreciation) in value of the fixed assets or the cost to eventually replace an asset due to its usage or the passage of time. In rare cases such as with a portfolio of newer buildings, it may be appropriate to add back a portion of the depreciation expense on the basis that the actual replacement of the building will occur many many years in the future and the cash outlay at that time (even with inflation) has a present value that is less than the depreciation expense. And it is appropriate to add back amortization of goodwill since goodwill is not usually an asset that is used up over time and it often appreciates in value. Deferred Income Taxes – These have to be paid eventually only after some years. The present value of this future outlay is less than the non-cash expense deducted under GAAP. Therefore, it is appropriate to add back some portion of this expense. I would be conservative with this and add back say 20% of the deferred tax expense. Preferred Share dividends – Technically net income is properly reported prior to any preferred share dividends. But most companies also show the deduction to arrive at net income applicable to common shares. For those companies that do not show the deduction, you must make that deduction. In summary every income statement has to be taken with a grain or two of salt. With some digging, you can make an informed adjustment to the published net income to calculate a normalized or adjusted net income. Conveniently, some managements provide an adjusted earnings figure. This goes beyond a disclosure of extraordinary items, which is required by GAAP, and includes a variety of unusual items. You should focus on that number when it is provided. But also check for any unusual items that management did not highlight.

 

The following is a summary of the categories that we currently use (as of June 22, 2002) to rate companies. This is subject to future refinement.

Strong Buy – The Price earnings ratio is less than 20. The return on equity is at least 15%. The historic five year growth in earnings per share is at least 15% and earnings per share are still growing at at least 15%. The company does not produce a commodity product with high fixed costs (which leads to excessive price competition). Debt levels are not excessive. There is little chance of a permanent loss of capital. Based on a reasonable forecast of earnings growth, the shares are trading at 75% or less of intrinsic value calculated at a 9% required rate of return.

Speculative Strong Buy – Most but not all of the above criteria are met, the risk level is higher and may be significant.

Buy – The Price earnings ratio is less than 20. The return on equity is at least 10%. The historic five year growth in earnings per share is at least 10% and earnings per share are still growing at at least 10%. The company does not produce a commodity product with high fixed costs (which leads to excessive price competition). Debt levels are not excessive. There is little chance of a permanent loss of capital. Based on a reasonable forecast of earnings growth, the shares are trading at 90% or less of intrinsic value calculated at a 9% required rate of return.

Speculative Buy – Most but not all of the above Buy criteria are met, the risk level is higher.

Weak Buy – Essentially a hold with a bit of a bias to the buy side.

Weak Sell – Essentially a hold with a bias to the sell side.

Sell – We think it is over-valued

Strong Sell – The analysis, based on fundamentals, indicates the stock is very over-valued. We think there is a strong risk that the stock could fall significantly.

Investors should realize that stock prices will often move in the opposite direction to the one our analysis indicates. Stocks are inherently risky and unpredictable.

However, we think that there is considerable merit in applying fundamental analysis as a screen. We hope and believe that we will be right more often than we are wrong.

This Site is dedicated to the idea that it is possible, through fundamental analysis, to identify certain stocks as being under-valued and others as being over-valued.

Most equity investors would agree that this is possible. But, there are many people who would argue that the market is “efficient” and that it is impossible to consistently pick winners and losers.

We rely mostly on published financial and operating information for each company. We thoroughly analyze the current sales and earning and the established growth trends. We examine liquidity and book value ratios. We look at the strength of the balance sheet. We look for any concerns regarding the reported earnings.

We also try to examine the outlook for companies by considering the general outlook for the industry that each company operates in. We do not have access to insider information.

Our screening process clearly favors stocks that have already demonstrated profitability and sales.

A company with no earnings but with tremendous growth in revenue might still pass muster with us (as a speculative pick). But a company that has essentially no sales is not going to pass our screen.

Our philosophy is that, on average companies that have established consistently high profitability but which are available at low prices are good bets.

The fact is, that our methods will fail to see the potential in certain start-up companies, particularly if they have not yet even established any sales. This would be true of many drug research companies, electronics research companies and junior mining companies. We consider these companies to be a bit like lottery tickets. Some of them will be big winners. Some people might even be able to pick the winners. We can’t. So we will stick to looking for companies that can be analyzed on the basis of proven sales, earnings, growth and other financial data.

When we analyze a company, we show you the data that we have used and explain how we reached our conclusions. You can then use your own judgment to see if you agree.

DISCLAIMER: The information presented is not a recommendation to buy or sell any security. The author is not a registered investment advisor and the information presented is not to be considered investment advice. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. The author may at times have a security position in the companies presented.

Copyright: investorsfriend.com 1999 – 2002 All rights to format and content are reserved.
Shawn Allen, CMA, MBA, P.Eng.

Imagine you want to save and invest your way to having one million dollars. And let’s also require that this be a million in today’s dollars.

How much would you have to save and invest each year and how many years would it take to get to a million dollars (in today’s dollars, adjusted for inflation)?

Based on past stock market performance (S&P 500 total return index which includes dividends), it turns out that if you want to get to a million dollars (adjusted for inflation) in 30 years, you have to invest about $15,000 per year. Since we want to get to a million in today’s dollars you also have to increase the amount saved to account for inflation each year.

The following graph shows what would have happened to people who started out and saved $15,000 per year, adjusted up each year for inflation. Each line on the graph is a different 30-year period. There is a line for 1926 through 1955, a line for 1927 – 1956, for 1928 – 1957 etc. all the way to 1982 – 2011. The money here is invested in the S&P 500 index and is in a tax-free account. Dividends are included. Any trading or money management costs are not accounted for.

The graph shows that in the great majority of the cases the portfolios reached at least one million. There were more cases that exceeded two million than there were that failed to reach one million. Cases that failed to get to one million were 1945 – 1974, 1949 -1978, 1950 – 1979, 1951 – 1980, 1952 – 1981, 1953 – 1982, 1954 – 1983, 1955 – 1984, 1956 – 1985, 1958 – 1987. The worse case was 1952 – 1981 which reached $693,678.
The savings portfolios that were started in the 50’s initially saw very strong returns but were badly hurt in the 70’s when stock returns were often deeply negative especially after the high inflation of those years.

Some readers may protest that almost no one had $15,000 peer year to invest in 1926. That is true but given inflation, our 1926 investor would have been happy to accumulate at least $100,000 by investing $1500 per year.

It’s interesting to note that if you want to be reasonably sure of accumulating one million in this fashion you have to save an amount that is likely to result in a lot more than a million. But even though you are highly likely to surpass one million (based on past stock market data) there is still a chance you will fall short.

If 30 years is simply too long, the chart also shows where investors stood after 10 and 20 years etc.

Longer investment period with smaller amount invested:

The task of saving $15,000 per year (and adjusting that upwards each year for inflation), may be far beyond the means of most people. If we extend our savings period to 40 years then the amount saved per year can be substantially reduced.

The graph below is based on saving and investing in stocks for 40 year periods. The amount saved is $6000 per year adjusted upwards each year for inflation. That is $500 per month in today’s dollars and a lot more do-able than is $15,000 per year.

The graph shows that in the great majority of the cases the portfolios reached at least one million. There were about as many cases that exceeded two million as there were that failed to reach one million. Cases that failed to get to one million were 1935 – 1974, 1939 – 1978, 1940 – 1979, 1942-1981, 1943-1982, 1944-1983, 1945-1984, 1951-1990 and 1955- 1994 and 1969-2008. The worse case was 1942 – 1981 which reached $816,000.

If saving $6000 per year is too much you can adjust for that. For example $600 per year would get you to 10% of the figures shown at year 40. You could be relatively sure of getting to $100,000 in 40 years by investing $600 per year or just $50 per month in a stock index fund. (This ignores fees but there are some very low cost index funds available. It also assumes a tax free account).

Conclusions:

If you want to accumulate a million dollars by saving and investing in stocks a constant amount each year (adjusted upwards for inflation) and if the savings period is 30 years you can be relatively confident of not falling short of that mark if the savings amount is $15,000 per year. If the savings period is 40 years you can reduce the savings amount down to $6000 per year and still be relatively confident of reaching one million. This is based on past stock market performance data for all 57 of the 30 year and all 47 of the 40 year calendar periods that have occurred since 1926.

Observations:

In reality no one invests a constant real dollar amount per year for 30 or 40 years. A more realistic scenario is that the amount invested each year would start out small and then rise rapidly in later years. Nevertheless it is informative to see what would have happened to stock investors who saved constant real dollar amounts based on actual past data for stock market returns and inflation.

Most of the lines on the graphs above show very high volatility. Savers experienced sharp drops. For more discussion of the volatility and also for results from balanced portfolios see our article that explores 30-year savings results for all-equity versus balanced approaches.

What if you already have $100,000 in the market?

The following graph shows what would have happened to past investors who started with $100,000 and then added $6000 per year (adjusted for inflation). The portfolios values shown in all the graphs in this article are in real dollars adjusted for inflation.

The next graph shows what has happened for those who started out with $250,000 and then invested $6000 per year (adjusted upwards each year to account for inflation). It shows not only where past investors in the S&P 500 index ended up after 30 years but also shows where they stood after 10 years or 20 years etc.

The graphs in this article can give you a sense of what is possible through investing. Some readers may find this to be motivating.

END

Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.

The data source for the above is a well-known reference book called “Stocks, Bonds, Bills and Inflation” 2012 edition. The book is published annually by Morningstar. (Ibbotson SBBI classic yearbook). The particular data series is for the total return on the S&P 500 index including dividends with all dividends reinvested.

This article is a book review of “what Works on Wall Street” by James P. O’ Shaughnessy. (1997 Revised Edition)

The book tests how various popular investing strategies would have worked by applying the strategies to 46 years of data (1951 through 1996) from Standard & Poor’s Compustat database.

In all cases the strategies were evaluated by creating a portfolio of the 50 stocks that rated the highest on a given strategy and then rebalancing to the new group of 50 best stocks once each year.

Strategies examined include:

• Value based approaches of buying stocks with the lowest Price /Earnings, the lowest Price/Sales, the highest dividend yields, the lowest Price / Book Value, the highest earnings yield.
• Momentum strategies of buying stocks that had risen the most in price during the past year.
• Profitability strategies of buying stocks with the highest return on equity or the lowest price to cash flow or the highest earnings growth in the past five years.
• Strategies of buying the stocks with the highest Price / Earnings
• Contrarian strategies of buying stocks that have fallen the most in the past year.

The conclusion was that (contrary to the efficient market hypothesis) some strategies consistently reward investors while other strategies consistently punish investors through massive under-performance.

The single best strategy found was to combine value, earnings growth and share price momentum.

50% of the portfolio is restricted to stocks with a price / sales ratio of less than 1.5 (a value screen). Stocks must also have year-over-year earnings growth. The stocks with the highest year-over-year share price momentum are then selected from this group.

The other 50% of the portfolio is invested strictly in market leading leading stocks (must be large cap stocks , utilities are excluded, larger than average number of shares outstanding, higher than average sales per share , cash flow at least 1.5 times the compusat mean). The stocks with the highest dividend yield from among these market leaders are selected. (Effectively this appears to be very similar to selecting the highest dividend yielding stocks, excluding utilities, from the largest 100 or so stocks by market capitalization).

This recommended strategy provided stellar returns (17.44% compounded return over 46 year) and minimal risk. It beat a strategy of investing equal dollar amounts in all stocks in the database (which yielded 13.35%) in 8 out of 10 years, in 34 of 40 rolling 5 year periods and in all rolling 10 year periods.

Other strategies that worked very well (though sometimes with higher risks were):

• Require Price to sales ratio less than 1, and choose stocks with the highest 1 year share price momentum. (Highest return but riskier than the recommended strategy).
• Require P/E < 20, choose stocks with highest 1 year share price momentum. (Results very similar to the strategy just above).
• Require Price to book less than 1, choose stocks with the highest 1 year share price momentum.

The worse strategies were those that selected stocks with the most extreme valuations such as highest price to earnings, highest price to book and highest price to sales. The single worse strategy was to select the stocks with the biggest year over year share price declines.

