FORTUNE May 1977 How Inflation Swindles the Equity Investor by Warren E. Busjett Reprintes through the courtesy af the Edtiors af FO} 1977 TIME INC.Reprinted from FORTUNE’S WHEEL How Inflation Swindles the Equity Investor ‘The future for stocks looks bleak to fone large vestor who has interests in over thirly corporations. The reaxon, says Warren Buffett, is that corporate earnings on shareholders? equity have Temaitied stuck at about 12 percent over the whole postwar peried, Back in the low-inflation years of the 1950's and early 1960's, that return towered overthe interest rates on honds, ‘and millions of lucky investors enjoyed market apprveiation as well. But bond yields have riven sharply since then to {ake account of inflation, while compa nies scem unable to improve on that 12 ‘pervent stock “coupon.” Buffett nevertheless believes that stocks are probably still the best of all the poor alternatives in un era of infla- tion-—at least, if you buy in at appto- priate prices.”-The'central problem in the stock market is that the return ‘on capital hasn't risen with inflation. It seems to be stuck at 12 percent. How Inflation Swindles the | deteriorate wondy iy en payeients, denomineted in, ieee oe ene gone snardlyneed 8. aie ais secu intel " gonvelational wedi fnpinted that stocks wors n hedge against jnslation. The prope partite ented i He fet tak atael ‘beatin’ dollars, op bonds rngiadip of compa edurtive facilities. Thess ‘let many, frvestors, hey, will Inini het the return cna bond _ While’ tho ‘itu ‘(Qe conspany’s ‘eornlnga).-cab’ very: anbatamtially: from, ome your to anather. Trae ennagh. Rut hurt tit hee beer enened x comme nine during the postwar sears. wk diss rover “something extraordinary: the sn equity have th fact moe Yared all “the coupenta icky : ‘Tw the first tan Youre after the war, the duende enditig. 18 1985—the ‘Dow Jones: industrials bad en average nal ratory om yearend lty of IB8 pareant In the second docude, the ‘figure wan 10,1 percent. Ln Uae third decade it, i sya 10.9 percent, Data for toner amle ors, the FORtUNe 500 Cehowe hintmry ines ak. caky Ws the soideADBR, BBL: ‘pate sorneurhaat «frie epniite s 18 per. nt i the decade oie, 3006, 148 ‘gures for i few inet subntantialy. higher Pe gh fr 1» BO iti 14,1 Heke fe 197) an oie 45 poropot TW-AN58 and 200}, Dat ‘over the years, nil in the seni ered this ae boateveie. “Uhr awn eat pare Seefe stodks don't Just buy. and bold. ta ‘tad, any tty to gotwit their fellow ‘Vestons in, ogden 4 macimnize iheir own ‘proportions of worporate: earnings. This ‘theashing: about, obviously. fruitiess. In apurepite, bui-no,irepact bn the. oauity ‘siupon hil retioes the inventors portion OF; poem fg ssevirn subatantial fice Hoa, conte, much a6 advivors foes and peokerage: charges. Theow Jal an active pbiona iaiket, whieh adda nothing 0 she: prodsctivity of Amertenn, wntorrive ‘oat ranstinya w cast of Khounanas 10, man ‘ie capi, and fyietlonwl devin, rise torther: Bs Sloska.acs peipetual ‘ete ang fre: that tn he reed world jnventons sie ly gat: ‘pay. ab book volo, Bamotimes they have ‘jamin abla to bO¥ Se balay bores uonaly awevers thes ve ued fo: phy noe than ‘ric Aan en, tha Raven hore 8 Tortie peanrsceatetteet TP peecebt CL sao thea relacionahtr Iatr. ‘Maaaiiitie: 124K ogan bn Un melo ‘paises an iofotion fine tecveuned, there arnt capita baa ok atential: ‘yj thnsaayaie by aquitien cenalve socutl- eb th nas atariybug. Aad ret — “uN ied oa wh bus donda Of owen, there are sonte important aifterences betiveen’ the bond snd stock forms, For openers, Donde. eventually come dus: ema require a long wait but tevniually the Bota ipventan, eta to Fe- rregatlata the: terra of hie pankract, furrent and prowpaetive eaten of inte tion make tis nid-eoupan tov nade: jueke, he san nedune 6 piay Tarther c> Jers cute eurrentay. being oftered fokindle hie intéront. Rohiething of 0's seat hat beet. going: on it resent. veers Stacha on tha athe hand, are: perpet au, Tho, hve acriabuiihy date of iofin- {ty, Inventonn: Os nfl ar ntl, with whatever rebity carparata Amerion tape to ary. seprate Anvertes Ie dontined:ia dann te patoent, then thet!» the jeveltnpenbors mast; fear to tive with, Am ac ert. mee saiventara ea twithor ont tus. sine Tenagebtnds. In tho amgregate; their commitment is setually increashag. Inifiviivat companiag can be old. or liquidated ‘and. corporations an ‘epuire)avg theix owii share; on belance, however, new equity Hotations, and re ninied warninay wuacactes thet the eavt- ty capital locked up fo, the eorpermte ay4- tom’ will increas. fo; aeove one far Yao bond forms Bond ‘ooupona eventuatly wit!'be renegotiated equity ‘‘eoupony? wont! It i truss of course, that tor # long time «22 percent ‘oupon dle not appar in,need of a whole lot of sorrevtion, ‘The bondholder gate intoxah “There in another asnjor diftersnce be: tnen thacgitdan varieay of bondtand abe new exitie 12 parent *wgaitty bobd” Chet comes ig: the Wall Stebel catanna ball ‘drensod in «-atock certificate. Yu the innit expe, a band. Investor te ceives hie entize coupe im cash. iid fet Yo teinvant ae Seat he sean, OEstock