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Lessons from Warren Buffett - XXII

Dec 13, 2007

Last week, we started with Warren Buffett's 1992 letter to shareholders and discussed his thoughts on issuing shares. Let us run a little further through the letter and see what other nuggets he has to offer.We have for long been a supporter of making long-term forecasts with respect to investing and we are glad that we are in extremely good company. For even the master thinks likewise and this is what he has to say on the issue.

"We've long felt that the only value of stock forecasters is to make fortunetellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last."

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The above lines were most likely written by the master in the early days of 1993, a year which was bang in the middle of the best ever 17 year period in the US stock market history i.e. the years between 1981 and 1998. However, this period did not coincide with a similar growth in the US economy. Infact, the best ever stretch for the US economy was a 17-year stretch, which started around 17 year before 1981 and ended exactly in 1981. Courtesy this economic buoyancy and the subsequent lowering of interest rates, the corporate profits started looking up and they too enjoyed one of their best runs ever. Thus, a period of buoyant GDP growth was followed by a period of strong corporate profit growth, which in turn led to increase in share prices. However, share prices grew the fastest because they not only had to grow in line with the corporate profits but also had to play catch up to the economic growth that was witnessed between 1964 and 1981.

Another extremely important factor that led to a more than 10 fold jump in index levels in the period under discussion had psychological origins rather than economic. Investors have an uncanny knack of projecting the present scenario far into the future. And it is this very habit that made them believe that stock prices would continue to rise at the same pace. However, nothing could be further from the truth. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction. Thus, while the share prices can play catch up to economic growth and corporate profits and hence can grow faster than the two for some amount of time, expecting the same to continue forever, could be a recipe for disaster. And even the master concurs.

We believe similar events are playing themselves out in the Indian stock markets with investors expecting every stock to turn out to be a multi bagger in no time. But as discussed above, this could turn out to be a proposition, which is full of risk of a permanent capital loss. Investors could do very well to remember that over the long-term share prices would follow earnings, which in turn would follow the macroeconomic GDP and this could be a very reasonable assumption to make.

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