Pure value strategies that ignore share price momentum did reasonably well. Low P/E over all stocks just slightly outperformed the index, but low price to book, low price to cash flow and particularly low price to sales all significantly outperformed the index.

Key learnings:

This book argues that a mechanical, screening based approach to stock picking is best. Attempting to apply judgment and bend the rules in certain cases will lead to trouble. A mechanical screening approach insures consistency.

The best stock picking strategies should always include at least one value screen to insure that you don’t pay an unreasonably high price. Positive price momentum is also a key factor that should be included.

Shawn Allen, CFA, CMA, MBA, P.Eng.
InvestorsFriend Inc.

Whenever a potential stock investment is mentioned the first question that is often asked is “does it pay a dividend”?

The assumption appears to be that only dividend paying stocks are good investments. If so, someone forgot to tell stocks like Berkshire Hathaway which has been a spectacular investment despite the fact that its last dividend consisted of a lowly and lonely ten cents paid in 1967. Another example is Stantec Inc. which has risen over 2000% from $2.50 in September 1999 to $53.66 today. It rationally did not pay a dividend and only started to pay a dividend in 2012.

Many investors insist on a high dividend yield. Others insist on a low price to earnings (P/B) ratio. Others insist on things like a low debt level, strong cash flow, strong revenue growth, strong earnings growth or a high return on equity.

These are all good qualities to look for in an investment. And they may tend to work on average. But there simply is no valuation ratio of this sort that is either strictly necessary or sufficient, on its own,to qualify a company as a good investment.

For one thing these ratios are calculated at a point in time. At many companies profits can be notoriously volatile. A profit figure that is affected by a large and unusual gain or loss can completely distort ratios such as the P/E ration, the earnings growth, return on equity and return on capital.

The payment of a dividend is no guarantee of a good investment. There have been many cases where companies continued to pay dividends even as earnings evaporated. Obviously, that can only occur for a limited period of time.

In some cases investors are far better off if the company does not pay a dividend. If a company has the opportunity to grow and can invest in highly profitable projects and expansion opportunities then investors may be better off if the money is sued for that investment rather than paid out as dividends.

In theory, every good investment in a stock should be made at a share price that is not greater than the estimated true (or intrinsic) value per share. In theory then a price to intrinsic value ratio must never be grater than 1.0. In practice it is impossible to ever know the intrinsic value. For some companies reasonable and conservative estimates can be made.

In conclusion, investors should be cautious when adopting strict rules about dividends or other value ratios. There simply is no one ratio that is both necessary and sufficient to assure that a given stock is a good investment. Nor can any one ratio conclusively rule out a company as a good investment.

END

Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.

Rewards of Saving versus Investing

There is, of course, a big difference between the returns to be expected from saving versus investing. In a related article I have provided my definition of what constitutes saving as opposed to investing.

This article looks at the returns available from saving and looks at the estimated long-term returns to be expected from equity investing.

First let’s take a look at the (rather scant) rewards currently available to fixed income savers and investors.

The following table is meant to be indicative of current interest rates or returns as of November 30, 2014. It’s meant to show the relationship between rates. It’s not intended to show the very best rates available in the market, rather it shows more typical rates available.

	Interest Rate or return	Potential for loss in dollar terms	Nominal dollar value of $1000 after 30 years at this rate, before taxes	Real value of $1000 after 30 years, at this rate, before taxes, but after 2.0% inflation
A typical bank account	approximately zero	none	$1000	$545
“High” interest savings Account	1.25%	none	$1452	$798
Five year GIC	2.22% (Average across banks according to Financial Post)	none	$1921	$1068
Five year Canadian government bond	1.43%	modest and temporary only	$1531	$842
Five year A rated corporate bond	2.33% Telus and Enbridge per TD direct investing	modest and temporary only	$1996	$1104
Five year rate reset preferred share	3.8% to 4.4% for higher quality issuers	modest and likely temporary only	$3061 to $3639	$1708 to $2037
Perpetual and highly rated preferred share	4.4% to 5.0% per a CIBC report	potential for permanent value loss with higher interest rates	$3639 to $4322	$2037 to $2473
Ten year Canadian government bond	1.9%	potential for temporary market value losses	$1759	$970
Ten year A rated Corporate bond	3.6% Manitoba Tel per TD direct investing	potential for temporary market value losses	$2889	$1610
30-year government bond	2.45%	potential for temporary market value losses	$2067	$1144
30 year A rated corporate bond	3.77% Enbridge Gas Distribution 4.45% Telus	potential for temporary market value losses	$3035 $3692	$1693 $2067
30- year government Real return Bond	0.63% plus inflation compensation	there is a risk of temporary value loss if real interest rates rise but the bond will mature at full purchasing power in the end	$2179 assuming 2% inflation	$1000

Most of the above returns available for savers are fully taxable unless invested in tax sheltered plans. Only the preferred shares would be subject to lower tax rates. In terms of availability of cash if needed, bank accounts are instantly accessible, GICs are locked in for the term and the remaining items can be sold on the market at any time.

None of the above investments seem very attractive at all. For money that is being saved for use within a year I would use a regular or a “high interest” bank account. The return is very low but the bank account offers safety and instant access to the money including the ability to spend it or send it to someone else instantly by electronic means.

For cash that will be used after about one year or cash that is essentially being parked in case attractive investments arise (such as would arise during a material stock market decline), I would favor the use of five year rate reset shares of high quality issuers. Due to the rate reset feature and due to the high quality of the company these can be expected to trade at about par value at the time of the rate reset in five years. Meanwhile they offer a better return than most of the alternative fixed income choices. And they won’t likely decline too much below par value even if interest rates rise. And if they do decline one can wait for the rate reset in five years.

When it comes to investing for longer periods such as 10 to 30 years, I find the available returns from fixed income to be unappealing. If inflation rises substantially, then these will turn out to have been terrible investments. If inflation and interest rates stay very low then they will still not be great investments. Possibly, the perpetual preferred shares at over 5% would be a reasonable investment. Bonds in the range of 4% will not turn out to be reasonable long term investments unless inflation averages less than about 1%.

Next, we can take a look at the potential returns from investing in common stocks. In the short term, the returns from investing in stocks are extremely unpredictable. In any given year a loss of 30% is not particularly unusual nor is a gain of 30%. And, that’s on a broad index of stocks. When it comes to individual stocks the range of annual returns in the short term is from minus 100% to gains of hundreds of percent. And the long-term average annual return range on an individual stock is from minus 100% to perhaps positive 25%. In the following table we use a range from 4% to 12%. Measured over the long-term (such as 30 years) it seems unlikely that the return from stock market indexes will be outside that range, although it is possible.

	Assumed long-term average annual return	Potential for loss in dollar terms	Nominal dollar value of $1000 after 30 years at this rate, before taxes	Real value of $1000 after 30 years, at this rate, before taxes, but after 2.0% /b>inflation
Stock Index	4%	high potential for temporary losses, little potential for permanent losses	$3,243	$1,811
Stock Index	6%	high potential for temporary losses, little potential for permanent losses	5,743	$3,243
Stock Index	8%	high potential for temporary losses, little potential for permanent losses	$10,063	$5,743
Stock Index	10%	high potential for temporary losses, little potential for permanent losses	$17,449	$10,063
Stock Index	12%	high potential for temporary losses, little potential for permanent losses	$29,960	$17,449

If stocks turn out to deliver at least 4% annually in the long run, then stocks are going are going to do better than almost any of the fixed income choices listed above. And if stocks end up delivering 8% or more, then stocks purchased or held now are going to dramatically outperform high quality fixed income investments purchased or held now. And if one can manage to earn 12% or more — unlikely for the stock index, but possible for some stock portfolios — then the out performance becomes truly staggering.

On top of that, stocks in taxable accounts face considerably lower income tax rates. Taxes on capital gains are deferred until the sale of the stocks and then taxed at half the rate of regular income and dividend income is also taxed favorably.

When it comes to investing for longer periods such as 10 to 30 years, stocks appear to to me to be the clear choice. As far as an allocation to fixed income, I see no reason for an allocation to longer term fixed income investments returning less than 4%. I would allocate some funds to cash and to short-term fixed income including five year rate reset preferred shares. I would do that, not as a permanent allocation but with a view to having funds available in the case of a material stock market decline to pick up bargains.

I would warn, however, that conventional wisdom is to always use a balanced portfolio approach and always maintain an allocation to fixed income. I don’t follow that wisdom. I have always said that I do not give advice on asset allocation because it is specific to each person’s circumstances. Above, I present the figures and offer my own conclusions. Ultimately, we all invest at our own risks and need to be comfortable with our own decisions.

END

Shawn Allen, CFA, CMA, MBA, P.Eng.
November 30, 2014

Why did Warren Buffett Buy Berkshire Hathaway in 1965?

On May 10, 1965 Warren Buffett, through his investment partnership, famously took over the management and control of Berkshire Hathaway Inc., a then large but struggling New England textile maker. His investment partnership had accumulated about 49% of the shares starting in 1962 and culminating with heavy purchases in early 1965.

In explaining why he bought it, Buffett was quoted at the time as saying “we bought Berkshire Hathaway at a good price”. My research has uncovered that this “good price” did not involve a low price to trailing earnings multiple. Instead, it refers to a good price in relation to the value of the assets. It may also have referred to a good price to expected forward earnings but that is not clear.

In later and in recent years Buffett has said that buying Berkshire was a mistake because back then it was only involved in the textile business. Textiles were a declining industry in 1965. It tied up a lot of his money in a poor business.

In his 1989 annual letter, Buffett said, under the topic “Mistakes of the First Twenty-Five years”:

“My first mistake, of course, was in buying control of Berkshire. Though I knew its business -textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal.

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. …”

Even if it was a mistake, Buffett had his reasons to buy Berkshire and those reasons, including exactly in what way “the price looked cheap” seem worthy of further exploration. This article will review some of the previously published reasons for this historic purchase and will add a more detailed exploration of Berkshire’s 1964 and 1965 financial statements which provide insight into Buffett’s probable reasons for the purchase and why it appeared to be under-valued in the market as Buffett was buying it.

Buffett’s policy was to keep his investments secret until the buying was completed. Accordingly, his limited partners did not even know about the purchase of a controlling interest in Berkshire Hathaway until some time after it was completed. In his July, 1965 letter to his investment partners, Buffett noted that the partnership had gained a control position in one of its investments. Only later was it revealed that this was Berkshire Hathaway.

In his January 1966 letter, further details were provided. Buffett described how the partnership had been accumulating shares in Berkshire Hathaway since 1962 on the basis that it was trading significantly below the value to a private owner. The first buys were at a price of $7.60. The discounted price reflected the large losses Berkshire had recently incurred.

The Buffett partnership’s average share purchase price was $14.86 reflecting very heavy purchases in early 1965 as Buffett took control of the company in the Spring of 1965. Buffett reported to his partners that at the end of calendar year 1965, Berkshire had a net working capital (without placing any value on plant and equipment) of about $19 per share.

Warren Buffett had begun accumulating shares in Berkshire Hathaway on the basis that it was trading at a significantly lower price than the value to a controlling private owner. Buffett had earlier made a number of investments on this basis and the usual outcome was to later sell the block of accumulated shares in the market or to another single buyer. In this case however Buffett ended up taking control of the company.

During this period one of the three categories of investments that the Buffett partnership was making was called a control situation, where Buffett would take control or become active in the management of the company. In a 1963 letter he said: Because results can take years, “in controls we look for wide margins of profit — if it looks at all close, we pass.” He also said he would only become active in the management when it was warranted.

On at least one previous occasion Buffett had taken full control of a public company. The Buffett partnership had purchased 70% of Dempster Mills Manufacturing in 1961. Buffett brought in a new manager at Dempster and had the manager reduce inventory and Buffett then had Dempster invest in marketable securities. If Buffett had not sold Dempster in 1963 it seems quite possible that it would have been Dempster that became his corporate investment vehicle rather than Berkshire.