investor's equity coupon, trast, is partially retained by the com pany and is reinvested at whatever rates the company happens to be exrning, In other words, going back to our corporate universe, part of Ue 12 percent earned annually is paid oot in dividends and the balance iy put right back into the universe to earn 12 percent also. The good old days ‘This characteristic Of stocks~the re- investment of part of the coupon—ean be ttood o bad news, depending on the rela- uttyactiveness of that 12 percent The news was very good indeed in the 1950'sand early 1960's. With bonds yield ing only 8 o¥ 4 percent, the right to rex invest automatically @ portion of the eauity coupon at 12 percent was of enor tioua value, Note that investors could not juat invest thelr own money and get that 12 percent return, Stock prices in this period ranged far above book value, and investors were prevented by the premi- lum prices they had lo pay from directly extracting out of the underlying corpo rate universe whatever rato that uni- verse was esrping. You can’t pay far above par for a 12 percent bond and earn 12 percent for yourself. Rut om their retained earnings, inves- wors could earn 12 percent, In effect, ings retention allowed investors to buy at book valun part of an enterpri thal, in the economie environment then existing, was worth a great deal more than book value, Tt was a situation thot left very little lo be said for cash dividends and a lot to be'swid for earnings retention, Indeed, the more money that investors thought likely to be ceinvented at the 12 percent rate, the more valuable they considered their reinvestment privilege, and. the more they were willing to pay for it In the early 1960's, investors eagerly paid topsscale prices tor electri¢ utilities situated in growth areas, knowing that these companies had the ability to rey invest very large proportions of their earnings, UUIities whose operating en- vironment dictated « larger cash payout rated lower prices. If, during this period, « high-grade, noneallable, long-term bond with « 12 pereent coupon had existed, it would have sold far above par, Aud ff it were ® bond with a further unusual character- istie—which was that mont of the coupon. payments could be automatically ree invested at par in similar bonds—the ine sve would have commanded an even Rreator premium. In evsence, growth Stocks retaining most of thelr earnings represented juat such « security. When their reinvestment rate on the added equity capital was 12 percent while in- tereat rates generally were around 4 per+ cent, investors became very happy—and, of eourso, they paid happy prices Heading for the exits Looking back, stock investors can think of themeelves in the 1046.66 peri- od as having been lavtled a truly bountiful, triple dip, First, they were the benefi- ciaries of an underlying corporate re- turn on equity thet was far above pr vailing interest rates. Second, a signif- feont portion of that return was re~ invested for them at rates that were otherwise unattainable, And third, they were afforded an escalating appraisal of underlying equity eapital as the frst two benefits became widely recosmized. This third dip meant thet, on top of the basic 12 percent or ao earned by corporations on their equity capital, investors were reoeiving a bonus as the Dow Jones ine dustrials increased in price from 138 per= tent of book value in 1946 t0 220 percent in 1966, Such « marking-up process tem- porarily allowed investors to acbieve a return that exceeded the inherent carne ing power of the enterprises in which they had invested, ‘This heaver-on-earth situation final- ly was “discovered” in the mid-1960's by many major investing institutions, But just aa these financis! elephants began trampling on one another in their rush to equities, we entered an era of ace calerating infation and higher interest rates, Quite logically, the marking-up process bogan to revorte itself. Rising in terest rates ruthlessly reduced the value of all existing fixed-coupon investments ‘And a long-term corporate bond rates egan moving up (eventually reaching the 10 percent area), both the equity return of 12 percent and the reinvest. ‘ment “privilege” began to look different, ‘Stocks are quite properly thought of a riskier than bonds. While that equity coupon is more or less fixed over periods does fluctuate somewhat from yor to year, Investors’ attitudes about the future can be affected substantially, although frequently erroneously, by those yearly changes, Stocks are also viskier because they come equipped with infinite maturities. (liven your friend. ly broker wouldn't have the nerve to peddle 2 100year bond, if he had any available, as "safe.") Because of the ad- ditional risk, the natural reaction of in vestors is to expect an equity return that is comfortably above the bond re- tur—and 12 percent on equity versus, say, 10 percent on bunds isxued by the seme corporate universe does not seem tw qualify as comfortable, As the spread narrows, equity investors start looking for the exits. But, of course, as a group they can't got out, All they can achieve