I’ve begun re-reading Berkshire Hathaway’s historic letters to shareholders.  In the letters from the late 1970’s / early 80’s, Buffett spends a lot of time describing the increasing ‘hurdle rate’ investors should demand due to the rampant inflation of the time period.  It is hard to believe, but annual CPI inflation reached above 16% here in the United States in the early ’80’s.  Berkshire’s book value was increasing nicely in this period, but Buffett reminded investors they must account for inflation and taxes. The return of a taxable investment (ie. stocks, corporate bonds) must beat the inflation rate experienced during the holding period in order for the investor’s pricing power to have increased. And its not just inflation investors must account for. Investment returns are eaten up by taxes as well. Buffett referred to this combined “Misery Index” of inflation and investment taxes as the minimum ‘hurdle rate’ of return an investor should seek.

High rates of inflation create a tax on capital that makes
much corporate investment unwise – at least if measured by the
criterion of a positive real investment return to owners. This
“hurdle rate” the return on equity that must be achieved by a
corporation in order to produce any real return for its
individual owners – has increased dramatically in recent years.

…For only gains in purchasing power represent real earnings on investment.
If you (a) forego ten hamburgers to purchase an investment; (b)
receive dividends which, after tax, buy two hamburgers; and (c)
receive, upon sale of your holdings, after-tax proceeds that will
buy eight hamburgers, then (d) you have had no real income from
your investment, no matter how much it appreciated in dollars.
You may feel richer, but you won’t eat richer.

…For example, in a world of 12% inflation a business earning
20% on equity (which very few manage consistently to do) and
distributing it all to individuals in the 50% bracket is chewing
up their real capital, not enhancing it. (Half of the 20% will go
for income tax; the remaining 10% leaves the owners of the
business with only 98% of the purchasing power they possessed at
the start of the year – even though they have not spent a penny
of their “earnings”).

Warren Buffett, 1980 Letter To Shareholders,

Buffett even compared Berkshire’s return against the return received from gold and oil.  During this time he often referred to the return an investor could receive from tax-free muni bonds as well. From the 1981 Letter:

During the past year, long-term taxable bond yields exceeded
16% and long-term tax-exempts 14%. The total return achieved
from such tax-exempts, of course, goes directly into the pocket
of the individual owner. Meanwhile, American business is
producing earnings of only about 14% on equity. And this 14%
will be substantially reduced by taxation before it can be banked
by the individual owner. The extent of such shrinkage depends
upon the dividend policy of the corporation and the tax rates
applicable to the investor.

Thus, with interest rates on passive investments at late
1981 levels, a typical American business is no longer worth one
hundred cents on the dollar to owners who are individuals. (If
the business is owned by pension funds or other tax-exempt
investors, the arithmetic, although still unenticing, changes
substantially for the better.) Assume an investor in a 50% tax
bracket; if our typical company pays out all earnings, the income
return to the investor will be equivalent to that from a 7% tax-
exempt bond.

Warren Buffett is often asked at Berkshire’s annual shareholder meeting what is the rate of return (hurdle rate) he seeks when investing in stocks.  I’ve found several references to 13% (early 2000’s) and 15% (mid-90’s).  On reading his letters, I propose that Buffett’s thinking along these lines is:

Minimum Hurdle Rate on taxable investments = (Inflation rate) + (Yield on long-term tax-free muni bonds)/(1-Cap. gains tax rate) + (Equity Risk Premium)

Diving in to each of these:

(Inflation rate):   As Buffett has described, inflation is quite mean-reverting.  I think Buffett would actually use the average of ‘current inflation rate’ and ‘long-term average inflation rate’.  In a late 1990’s Fortune article Buffett described inflation as mean-reverting and mentioned 4.3% as the long-term rate of inflation.  So the initial equation factor becomes ((Current Inflation) + 4.3%))/2

(Yield on Long-Term Muni Bonds):   Buffett referred to a basket of national Muni bonds as the safer, tax-free alternative to stocks and other bonds.  Muni bonds offer another advantage as well – they have a fairly wide range of credit ratings (ie. AAA to A and lower).  So for an individual stock you are reviewing, you might use the muni yield which has the same credit rating as your stock (ie. AAA rated stock use AAA rated muni bond rate).  National muni bond yields can be found here.

(1- long term Capital Gains tax rate):   This factor ensures the taxes you pay after owning the stock or other taxable investment at least 1 year do not take away from your final purchasing power.  The current capital gains tax rate is either 0%, 15% or 20%, depending on your tax bracket.  For most investors it is 15%, so this factor is 1-0.15 = 0.85

(Equity Risk Premium):   Without an ERP, the equation results in a final return that only matches the yield on long-term tax-free Munis.  Obviously you expect a higher return from stocks vs muni bonds.  I’ve seen ERP estimates from 2% to 6%.  I’ll use an average 4%.