Buffett noted that back in 1948 Berkshire had had 11 mills and 11,000 workers but by the time Buffett took control it had only 2 mills and 2,300 employees. Buffett also noted that in “a very pleasant surprise” existing management employees were found to be excellent. Ken Chace, he said, was now running the business in a first-class manner and it also had several of the best sales people in the business. Before taking control, Buffett knew that Ken Chace was available to manage it.

Buffett indicated that Berkshire was not going to be as profitable as the likes of Xerox but that “it was a very comfortable sort of thing to own” and “a delight to own”.

Berkshire Hathaway’s 1964 Balance Sheet

A recently published book put together by Max Olson has compiled all of Buffett’s letters to Berkshire Shareholders and it includes previously hard to obtain information on Berkshire Hathaway’s 1964 balance sheet as follows:

Assets	$ millions	Liabilities	$ millions
Cash	0.9	Notes Payable	2.5
Accounts Receivables and Inventories	19.1	Accounts Payable and Accrued Expenses	3.2
Net Property, Plant and Equipment	7.6	Total Liabilities $5.7
Other Assets	0.3	Shareholders’ Equity 1.138 million shares book value $19.46 per share	22.1
Total	$27.9	Total	$27.9

Buffett had therefore taken control of Berkshire Hathaway for the partnership at an average price that was 76% ($14.86 / $19.46) of book value. The cash, accounts receivables, and inventories of $20.8 million were, after deducting total liabilities of $5.7 million, worth $15.1 million or $13.30 per share. In effect one could argue that Buffett had purchased the company at approximately the value of its current assets minus all liabilities

He was therefore paying almost nothing for the property, plant and equipment and any going concern value of the business. There was at least some market value in the property plant and equipment. And there was some value as a going concern.

The book value of $19.46 per share, at the end of fiscal 1964, can be broken down, on a percentage basis, as follows:

Cash 3%
Accounts Receivable and Inventory 69%
Net Property, Plant and Equipment 27%
Other Assets 1%

This indicates that the assets which were purchased for 76% of book value were relatively high quality assets. Most of the assets were relatively liquid (assuming that the inventory could be sold for cash at close to its stated value). It is possible that there was land that was worth more than its balance sheet value. However it is also possible that the plant and equipment was worth far less than book value. However, the $7.6 million net value of the property plant and equipment had already been reduced on the 1964 balance sheet to reflect an expected $4.2 million loss on a property expected to be sold.

The Balance Sheet reveals that Berkshire Hathaway was ostensibly attractive given the price of 76% of book value. And it turns out that the 1964 balance sheet was in effect missing an important hidden financial asset in terms of available past losses that could be used to eliminate substantial future income taxes. Subsequently, Berkshire did make substantial profits in 1965 and 1966 that benefited greatly from a lack of income taxes. The extent to which Buffett valued the potential use of the past tax losses is unknown.

In his 1979 letter to Berkshire shareholders Buffett said “It probably also is fair to say that the quoted book value in 1964 somewhat overstated the intrinsic value of the enterprise, since the assets owned at that time on either a going concern basis or a liquidating value basis were not worth 100 cents on the dollar.” Even though, as we calculated just above, Buffett paid an average of 76 cents on the dollar this 1979 statement arguably contradicts the notion that the price looked cheap in 1965. (Paying 76 cents on the dollar for assets worth somewhat less than a dollar might not fit Buffett’s definition of being cheap.)

Berkshire Hathaway’s Earnings at the Time of Buffett’s Purchase

Next we will look at Berkshire’s earnings at the time of Buffett’s purchase.

There was certainly no strong history of profits to make Berkshire Hathaway attractive or “cheap”. In fact it had lost a total of $10.1 million in the nine years prior to the 1964 balance sheet depicted above. The company was shrinking rapidly as its assets fell from $55.5 million in 1955 to $28.9 million in 1964. Despite the $10.1 million in losses it had paid out $6.9 million in dividends and paid out $13.1 million to repurchase shares. This was funded, in part through asset sales and also through non-cash depreciation expenses since investments in new and replacement equipment were likely less than the depreciation amount. Selling textile mills as they were closed down generated cash even if the mills were sold at a loss.

The company had earned only $0.126 million in 1964. This was approximately 11 cents per share. This suggests that Buffett’s $14.86 average purchase price represented a P/E ratio of 135 times trailing earnings! On a cash flow basis the ratio may have looked better since capital spending was apparently lower than the depreciation expense.

However, the company earned $2.279 million in the year ended October 2, 1965. This was $2.11 per share. This suggests that the purchase at $14.86 represented an attractive P/E ratio of 7.0. The company’s equity at the end of 1965 was $24.5 million or $24.10 per share. Before an apparently discretionary charge equivalent to income taxes, the actual net income for 1965 was $4.319 million and earnings per share were about $4.00. Buffett apparently did not consider the $4.319 million in earnings to be representative since it reflected zero income taxes due to temporary deductions available. Still, it is a fact that the P/E ratio based on the $14.86 price paid and this $4.00 per share earnings was only about 3.7! The fact that the actual earnings of Berkshire in 1965 were about $4.00 per share is consistent with a figure of $4.08 pre-tax indicated for 1965 in Buffett’s 1995 letter to shareholders given that the GAAP income tax was apparently zero in 1965.

Berkshire’s profit (before the discretionary allowance for income taxes that were not actually payable due to past tax losses) in 1965 at $4.3 million was considerably higher than it had made in recent years. It’s not clear to what extent this was due to strong profit margins in the industry that year, a reduction in overhead costs, the closing and sale of an unprofitable textile mill, or what. Possibly Buffett became aware that 1965 was going to be an exceptionally profitable year. He had undoubtedly studied the industry and would have been aware if this cyclic industry was entering a period of higher profitability. Or, possibly it was his actions in controlling the company in the last five months of fiscal 1965, including any influence before taking control, that led to the sudden profit. The 1965 letter to shareholders does not shed much light on the reasons for the increased profits but does say that the company made substantial reductions in overhead costs during 1965. It seems likely that while the reduction in overhead costs was partly or fully due to Buffett,  1965 was probably going to be at least a reasonably profitable year in any event.

The surge in earnings in fiscal 1965 was not due to investments in stocks. It does not appear that Buffett had already started to accumulate any significant stock market gains for Berkshire in its first few months under his control – the vast majority of the marketable securities at the end of 1965 were in short-term certificates of deposit.

It is certainly not clear what earnings Buffett might have expected Berkshire to earn going forward. In his 1985 letter, Buffett stated that at the time of the purchase he had expected Berkshire’s textile operations to be much better ran under Buffett’s chosen manager than had been the case in the past. And we know that it ended up earning an impressive $4.89 per share in 1966. Recall that Buffett paid an average of $14.86 per share to take control of Berkshire. These 1966 earnings would have been lower but still reasonably strong at $2.71 per share if not for past tax losses that were available to eliminate income taxes.

Other Reasons for the Purchase

Alice Schroeder’s book (The Snowball) indicates that Buffett was initially attracted to Berkshire simply due to the fact that he could buy about $19 worth of book value for $7.50. A friend of Buffett’s at that time suggested that the whole company could be purchased and liquidated. Buffett later met with Berkshire management and offered to let the company buy back his shares for $11.50. Apparently, management promised to do so but then formally offered only $11.375. Apparently, Buffett was incensed and decided to buy control of the company and oust the current management. By the time Buffett bought the company he had picked one of the employees to run it and he had toured its operations and become familiar with it. He promised that he had no intention of liquidating the business.

The then 34 year old Buffett may also have been attracted to the idea of gaining control of a company with 2300 employees. There was, presumably, a certain amount of “psychic income” in that. It is also likely that he wanted to “show” the outgoing management and everyone else that he could run the company far more profitably than they had. Keep in mind that Buffett is an extremely competitive man.

Advantages of Controlling Ownership of a Corporation

In this section, we explore certain advantages of owning Berkshire apart from its book value and its earnings. These advantages may have also factored into Buffett’s decision to purchase Berkshire.

There are certain advantages that are associated with purchasing a controlling but not full ownership of any corporation. And these advantages are magnified by purchasing a controlling interest at less than book value. These advantages are not unique to Berkshire.

It is therefore important to note that Buffett did not buy 100% of Berkshire. He got control of Berkshire by purchasing about 49% of the shares. As controlling owner he controlled 100% of Berkshire’s book value and assets. He had paid about $8.3 million (49% of 1.138 million shares at an average purchase price of $14.86). But Buffett now controlled all of Berkshire’s $22.1 million in equity capital. And he controlled all of its $27.9 million in assets. In effect this was a way of getting an extra $13.8 million ($22.1 – $8.3) in investor capital under his management without actually having to raise that capital from investors.

Furthermore, and perhaps very importantly, this was investor capital that the public shareholders of Berkshire had no ability to extract. Shareholders could sell their shares to others but the capital would remain with Berkshire. In contrast, in Buffett’s partnership operation, investors were free to withdraw their capital at the end of any calendar year which would have required Buffett to maintain a significant cash balance rather than investing all of the partnership’s assets.

In his 1964 letter, written four months before the takeover of Berkshire, Buffett noted that his limited partners had complained about their income tax liabilities. These would have arisen mostly as the partnership sold securities it had invested in at large capital gains. Buffett may have considered the fact that if the investments were made through a corporation in which his “partners” owned shares then all capital gains and other income would be taxed only in the hands of the corporation. As long as there were no dividends to the shareholders, and as long as they did not sell their shares, his investees would not face personal tax liabilities.

In the ten years prior to 1964, Berkshire had raised substantial cash by selling off property (textile mills). Much of this cash had gone to paying dividends and buying back stock. Just prior to Buffett taking control in May 1965, Berkshire was in the process of or had recently sold another mill. While it was sold at a loss it nevertheless generated some cash. Buffett may have planned to divert any cash previously used for dividends and buybacks to investing in marketable securities.

Buffett apparently stopped Berkshire’s long-standing practice of buying back shares. That practice had been draining capital (money) from the company.  Buffett apparently felt that he could find better uses for that money than repurchasing shares. No shares were repurchased in fiscal 1966, the first full year under Buffett’s control..

There was also additional leverage associated with Berkshire’s $5.7 million of debt and accounts payable. In total Buffett now had control over Berkshire’s $27.9 million of assets by investing $8.3 million.

The purchase of of 49% of Berkshire Hathaway also brought in the owners of the remaining 51% as new participants and “audience” members for Buffett’s wealth building and for his investment writings. He might also have considered that ownership of a publicly traded company would bring him more public notice. It seems likely that even at this time Buffett immensely enjoyed the process of making his partners (including minority shareholders) rich and he enjoyed the public notice that came along with that. Purchasing Berkshire therefore added to his enjoyment.

Buffett also likes history and was interested in and intrigued by Berkshire’s long history. Roger Lowenstein in his book about Buffett recounts how Buffett was excited to find that copies of Berkshire’s financials going back to the 1920’s were were available.

Disadvantages of Investing in a Corporation

Offsetting the advantages of investing in corporate form which are described above, there is an income tax disadvantage. Buffett has explained that investing in a corporate form has certain disadvantages for the owners as opposed to investing directly or through a partnership. Those who invest through a corporation are subject to a certain amount of double taxation. The corporation pays income taxes and then its owners pay income taxes on dividends and, if they sell their shares, capital gains. Buffett limited this disadvantage in several ways. Berkshire itself often holds shares for decades which defers capital gains taxes. And Berkshire does not pay any dividend which eliminates the personal tax on dividends. A shareholder who buys and holds Berkshire for decades does not incur any personal tax until the shares are sold.

Conclusion

In the end, it appears that there were several reasons that contributed to Buffett wanting take control of Berkshire Hathaway. The initial purchases were based on the fact that the shares were selling well below the value to a controlling owner. It appears that taking full control later became the best way to realize value on the initial investments.

The purchase, below book value, of about 50% of this publicly traded company provided leverage and allowed Buffett to control an additional $28 million of assets for an investment of $8 million. It also brought the public shareholders into his “tent” enlarging his audience and helped to bring Buffett to the attention of the wider public. Buffett was likely excited to be taking control of a company with 2300 employees. And, it appears that he thought that it would make at least a reasonable profit as an operating business. He likely knew that Berkshire had entered a cyclic period of higher profitability. And he would have been aware of the value of past tax losses in reducing income taxes payable on any anticipated profits.