is a lat of mavemant, substantial frictional costs, ‘and a new, much lower level of valuation, refiecting the lessened attractiveness of the 12 percent equity coupon under inflae tlonary conditions. Bond investors have hhad 2 succession of shocks over the past Aecade in the course of discovering that there is ne magic attached to any given coupon level: st 6 percent, or 8 percent, fr 10 percent, bonds can still enllapse in price. Stock investors, wha ara in gen- feral not aware that they too have a "eou- pon," are still receiving their education fn this point Five ways to improve earnings Mast we really view that 12 percent equity coupon as immutable? Ts there any law that says the corporate return ‘on equity eapital cannot adjust itself up- ward in responso to a permanently high- ‘or average vate of inflation? ‘There is no such law, of course. On the other hand, corporate Americs can: rot inereane earnings by desire or de- cree, To raise that return on equity, eor~ porations would need at least one of the following: (1) an increase in turnover, i.e, in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (8) more leverage:(A) lower ineume taxes; (6) wider op erating margins on sales, “And that’s it, There simply are no other ways to inerease returns on coms mon equity, Let's see what can be done swith thes We'll begin with turnover. The three major categories of avsets we ave to hink abvut for this exercise are Ac- counts yecelvable, iaventories, and fixed assets such a3 plants and machinery. ‘Accounts receivable go up propor: tionally as sales go up, whether the Ine crease in dollar sales is produced by ‘more physieal volume or by inflation. Ne room for improvement here. With inventories, the situation is not quite so simple. Over the long term, the trend in unit inventories may be expect ‘ed to follow the trend in unit sales. Over the short term, however, the plu'sical turnover rate may bob around because of spacial influences—e.s., cont expec tations, or bottlenecks. ‘Tho use of last-in, first-out (IFO) in- ventory-vabuution methods serves to i crease the reported turnover rate during inflationary times, When dollar sales are rising because of inflation, inventory val uations of « LIFO compuny either will retain level (Jf unit sales are aut tis {ng} or will trail the rise in dollar sales Gf unit mules are rising). Tn either ease, Gollar turnover will increase. During the early 1970's, there was pronounced awink by corporations: to ward LIFO accounting (which has the effoct of lowering 8 company’s reported earnings and tax pills). ‘The (vend now ‘seems ty have slowed, Still, the existence ‘of «lot of LIFO companies, plus the like~ ihood that some others will join the crowd, ensures yome forther inereuse in the reported turnover of inventory, ‘The gaine are apt to be modest In the case of fixed assets, any rine in ‘he inflation rate, assuming it affects all products eqmlly, will initially have the fffect of increasing turnover. That is true because sales will immediately re fect the new price level, while the fixed: awvet account wil vetlect the change only gradually, ie, a8 existing assets are re- tired and replaced at tho new prices, Ob- Viounly, the more slowly 6 eompany Koes WARREN BUFFETT IS IN STOCKS ANYWAY about this replacement process, the £0re the turnover ratio will rise, The action stops, however, when a replacement is completed. Aasuating a constant rate ff inflation, sales and fixed assets will then hingin to vise in concert at the rate of Inflation. ‘To sum up, tnflation will produce some gains in turnover ratios, Some improve ment would be certain becaute of L1FO, ‘and some would be possible (Ur inflate necelerates) because of seles rising avore vapidly than fixed assets. But the gains ‘are apt te be modest and not uf a misgnte tude to produce substantial improvement: in roluens on equity capital, During the decade ending in 1975, despite generally: daccclerating inflstion and the extensive bse of LIFO accounting, the turnover ratio of the FoRTUNE 800 went only from 1.18/1 to 1.20/1, le ‘The nuthor i, in fact, one of the most vise stockmarket inverturs inthe ULE, these dyn, He's had plenty to n= Seal for hia gin arcount ever sinew he Thede $25 million running, an investment fuctnerebip daring the 1960's, Tutfett Paranormhip ad, based in Omaha was iaumengely sucessful operation, but Ihe nevertheless closed up shop at the end i ahe decade, A Jeneary, 70, FORTUNE friicle explained 3m detinion! “he SCapects that some of the jules has gone SUING the stoeke market and that sizable (sine sn the [ture ave going, Uo be YOY Raed to eume by” ‘Buttes, who ts now forty-six and stil opsrating out of Omaha, ep & dlverse relies tie and business he controls Rave interests tn over thirty, public cor~ portions, His major holdings: Berk Mie Hathaway che owas about $35 TeiMlon wove) and ilu Chip Stasnps at $10 milion). Hs wisi re (ENUY itereaned hy Wid Street Joo nial profile, wflects hie active manogerial le fn. beth connparies, both of whieh fiivwal im mide cavqe ot euterprise She ig the Washington Pant “\ind why. dove @-man who in eloomy