Why even a 20% annual return may not make you richer: Warren Buffett's 1979 warning on inflation and tax

Berkshire's earnings per share rose about 20% in 1979, yet Buffett called it "an improper figure upon which to focus."

He explained that the company had substantially more capital to work with in 1979, and its performance in utilising that capital actually fell short of the previous year, even though per-share earnings rose. He wrote: "Earnings per share will rise constantly on a dormant savings account or on a U.S. Savings Bond bearing a fixed rate of return simply because earnings are continuously plowed back and added to the capital base. Thus, even a stopped clock can look like a growth stock if the dividend payout ratio is low".

The primary test of managerial economic performance, he said, is the achievement of a high earnings rate on equity capital employed, without undue leverage or accounting gimmickry, and not consistent gains in earnings per share.

Berkshire's book value per share grew from $19.46 in 1964 to $335.85 at the end of 1979, compounding at 20.5%annually. Yet Buffett spent a significant portion of the letter explaining why even that extraordinary record might not be enough to preserve purchasing power. The humility in that admission, from someone delivering 20% annualised returns, is itself a lesson for investors who assume their recent returns will continue indefinitely.

Buffet warned that a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than those prevailing in 1979.

"If we should continue to achieve a 20% compounded gain and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate."

The misery index is the inflation rate plus the tax rate the investor pays to convert nominal gains into cash. When this index exceeds the return on equity, purchasing power shrinks even if the investor consumes nothing.

Buffett admitted that he had purchased Waumbec Mills at an extraordinary bargain, well below the working capital of the business, getting substantial machinery and real estate for less than nothing. Yet the purchase was a mistake. He wrote: "Both our operating and investment experience cause us to conclude that turnarounds seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price".

Buffett devoted an unusual amount of space to arguing that very long-term fixed-interest bonds are dangerous in an inflationary world. He pointed out that insurance companies had moved to six-month auto policies because they could not estimate costs one year ahead, yet they were simultaneously locking in money at a fixed price for thirty or forty years through bond purchases.

He wrote: "The very long-term bond contract has been the last major fixed price contract of extended duration still regularly initiated in an inflation-ridden world".

"Our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years," Buffet wrote.

Buffett quoted investor and author Phil Fisher's analogy of a restaurant: a restaurant could seek a given clientele and obtain devoted regulars, but if it vacillated between French cuisine and take-out chicken, the result would be confused and dissatisfied customers. Buffett wrote: "So it is with corporations and the shareholder constituency they seek. You can't be all things to all men, simultaneously seeking different owners whose primary interests run from high current yield to long-term capital growth to stock market pyrotechnics"