Productive assets – businesses, residential real estate, etc. – beat debt over the long term. This claim is not at all controversial, and I do not suspect that anyone would disagree that, over long periods of time, the total return from productive assets beats debt investments.
I won’t get any hate mail for saying that stocks beat bonds. Or that real estate tends to beat mortgage-backed securities.
Finding the “Why”
The question that is more deserving of an answer than any always begins with “why,” never “who,” “what,” or “how.” Remember that.
Let’s first define the incredible power of earnings in perpetuity. Suppose you own a piece of real estate or a business with $1 in revenues and $.80 of operating costs. Thus, your profits are $.20 in year one. Over time, we’ll assume an annual rate of inflation in both the revenues to the firm, as well as operating costs of 3% per year.
In year 1, revenues are $1, costs are $.80, and operating profits are $.20. In year 20, revenues are $1.75, costs are $1.40, and profits are $.35. Conveniently, so long as your productive assets are used in a business which has pricing power (one that can increase prices at an exponential rate greater than or equal to the exponential growth in its own costs; the rate of inflation) you never lose to inflation.
That is to say that in year 1 you’ll earn $.20. In year 20, you’ll earn $.35. The $.35 of earnings in year 20, when adjusted for inflation, is exactly equal to $.20 in year 1.
This concept is so simple, yet one that investors love to ignore. Any time you invest in a business with pricing power, you can expect very good positive long-run returns.
Productive Asset Protection
Suppose that in year 0 you purchased your productive asset for $2. In effect, you receive a 10% yield on your investment, as you earn $.20 in year 1. You also receive a 10% net yield in perpetuity – forever. That $2 investment will earn you $.20 in year 1, $.206 in year two, and on and on.
Let’s say the market prices this investment at 10x owner earnings. Therefore, you would have paid $2 in year 0 for your productive assets. In year 20, you’re ready to sell. The productive assets generate you $.35 in profits, and at the same price-earnings multiple, you can sell your holdings for $3.50 in nominal value. Discounted back 20 years at 3%, $3.50 is equal to the purchasing power of $2 at the time you purchased the assets 20 years earlier.
Notice the relationship between revenues, costs, and asset valuation. Your revenues and costs increase at a constant rate of 3% annually, and naturally so do your profits. As your profits rise at a rate of 3% per year, the value of these assets also increases at a 3% clip.
Assuming you receive the same price to earnings rate at the time of sale that you paid at the time of purchase, you can sell your business at any point along the curve at a price consistent with your original investment plus inflation during the period.
Compare this to debt
Compare this example to debt. Let’s suppose that instead of taking the “riskier” business, you purchase a bond yielding 6% for 20 years, and invest $2. You receive a series of $.12 cash flows per year for 20 years until your principal investment of $2 is returned to you 20 years from today.
At no point are these cash flows increased to account for inflation. Thus, each cash flow has less and less value in terms of purchasing power. In year 20, you’ll receive your $2 back, but that $2 will only buy what $1.04 would have purchased in year 0. You’ve lost considerably in terms of purchasing power while accepting a much lower yield on your investment.
Also, every single cash flow during that 20 year period is depreciated by inflation.
Thanks for the 8th Grade Algebra Lesson, JT
But really, find me an eighth grader that can do algebra and we can turn him into a successful investor. Warren Buffett speaks simply when he does, but what concept do you think Warren wants to convey when he says, “Time is the friend of the wonderful company, the enemy of the mediocre?”
He’s not talking about Time Magazine. Nor is he talking about how awesome offices look after 80 years of wear and tear. He’s talking about wonderful companies – companies with pricing power. That’s the differentiator. Companies that can pass on rising costs over the long term do very well. Companies that can increase costs at a rate faster than their own costs do spectacularly well.
(This concept is found implicitly in the very first few pages of Security Analysis. If I weren’t such a firm believer in the merits of free speech, I’d embrace making it required reading for a license to speak on the topic of financial markets.)
Coca-Cola is an example of a fantastic Berkshire Hathaway investment. Over time, the amount of effort required to produce Coca-Cola has only gone down while amount people willing to pay for Coke has only gone up. Not only has Coca-Cola increased prices faster than its own costs over its storied history, it’s also introduced its product to more customers.
Here’s Coca-Cola’s profit margin over the last 10 years:
The only way Coke’s profit margin could stay virtually the same over the last 10 years is if Coca-Cola could pass increasing costs to consumers. Over the long-haul, it has done just that. Coke products have only gotten more expensive since 2002, yet it continues to sell relatively more and more soda and other beverage products each year. In 2002, the company sold $20 billion worth of product. In 2011, it sold $46 billion worth.
Coke products are not 2.3 times more expensive today than in 2002, so much of the increased revenues are due to volume. However, Coke’s margin (the difference between revenues and costs) is held nearly constant because Coke has pricing power. It costs more to produce Coke products today than it did in 2002. However, Coke products sell for more today than in 2002.
You see, sugar water is not at all more difficult to make today than it was years ago. In fact, the power of technology makes it easier every day. And technology also makes it possible for people in India, China, wherever to earn more money – and use the surplus on tasty treats like a can of Coca-Cola.
It’s Pricing Power
Buffett’s a kingpin at finding companies with pricing power and growth. It’s a magical combination. But let’s focus on no-growth companies. We’ll take out Buffett’s magic pixie dust from the equation.
I mean, look at it this way – you can buy a stock with an earnings yield of 10%, essentially making you $1 for every $10 you invest. Or you can buy a bond with a yield of 6% from the same company, essentially making you $.60 for every $10 you invest.
Provided the company in which you purchase equity or debt has pricing power, equity is always the better option. Always.
In the event the company in which you invest does not grow by even a single customer account, its ability to pass on inflationary pressures protects your original investment from the effects of inflation. Bonds have no such inflationary insulation.
Therefore, bonds expose you to inflationary risks while providing you a lower return, 6% vs. 10% in this case, for accepting higher inflationary risk. Hence why productive assets (businesses, real estate, whatever) will outperform an investment in debt instruments over the long-haul. The only complication is finding businesses with pricing power, but I’ll hit on that in another post at a later time.
That, too, is less difficult than you might think. (It goes back to the basic premise outlined in my comparison between restaurants and stock selection.)