shout storks own s0 much Huck? “Partly RN nabit,” he admits, "Purely, t's Jost Gar stocks mean hisiness, and owning Susbnesces is much prove antereating than scold or fustnland. esis, atoek SUip all che best of ll the poor Shetnatives ing eed of ination ~ab Hage dey ave you bay 10 at appre priate prices.” Cheaper leverage? Not likely, High rates of inilation generally eause bors owing to become deaver, not cheaper Galloping. ratey of inflotion create gale oping capital needa: and tonders, as they become increasingly distrustful of long term contracts, become more demanding But wen if there ig ae further rise it Interest rates, leverage will be gettinix more expensive because the averasce cost tf the debt now or: corporate banks is leas than would be the cost of roplacins it ‘And replacement will he required as the esisting debt matnres, Overall, thet £0 ture changes in the cost of leverage seer likely to have a anfldly depressina effect fon the return on equity. More leverage? American business al eeudy has fired rpany, iT not most, of the tmoredeverage bullets once available to it. Proof of tht proposition ean be seenin some other FORTUNE 500 statiaties : in the twenty years ending in 1975, atook- holders’ eyuity a» a percentage of total assets declined for the 690 from 63 per~ cent to just under 80 percent. In other words, each doliar of equity capital now i leveraged much more heavily than it tased to be. ‘What the lenders teamed ‘An irony of inflation-induced financial requirements is that the highly profit able companies—generally the best cred- ita—require relatively little debt enpital But the laggards in profitability never can get enough. Jenders understand this problem much better than they did a Geeade ago—and are correspondingly less willing (© let capital-hungry, lows profitability enterprises leverage them- selves to the sky. Nevertheless, given inflationary con- ditions, many corporations seem sure in the future to turn to atill more leversge as # means of shoring up equity returns. ‘Ther mariagements will make that move they will mead enormous amounts of eapital—often merely to do the same physical volume of business— and will wish to get it without cutting dividends or making equity offerings ‘that, because of inflation, are not apt to shape up as attractive, Their naturel re- sponse will be to heap on debt, slmost re gardless of cost, They will tend to behave Tike those ubility companies that argued cover an eighth of a point in the 1960's and were grateful to find 12 percent debt financing in 1974. ‘Added debt at present interest rates, however, will do Tess for equity returns than did added debt at 4 percent rates in the early 1960's. Theve i algo the prob- lem that higher debt ratios cause credit ratings to be lowered, creating a further rise in interest costs. “ So that fs another way, to be added to those already discussed, in which the cost of leverage will be rising, In total, the higher eostx of leverage are likely to offnet the benefits of greater leverage. ‘Besides, there is already far more debt in corporate America than is conveyed by conventional balance sheets, Many companies have massive pension obliga- because tions goared to whatever pay levels will be in effect when present workers retire. [At the low inflation rates of 1965-85, the liabilities arising from such plans were reasonably predigtable. Today, nobody ean really know the company's ultimate obligation, But if the inflation rate aver: ‘ages 7 percent in the future, a twenty- fye-year-old employee who i now earn: ing $12,000, and whose raises do no more than match increases in living costs, will be making $180,000 when he retires at sixty-five. ‘Of course, there is s marvelously pre= ciae figure in many annual reports each year, purportitg to be the unfunded pen- sion liability. If that figure were really believable, a corporation could simply ante ip that sum, add to It the existing pension-fund aagets, turn the total ‘amount over to an insurance company, tnd have it assume all the corporation's present pension liabilities. In the real orld, alas, it is impossible to find an insurance company willing even to listen to auch a deal. ‘Virtually every corporate treaaurer in America would recoil at the idea of issu ing a “cost-of-living” bond—a noneall- able obligation with coupons tied to a priee index, Rut through the private pen- sion aystem, corporate America has in fact taken on 4 fantastic amount of debt that is the equivalent of such a bond. More leverage, whether through con- ventional debt or unbooked and indexed ‘pension debt," should be viewed with skepticism by shareholdevs. A 12 pereent return from am enterprise that is debt- free is far superior to the same veturn ‘achieved by a business hocked to its oye- balls, Which means that today's 12 per- cent equity returns may well be less valu- able thats the 12 percent returns of twen- ty years ago. ‘More fun in New York Lower corporate income taxes seem unlikely. Investors in American eorpor: tions already own what might be thought of as # Class D stock. The Clase A, B, and © atocks are represented