Playing With Fire
Someone recently asked Charlie Munger what he thought about today’s combination of quantitative easing and large fiscal deficit. He responded:
Well, there I’ve got a very simple answer and that is it’s one of the most interesting questions anybody could ask. We’re in very uncharted waters. Nobody has gotten by with the kind of money printing we’re doing now for a very extended period without some trouble. I think we’re very near the edge of playing with fire.
Later, someone asked how equity returns over the coming decade will compare to last decade’s return. Munger said “I think that the returns will go down, yes. In real terms, the returns will be lower.”
I’m no detective, but I think inflation is on Charlie Munger’s mind. It’s been on my mind, too, ever since I saw the Federal Reserve’s chart of total checkable deposits.
According to the Wall Street Journal, we’re already miles ahead of the pace we set in 2008:
The Federal Reserve, European Central Bank and Bank of Japan have collectively expanded their balance sheets by around $8 trillion in 2020. It took them almost eight years to achieve the same growth following the seizure of global financial markets in September 2008.
Barron’s has inflation on their mind too. In December, they wrote:
Back in the 1970s, inflation was the biggest financial risk that America faced. Lawmakers not only respected inflation, they feared it. President Nixon imposed wage and price controls to no avail. The spiraling consumer price index prompted President Ford to marshal the Whip Inflation Now movement. Inflation and high energy prices were big contributors to cardigan-clad Jimmy Carter’s one-term presidency.
Policymakers nowadays aren’t worried about inflation. In fact, many of them, including Fed governors, would welcome it. This year’s federal budget deficit is set to exceed $3.5 trillion, or about 17% of gross domestic product. Money creation is pushing similar extremes: Money supply has mushroomed a whopping 25% year over year, its largest annual expansion on record. Washington policymakers are banging the inflation beehive with a baseball bat, hoping inflation re-emerges. Be careful what you wish for.…
Besides fiscal and monetary stimulus, pandemics themselves are inflationary. The Economist reports:
Researchers from the Bank of England who looked at 800 years of (admittedly patchy) records have concluded that inflation does typically rise in the year after a pandemic begins. A recent paper by Robert Barro of Harvard University and colleagues finds that the influenza pandemic of 1918-20 “increased inflation rates at least temporarily.”
It’s been forty years since Americans last experienced meaningful inflation. Few have experienced it personally. In December 1980, the prime rate hit a record 20.5% (here’s a 12/17/1980 Washington Post story about it). That’s unimaginably high compared with today’s 3.5% prime rate. But if 2020 (and 2021) have taught us anything, it’s that the unimaginable happens all the time.
Today I’m going to discuss what inflation is, why it’s bad, and how we plan to protect ourselves from it. If there’s a silver lining to inflation, it’s that the most inflation-proof assets turn out to be the high ROIC businesses Dan and I already favor. This is more than convenient. It means we don’t need to predict inflation to protect ourselves from it.
What Is Inflation?
Inflation is the phenomenon of rising prices. As prices rise, each dollar buys fewer goods, services, and assets. Inflation erodes wealth by destroying purchasing power.
Inflation occurs when too many dollars chase too few goods. Economists describe the relationship between the price (P) of goods, the quantity (Q) of goods, the money supply (M), and the velocity of money (V) using the equation: P*Q=M*V.
The Treasury’s direct fiscal stimulus and the Fed’s bond-buying have significantly increased the money supply. So far, a decrease in velocity has offset the increase in money. There are more dollars in the system, but they’re mostly sitting idle inside banks.
It seems reasonable (but not guaranteed) that velocity will revert towards its mean someday. As Jason Zweig says “mean reversion is the most powerful law in financial physics.”
If velocity increases, more dollars (M*V) will chase the same goods (Q), pushing prices (P) higher. Inflation could be even more pronounced in sectors where the pandemic has destroyed supply, like hotels.
How Inflation Swindles the Equity Investor
In 1977 Warren Buffett wrote an article in Fortune Magazine explaining how inflation harms investors. The following follows the logic in that article.
Imagine a business that earns a $25 profit by employing $100 of capital. That’s a 25% return on invested capital (ROIC), which is solidly above-average. Then, the price level doubles. To maintain its real purchasing power, the business must double nominal profits. So, it doubles its prices. Voila!
Not so fast. The company’s suppliers will have raised their prices too. As a result, the company will need to double its nominal investment in working capital (inventory, payables, receivables) to support the same unit volume. Eventually, the company will also need to replace its long-lived fixed assets (property, plant, equipment), which will also have doubled in price.
So, the company’s capital will increase from $100 to $200, and profits will increase from $25 to $50. Real purchasing power and ROIC will remain unchanged.
The swindle? The company’s investors were forced to invest an additional $100 of capital merely to maintain the purchasing power of their profits. $100 of capital was consumed with no real return to show for it. No one benefits — not investors, laborers, or society -- when inflation consumes capital. That’s why Warren Buffett called inflation a “gigantic corporate tapeworm.”
Inflation Doesn’t Hurt Every Business Equally
Inflation hurts any unleveraged business that requires net tangible invested capital to operate (virtually all do). The less tangible capital a business needs, the better it will weather inflation.