2015 Minimum Hurdle Rate (era of low inflation, low yields, relatively low taxes)

Current Inflation = 1.6%,  Long-term AAA Muni Bond Yields = 2.65%

2015 Hurdle Rate = (1.6% + 4.3%)/2 + 2.65%/0.85 + 4.0% = 10%

1981 Minimum Hurdle Rate (era of high inflation, high yields, higher taxes)

Inflation = 16%, AAA Muni Yield = 14%, Capital Gains tax rate = 20%

1981 Hurdle Rate = (16% + 4.3%)/2 + 14%/0.80 + 4.0% = 31.7%

Quite the difference.  1981 was of course a historically high era in the U.S. for inflation.  And taxes were higher as well. 

How to Use This Equation:

Buffett was referring to the necessary minimum Return on Equity (ROE) of stocks he was evaluating for investment. I believe the equation can also be used for inputs into stock Discounted Cash Flow (DCF) calculations.  So right now you might use a 10% discount rate.  Then when inflation returns and other rates respond by rising, just remember to adjust your requirements higher.

Investment Rules by Warren Buffett

Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1

Ben Graham wanted everything to be a quantitative bargain. I want it to be a quantitative bargain in terms of future streams of cash. My guess is the last big time to do it Ben’s way was in ’73 or’74, when you could have done it quite easily. I (Warren Buffett) am willing to pay more for a good business and for good management than I would 20 years ago. Ben tended to look at the statistics alone. I’ve looked more and more at the intangibles.

The market is there only as a reference point to see if anybody is offering to do anything foolish. When we (Warren Buffett & Charlie Munger) invest in stocks, we invest in businesses.

I (Warren Buffett) consider there to be three basic ideas, ideas that if they are really ground into your intellectual framework, I don’t see how you could help but do reasonably well in stocks. None of them are complicated. None of them take mathematical talent or anything of the sort. [Graham] said you should look at stocks as small pieces of the business. Look at [market] fluctuations as your friend rather than your enemy — profit from folly rather than participate in it. And in [the last chapter of The Intelligent Investor ], he said the three most important words of investing: ‘ margin of safety.’I think those ideas, 100 years from now, will still be regarded as the three cornerstones of sound investing.

The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation or pays no income taxes during years of 5 percent inflation. Either way, she is ‘ taxed’in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax but doesn’t seem to notice that 5 percent inflation is the economic equivalent.

If we (Warren Buffett & Charlie Munger) find a company we like, the level of the market will not really impact our decisions. We will decide company by company. We spend essentially no time thinking about macroeconomic factors. In other words, if somebody handed us a prediction by the most revered intellectual on the subject, with figures for unemployment or interest rates or whatever it might be for the next two years, we would not pay any attention to it. We simply try to focus on businesses that we think we understand and where we like the price and management. If we see anything that relates to what’s going to happen in Congress, we don’t even read it. We just don’t think it’s helpful to have a view on these matters.

Ben Graham wasn’t about brilliant investments and he wasn’t about fads or fashion. He was about sound investing, and I think sound investing can make you very wealthy if you’re not in too big of a hurry. And it never makes you poor, which is better.

(On wny Ben Graham’s theories have seldom been included in college curriculums) It is not difficult enough. So, instead, something is taught that is difficult but not useful. The business schools reward complex behavior more than simple behavior, but simple behavior is more effective.

We (Warren Buffett & Charlie Munger) have no idea how long the excesses will last, nor do we know what will change the attitudes of the government, lender, and buyer that fuel them. But we know that the less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

When I (Warren Buffett) worked for Graham – Newman, I (Warren Buffett) asked Ben Graham, who then was my boss, about that. He just shrugged and replied that the market always eventually does. He was right: In the short run, the market is a voting machine; but in the long run, it’s a weighing machine.

The fact that people will be full of greed, fear, or folly is predictable. The sequence is not predictable.

The market, like the Lord, helps those who help themselves.

John Maynard Keynes essentially said, Don’t try to figure out what the market is doing. Figure out a business you understand, and concentrate.

For some reason, people take their cues from price action rather than from values. What doesn’t work is when you start doing things that you don’t understand or because they worked last week for somebody else. The dumbest reason in the world to buy a stock is because it’s going up.

The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long – term values.

There is no formula to figure out intrinsic value. You have to know the business, whose stock you are considering buying.

Valuing a business is part art and part science.

A stock doesn’t have to be rock bottom to buy it. It has to be selling for less than you think the value of the business is, and it has to be run by honest and able people. But if you can buy into a business for less than it’s worth today, and you’re confident of the management, and you buy into a group of businesses like that, you’re going to make money.

Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.

You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Rationality is essential.

We (Warren Buffett & Charlie Munger) like stocks that generate high returns on invested capital where there is a strong likelihood that it will continue to do so. For example, the last time we bought Coca – Cola, it was selling at about 23 times earnings. Using our purchase price and today’s earnings, that makes it about 5 times earnings. It’s really the interaction of capital employed, the return on that capital, and future capital generated versus the purchase price today.

