Monday, March 13, 2006

Will Your Grandchildren See Dow 2,000,000?

Warren Buffet's recent letter to shareholder contains a few gems. In reading the letter, I am struck by his ability to simply and clearly articulate highly complex and challenging subjects - like insurance, derivatives, and signal rather than noise.

While the letter is full of interesting comments, one really struck me.

To paraphrase, from Dec 31 1899 to Dec 31 1999, the Dow Jones rose from 66 to 11,497. While a rise of 174x over the 100 years, the return to shareholders, a powerful illustration of the power of compound interest, was only 5.3%.

If we extrapolate the 5.3% rate of return over the next 100 years, the Dow Jones will close on Dec 31, 2099 at 2,011,011.23, or 11,497*(1.053)^100. The begging question is will the next 100 years see the same level of corporate wealth creation. Also, how many of you think the equity rate of return will not be higher than 5.3%? If the rate of return is 10%, for example, the Dow will hit 158,435,700 on Dec 31 2099.

Mr Buffet suggests that the replication of the past century's performance will be challenging. He argues that, "For investors as a whole, returns decrease as motion increases." His core premise and criticism is that shareholder wealth is a zero sum game. He argues that transactions (ie motion), transaction fees, and transaction agents (bankers, LBO funds, consultants) are transferring wealth from shareholders to service providers and threatening the future value of shareholder holdings. I suppose the key is to focus on true wealth creation rather than wealth transfer.

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