by the in- ccotve-tax claims of the federal, state, and ‘municipal governments. Jt is true that these “investors” have no claim on the corporation's assets; however, they get ‘a major share of the earnings, including enerated by the equity buildup resulting from retention of part of the earnings owned by the Class D shares holders ‘A further charming characteristic of these wonderful Class A, B, and C stocks is that thelr share of the corporation's ‘earnings can be inevensed immediately abundantly, and without payment by the Unilateral vote of any one of the “stock- holder” classes, ¢.g., by congressional nc tion in the ease of the Class A. To add to the fun, one of the classes will sortetimes vote to inereass its ownership share in the business retroactively—as compa: nies operating in New York discovered to their dismay in 1975, Whenever the Class A, B, or © “stockholders” vote Uhemselves a larger share of the bus! ness, the portion remaining for Class D —that’s the one held by the ordinary investor—declines. Looking ahead, it seems unwise to a sume that thoge who control the A, B, ‘and C shares will vote to reduce their ‘own take over the Jong run. The Claas D shares probably will have to struggle to hold their own. Bad news from the FTC ‘The last of our five possible sources of increased returns on equity is wider op- erating margins on scles, Here ia where some optimists would hope to achieve ‘major gains. There is no proof that they. ave wrong. But there are only 100 cents in the sales dollar and a lot of demands fon that dollar before we gat down to the residual, pretax profits. The major elaimm- ants are labor, raw materials, eneray, and various non-income taxes. The rela tive importance of these costs hardly seems likely to decline daring an age of inflation. Recent statistical evidence, further- more, does not inspire confidence in the proposition that margins will widen in @ period of inflation. Jn the decade ending: in 1965, « period of relatively low ints ‘lon, the universe of manufacturing com. panies reported on quarterly by the Feds eral Trade Commission had sn average annual pretax margin on sales of 8.6percent, In the decsda ending in 1975, the average margin wes 8 percent. Mare ising were down, in other words, despite 1 very considerable increase in the in ‘ation rate, Tf business was able to base its prices ‘on replacement costs, margins would widen In inflationary periods, But the simple fact ia that most large businesses, ‘despite 2 widespread belief in thelr mar- ‘ket power, just don't manage to pull it off, Replacement cost accounting almost always shows that corporate earnings have declined significantly in the past decade, If such major industries as oil steel, and aluminum really nave the oll: opalistie muscle inaputed to them, one cean only conclude that their pricing pol foles have been remarkably restrained. ‘There yu have the eomplete Hneup five factors that can improve returns on comaon equity, none of which, by my analysis, ave likely to take us very far in that direction in periods of high infia- tion, You may have emerged from this exercise more optimistic than T am, But remember, returns in the 12 percent area have heen with us x Jong time The invostor’s equation yen if you ageve that the 12 percent equity coupon is more or less immutable, you atill may hope to do well with it in the years aheud. IU’ concelvable that you will After all, a lot of investors did well with it for a long time, But your fatore results will be governed by three vari- ables; the relatiunship between book val- tue and markt value, the tax rate, and the inflation rate. Jet's wae through a little arithmetic about book and market value, When ‘stocks consistently sell at book value, it's all very simple, If x otock has a book value of $100 and also an average mar~ kot value of $100, 12 percent earnings by business will produco a 12 percent return for the investor (less those frie- tional costs, which well ignore for the moment), TF the payout ratio is 50 per: cent, our snvestor will get $6 vin dive dends und a further §6 from the increase in the book value of Uhe business, which will, of course, be reflected in the mar- ket value of his holdings. Af the stock sold at 150 percentof book value, the picture would change. ‘The in~ vestor would receive the same §5 cash dividend, but it would now represent unly a d percent return on his $150 cost ‘The book value of the businew would still increase by 6 percent (to $106) and the market value of the investor's hold~ ings, valued eonsistently at 150) percent of book value, would similarly increase by 6 nercent (to $159). Hut the inves- tor’s total retura, Le, from appreciation plus dividends, would be only 10 percent ‘wrrus the underlying 12 pereent earned ‘by the business. ‘When the investor buys in below boole value, the process 1s reversed. For ex- ample, if the stock ellk at 80 percent of ouk value, the same earnings end pay oat assiimptions would yield 7.5 pereent From dividends (#6 on an $80 price) and 6 percent from anpreciation—a total re turn of 18.4 pervent. In other words, you