It’s not clear to what extent he had immediate plans to attempt to extract cash from Berkshire by some combination of increasing profits, reducing inventory, and continuing to harvest depreciation cash flows and plans to then invest that cash in more profitable businesses and in stocks and bonds. Buffett’s 1995 letter to shareholders does indicate that he and Charlie Munger “knew in a general way what we hoped to accomplish” in regards to growing both marketable securities and operating earnings.

In part, the controlling purchase was motivated by a conflict with the existing management that led to his conclusion that management needed to be changed. Like most investments it was probably based partly on emotion and partly on numerical analysis. Knowing Buffett, it seems likely that the purchase was fully justifiable on the numbers alone.

In part, the purchase is explained by Buffett’s longstanding habit of being a man of action. In Berkshire he saw the opportunity to improve his return by taking control and changing management. As is his habit, he acted swiftly. Having decided that the best course of action was to take control, he did so. Despite Buffett’s decades later comment that the purchase of Berkshire was a mistake it certainly ended up working out rather well, most especially for the remaining public shareholders of Berkshire Hathaway.

END

Shawn Allen, CFA. CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
January 4, 2014 (With minor edits to December 1, 2017)

Prologue and lessons learned:

Despite Buffett’s comments that purchasing Berkshire was a mistake, it’s hard to agree with that assessment.

Everything that Berkshire has grown into today came from the very wise way in which Buffett reinvested the profits and cash flows of the original textile operation in highly profitable ways.

Berkshire’s book value at the end 2012 was a staggering 8,654 times higher than it had been just prior to Buffett’s purchase. That’s an increase of 865,400%. Meanwhile the share count had increased by only 44%. The shares that existed at the end of 1964 still accounted for 69% of the ownership in 2012 and these shares had increased in book value by 586,817%. The only new capital that has come into Berkshire occurred when Berkshire very occasionally issued shares in making acquisitions. Fully 69% ($132,196 million) of Berkshire’s equity capital at the end of 2012 of $191,588 million can be traced solely to the growth of the initial equity of $22 million that Buffett started with.

Buffett’s first major move in re-deploying Berkshire’s equity came within two years of assuming control of Berkshire. In early 1967 Berkshire Hathaway purchased a pair of property insurance companies for $8.6 million million. A key characteristic of insurance companies is that the insurance premiums which are ultimately ear-marked to pay claims can meanwhile be invested.

The cash for this purchase came mostly from Berkshire’s unusually high profits in 1965 and 1966, which totaled $9.3 million. The cash did not come primarily from reducing inventories, receivables or assets of the textile operation, although as indicated in Buffett’s 1985 letter that was partly the source of the cash for the purchase. Buffett was careful not to pour much additional capital, including profits from the textile business, into the textile business. Instead, he extracted much of its profits for other purposes. But it is not the case that he materially reduced the capital in the textile business. Berkshire Hathaway’s textile business remained operational under Buffett’s control for 20 years until 1985.

Reviewing Buffett’s 1965 purchase of Berkshire Hathaway is interesting enough just for its historical significance. But it also may offer some important lessons for today’s investors and investment managers.

What might today’s investment managers learn from Buffett’s purchase?

They might learn to look for investments that could work out in several ways. Buffett’s purchase price was cheap in relation to book equity and also in relation to the profitability that occurred in the years immediately after the purchase. In the case of the earliest purchases, Buffett also knew that the company itself might repurchase his shares at a substantial gain.

Buffett’s Berkshire purchase illustrates how a large investor can gain complete control of a company by purchasing a controlling but not full interest.

Most importantly, Buffett’s purchase of Berkshire and its subsequent operation provides valuable lessons in how the profits and cash flows of a sub-par business can be redeployed into much more lucrative investments.

END

How to Value Known Cash Flows

Investors are often faced with the problem of knowing the fair value of an investment that is expected to deliver future cash flows. Fortunately, there is some standard mathematics that can be applied.

In regards to estimating the value of an investment, Warren Buffett, in his 1991 letter to Berkshire Hathaway share owners said:

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.”

So it’s all very simple in theory:

The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.

Therefore, to place a value on any financial investment we need to do two things each of which is simple to describe but is hard to do:

1. We must know or estimate the future net positive cash flows, and their timing, that will emerge from the investment, and
2. We must discount these cash flows at an appropriate interest rate to calculate their “present value” as of today.

In the case of the safest bonds or of money on deposit at a bank, the cash flows and their timing are known with (almost total) certainty and so step 1 is essentially done for us and we are left with step 2.

This article explains how we can calculate the present value of any known future cash flow. The summation of the present value of the individual cash flows that an investment will produce is the value of the investment.

Perhaps the most basic concept of borrowing, lending and investing is the following:

A dollar to be received in the future is less valuable than a dollar in hand today.

To illustrate, imagine that risk-free bank accounts pay 3% annually. What then it the value of a guarantee to receive $1.00 in ten years?

The answer is that the $1.00 to be received in ten years has a value today of only 74.4 cents. This is the case because 74.4 cents deposited at 3.0% annual interest in a simple bank account will grow to that same $1.00 in ten years.

In the language of finance, the present value (i.e. today’s value) of a guaranteed $1.00 to be received in ten years when the risk-free interest rate is 3.0% is 74.4 cents. Alternatively stated, the discounted value today of this $1.00 to be received in ten years is 74.4 cents.

The formula to confirm this on your calculator is 1 divided by (1 plus the interest rate) raised to the power of 10. In this case $1.00/(1.03)^¹⁰

This simple formula can be used to calculate the present value of any cash flow when you know, with certainty, the amount to be received and when it will be received.

In theory, the risk-free interest rate should compensate you for two things:

1. A percentage rate to compensate you for the lost opportunity to spend the money now as opposed to in the future. This is known as the compensation for the time value of money.

2. An additional percentage rate to compensate you for expected inflation, which is the expected decline in the purchasing value of money.

In practice, the risk-free interest rate can simply be observed as the interest rate available on risk-free investments. For individuals the interest available from banks on guaranteed investment certificates can usually be considered the risk free interest rate.

In practice the two components of the risk free interest rates (compensation for delaying the ability to spend the money and compensation for expected inflation) are not separated. Also, in practice, the available risk free investments may not really offer a “fair” compensation. This appears to be the case today as governments appear to have worked to push interest rates down to unnaturally low levels.

The process of finding the present value of know cash flows is illustrated in the following table. This is an example of a ten year $1000 bond that pays 2.5% ($25.00) at the end of each year for ten years and then returns the $1000 face value. The present (today’s) value of each individual cash flow is calculated in the table.

Year	Cash received	Market Interest Rate	Present Value
1	$25.00	1.30%	24.68
2	25	1.65%	24.19
3	25	1.65%	23.8
4	25	1.70%	23.37
5	25	2.00%	22.64
6	25	2.05%	22.13
7	25	2.10%	21.62
8	25	2.17%	21.06
9	25	2.23%	20.49
10	1,025.00	2.30%	816.52
Total	$1,250.00		$1,020.51

The market interest rates shown in this table are the actual interest rates applicable to guaranteed investment certificates (GICs) at the Royal Bank of Canada at this time.

The present value of the $25.00 to be received at the end of the first year is $24.68. That’s because $24.68 deposited for one year at the market rate of  1.30% will grow to $25.00 in one year. Similarly, $22.64 is the present value today of the $25.00 cash flow to be received at the end of year five. That’s because $22.64 deposited for five years in a compounded GIC year at the market rate of  2.00% compounded will grow to $25.00 in five years.

This bond will ultimately pay out $1250.00 in total cash flows over its life. But at the market interest rates of today it is worth $1020.51.

If the unlikely event that one were to come across this bond offered in the market  at $1000, then it would be a bargain as it would provide a return slightly higher than the going market rate.

The next example deals with the valuation of a risk-free perpetual preferred share.Imagine that there exists a perpetual risk-free preferred share that will pay out $1.00 per year in perpetuity.

The formula to value such in investment is simply the annual cash flow divided by the applicable interest rate.

It can be very difficult to determine the risk-free rate for such an investment because risk-free perpetual investments are quite rare.

If the applicable interest rate in this case is 4.00% then the investment is worth $1.00 / 0.04 of $25.00. It’s worth $25.00 because this $25.00 if deposited in an account that paid 4.00% in perpetuity would return the same $1.00 per year.

It’s interesting to observe that the total cash that is to be paid out from now until forever is infinite. Nevertheless, the value of the perpetual investment is far from infinite due to the fact that interest rates reduce the value today of a dollar to be received in the future. In theory, the value of a perpetual investment would approach infinity as extremely long-term interest rates approached zero. Today, short-term interest rates are about zero, But long-term interest rates are still well above zero.

A final example is to calculate the value of an investment that starts paying out $1.00 per year but where that $1.00 is expected to grow each year.

Imagine a common share that currently pays out $1.00 per year and where that dividend is expected to increase by 2% forever.

The formula to calculate the value of such a perpetual, and growing annual cash flow is: The annual payment divided by (the applicable interest rate minus the growth rate).

Unfortunately, the reality is that we will not find such an investment that is risk free. But, assuming we could, and assuming that the very long-term risk free interest rate was 4.00% then the value of the cash flows described here would be: $1.00 / (0.0400-0.0200) = $50.00

Compared to the value of the constant cash flow of $1.00 per year forever, the value of a dollar growing at just 2% per year is twice as high in this example. This illustrates the amazing impact that growth has on valuation.

END

Shawn Allen, CFA, CMA. MBA, P.Eng.
November 22, 2014

There is, of course, a big difference between saving and investing. There are also different time frames and goals within the overall broad categories of each of saving and investing. There is also something of a continuum between these two categories. The approaches and the reasonable expectations and the risk differ.

The meaning of Saving:

To save money is to set money safely aside for future use.  In a primitive world without money or in the animal kingdom one might save or set aside food for use in winter or in times of shortage. The goal would be to preserve the food and keep it safe from loss, theft or spoilage. In this example there would be no expectation that the saved stockpile of food would grow in any way. In the modern world saving money is the equivalent of the ancient practice of setting aside and safeguarding food and fuel for future use.

The meaning of investing:

Warren Buffett has provided a definition of investing as follows:

“At Berkshire we … [define] 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. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.” (From Warren Buffett’s 2011 annual letter)

Saving versus Investing:

There is probably no exact description that always differentiates saving from investing because there is likely some overlap when it comes to long term saving versus investing. However, I would argue that the essential difference is that saving should involve zero or close to zero risk of loss of capital even on a temporary basis. Investing will almost always involve accepting that there can (and almost certainly will) be times when capital declines on at least a temporary basis. This risk is accepted in return for a reasonable expectation (but usually not a certainty) of growth in after tax and after inflation purchasing power of the investments over the longer term. If there is not a very high expectation of an ultimate growth in purchasing power, at least on a portfolio basis, then one has probably entered the realm of speculation or gambling.

A few words about gambling and speculation:

Many people believe that investing, particularly in stocks, equates to gambling or speculation. That is not the case when investing is done properly. Gambling and speculation are different in that there is often an expectation of loss. Gambling and speculation lack the high expectation for ultimate long-term gains that define investing. Gambling and speculation usually offer a small chance of a very high return. However, it is often expected that the full amount risked will most likely be lost. But this is accepted in return for the possibility, usually very slim, of a big pay off.

Preservation of Capital:

We live and certainly save and invest in a monetary economy. When it comes to preserving capital and understanding what is meant by preservation of capital we need to understand some distinctions.

Preserving capital in terms of dollars or units of any currency is different than preserving capital in terms of purchasing power. In the short term, barring hyper inflation, the two are the same. For shorter terms (and the definition of “short” depends on the level of inflation) it is sufficient to preserve capital in terms of dollars and to not worry about the decline in purchasing power of the dollar since such decline is expected to be very small in the short term.  In the longer term whether we are saving or investing we should be concerned about preserving purchasing power. If you have preserved a thousand dollars for thirty years in a safe, it is very unlikely that this is satisfactory if the purchasing power of each dollar has fallen substantially.

