Buffett on inflation, EPS and buybacks (1978-81 letters)

This story is part of our ongoing series decoding Warren Buffett's annual letters, not just for what he said, but for how we can use his wisdom today. Between 1978 and 1981, the world changed dramatically for investors. Inflation roared, interest rates soared, and equity investing lost its halo. Buffett, as usual, saw it all with unusual clarity without even blinking.

Let's decode the fundamental lessons from his 1978-1981 letters to Berkshire shareholders.

The cruel math of commodity businesses

In 1978, Buffett turned a candid eye toward Berkshire's textile business—a classic case of what he called a commodity business. Despite appearing "cheap" on paper (machines booked at a fraction of their replacement cost), the returns were perpetually unsatisfying. Why?

Because capital turnover was low and margins were thin—a double whammy. Even the best efforts of management couldn't overcome the fact that everyone in the industry was trying to do the same thing: lower costs, improve efficiency, chase trends.

As Buffett wrote, textile businesses—and other producers of undifferentiated goods—don't earn good returns unless supply is tight. And when there is excess capacity, prices fall to meet operating costs, not capital invested. It's a rigged game but not in your favour.

Return on equity vs the earnings mirage

Buffett has always warned against taking earnings per share (EPS) at face value, and his 1979 letter makes that warning explicit. A rising EPS can be as misleading as a stopped clock. You could be looking at nothing more than the effect of compounding on retained earnings—the way a savings account accrues interest—and mistake it for genuine business growth.

Instead, Buffett insists we look at return on equity (ROE) —not bloated with leverage or distorted by accounting tricks, but clean and simple. If a business can't produce strong returns on the equity shareholders have invested, it doesn't matter how steady the EPS looks.

It's a simple idea that most investors and many CEOs conveniently forget.

Turnarounds seldom turn

It's one of Buffett's most repeated lines: "Turnarounds seldom turn." In both 1979 and 1980, he reiterated his scepticism of the corporate comeback story. The fantasy goes like this: a brilliant manager takes over a troubled company and transforms it into a winner.

Reality is harsher. Most bad businesses stay bad, no matter who's steering. The lesson? Don't fall in love with the toad. Marry the prince.

Buybacks over bloat

By 1980, Buffett was championing a now-familiar cause: share repurchases. But only when done right.

If a good business is trading at a discount to intrinsic value, the smartest thing management can do is buy back shares. It's a rare moment when the stock market gives you the chance to buy more of what you already own—at a discount.

Compare that to acquiring another business at a premium just to grow bigger. The former builds wealth quietly; the latter often builds empires of regret.

Inflation: The hidden tax that eats capital

Perhaps the most powerful insight from this period comes from Buffett's 1980 warning on inflation. At high enough rates, inflation becomes a tax on capital—one that makes real investment returns vanish even when reported profits look fine.

Imagine earning a 20 per cent return on equity. Sounds great. But if you are in the 50 per cent tax bracket (then in the US) and inflation is at 12 per cent, you are actually losing purchasing power. Your capital is being chewed up while you are being congratulated for having "earnings".

The danger here is subtle but brutal. Inflation taxes not just your returns, but your illusions.

And it gets worse.

Because inflation also forces even low-return businesses to retain more capital—not to grow, but just to survive. A bad business in an inflationary world must hoard cash to finance more inventory, more receivables, more everything. It doesn't want to, but it has no choice.

It's a cruel joke: the worse the business, the more capital it needs—and the more it wastes.

The princess, the toad, and the dangerous acquisition

In 1981, Buffett took aim at the psychology behind high-priced acquisitions. Too often, he wrote, CEOs fall for the fairytale: that their managerial kiss will transform a lousy company into a gem.

The problem? The toad usually stays a toad. And the shareholders of the acquiring company are the ones left holding the bag.

What explains this irrational behaviour? Ego, empire-building, and a misplaced belief in synergy. Size, after all, still gets you a higher spot in the Fortune 500. But it doesn't get you better returns.

Buffett's advice was simple: you are better off buying 10 per cent of a wonderful business at a fair price than 100 per cent of a mediocre one at a foolish price.

Is equity still worth it?

The final question Buffett poses in this era is the hardest: is equity capital still earning its keep?

In the early decades, businesses earned 11 per cent on equity while interest rates on bonds were far lower. Stocks deserved a premium. But by 1981, bond yields had soared past equity returns. Worse, those equity returns would be taxed before reaching shareholders.

For the individual investor, stocks were no longer clearly superior to bonds. In fact, many were value-destructive. The value-added premium that equity investors once enjoyed had quietly disappeared.

Unless inflation comes down and interest rates follow, Buffett warned, most American businesses will remain "bad" in economic terms. They may report profits. But they won't create real wealth.

Conclusion: When the world changes, don't stay the same

Buffett's letters from 1978 to 1981 are a masterclass in uncomfortable truths. The world was changing fast—be it inflation, interest rates or investor expectations—but most managers and investors were still clinging to old assumptions. Buffett refused to. He questioned everything—earnings, acquisitions, equity itself.

And in doing so, he reminds us that investing is not about finding comforting stories. It's about facing economic reality—even when it's inconvenient.

Better to wake up early than stay asleep in a dream.

Also read: Buffett's 1988 letter on accounting tricks and CEO missteps

This article was originally published on November 15, 2024, and last updated on April 03, 2025.