Go better by buying st @ diseount rather than a prem would suggest. Daring the postwar years, the market value of the Dow Jones industrials hi» been as low a8 84 pereont of book value in 1974) and as high as 282 percent (in 1995); most of the time the ratio hus been woll over 100 parent, (Early thi spring, it wes around 120 percent.) Let's ‘assume thal in the future the ratio will bbe something close tv 100 percent— mesning that investors in stocks could earn the full 12 percent: At least, they: could earn thet figure before taxes and before ination. om, juxt ax common ons T percent after taxes How large a bite might texen take out of the 12 percent? For individual inves tors, it seems reasonable to aseume that federal, state, and local income taxes will average perhaps 50 percent on divt- ends and 30 percent on capital gains. A majority of investors may have marginal rates somewhat below these, but many swith larger holdings will experience sub- ntantially higher rates. Under the new tax law, a8 FORTUNE observed lant month, a high-income investor ina heavily taxed city could have 8 marginal rate on capi- tal gains at high as 56 percent. (See phe Tax Practitioners Act of 19762") Bo let's use 50 percent and 80 pervent as representative for individnal inves tors, Let's algo assume, in Tine with re- ceent experience, that corporations earn ing 12 peveent on equity pay out 5 percent in eash dividends (2.5 percent after tax) and retain 7 perrent, with those reteined earnings producing a cor- responding market-value growth (49 percent sfler the 80 pereet tax). The after-tax return, then, Would be 7.4 per= cent, Probably thi should be rounded down {o about 7 percent to ullow for frictional costs, To push our stocks-25- diaguined-bonds thesig one notch fur ther, then, stocke might be regarded a5 the equivalent, for individuals, of 7 per- cont tax-exempt perpetual bonds, ‘The number nobody knows Which brings us to the erucial ques- tfon—the inflation rate, No one knows the anewer on this one—including the politicians, economists, and Establish- ment pundita, who felt, «few years back, that with alight nudges here and there onemployment and infigkion retes would respond like trained seals ‘But many signs seem negative for sta- bile prices: the fact that inflation ia now worldwide; the propensity of major roups in ovr society to utilize their elec toral muscle ta shift, mafluer than colve, economiie problems; the demonstrated AMlingness to tackle even the most vital proUlems (e.g., emery and nuclear proliferation) if they can be postpuned ‘and u political system that rewardy lei islators with reelection. sf their actions appear (o produce short-term benefits even though their ultimate imprint wil be to compound lang-terth pain. Most of those in political oflee, quite understandably, are firmly against infla- tion and firmly in fuyor of policies pro ducing tt (This schizophrenia hasn't ‘caused them to lose touch with reality, however: Congressmen have made sure that (heir pensiont—unlike practically all granted in the private sector—are indexad to cost-of-living changes after retirement.) Discussions regarding future inflation rates usually probe the subtleties ofmonetary and figeul policies. These are important variables in determining the iteome of eny specific inflationary equatinn, But, at the souree, peacetime nation ie @ politiesl problem, not an connate problema, Human behavior, not mouetaty behavior, is the key. And when ery hiiman politicians chonse between the next election and the next genera fron, its clear what usually happens. Suich broad generalizations do not pro- nee precige numbers. However, it seems unite possible to me that inflation vatew vill swernge T percent in future years. I hope this fuvecust proves to be wrong. And it may swell be. Boveessts usualy tell tie more of the fereeaster than of the fie, You ave free to factor your own vate sno the investor's equa if you foresee # vate averaging wearing tion. Bi herent wr 8 pereent, vou ifferent lasses than 1 am, So there we are: 12 percent before Faxes and inatlan, 7 percent after tave: sn befare inflation; ind maybe mare pereont after taser ond ination Tt hardly swinds like a formula that will keop all those cattle stampeding on TV. ‘As a eomimion stockholder you Will have nore dallans, but you may have no move punchasing power. Ont with Ben Franke Tin ea peng: saved in 2 perny earned”) nal in with Milton Petedman (a man night as well consume his e: vent i) What widows don't notice ‘Phe arithmetic makes tt plain iat in minve devastating tax than vunything, that hus been enacted hy our iogistatanas, The inflation tax has a fan tustig ability to simply consume eapit Temukes no difference to x whdow with her savings in a 5 pereent passhuoke ae coimt whether she pays 190 percent in- come tax ont he interest income during period of zevy Intlatlon, ‘or pays mu ine come taxes during years of 8 ation, Either way, she ie nranuer that leaves her no real income whatsoever, Any money she spends comes right ont of capital. She would find out agus a 220 percent incume tax, but docsn’t seem to