Summary Table:

Given a spectrum between saving and investing, and given a low inflation world, I have laid out in a table the different categories and their characteristics, as I see them — and the categories and time frames are necessarily somewhat arbitrary and subjective.

Category	Goals concerning return	Concern about Preservation of Capital	Willingness to Accept short-term volatility(loss)	Concern about Income Taxes
Short Term Saving (under one year)	Unimportant, some level of interest would be welcome but is not required.	Safety is paramount. Preservation of value in terms of dollars will suffice.	Loss in the monetary value is unacceptable.	With little or no return, taxes are not a concern.
Medium Term Saving (one to ten years)	A return sufficient to offset inflation and taxes is desired.	Safety remains paramount. Preservation of purchasing power rather than just of dollars starts to become important as the time frame lengthens and if inflation is more than very modest.	Usually little appetite for even temporary loss. Moderate loss in monetary value may be acceptable if it is known that the investment will mature at a certain monetary value.	It is preferred to avoid taxes but they may be considered unavoidable.
Long Term Saving (over ten years)	A return sufficient to offset inflation and taxes is desired. There would often be an expectation of some growth in purchasing power but this expectation is not a strict requirement for a saver.	Safety remains paramount. Since this is long term, preservation of purchasing power and not just the dollar value is important.	Moderate loss in monetary value may be acceptable if it is known that the investment will mature at a certain monetary value.	It is preferred to avoid taxes but they may be considered unavoidable.
Short term investing (under five years which may be an oxymoron)	A return sufficient to offset inflation and taxes and also some growth in purchasing power is expected but often may not occur due to the short term.	A very high concern for such safety is probably incompatible with the concept of short-term investing.	Having moved from saving into the world of investing some willingness to accept the possibility of loss is unavoidable.	Strategies to favor lower-taxed investments may be important.
Medium term investing (perhaps five to ten years)	A return sufficient to offset inflation and taxes and also some growth in purchasing power is expected but occasionally may not occur due to the relatively short term.	There probably has to be some willingness to accept a loss of capital purchasing power though it is expected that capital will most likely be preserved and grow.	Volatility of the value of the investment is accepted given the expectation of a higher return in the long term.	Strategies to defer taxes and to favor lower-taxed investments are important.
Long term investing (ten years to many decades)	An expected long-term average return which offsets inflation and taxes and which offers a high expectation for reasonable growth in purchasing power.	It is highly expected that in the long-term capital will not only be preserved but will grow and perhaps substantially.	Volatility of the value of the investment is accepted given the expectation of a higher return in the long term.	The expected return must be acceptable after taxes.Strategies to defer taxes and to favor lower-taxed investments are important.

See also our related article for a look at the rate of return and portfolio growth rewards of savings versus investing.

END

Shawn Allen, CFA, CMA, MBA, P.Eng.
November 15, 2014

What Has Warren Buffett Accomplished for the American Economy Since 1965?

As we approach the 50th anniversary of Warren Buffett’s taking control of Berkshire Hathaway on May 10, 1965 it is timely to look at what he has done for the American economy.

Opinions on what, if anything, Buffett has done for the overall American economy would vary widely. The two bookends of the spectrum of opinion might be something along the lines of the following:

The view of the harsher Buffett bashers and doubters might be: Buffett has done little or nothing for the wider economy. He owns companies and shares in companies that would have existed with or without him. He did not start these companies. Far from contributing to the economy he has simply sucked out billions for himself.

The view of the most devoted Buffett believers and fans might be: Buffett has done a very great deal for the wider American economy. Under his ownership employment at Berkshire has increased from about 2000 in 1965 to about 331,000 today. Berkshire’s revenues have increased from $49 million in 1965 to $182,150 million in 2013. Under Buffett, Berkshire has paid many billions in income tax.

For a realistic view of what Buffett has accomplished for the economy through his control and management of Berkshire we have to recognize that each of the views above has some truth behind it but that each of these two book ends is too extreme.

We can divide Buffett’s activities and economic accomplishments at Berkshire into three main categories:

1. The purchase and relatively passive holding of shares in various companies and also of bonds of corporations and governments.
2. The purchase and particularly the subsequent control, management and (usually) growth of numerous businesses.
3. The allocation of Berkshire’s earnings to selectively reinvest in its controlled companies, to purchase additional controlled companies and to make additional passive investments.

We can look at what, if anything Buffett has accomplished for the economy under each of these categories in turn. In reviewing each of the three categories I will err somewhat to the side of concluding that there was no benefit to the overall economy unless the benefit is relatively clear.

1. The purchase and relatively passive holding of common shares and bonds

My conclusion here is closer to the Buffett basher or doubter view. This passive investment activity itself did not really add anything to the American Economy. It is true that investors as a population contribute to the economy by providing investment capital to businesses. But that basically occurs at the stage where investors provide capital to corporations at their start-up phase or by buying shares in initial public offerings and in subsequent share offerings. But Buffett rarely, if ever had Berkshire invest in initial public offerings or share issues by companies. He mostly bought shares from other investors on the open market.
For example, when Buffett (i.e. Berkshire) bought and held American Express shares, that did not change the economic output of American express. I don’t believe that the purchase and subsequent passive holding of securities by Buffett from other investors can be said to have done anything for the wider American economy.

In any cases where Buffett became an active minority owner and had a material influence on management, I would give credit for that in category 2, where I deal with his management of companies. I would exclude from this passive category his direct cash infusions into companies such as the very large preferred share investments in selected companies during the credit crisis. That activity perhaps fits better in category 3, the selective allocation of capital to various companies.

Some of his bond investments would have been purchased directly from the issuing companies. But, in most cases the bonds would have been purchased by other investors if Buffett had not purchased them and so the fortunes of the issuing companies were not changed and I do not see any clear benefit to the larger economy caused by those bond purchases.

2. The control, management and growth of numerous businesses

To the extent that Buffett had Berkshire purchase private companies and then continued to run those companies in the same way and often with the same managers then it is not apparent that this would be a benefit to the wider economy. However, to the extent that Buffett was able to encourage a culture of efficiency and doing more with less, that is a benefit to the wider economy. I believe this efficiency effect has occurred. Buffett has down-played his influence on his subsidiary companies and it would be very difficult to estimate the magnitude of his benefit to the wider economy through his management process. But it seems clear that there was some benefit to the economy here.

3. The selective allocation and reinvestment of Berkshire’s earnings

I believe Buffett’s selective approach to reinvestment of Berkshire’s earnings did have a very material benefit to the wider economy. In his earliest days controlling Berkshire he was able to harvest profits and cash flows from its original textile operations and begin investing those in securities and in buying an insurance company. This included harvesting some capital by selling some real estate and by reducing inventories and accounts receivable. At that time, other textile operations continued to plow cash flows back into the declining textile industry rather than diversify.

It would have been a waste of economic resources for Berkshire to continue to reinvest cash flows into this fading industry. It was a benefit for the economy to have that cash invested into growing industries. Even where Buffett used the cash to simply buy shares from other investors, rather than invest that cash in more textile equipment, that was beneficial since the seller of the shares then had the cash to spend in the economy. It is not a good thing for the economy if resources are invested into assets that are not needed. For example the American economy would not have benefited if the proverbial buggy whip manufacturers had invested in machines to become more efficient at producing buggy whips as automobiles made horse and buggy transportation obsolete in the early 1900s.

By owning and controlling numerous businesses under Berkshire, Buffett was able to direct profits and cash flows from declining or stable companies towards companies that were both fast-growing and that could derive the most profit from capital investments. Directing scarce capital investments away from less productive uses and towards more productive uses is a benefit to the larger economy.

Conclusion

It is difficult or impossible to estimate the overall positive impact that Buffett has had on the wider economy. It seems clear that there has been some benefit due to efficient management and particularly the efficient allocation of capital to the most productive uses.
But also, undeniably, some of the wealth that Buffett and the other long-time Berkshire share holders have amassed would have simply gone to others in the absence of Buffett.

Some people may cling to the extreme view that Buffett has sucked billions of dollars out of the economy for his own benefit. This is not true. Since Berkshire does not pay a dividend and since Buffett has never sold any share except for charitable purposes, and since furthermore he takes a salary of only $100,000 per year he has in fact consumed NONE of the vast wealth that he owns in Berkshire.

Warren Buffett, through Berkshire Hathaway, has accomplished much for the economy. It’s not an accomplishment that can be easily measured but clearly a great deal has been accomplished.

END

Shawn Allen, CFA, CMA. MBA, P.Eng.
President, InvestorsFriend Inc.
November 1, 2014

The following table describes the features of existing Defined Benefit (D.B.) pension plans, Defined Contribution (D.C.) pension plans and the Canada Pension Plan. We then explore in a second table the features that a more sustainable and workable pension plan should have. This article is focused on pension plans in Canada.

