Warren Buffett’s investment choice: productive assets

In his Feb 25, 2012, letter to Berkshire Hathaway shareholders for FY2011, Warren Buffett listed three categories of investments under the headline of “The Basic Choices for Investors and the One We Strongly Prefer”:

(i) Investments that are denominated in a given currency, including money-market funds, bonds, mortgages, bank deposits, and other instruments.

(ii) Investments in assets that will never produce anything. The major asset in this category is gold.

(iii) Investments in productive assets: businesses, farms, or real estate.

Guess which of the abovementioned three investment categories Warren Buffett prefers?

You’re right if you say category (iii), that is investments in productive assets: businesses, farms, or real estate.

Before understanding why Warren Buffett picks category (iii), one has first to understand how Warren Buffett defines investment. An investment is often described as the process of laying out money now in the expectation of receiving more money in the future. Warren Buffett’s Berkshire Hathaway takes a more demanding approach, defining 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,” says Warren Buffett.

With the above-mentioned investment definition as the backdrop, let us examine why Berkshire Hathaway does not prefer category (i), that is investments that are denominated in a given currency, including money-market funds, bonds, mortgages, bank deposits, and other instruments.

Warren Buffett’s argument is that while most of these currency-based investments are thought of as ‘safe’, they are in truth among the most dangerous of assets. “Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal,” says Warren Buffett. “This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time.”

Warren Buffett says a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt today: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

Berkshire Hathaway also doesn’t prefer the second major category of investments, that is one involving assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. “Tulips, of all things, briefly became a favorite of such buyers in the 17th century.” Warren Buffett is of course referring to what many term as “tulipomania”.

The main asset in this second category of investments is gold. Warren Buffett said in the letter that gold then was a huge favorite of investors who feared almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). For gold, Warren Buffett sees two significant shortcomings: being neither of much use nor procreative. While gold has some industrial and decorative utility, the demand for these purposes is both limited and incapable of soaking up new production, says Warren Buffett.

“Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis.

“As ‘bandwagon’ investors join any party, they create their own truth – for a while. Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these
bubbles, an army of originally skeptical investors succumbed to the ‘proof’ delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling.

“But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: ‘What the wise man does in the beginning, the fool does in the end’.”

Warren Buffett argues that the first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold.

As to why he prefers the third category – investment in productive assets, whether businesses, farms, or real estate – Warren Buffett says that, ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. “Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test,” says Warren Buffett. “…Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

“Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial ‘cows’ will live for centuries and give ever greater quantities of ‘milk’ to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).

“Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.”

Recommended reading:

(1) The Essays of Warren Buffett: Lessons for Corporate America, Third Edition

(2) Berkshire Hathaway Letters to Shareholders, 1965-2013