notice that 6 percent in- Hation is the economic equivalent, If my ination assumption is close to conveet, disappointing results will occur not because the market falls, but in spite of the fact that the market rises, At hivonnd 920 early last month, the Dow vas up fifty-five points from where itwas ton sears asco, IRvt adjusted for infla- tion, the Dow is down almost £45 points From 8 to 620, And about half of the earnings of Uhe Dow hid to be withheld frum thelr owners and reinvested in ‘oraor to achieve even that result In the next ten yewrs, the Dow would be dowhled just by a combination of the 12 percent equity. coupon, a 40 pereent avout ratio, and the present 110 pre- cont ratio af market to book value, And with 7 yercent inllation, investors who sole at 1800 seoul atill be considerably swore off than they are today after nay ing. thely capital-gains tuxes. Tean almost hear the reaction of some investors to these downbeat thoughts. It will be to assume that, whatever the dif- ficulties presented hy the new investment fora, they will sumchow contrive to turn. in superior results for themselves, Their suiecess ix most unlikely. And, tn aggre: te, of course, impossible. If you feet ai ean dunce in and out of securities fil a way that defeats the inflation tax, T would Tike to be your broker—but not winar prtner, Even the so-called lax-exempt inves- tors, suchas pension funds and college nulewment fonds, do nat eseape the in- latin tax, If my assumption of a7 per- ‘cont inilation ute is correct, collexe treasurer shoold regard the frst 7 per- ‘cent earned gach year inerely as a re- plenishment of purchasing power. E dowment finds are earning notising hintil they have outpaced the infiation trendmill, AUT percent inflation and, ‘say, overall investment return of 8 per: cent, these institutions, which believe they are tax-exompt, are in fact paying come taxes" of 871 percent. ‘The soclal equation Unfortunately, the majot problems from high inflation rates [low not to in- vestors but to society 25 a whole, Invest ment income ia a small portion of na tioual income, and ff per capita real Income could grow at a healthy rate alongaide zero real investment returns, social justice might well be advanced. 'A. market economy creater some lop- slded payoffs to participants, The right ‘endowment of voeal chords, anatomical strocture, physical strength, or mental powers can produce enormous piles of claim checks. (stocks, bonds, and other forms of eapital) on future national out- put, Proper selection of ancestors simi- larly can result in lifetime supplies of such tickets upon birth. If zero real in- vestment, returns diverted x bit greater portion of the national output from such stoelcholders to equally worthy and hard- working citizens lacking jackpot-pro- ducing talents, it would seem unlikely to pose such an insult to an equitable world ‘ag to risk Divine Intervention. But the potential for real improve: ment in the welfare of workers at the expense of affluent stockholders is not significant, Employee compensation al- ready totals twenty-eight times the amount paid out in dividends, and alot of those dividends now go to pension funds, nonprofit institutions such as universi- ties, and individual stockholders who are not affluent, Under these circum- stances, If we now shifted all dividends of wealthy stockholders into wages— something we could do only once, like ailling a cow (or, if you prefer, x pig) — we would increase real wages by less than we used to obtain from one year’s growth of the economy. ‘Therefore, diminishment of the af ent, through the impact of inflation on their investments, will not even provide material shoré-torm aid to those who are not affluent. Their economic well-being will rise or fall with the general effects ‘of inflation on the economy. And those effects are not kely to be good. Large gains in real eupital, invested in modern production facilities, are re ‘quired to produce large gains in eco- rnomie well-being. Creat labor avatlabil- ity, great consumer wants, and great government promises will lead to noth- ing but great frustration without con- tinuous ereation and employment of ex-pensive new capital asuets throughout industry. That’s an equation understood by Russians as well av Rockefellers, And it’s one that has been applied with stun. ning success in West Germany and Japan, High capital-secumulation rates hhave enabled those countries to achieve gaine in living standards at rates far exceeding oure, even though we have en- Joyed much the superior porition in energy. To understand the impact of inflation ‘upon real capital accumulation, a little ‘math is required. Come bsek for a moe ment to thet 12 percent return on equity tal, Such eavnings ara stated after depreciation, which presumably will al- ow replacement of present productive expucity—if hut plant and equipment: ‘ean be purchased in the future at prices similar to their original cost. ‘The way It was Let's arsume that about half of earn- ings are paid out in dividends, lonving 6 percent of equity capital available to finance fulure growth, If inflation