Characteristic	D.B. Pension	D.C. Pension	Canada Pension Plan
Ultimate Goal of the pension	To provide adequate funds for living expenses in retirement in combination with other sources of income. The specific target is often to replace up to 2% of the purchasing power of final earnings per year in the plan. Often the target is 2% in combination with the Canada Pension Plan. Full inflation protection would be required to fully meet this goal.	To provide adequate funds for living expenses in retirement in combination with other sources of income. The specific target would vary by individual. Achieving full inflation protection would be required to fully meet this goal.	To provide adequate funds for living expenses in retirement in combination with other sources of income. The specific target is to replace 25% of income up to a maximum level and to fully protect against inflation. Starting in 2019 the target is being very slowly raised over a 40 year period to replace 33% of income.
Pension pay-out amount	As high as 2% of highest five year average wages per year worked. (70% for 35 years worked) Many plans pay 1.4% per year up to the Canada Pension Yearly Maximum Pensionable Earnings amount (YPME) and 2% above that.	No set pay-out amount.	Approximately 0.625% of final wages (up to a maximum wage amount) per year contributed. Maximum pension in 2023 is $15,679 per year and requires 39 years of contributing with earnings at or above the yearly maximum to qualify for that.
Inflation Protection	Usually there is partial but not full indexing for inflation. Canadian Federal government employee pensions are fully indexed.	The available pay-out is tied to investment market performance and not directly linked to inflation.	The Canada Pension Plan benefit is fully indexed for inflation (official CPI).
Age of Retirement	Usually 65, but sometimes younger There is often a 3% per year reduction for early retirement. Government plans often have a feature that forgives the early retirement reduction if age and years of service sum to a certain minimum “magic number”.	No set age. Retiring earlier reduces the amount available and reduces the safe withdrawal rate.	65 but with actuarially sound reductions (7.2% per year) for retiring and collecting as early as age 60 and actuarially sound increases (8.4% per year) for retiring as late as age 70.
Other benefits such as disability or survivor benefits for minor children	Typically not included	Typically not included	CPP includes disability benefits and survivor benefits for minor children
Ability to access the Commuted Value of the expected pension payouts	Often very generous ability to do so but only up to a certain age such as 55. The commuted values are calculated based on bond interest rates and recently far exceeded the amount that would apply if the expected return on plan assets were used. Some plans have made the commuted value amounts less generaous than previous.	Not applicable. Since there is no set pension amount, the concept of commuted value of the pension does not apply.	No ability to access the commuted value.
Contributions	Often shared 50 / 50 with the employer and sometimes the employer pays it all. Some plans now require 15% of wages or more from each of the employee and employer.	Employers often pay half of the contributions.	In 2023 employers and employees each contribute 5.95% of wages up to the Yearly Maximum Pensionable Earnings (YMPE) which is $66,600 for 2023.
Percent return on total employee and employer contributions assuming an average age of death	Logically a fully funded D.B. pension should provide a return that approximates the long-term return achieved on the invested assets	The percent lifetime return depends on the investments chosen	The CPP is only about 32% funded (see last row below). It’s return on total contributions is about two thirds driven by the percent increases in average wages and about one-third driven by investment returns and therefor the return can be expected to be LOWER than that on a DB which invests about  100% of contributions.
Mandatory?	Yes, almost always mandatory	May not be mandatory	Yes, this is mandatory for all Employees in Canada but  discretionary for self-employed people.
Portability	There is some portability to certain other DB plans.	The money belongs to the employee but a new employer may not have a DC plan and if it does it may not allow the employee to transfer in existing amounts. In some cases these DC amounts could be transferred to a new employer with a DB plan.	Not an issue. The CPP pension is administered by the government and any new employer continues to remit both the employee and employer share of the required contributions
Risk to Retiree	Often no risk other than usually at least some inflation risk. Retiree has some risk in extreme cases where the plan sponsor goes bankrupt.	Highly risky, the retiree is at risk for market performance and inflation and must manage the investments.	No risk.
Survivor Benefit	Often 50% or 67% but can be as high as 100% in return for taking a smaller initial pension.	100% of the funds can go to a surviving spouse with no immediate income tax payable on the transfer.	A surviving spouse receives 60% but this is subject to a cap whereby no individual can receive more than the maximum CPP pension. This means that the survivor benefit is zero where both spouses were already at the maximum
Value to Estate	No value to the estate after the death of the retiree and spouse	High value – the estate owns the remaining D.C. pension but faces some income tax as any unrealized capital gains in the portfolio will be deemed to have been realized in the year of death.	No pension value to the estate after the death of the retiree and spouse. Does provide survivor benefits for minor children.
Longevity Risk	The “risk” of living for a very long time in retirement is pooled. Those who die early effectively subsidize those who live longer. This key feature means the plan only has to fund (on average) for average lifespan not for maximum lifespan.	The individual bears the “risk” of living a long time in retirement and must plan to fund for maximum lifespan rather than average lifespan. Therefore a larger pot of money is needed and DC plans are inherently more expensive to fund than DB plans for that reason.	As a specific example of a DB plan, the CPP pools longevity risk and only needs to fund for average lifespan, on average.
Market Risk to Employee	Employees face rising contributions when market returns are lower or deficits develop. But the risk is shared with the employer.	Employee is fully at risk for market performance.	Employees can face rising contributions when market returns are lower or deficits develop. But the risk is shared with the employer.
Market Risk to Employer	High risk, employers must raise contributions when market returns fall. Employers face unfunded liabilities appearing on their balance sheets. Gains and losses related to DB pensions can also flow into the income statement creating volatility in reported income	Typically none.	Employers face the risk of higher contributions but do not have to worry about unfunded liabilities appearing on their balance sheets.
Multi-employer?	Sometimes yes, but typically it is a single employer and that sharply increases the risk to employees where bankruptcy is a possibility and requires the single employer to show any funding shortfall as a pension liability	DC plans are typically single employer but could be multi-employer.	CPP includes every employer in Canada. As a result employees face no CPP risk from bankruptcies of the employer and employers never have CPP unfunded pension liabilities on their balance sheets.
Market Risk Pooling	A DB plan typically expects to exist indefinitely. It can therefore pool the risk that the employment and/or retirement years of a particular employee cohort will feature unusually low average market returns.	No pooling of any risk is possible and a DC plan contributor should be conservative and plan for a market return that is at the lower end of the expected range.	As a specific example of a DB plan, the CPP pools market performance risk and can plan to achieve average market returns over many decades. Unfortunately is is mostly a pay-as-you-go plan and only about one third of contributions are invested.
Cross subsidies and mathematical soundness	Cross subsidies can be high. Those with sharply rising salaries over their career are subsidized. Unreduced (magic number) early retirement features are cross subsidized by those that do not qualify. Early retirement reductions are not as severe as they should be due to the magic numbers approach.	No cross subsidies as each plan is individual.	Less cross subsidies than most DB plans since benefits are based on contributions over up to 39 years. The maximum benefit requires one to have made the maximum contributions for 39 years. The reduction for collecting at age 60 is mathematically sound. There are no “magic number” type subsidies. Those who die early do cross subsidise those who die late and healthy people subsidise those that collect CPP disability. Employees today however are cross subsidising current retirees because past contributions were too low.
Investment Choices	Typically no restrictions but the plan will almost always follow relatively conventional rules for asset allocation and risk management. Employees have no say in how the funds are invested.	May face restrictions such as having only a small family of mutual funds to choose from. Or on the other extreme, in other cases, there may be “freedom” to take huge risks and place all the money in penny stocks if one wished.	Little or no restrictions on the CPP investment managers. The plan follows relatively conventional and contemporary asset allocation and risk management strategies. Employees and Employers have no say in how the funds are invested.
Money management costs	Usually low due to the scale of the plans	Can be quite high and there may be no option to use low cost ETF products.	Low, due to the scale of the plan.
Capacity for Risk	Generally high because the plan has an indefinite life and can share market risks across age cohorts and there is some ability to increase contributions to make up for poor returns.	Generally lower because there is no ability to pool risks with anyone else or across time.	Higher risk capacity for the same reasons as DB and because the Canadian government does not face the risk of insolvency under any reasonably conceivable scenario
Equity Type Investment Proportion	Typically in the range of 60%	Totally at the discretion of the employee.	Probably in the range of 60%.
Funded Status	Varies but in 2022 most plans are well funded such as about 100% funded or more, even based on conservative assumptions.	Not applicable since there is no promised pay-out amount	The plan indicates that it is sustainable for the long run. But at the end of 2021 it was only 32% funded since it is mostly a pay as you go plan. The funded status is projected to reach 100 over the next 75 years.
Characteristic	D.B. Pension	D.C. Pension	Canada Pension

Features of a more workable and sustainable Pension Plan:

It has been well documented that many Defined Benefit pension plans had developed unfunded liabilities in the early 2000’s and and after the financial crisis years due to low interest rates and poor stock market returns. And this was often in spite of
relatively massive increases in contribution levels. Many have concluded that the concept of a defined or guaranteed pension benefit is and always was mathematically unsustainable.

In summary a more workable, fair, sustainable and rational pension plan should: retain the group features of a DB plan and pool longevity risk since this lowers the funding requirements, be a group plan intended to continue indefinitely since this allows the pooling of market return risks across the lives of different employee / retiree age cohorts which reduces funding costs, be multi employer to reduce risks and increase portability, target full inflation protection, provide a target rather than guaranteed pension since it is not feasible to shield retirees from all risks, have pension benefits that are directly and mathematically tied to the contributions of each year and to the time each year’s contribution has been in the plan since this will prevent unfair and unjustifiable cross subsidies.

The detailed features of a more sustainable and mathematically fair pension plan are summarized in the table below.

Feature	Comment
Ultimate Goal of the pension	To provide adequate funds for living expenses in retirement in combination with other sources of income. Full inflation protection would be required to fully meet this goal.
Pension pay-out amount	The target payout should be some percentage of the inflation (or average market return) adjusted wages for every year worked. To get the math right and to avoid cross subsidies there should be a table of the percentage that applies to each year. It might be 3% of wages earned 30 years ago (Say 12% contributed – if that was the contribution rate 30 years ago – times five for average market growth times 5% of that equals 3%) and perhaps only 1% of wages from the last year worked. Say 20% contributed (which is a typical total contribution rate today) plus about 0% for growth times 5% of that equals 1%. The 5% is approximately the “safe withdrawal rate” for pooled pensions.
Inflation Protection	Full inflation protection should be targeted but not guaranteed. It’s only fair that pensioners be protected from purchasing power erosion. But only if the market returns on the funds allow it.
Age of Retirement	The normal age should probably be set at 65. Reductions for retiring earlier should apply in all cases and be actuarially sound and therefore fair. Increases for retiring later should also apply and be actuarially sound and therefore fair.
Defined Benefit Feature	Ideally the payout as calculated in the cell above would be fixed and known by formula but to mitigate risks there may need to be some ability to adjust the pensions (either up or down) to reflect market performance of the assets. Therefore it would be a target rather than a defined or guaranteed pension.
Survivor benefit for a spouse	Minimum 60% and with the ability to choose 100% in return for a lower starting pension.
Other benefits such as disability or survivor benefits for  minor children	Should NOT be included in the pension plan since they are not related to retirement income but should be provided elsewhere through disability and life insurance.
Ability to access the Commuted Value of the expected pension payouts	This should not be allowed. If it is allowed the discount rate should equal the expected return on plan assets rather than the more lucrative (to the departing employee) discount rate based on bond returns. Commuted values based on bond returns allow employees to remove risk free sums of money but leave the risk of asset performance with the plan and for that reason should not be allowed.
Contributions	Contributions, including contributions to a government pension plan like CPP should probably not exceed 10% from each of the employer and employee. Employers should be able to choose lower contribution levels and to choose whether they partially or fully match the employee contributions. Since the plan is meant to pay benefits directly in proportion to contributions, employees should probably be allowed to contribute additional amounts, if they wish.
Mandatory?	Employers probably should be allowed to set a minimum mandatory contribution level. The default option should be to opt into the plan with possibly the ability to opt out especially where there is no employer contribution.
Portability	Yes, should be portable to all other pension plans that allow incoming portability. Transfer values should be based on standardized return on plan asset assumptions, not on low risk bond returns.
Risk to Retiree	Unlike in DB plans there should be some ability to have retirees share the risk of lower market returns. Placing all risk on employers and and current employees has proven unsustainable in the face of persistently low market returns.
Value to Estate	There should be no residual value to the estate once the retiree and spouse are deceased. The savings from those dying early are needed to pay those who live unusually long and this is one of the key features that is needed to make pension plans affordable.
Longevity Risk	A workable plan should pool longevity risk and the risks of low market returns in certain time periods. This allows the plan to fund for only average life spans rather than for maximum life span.
Market Risk to Employee	This will always be present but is mitigated by pooling the risk with many employees and across different age cohorts of employees and retirees.
Market Risk to Employer	This will always be present but is mitigated by pooling the risk with many employees and across different age cohorts of employees and retirees. These should be no requirement to show unfunded liabilities on balance sheets due to the multi-employer nature of the plan.
Multi-employer	A workable and sustainable pension plan should be multi-employer and at arms length from the employers. This reduces risks for all parties.
Market Risk Pooling	The pension plan should be an arms length multi employer organization that plans to exist indefinitely and can therefore pool market risks across different age cohorts.
Cross subsidies and mathematical soundness	As a principle, cross subsidies should be avoided other than pooling of longevity risks and pooling the risks of lower market returns in certain time periods. (Both of those lower funding costs on average and are required features). The discount for early retirement should be actuarially sound. There should be no unusual windfalls or early-retirement-without-penalty for reaching “magic numbers”. The pension should be related to actual inflation- or average-return-adjusted salary over ALL years and not based on the highest five year average earnings.
Investment Choices	There should be few if any restrictions on the fund manager other than sound diversification.
Money management costs	Should be low due to scale.
Capacity for Risk	This plan will have a higher capacity for risk than a typical DB plan given the ability to share risks across multiple employers and employees (and even retirees) and the ability (like DB plans) to share risks across age cohorts and because the plan has an indefinite life.
Equity Type Investment Proportion	Given the capacity for risk and the higher expected returns from stocks there should be a high allocation to equities of at least 60%. Asset allocations should allow for reduced equity exposure during equity bubbles and reduced long-term bond exposure when interest rates are abnormally low.
Funded Status	These plans should target to be about 120% funded which allows a cushion for times when discount rates or expected or actual returns decline.
Feature	Comment

Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.
June 15, 2013 (with minor edits through March3, 2024)
See also our other pension articles

What Has Warren Buffett Accomplished for Berkshire Share Owners Since 1965?

As we approach the 50th anniversary of Warren Buffett’s taking control of Berkshire Hathaway on May 10, 1965 it is timely to look at what he has done for Berkshire’s share owners (so
far).

The book value per share at the beginning of the fiscal year in which Buffett took control was $19.46. This was at the beginning of October 1964. As of the end of Q2 2014 the book value per share had increased to $142,483 (Calculated as $234,005 million equity divided by 1.642335 million class-A equivalent shares).

That’s an increase in book value per share of 732,084%. This is a staggering and almost unfathomable increase. It’s almost three quarters of a million percent. On an annual compounded basis it’s 19.6% per year compounded for 50 years (49.75 years, to be precise).

