Economic Cycles and Mean Reversion

Understanding Reversion to the Mean: Revisiting Buffett’s 1999 Fortune Article

In 1999, Warren Buffett gave a rare explanation of why he felt the stock market would generate poor returns for investors over the long haul.[1] He used simple arithmetic to show that elevated valuations and profit margins made equities vulnerable. The piece was 9 pages, over 4,000 words long, and had a single exhibit.

In an age of factually light 200-character Twitter “tribalism”, we are not surprised the work has faded from investors’ frontal lobes. The piece is also not conducive to frenetic IPOs, SPACs, and other recently popular activities. Having read the piece when it was published, the concept has survived in KCR’s collective memory due to its elegant simplicity and incontrovertible arithmetic truths.

Mr. Buffett explains that over the long-term, there are five principal drivers of returns. They are:

• profit margins: subject to competition and policy, they cannot rise forever
• interest rates: the “gravity” of valuation, we are coming off the zero bound
• starting valuation: current valuations are now above the peak of the dot.com bubble
• ending valuation: to each their own, influenced by sentiment and rates
• the growth rate of GDP: aggregate economic activity is the source of long-run equity returns

Knowing where you are at any given moment can be of immense service in sizing risk appetites.

Warren Buffett’s Warning was Not a Forecast

Buffett’s missive was not a forecast. He was clear that market prices can decouple from value for long stretches. At the same time, he was equally clear that, eventually, valuation matters. The article starts off by defining investing as the act of “…laying out money now to get more money back in the future-more money in real terms, after taking inflation into account.”

Over the years, some KCR subscribers have taken umbrage at our frequent use of Buffett’s market cap to GDP chart. The objections usually come from…. interest rates and margins. So this piece will focus on past and present margins using Mr. Buffett’s 1999 article as the cornerstone from which we work.

We believe changing profit margins are one of the most interesting aspects of the simple algebra that underpins market returns. Over the long-term, the market’s valuation must be connected to the growth in the real economy (GDP). While most people are comfortable estimating 2%-5% GDP growth, margins are, in many ways, the great unknown.

History is clear that margins are subject to various economic cycles and mean reversion. Margins possess a sort of analytical aphrodisiac during boom times and can foment the irrational euphoria that characterizes market peaks. Contrarily, margins can also add to the “hangover” after such periods, amplifying negative sentiment.

KCR has read a great deal of precision work around the recent boom in margins, its sources, and possible persistence or lack thereof. While always interesting, we believe the specificity frequently professes a level of certainty outside our comfort zone.

This piece is designed to put today’s market valuations and margins in historical context. We believe forecasting the future is futile, but tremendous insights can be drawn by studying the past. In the spirit of that belief, our review of Mr. Buffett’s views in 1999 will hopefully highlight one of the most significant structural risks to investors today.

Our concerns should not be confused with a forecast. At the end of the paper, we explain a tool we offer to subscribers. You can input your own assumptions around margins, growth, valuations, and interest rates to see what 10-year returns various assumptions generate using Mr. Buffett’s arithmetic.

With that, we will dive into a brief review of Mr. Buffett’s 1999 missive on profit margins.