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Warren Buffetts Hurdle Rate

February 28, 2015

Ive begun re-reading Berkshire Hathaways historic letters to shareholders.  In the letters from the late 1970s / early 80s, Buffett spends a lot of time describing the increasing hurdle rate investors should demand due to the rampant inflation of the time period.  It is hard to believe, but annual CPI inflation reached above 16% here in the United States in the early 80s.  Berkshires book value was increasing nicely in this period, but Buffett reminded investors they must account for inflation and taxes. The return of a taxable investment (ie. stocks, corporate bonds) must beat the inflation rate experienced during the holding period in order for the investors pricing power to have increased. And its not just inflation investors must account for. Investment returns are eaten up by taxes as well. Buffett referred to this combined Misery Index of inflation and investment taxes as the minimum hurdle rate of return an investor should seek.

High rates of inflation create a tax on capital that makes

much corporate investment unwise at least if measured by the

criterion of a positive real investment return to owners. This

For only gains in purchasing power represent real earnings on investment.

If you (a) forego ten hamburgers to purchase an investment; (b)

receive dividends which, after tax, buy two hamburgers; and (c)

receive, upon sale of your holdings, after-tax proceeds that will

buy eight hamburgers, then (d) you have had no real income from

20% on equity (which very few manage consistently to do) and

distributing it all to individuals in the 50% bracket is chewing

up their real capital, not enhancing it. (Half of the 20% will go

for income tax; the remaining 10% leaves the owners of the

business with only 98% of the purchasing power they possessed at

the start of the year even though they have not spent a penny

of their “earnings”).

Warren Buffett, 1980 Letter To Shareholders,

Buffett even compared Berkshires return against the return received from gold and oil.  During this time he often referred to the return an investor could receive from tax-free muni bonds as well. From the 1981 Letter:

During the past year, long-term taxable bond yields exceeded

16% and long-term tax-exempts 14%. The total return achieved

from such tax-exempts, of course, goes directly into the pocket

of the individual owner. Meanwhile, American business is

producing earnings of only about 14% on equity. And this 14%

will be substantially reduced by taxation before it can be banked

by the individual owner. The extent of such shrinkage depends

upon the dividend policy of the corporation and the tax rates

1981 levels, a typical American business is no longer worth one

hundred cents on the dollar to owners who are individuals. (If

the business is owned by pension funds or other tax-exempt

investors, the arithmetic, although still unenticing, changes

substantially for the better.) Assume an investor in a 50% tax

bracket; if our typical company pays out all earnings, the income

return to the investor will be equivalent to that from a 7% tax-

exempt bond.

Warren Buffett is often asked at Berkshires annual shareholder meeting what is the rate of return (hurdle rate) he seeks when investing in stocks.  Ive found several references to 13% (early 2000s) and 15% (mid-90s).  On reading his letters, I propose that Buffetts thinking along these lines is:

Minimum Hurdle Rate on taxable investments = (Inflation rate) + (Yield on long-term tax-free muni bonds)/(1-Cap. gains tax rate) + (Equity Risk Premium)

Diving in to each of these:

(Inflation rate):   As Buffett has described, inflation is quite mean-reverting.  I think Buffett would actually use the average of current inflation rate and long-term average inflation rate.  In a late 1990s Fortune article Buffett described inflation as mean-reverting and mentioned 4.3% as the long-term rate of inflation.  So the initial equation factor becomes ((Current Inflation) + 4.3%))/2

(Yield on Long-Term Muni Bonds):   Buffett referred to a basket of national Muni bonds as the safer, tax-free alternative to stocks and other bonds.  Muni bonds offer another advantage as well they have a fairly wide range of credit ratings (ie. AAA to A and lower).  So for an individual stock you are reviewing, you might use the muni yield which has the same credit rating as your stock (ie. AAA rated stock use AAA rated muni bond rate).  National muni bond yields can be found here.

(1- long term Capital Gains tax rate):   This factor ensures the taxes you pay after owning the stock or other taxable investment at least 1 year do not take away from your final purchasing power.  The current capital gains tax rate is either 0%, 15% or 20%, depending on your tax bracket.  For most investors it is 15%, so this factor is 1-0.15 = 0.85

(Equity Risk Premium):   Without an ERP, the equation results in a final return that only matches the yield on long-term tax-free Munis.  Obviously you expect a higher return from stocks vs muni bonds.  Ive seen ERP estimates from 2% to 6%.  Ill use an average 4%.

2015 Minimum Hurdle Rate (era of low inflation, low yields, relatively low taxes)

Current Inflation = 1.6%,  Long-term AAA Muni Bond Yields = 2.65%

2015 Hurdle Rate = (1.6% + 4.3%)/2 + 2.65%/0.85 + 4.0% = 10%

1981 Minimum Hurdle Rate (era of high inflation, high yields, higher taxes)

Inflation = 16%, AAA Muni Yield = 14%, Capital Gains tax rate = 20%

1981 Hurdle Rate = (16% + 4.3%)/2 + 14%/0.80 + 4.0% = 31.7%