When it comes to the increase in the share price, the increase is even larger. The trading price of the shares in early May 1965 just before Buffett took control was about $18. Today those very same shares trade for $208,133 per share. That is an increase of 1,156,194%, or 1.16 million percent! It’s an increase of 11,562 fold! On a compounded annual basis that’s an increase of an average of 20.8% per year for 49.5 years.

Every $1000 invested in Berkshire as of May 1965 is now worth $11.6 million. Every $1.00 worth of Berkshire shares from 1965 is now worth $11,562. Many investors are ecstatic when they achieve a 10 fold increase, a 10 bagger. Here we have an 11,562 bagger, and counting!

By any standard, Warren Buffett has accomplished truly unmatched and extraordinary results for Berkshire share owners.

At the beginning of that fiscal year that Buffett took control of Berkshire it had 1,137,776 shares outstanding and the book value was $22.139 million. Today, 50 years later the total share count has increased to 1,642,335 shares (with the class B shares counted on a basis equivalent to the original shares now called class A). So the share count has increased by 44%.

The shares that existed in 1965 had 100% ownership of a declining textile business with a book value of $22.139 million. Today, those same shares (and they almost all still exist since relatively few shares were ever bought back by the company) represent 69% ownership of a world-class business that has a book value of $234,005 million. For the 69% that is $162,114 million. A gain of 732,255%. The same 732,084% increase in book value per share mentioned above, with the very small difference being attributable to rounding. The business, which these shares
represent 69% ownership of, now includes a huge rail road, a huge utility operation, a huge insurance operation, dozens of smaller business and a huge stock portfolio. This business was ranked number four on the latest Fortune 500 list and Forbes ranked it the number five largest business in the world. And about 69% of the ownership is represented by growth of the original $22.2 million equity capital that Buffett started with.

It seems safe to say that no other business in the world with at least $10 million in equity in 1965 has grown its equity per share at a faster rate.

One of the reasons for the unimaginable growth that has been achieved is that Berkshire has paid no dividends since Buffett acquired it. Well, ironically enough, with the exception of one thin dime paid out in 1967. With the exception of that dime, when the share count was about 1,017,547 amounting to a total dividend paid out of $101,755, every dollar of earnings has been retained
and reinvested for growth. Those cumulative retained earnings now amount to $154,848 million.

Warren Buffett has basically accomplished the seemingly impossible and the unfathomable for his shareholders over these last 50 years. The accomplishment of growth per share in the range of one million percent is almost beyond comprehension.

END

Shawn Allen, CFA, CMA. MBA, P.Eng.
Dated September 28, 2014 (50.0 years from the time that Buffett tracks his performance from the beginning of the fiscal year in which he took over the company)

One could argue endlessly about what it means to be rich in financial terms. But most definitions would indicate that being rich means the ability to spend a large amount of money annually and to sustain that for many years, ideally for life. I would argue that while all rich people do not necessarily actually spend a lot each year, having the ability to do so, for many years or indefinitely, if desired is a necessary prerequisite to being rich. What constitutes a large amount of spending per year depends on your perspective and frame of reference and is not a set amount. Most people might agree that those who make say five times more than they do are rich. So a minimum wage earner might consider everyone making $100,000 per year to be rich, while those making $100,000 per year consider that it takes $500,000 per year to be rich.

Whatever your definition of what it means to be rich, this article discusses how it might
be achieved.

In our economy there are basically two sources of income available to individuals. There is income from employment and there is income from assets owned. In this case we might define assets as anything of value that produces a current income, is expected to produce a future income, or can be sold now or in the future for cash.

We could perhaps also include income from government social programs. But if we are focusing on how to get rich we can pretty much ignore that source of income.

The following are three main categories of how to get rich. There would be some overlap between them and many rich people have probably achieved their success from more than one category.

Getting rich from working

A relatively few people in society are basically rich through employment income. There are certainly executives making $300,000 per year and there a few making over one million per year. And in some cases (but probably not most) they will make these incomes for decades and then receive very lavish pensions for life.

Those on the lower end of the income scale would likely include many of the higher paid government workers in this category as well. A couple with two well-paying government jobs and the associated pensions might well be viewed as rich by those who must get by on jobs that pay less than half and which include no pensions or other benefits.

Specialist doctors, dentists and many senior lawyers might qualify as rich through employment income. However in some or many of these cases there is no pension and so the income cannot be relied on for life.

Some top entertainers and sports stars certainly earn incomes that would qualify them as being rich in most people’s eyes. But some of these careers are short-lived.

Getting rich from owning and controlling a business

Some business owners would qualify as being rich. These people don’t make up a large percentage of the population. Still, there are many thousands of people who own businesses that produce large incomes for the owners and that will continue to do so, perhaps indefinitely. These would include some of the owners of the more successful franchise businesses, especially those who own multiple locations.
Also included might be owners of large car dealerships and industrial dealerships. At the very top end are the controlling owners of the largest businesses in the country.

Getting rich (slowly) through saving and investing

It may be that very few of the world’s ultra rich got that way through saving and investing. But certainly many moderately rich people got that way through saving and investing.

For most people this is likely the best way to get rich. Most people are simply never going to earn employment income sufficient to be considered rich from that income alone. And there are many barriers to getting into business and most people are never going to own their own business and also the vast majority of business owners remain small business owners and do not become rich (although that depends on your definition of rich).

I contend that over a lifetime it is quite feasible to become rich through saving and investing.

Over periods of 30 years the U.S. stock market has never failed to return an annual return of at least 4% over inflation and very seldom has it been under 5% and it has been above 6% (as a compounded average over the full 30 years) about 75% of the possible 30 calendar year periods since 1926.

So let’s assume that you can make 5% on investments over and above inflation.

How does money then grow?

A $10,000 one-time investment would grow as follows:

Start – $10,000

Year 5 – $12,763

Year 10 – $16,289

Year 15 – $20,789 (doubled in 15 years)

Year 20 – $26,533

Year 25 – $33,864

Year 30 – $43,219 (more than quadrupled in 30 years)

Year 35 – $55,160

Year 40 – $70,400

Year 45 – $89, 850

Year 50 – $114,674 (more than a 1000% gain in 50 years, and this is after inflation)

In reality we can’t know what return we will get from investing. But the above illustrates that the rewards of investing eventually become very large over the decades.

I believe that a realistic goal for a young person would be to eventually build up financial assets that will produce an income similar to his or her wages from working. This would allow the person to eventually retire. To be free of the need to work. This could be defined as financial independence. It’s not an easy task. But it is a goal that the data suggests is achievable.

END

Shawn Allen, CFA, CMA. MBA, P.Eng.
President, InvestorsFriend Inc.

April 6, 2014

Who Gets the Spoils of the Economy?

A modern economy produces an amazing abundance of products and services. Modern grocery stores are filled with a mind-boggling abundance. A Costco store contains a stunning array of high quality goods. Car dealerships are filled with enticing products. Modern homes are comfortable and often have as many washrooms as people. Entertainment is abundant. Communications services are instant, reliable and ubiquitous.

But all of this great abundance is neither created equally nor shared equally.

How is the abundance shared?

In economics, it is recognized that the economy must pay both the wages of labor
and the wages of capital.

A good deal of what the economy produces can be purchased by people in proportion to their incomes from working or their incomes from social programs. This is the share of the economy that goes to pay the wages of labor.

But a large slice of what is produced can be purchased by people in proportion to their incomes from owning shares in businesses or from interest on lending money to businesses and individuals. This is the share of the economy that goes to pay the wages of capital. Sadly, most people have no income from this category because they own little or productive capital.

An example of the wages of labor versus the wages of capital

A farm needs land, labor, machinery and supplies to produce food. If the farmer owns and supplies everything then he or she rightly is entitled to all of the income that the farm produces. But what if there is a tenant farmer who supplies only labor and perhaps also purchases the supplies (seeds fertilizer). Few people would argue that the tenant farmer should then receive all of the income.The owner of the land and machinery should also receive a share of the income.

One could argue endlessly about how the income of a farm should be shared between the owner of the land and the tenant farmer. In modern economies the sharing “formula” get set by the market and in part by government taxation policies.

The price that a tenant farmer has to pay to rent farmland depends on the relative supply and demand of farmland. And the total price received for the crops or other farm production gets set largely by supply and demand.

Governments have an impact as well as they set tax rates for the tenants farmer’s rental income and the land owner’s rent income and the land owner’s gain in land value (usually no tax until the land is sold and then the gain is taxed at half the rate of rent and farm income).

Observations and conclusions

A key observation is that in a modern economy a significant share of the income of the economy is always going to go to the owners of land, machinery and businesses.
That is, a share of the income of the economy is always going to go to the owners of productive capital. This being the case it occurs to me that the logical thing to do is to become an owner of productive capacity.

Individuals should attempt to save some of their income and invest it and become owners of productive capital. Eventually the ownership of productive capital can provide an income larger than a typical income from employment.

In effect the choice is to remain forever the tenant farmer or to take steps to eventually become the land owner.

A strategy of becoming an owner of productive capital can apply not only to individuals but to families on a multi-generational basis.

For most people the easiest route to becoming an owner of productive capital is through the stock market. It typically takes decades but it can be done.

Many people don’t like the fact that the owners of productive capital receive such a large share of the spoils of the economy. Some people continue to complain, others work to become owners of productive capital.

Each of us must choose.

END

Shawn Allen, CFA, CMA. MBA, P.Eng.
President, InvestorsFriend Inc.
April 6, 2014

Updated March 4, 2025 with the latest data

This article shows you Canada’s GDP by industry, Canada’s exports and imports by product segment and importantly, Canada’s NET exports by product category. Believe me, it’s an eye opener! 

Which industries contribute the most to Canada’s economy? In terms of Gross Domestic Product (GDP) what are the percentages from oil and gas, real estate, construction, government services, forestry, farming, financial services and manufacturing etc.? The answers below might surprise or even shock you.

What portion of Canadian GDP do imports and exports make up? What products does Canada Import and Export? Which countries, other than the United States, are important trading partners of Canada? What products is Canada a net exporter of and what is it a net importer of? The sometimes surprising answers are provided below in a brief and graphical format.

Firstly, what is the meaning of GDP?

GDP or Gross Domestic Product refers to the total dollar value of recorded economic production within a country. It measures the final value of all goods and services produced. The GDP of a particular industry is (roughly) the value of its sales minus the costs of goods or services purchased from other entities. The GDP of a particular industry measures the economic activity directly generated by that industry. The GDP of a particular industry is not a measure of its profit or value added since it does not deduct the cost of labour from the value of sales nor does it deduct the cost of capital including interest payments on debt.

GDP is often criticized because it does not include the value of unpaid work or of unreported economic activities such as the “underground economy” or the value of “do-it-yourself” labour. Nevertheless, GDP is the best available figure for use in understanding the economy and the relative importance of each industry to the economy. There is one strange exception to the rule of not including unpaid and unreported economic activities. GDP includes a significant amount for the “imputed” rental value of owner-occupied houses.

What is Canada’s GDP by industry or sector?

As of Q4 2024, Canada’s reported GDP per year, in 2024 dollars, was running at $3.135 trillion or $3,135 billion per year.

The following chart shows the percentage contribution of the various goods and services sectors to the total as of December 2024. Note however that this is based on something Statistics Canada calls 2017 chained dollars, which (I understand) basically assumes that there were no relative price changes among the sectors since 2017. I would prefer to use current dollars. However, for complicated reasons, Statistics Canada produces figures on GDP by industry in current dollars only on a three year lag basis. Chained dollars do a good job of measuring changes in volume or activity over time but may distort the relative contributions by segment in today’s dollars. This may be particularly true for commodity industries where price changes can be far different than the overall inflation level.

Data Source: Statistics Canada

Quarterly GDP by Industry

https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=3610043403

The figures show that “Real estate and rental and leasing” is the largest segment of Canada’s economy at 13.2% of the total. This category (strangely) includes the “imputed” rental value of owner-occupied homes and that explains why this component is so very large. A large component here is the renting / leasing of real estate but it also includes auto and equipment leasing. Most retailers and office users rent their space. This category includes real estate brokers. Note that this category does not include constructing real estate! The high percentage related to the use of real estate (plus auto and equipment leasing) may seem high. But it includes the imputed rental value of owner occupied homes.