If the business does well, the stock eventually follows.

As long as a business can make an annual 15 percent return on equity, I (Warren Buffett) don’t worry about one quarter’s results.

Pension fund managers continue to make investment decisions with their eyes firmly fixed on the rearview mirror. This general fight – the – last – war approach has proven costly in the past and will likely prove equally costly this time around.

Of course, the investor of today does not profit from yesterday’s growth.

I  (Warren Buffett) put heavy weight on certainty .

If you do that (i.e. go by certainty), the whole idea of a risk factor doesn’t make any sense to me. You don’t do it where you take a significant risk. But it’s not risky to buy securities at a fraction of what they’re worth.

Risk comes from not knowing what you are doing.

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Isaac’s talents didn’t extend to investing. He lost a bundle in the South Sea Bubble, explaining later, ‘ I can calculate the movement of the stars, but not the madness of men.’If he had not been traumatized by the loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.

The propensity to gamble is always increased by a large prize versus a small entry fee, no matter how poor the true odds may be. That’s why Las Vegas casinos advertise big jackpots and why state lotteries headline big prizes.

We do not need more people gambling on the non-essential instruments identified with the stock market in the country, nor brokers who encourage them to do so. What we need are investors and advisers who look at the long – term prospects for an enterprise and invest accordingly. We need the intelligent commitment of invest ment capital, not leveraged market wagers. The propensity to operate in the intelligent, prosocial sectors of capital markets is deterred, not enhanced, by an active and exciting casino operating in somewhat the same arena, utilizing somewhat similar language, and serviced by the same workforce.

Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised.

It’s only when the tide goes out that you learn who’s been swimming naked.

We (Warren Buffett & Charlie Munger) look at the arbitrage deal, once something is announced. We look at what they’ve announced, what we think it will be worth, what we will have to pay, how long we’re going to be in. We try to calculate the probability it will go through. That is the calculation: the name [of the companies involved] doesn’t make much difference.

Never ask the barber if you need a haircut. (about asking brokers on stock recommendation)

You should have a knowledge of how business operates and the language of business [accounting], some enthusiasm for the subject, and qualities of temperament, which may be more important than IQ points. These will enable you to think independently and to avoid various forms of mass hysteria that infect the investment markets from time to time.

(Understanding the fundamentals of accounting) When managers want to get across the facts of the business to you, it can be done within the rules of accounting. Unfortunately, when they want to play games, at least in some industries, it can also be done within the rules of accounting. If you can’t recognize the differences, you shouldn’t be in the equity – picking business.

Investment must be rational; if you can’t understand it, don’t do it.

Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times.

I (Warren Buffett) would take one industry at a time and develop some expertise in half a dozen. I would not take the conventional wisdom now about any industries as meaning a damn thing. I would try to think it through.

If I (Warren Buffett) were looking at an insurance company or a paper company, I would put myself in the frame of mind that I had just inherited that company and it was the only asset my family was ever going to own. What would I do with it? What am I thinking about? What am I worried about? Who are my competitors? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus other ones. If you’ve done that, you may understand the business better than the management.

Anybody who tells you they can value, you know, all the stocks in Value Live and on the board must have a very inflated idea of their own ability because it’s not that easy. But if you spend your time focusing on some industries, you’ll learn a lot about valuation.

Our principles are valid when applied to technology stocks, but we don’t know how to do it. If we are going to lose your money, we want to be able to get up here next year and explain how we did it. I’m sure Bill Gates would apply the same principles. He understands technology the way I understand Coca – Cola or Gillette. I’m sure he looks for a margin of safety. I’m sure he would approach it like he was owning a business and not just a stock. So our principles can work for any technology. We just aren’t the ones to do it. If we can’t find things within our circle of competence, we won’t expand the circle. We’ll wait.

I (Warren Buffett) read annual reports of the company I’m looking at, and I read the annual reports of the competitors — that is the main source of material. If you have to go through too much investigation, some thing is wrong.

I  (Warren Buffett) can’t be involved in 50 or 75 things. That’s a Noah’s Ark way of investing — you end up with a zoo that way. I like to put meaningful amounts of money in a few things.

If calculus were required, I  (Warren Buffett) would have to go back to delivering papers. I’ve never seen any need for algebra. Essentially, you’re trying to figure out the value of a business. It’s true that you have to divide by the number of shares outstanding, so division is required. If you were going out to buy a farm or an apartment house or a dry cleaning establishment, I really don’t think you’d have to take someone along to do calculus. Whether you made the right purchase or not would depend on the future earning ability of that enterprise, and then relating that to the price you are being asked for the asset.

Read Ben Graham and Phil Fisher, read annual reports, but don’t do equations with Greek letters in them.