is low say, 2 percent—a larxe portion of that avowth can be real growth in physieat output. For under these conditions, 2 percent more will have to be invested in receivable, inventories, and fixed assets next year just to duplicate this year's physical output—teaving 4 percent for investment in assets to produce more physical goods, Tho 2 percent finances illusory dollar geowth reflecting inflatfon and the remaining 4 percent finances real growth. If population growth 48 1 rpereent, the 4 percent gain in real out~ put translates into a 8 percent gain in eal per capita net ieome, That, very’ roughly, is what used to hapnen in our economy. Now move the ihflation rate to 7 per ‘sent and compute what ia left for real growth after the financing of the manda- tory inflation component. The answer is, nothing —if dividend polieieg and lever- fage ratios remain unchanged, After half of tho 12 percent earmings are paid out, the samo 6 percent ix left, but it is all conscripted to provide the added dollars needed to transact last year’s physical volume of business, ‘Many companies, faced with no renl retained earnings with which to finance physical expansion after normal divi- dend payments, will improvise, How, they will ask themselves, can we stop or reduce dividends without risking stock- holder wrath? T have good news for them: a ready-made set of blueprints is available In recent yoars the electrie-ptility ine dustry hus hud [litle oF no dividend-pay- ing capacity, Or, rather, it has had the power to pay dividends if investors agree to buy stock fram them. In 1975 electric utilitios paid common dividends of $3.3 billion and asked investors to re turn $3.4 billion, Of course, they mixed In a little solicit-Peter-to-pay-Paul tech nique #0 a8 not to acquire « Con Fd repue tation, Con Bi, you will remember, was unwise enough in 1974 to simply tell its shareholders it didn't have the money lw pay the dividend, Candor was rewarded with calamity in the marketplace ‘The more sophisticated utility main- taina--perhaps increases. the quarter ly dividend and then asks shareholders, (either old or new) to mail back the money. In other words, the comp ues new slock, This procedure diverts massive amounts of eapital to the tax collector and substantial sums to under- writers. Everyone, however, seems to re- ‘main in guud spirits (particularly the underwriters) More joy at A.T.aT. Encouraged hy such suczess, some ulilitiey have devised a further shortcut. In thie case, the company declures the dividend, the shareholder pays the tax, and—presto—more shares are issued. No cash changer hands, although the IRS, qpoilaport as elways, persists in ‘treating the transaction as if it had. A.D&T., for example, instituted x ividend-reinvestmont program in 1973. ‘This company, in fairness, must be de- seribed as very stockholdor-minded, and its adoption of this program, considering: the folkways of finance, must be regard ed as totally understandable. But the substance of the program is out of Aliee in Wonderland. In 1976, AT&T. paid $2.8 billion in ‘nah dividends {o ubout 2.9 million owne ‘ers of it common tock, At the ond of the year, 648,000 holders (up from 601,- 000 the previous year) reinvested $432 ralllion (up feo BR2T million) in wadi- tlomal shares supplied directly by the ‘company. Just for fun, let's assume that alt A.TA&T. shareholders ultimately sign up for this program. In that ease, no cash fat all would be mailed to sharehaldera— just ns when Con Ed passed a dividend, However, each of the 2.9 million owners ‘would be notified that he should pay come taxes on hig ahare of the retained earnings that had that year been called a “dividend.” Assuming that “divi- dends” totaled $2.3 billion, as in 1976, and that sharcholders paid an average tax of 30 percent on these, they woutd end up, courtesy of this marvelous plan, paying nearly $700 million to the TRS. Tmagine the joy of shareholders, in such irovmstances, if the directors were then to double the dividend, ‘The government will ty to do It We ean expect to see more use of Aisguised payout reductions as business struggles with the problem of real capi tal accumulation, But throttling buck shareholders somewhat will not entirely solve the problem. A combination of 7 pervent infigtion and 12 poreent returns will reduce the stream of corporate capi- tal available to ficance real growth. ‘And #0, 28 conventional nrivate cap- tal-aceumulation methoua falter under inflation, our government will increas. ingly attempt to Influence capital flows to industry, either unsuccessfully ax in England or successfully as in Japan. The necessary eultural and historical under pinning for a Jepaneve-style enthusias. tle partnership of government, business, and Inbor seoms lacking here, If we are lucky, we will avoid following the Ens- lish path, where all segments fight over Alvision of the pie rather han pool their enernien to enlarge it (On belance, however, it seems likely that we will hear a great deal more «3 the yours unfold about underinvestment, stagflation, and the {elluren of the pr vate sector to fulfill needs, END