Manufacturing, while it may be lower than in years past, is still a very large portion of GDP and is the second largest component at 9.6%. Note that manufacturing includes process industries such as oil refineries, pulp mills and chemical plants.

Surprisingly, mining, quarrying, and oil and gas extraction has fallen down to the tenth largest item at 5.3% of total GDP. It would rank significantly higher than that in current dollars as opposed to 2017 chained dollars. The mining, quarrying and oil and gas extraction segment would rank higher in current dollars since oil prices were considerably higher in 2023 versus 2017.

Review the rest of the chart to see the composition of the Canadian economy and the percent contribution of different segments.

In total, goods-producing industries contributed for 26% of Canada’s GDP while service-producing industries contributed 74% of GDP. The public sector (which would be mostly or almost entirely service-producing) contributed 21% of the total GDP.

See the link to the source data just above to see the raw data if desired.

Who Consumes Canada’s GDP?
Canada’s 2023 GDP was consumed in the following fashion: (Q3 figures seasonally adjusted at annual rate)

Personal Household consumption:                            59%
Government consumption:                                         22%
Investment in non-residential structures                  8.5%
Investment in residential buildings                            6.5%
Investment in intellectual property and inventory  2%
Government Investment:                                             4%
Net Exports:                                                                   -2%

Total:                                                                                100%

When you hear that consumers “account” for most of Canada’s GDP, that does not mean that businesses account for little. In fact Businesses and (yes) government create the GDP and consumers consume the largest share. Government also consumes a large share but this is done to serve people (those same consumers) for example direct service in the case of education and health care and other direct services and indirect service in the case of police, the court, the army and other government services. This should not be considered surprising or alarming. Why else should things be produced except for consumption? (and for some investment to fuel future consumption).

A surprisingly large 21% of Canada’s GDP is expended on investment in (the creation of) longer lasting assets such as buildings (including houses) and equipment rather than being consumed for immediate gratification. This includes replacing and upgrading worn out buildings and assets which may account for it being so high.

What does Canada Export?

As a country, Canada imports goods and services that amount to $1,029 billion per year or about 33% of GDP. That would not be sustainable unless exports were at a roughly similar level, which, luckily, they are. Exports in 2024 were $999 billion or about 32% of GDP. Total In a sense it can be said that every country that imports things needs to export something to pay for those imports – unless the country collectively is to run down its savings or run up its debts to pay for imports.

Here is a breakdown of Canada’s exports by category:

Data Source: Statistics Canada

Exports and imports of goods and services quarterly (choose current dollars, not chained 2017)

Canada’s largest category of exports by far is energy products at $183 billion or 18% of the total – crude oil is the great majority of this followed by natural gas then refined petroleum products and coal and a minor amount of electricity and nuclear fuel. Commercial services which includes management services, financial services and information services is the second largest category at $125 billion or 12.5% of the total. Metal and non-metallic mineral products is the third biggest export category at $112 billion or 11%. Consumer goods, perhaps surprisingly, is fourth largest at $97 billion or 10% of the total. Motor vehicles have declined to the fifth largest export segment at $93 billion or 9% of total exports.

Canada has a reputation for exporting relatively unprocessed natural resources. That is certainly true in regards to oil and metal and mineral ores. But most of Canada’s exports are not raw materials. For example, under forestry products, raw logs represent only 1% of that category.

To Which Countries Does Canada Export to (Excludes Services)?

The answer to that question is alarming especially in light of the current tariff war:

 

Data Source, Statistics Canada

International merchandise trade for all countries and by principal trading partners, quarterly seasonally adjusted (multiply by four to annualise).
http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/gblec02a-eng.htm (monthly)

Note that our data source does not include services in the exports-by-country data.

The United States accounted for the great majority of Canadian goods (merchandise) exports at $604 billion or a staggering 75% of the total. (Our figures are based on Q4 seasonally adjusted and annualized.)  The European Union collectively is the second largest export destination at $39 billion or 5% of the total. The U.K. and China at about $32 billion each represent about 4% of the total. Mexico, despite its proximity imports only about $9 billion annually of goods from Canada or 1% of Canada’s total exports.

Things may be changing and China is an important  “customer” country for Canada. But the fact is, for now, when it comes to Canadian exports, the United States remains our number one export destination by far. Mexico, despite its proximity accounts for only $9 billion annually or 1.2%. Canada’s exports to all but a tiny handful of countries are almost insignificant. Treating the European Union collectively, you can literally count all of Canada’s important trading destination countries on the fingers of one hand. The extent of the reliance on exports to the U.S. is sobering and, given their increasing “America-First” rhetoric and policies, alarming.

What Does Canada Import?

Canadian Imports by Category:

In 2023 Canada’s imports of goods and services at $946 billion were about 33% as large as its GDP.

The following chart shows imports by industry segment as a percentage of total goods and services imports.

Data Source: Statistics Canada
https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=1210013401

The data indicates that consumer goods are Canada’s largest import category at $166 billion or 17% of the total. Motor vehicles and parts at $142 billion constituted 14.5% of total goods and services imports. Commercial services constitutes $120 billion or 12% of the total.

Exports and imports of goods and services quarterly (choose current dollars, not chained 2017, and choose imports)

From Which Countries Does Canada Import Goods?

Data Source, Statistics Canada

International merchandise trade for all countries and by principal trading partners, quarterly seasonally adjusted (multiply by four to annualise).

Note that our data source does not include services in the imports-by-country data.

The United States accounts for $499 billion or 62% of Canada’s annual goods imports. The European Union collectively accounts for $73 billion or 9%. China accounts for $62 billion or just 8% of the total.  Mexico accounts for for $31 billion or 4%% and the U.K for $10 billion or  just 1%. The remaining $130 billion or 16% is spread widely around the globe. Most of the other countries in the world are insignificant to Canada in terms of imports. But there may be some countries from which Canada imports more than Mexico and certainly the U.K. This is the way our data source breaks down the countries.

For Which Products and Services is Canada a Net Exporter and For Which a Net Importer?

Energy – largely crude oil – is Canada’s largest NET export (exports minus imports) at $144 billion. And it’s “no contest”. That’s 3.4 times larger than the next highest net export category which is “metal and non-metallic mineral products”  – which includes steel and aluminum products at $45 billion. Oil is “bringing home the bacon” to this country and in a sense provides the dollars to pay for the things that Canada imports. Metal products, farm, fishing and intermediate food as well as forestry also bring home some bacon to this country.

Canada is a net exporter of commodities including notably energy products, metal & mineral products, farm, fishing & intermediate food products, and forestry products.

Canada is a net importer in most manufactured and finished goods categories including consumer goods, motor vehicles & parts, industrial machinery, and electronic & electrical equipment. Given all the support to that industry, it might be a surprise to see that motor vehicles are a large net IMPORT category for Canada.

Canadians don’t actually operate as one giant sort of “team”. But it can be argued or observed from this data that, for the country as a whole, the net exports of energy (oil) in particular and to a lesser extent other commodity products are what pay the bills to allow the country to be very much a net importer of consumer and manufactured goods.

The net contribution or surplus on energy products (mostly oil) is staggeringly large as indicated in the chart just above.

END
Shawn Allen, CFA, CPA, MBA, P.Eng.
President, InvestorsFriend Inc.
Article originally created November 3, 2007, the latest annual update was March 4, 2025.

Send any questions about this article to shawn@investorsfriend.com

Economic theory suggests that abnormally high returns on equity or ROEs cannot be sustained in the face of competition. Reality however, begs to disagree.

The ROE of the Dow Jones Industrial Average

Recent data from Dow Jones indicates that the average P/E ratio of the 30 companies in the Dow Jones Industrial Average was 16.63 as of November 30, 2013. And the Price to Book Value ratio was 3.01.

The ROE of the DOW can be calculated from the above using the following formula.

ROE =earnings/equity = price/book equity divided by price/earnings.

Therefore the DOW ROE is 3.01/16.63 = 0.181 = 18.1%.

In a world where short term interest rates are close to 0% and a 30-year US. government bond earns 3.9%, an 18.1% ROE is a staggeringly high return. And this is no anomaly, the ROE on the DOW has been at similar levels for many years. Below I will discuss some possible reasons for this high ROE.

The ROE of Selected large Companies

Here are the recent ROEs, as well as P/B and P/E data, of some (mostly) large companies:

Company	ROE	P/B	P/E.
Canadian National Railway Company (CNR, Toronto CNI, New York)	22%	4.4	20.2
Canadian Western Bank (CWB, Toronto)	13%	2.2	17.4
Stantec Inc. (STN, Toronto)	18%	3.7	20.2
Canadian Tire (CTC.a, TO)	11%	1.6	14.6
MELCOR DEVELOPMENTS LTD. (MRD, Toronto)	8%	0.9	11.0
Alimentation Couche-Tard Inc., ATD.B	20%	3.9	19.3
FIRSTSERVICE CORPORATION (FSV, Toronto) (FSRV, NASDAQ)	21%	6.2	27.4
Wal-Mart (WMT, New York)	23%	3.5	15.1
FedEx (FDX,NY)	11%	2.6	23.0
Microsoft (MSFT, NASDAQ)	33%	4.6	13.8
Berkshire Hathaway Inc. (BRKB, New York)	7%	1.4	20.6
Boston Pizza Royalties Income Fund (BPF.un, Toronto)	13%	2.1	16.9
Costco (COST, N)	18%	4.7	25.6
Wells Fargo (WFC, United States)	14%	1.6	12.0
Toll Brothers Inc. (TOL, New York)	5%	2.0	38.4
RioCan Real Estate Investment Trust (REI.UN, Toronto)	7%	1.1	15.6
Bank of America Corporation (BAC, New York)	3%	0.8	24.1
Dollarama Inc. (DOL, Toronto)	27%	6.9	26.3
VISA (V)	18%	5.3	29.8
Constellation Software Inc. (CSU, Toronto)	73%	18.3	25.2
Liquor Stores N.A. Ltd. (LIQ, Toronto)	7%	1.0	15.4
eBay (eBay, NASDAQ)	13%	3.2	24.1

This table shows a few companies with low ROEs, however many of them are very high. Unfortunately the companies with high ROEs also tend to have prices that are high multiples of book value.

How do Some Companies Sustain High ROEs?

Since competition is supposed to prevent abnormally high ROEs, the usual way to sustain a high ROE is to avoid intense price-based competition.

Some companies avoid competition by producing unique products that are protected by patents or intellectual property laws.

Some companies avoid intense price-based competition simply because existing customers find it quite inconvenient to switch to another provider. This may be the case in basic banking services. cell phone service and in software.

Some companies avoid intense price-based competition through the power of brand loyalty. This includes Coke and Starbucks.

Some companies achieve a high ROE in spite of facing intense price-based competition. This can be done by being the low cost producer. This includes Costco and probably some commodity producers. Sometimes the largest company in an industry achieves economies of scale that others cannot achieve.

One possible explanation for the high ROEs of large established companies is that they have land, buildings, factories, know how and other assets that are on their “books” at a fraction of the price that new competitors would have to pay to obtain similar assets. This is certainly part of the explanation. However, it appears that large companies are also making relatively high return on equities on new investments. Consider that a company making an 18% return on equity and dividending out half of its earnings is retaining and reinvesting 9% of equity each year which will double its book equity in just eight years and quadruple its book equity in sixteen years. These large companies could not sustain high ROEs for very many years unless they were also making high ROEs on reinvested earnings.

It appears that large companies have often found ways to protect themselves from intense price-based competition and are therefore able to sustain high ROEs.

Wise investors will focus their investments on such companies.

END

Shawn C. Allen, CFA, CMA, MBA, P.Eng.

President, InvestorsFriendInc.

January 5, 2014

Here are some of our related articles regarding ROE

How To Pick Stocks Using Return On Equity

The Incredible Importance of a High Return On Equity