A Lesson on Inflation by Warren Buffett #84
Key lessons include understanding the impact that inflation can have on returns, the Investor's Misery index, businesses that do well with inflation
Investing during an Inflationary Period
There's been a lot of talk on the idea of inflation over the past month.
Here are a couple of headlines to demonstrate my point:
'Big Short' investor Michael Burry says 'prepare for inflation' - and warns bitcoin and gold might be at risk. In a series of now-deleted tweets, Micheal Burry points out the long-term challenges associated with funding a $1 of GDP with $3 of debt and warns us about unforeseen levels of inflation that is about to take place.
There was then the 'Great Inflation Debate' on the All-In Podcast. While it was interesting to see the differing points of view on what this might mean, it was clear that we should expect some forms of inflation over the next few years. I'd check out this presentation by David Sacks on the risks of inflation.
Part of Michael Burry's tweets had apparently included references to Warren Buffett's shareholder letter from 1980. This pushed me to go through Buffett's letters from 1979-1981 and learn how inflation can impact the way we think about returns.
Here's a quick summary as I take excerpts from each letter and compile this lesson on inflation by Warren Buffett.
From the 1979 letter (wherein retrospect, we had hit peak inflation):
"A few years ago, a business whose per-share net worth compounded at 20% annually would have guaranteed its owners a highly successful real investment return. Now such an outcome seems less certain. For the inflation rate, coupled with individual tax rates, will be the ultimate determinant as to whether our internal operating performance produces successful investment results - i.e., a reasonable gain in purchasing power from funds committed - for you as shareholders.
Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail.
If we should continue to achieve a 20% compounded gain - not an easy or certain result by any means - and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.
That combination - the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity."
Let's stay away from the actual numbers (e.g. 8% treasury note, 14% inflation rates). The idea that a +12% (20% compounding return vs. 8% Treasury note) differential in overall returns (pre-tax) can be considered sub-optimal in an inflationary environment is quite scary. If we look into Buffet's Investor's Misery Index (inflation rate + overall tax rate), it's quite easy to see both sides of the index - inflation (via more money printing) and taxes (to service government debt/spending) growing quite rapidly. The All-In Podcast episode I reference above points to the issues relating to this without quoting the Investor’s Misery Index.
"At present inflation rates, we believe individual owners in medium or high tax brackets (as distinguished from tax-free entities such as pension funds, eleemosynary institutions, etc.) should expect no real long-term return from the average American corporation, even though these individuals reinvest the entire after-tax proceeds from all dividends they receive. The average return on equity of corporations is fully offset by the combination of the implicit tax on capital levied by inflation and the explicit taxes levied both on dividends and gains in value produced by retained earnings. As we said last year, Berkshire has no corporate solution to the problem. (We’ll say it again next year, too.) Inflation does not improve our return on equity.
Indexing is the insulation that all seek against inflation. But the great bulk (although there are important exceptions) of corporate capital is not even partially indexed. Of course, earnings and dividends per share usually will rise if significant earnings are “saved” by a corporation; i.e., reinvested instead of paid as dividends. But that would be true without inflation. A thrifty wage earner, likewise, could achieve regular annual increases in his total income without ever getting a pay increase - if he were willing to take only half of his paycheck in cash (his wage “dividend”) and consistently add the other half (his “retained earnings”) to a savings account. Neither this high-saving wage earner nor the stockholder in a high-saving corporation whose annual dividend rate increases, while its rate of return on equity remains flat, is truly indexed.
For capital to be truly indexed, return on equity must rise, i.e., business earnings consistently must increase in proportion to the increase in the price level without any need for the business to add to capital - including working capital - employed. (Increased earnings produced by increased investment don’t count.) Only a few businesses come close to exhibiting this ability. And Berkshire Hathaway isn’t one of them."
The last point is particularly interesting as it points to the type of business models that will be able to adapt relatively well to an inflationary environment. Buffett goes into a bit more detail on this in his next letter.
"We should acknowledge that some acquisition records have been dazzling. Two major categories stand out.
The first involves companies that, through design or accident, have purchased only businesses that are particularly well adapted to an inflationary environment. Such favored business must have two characteristics:
An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume
An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.
The second category involves the managerial superstars - men who can recognize that rare prince who is disguised as a toad, and who have managerial abilities that enable them to peel away the disguise. We salute such managers as Ben Heineman at Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at National Service Industries, and especially Tom Murphy at Capital Cities Communications (a real managerial “twofer”, whose acquisition efforts have been properly focused in Category 1 and whose operating talents also make him a leader of Category 2). From both direct and vicarious experience, we recognize the difficulty and rarity of these executives’ achievements. (So do they; these champs have made very few deals in recent years, and often have found repurchase of their own shares to be the most sensible employment of corporate capital.)"
These points should resonate fairly well with those of you who have gone through Mark Leonard's letters. At a broader level, the general goal should be to invest in businesses that can maintain/grow in demand despite the broader macro-environment while having great unit economics.
While the actual numbers and nature of businesses have changed since 1979, the lessons of how to invest in an inflationary environment (as explained by Warren Buffett) haven't changed too much. I'd highly recommend going through the actual letters if you have time.
Another great read Suthen! Curious to know what your thoughts are on the prospects of Constellation using Buffett's favoured characteristics in an inflationary environment. I makes sense that with many of the VMS businesses there is a captive customer base from which prices can be moved up without people leaving too quickly or complain too loudly, but how does Constellation fit into the second characteristic? Especially in light of the fact that Constellation's growth is likely going to come from acquisitions going forward, and that competition will (or already has) "become fierce" as more and more groups/people/PE open their check books and start signing. Welcome your thoughts on that and whatever you can share! Happy reader and please keep on!