To illustrate, imagine two businesses: Wonderful and Mundane. They have the same book value (i.e., net invested capital) and the same valuation multiple (10x earnings). The difference? Wonderful earns 25% on its capital while Mundane earns only 10%. Accordingly, Wonderful makes $25 and is worth $250 while Mundane makes $10 and is worth $100.
If the price level doubles, both businesses will need to increase their invested capital by $100. Therefore, both sets of investors are swindled.
Source: Author
However, Wonderful’s investors are better off than Mundane’s. Wonderful’s owners invested $100 and received a $250 increase in valuation, a 150% return on investment.
Mundane’s owners invested $100 and received a $100 increase in valuation, zero return on investment. Mundane, therefore, is like a bank account. If you add $100, the account’s value increases $100, but you've not created any value.
Adding capital to high-return businesses creates value. Adding capital to low-return businesses doesn’t. This is why we prefer to own high-return businesses that can reinvest profits at high rates of return.
Gold Is Inferior To Wonderful Businesses
Conventional “wisdom” holds that real assets like gold, real estate, and commodities offer the best hedge against inflation. This is wrong. Businesses laden with tangible assets and natural resources tend to resemble Mundane more than Wonderful. Capital-intensive businesses require owners to reinvest lots of capital relative to the incremental profit they receive, making them poor investments.
The chart below shows the S&P 500 denominated in ounces of gold, not U.S. dollars. Despite significant volatility, it takes an ever-increasing amount of gold to buy one share of the S&P 500. Said differently, the S&P 500’s purchasing power has risen faster than gold’s. And let’s not forget that gold has associated storage costs akin to a negative yield while the S&P 500 pays dividends. Neither are included in this chart.
Source: PricedInGold.com
While gold and other real assets might be superior to cash under your mattress, they’re inferior to the average business and far inferior to high ROIC businesses.
How to Protect Yourself From Inflation
In 2004 a Berkshire shareholder asked Buffett and Munger how to protect himself from inflation. Buffett said:
The best thing is to have a lot of earning power of your own. If you're the best brain surgeon in town, or even the best lawyer in town, you will retain purchasing power, in terms of your income, no matter what happens, you know, whether people are using seashells for money, or whatever as time goes by.
This echoes Dean Martin’s career advice: “Be so good they can’t ignore you.” If you are the best at what you do, you’ll be able to raise your prices or negotiate a higher wage during bouts of inflation.
Munger added:
One of the great defenses to being worried about inflation is not having a lot of silly needs in your life. In other words, if you haven’t created a lot of artificial demand to drown in consumer goods, why, you have a considerable defense against the vicissitudes of life.
These qualities (pricing power + low overhead) will also protect a business from inflation. So, which businesses fit this mold?
Many businesses with a “take rate” come to mind. For example, Visa, Mastercard, American Express, Moody’s, MSCI, and Black Knight. These businesses take a fixed percentage of the money flowing through their “pipes.” Their revenues will naturally inflate without price hikes. High-ROIC auction houses, like eBay, Copart, Facebook, and Alphabet, will likewise see auction prices rise, and their take, grow alongside inflation. None of these businesses require much working capital, fixed assets, or capex, and they can all accommodate new business at high incremental margins.
Asset managers will probably do well too. KKR, Blackstone, Apollo, BlackRock, Diamond Hill, and Pzena Investment Management come to mind. They earn a percentage of assets under management and require virtually no capital. Inflation causes nominal asset values to rise, which will naturally increase their fees.
We already see asset price inflation as a result of stimulus — Tesla, a RobinHood favorite, is up about 50% since I wrote its nosebleed valuation about it two weeks ago in Financial Euphoria. Bitcoin is already up 40% year to date. For a more extreme case, take a look at Argentina's stock market over the last ten years. Nominal prices are up tenfold due to severe inflation.
Source: Trading Economics
Franchisors, like Hilton, Wyndham, Restaurant Brands International, and Wendy’s, similarly earn a royalty on franchisee’s revenues. They’re capital-light businesses with extraordinary returns on capital and minimal capex requirements. Hilton is little more than a URL, logo, and rewards program these days. However, franchisors only prosper when franchisees prosper, and franchisees run low ROIC businesses with limited pricing power. Demand for hotels will cool if the price of a room-night double, limiting pricing power. If franchisees are pouring their profits back into their business to maintain the real purchasing power of their profits, they’ll have little appetite for unit expansion.
A business with long-lived assets like real estate or Berkshire’s Burlington Northern Santa Fe (BNSF) railroad will do alright, for a spell. Initially, BNSF’s revenues will increase prices alongside inflation, driving nominal revenue growth. Railroad track lasts 40 years, which will delay inflation’s effects on BNSF’s capex. For a time, BNSF’s ROIC could rise, but it will be a mirage of accounting. Eventually, BNSF will replace its track at inflated prices, and ROIC will revert to where it started.
Inventory-heavy businesses with negative working capital, like AutoZone and AmerisourceBergen, are an interesting edge case. Inflation will require more inventory. But since accounts payable exceed inventory, more inventory won’t require more cash.
Ferrari also has negative working capital. They can manufacture and sell a car before they pay for the raw materials in it. Ferraris are also a Veblen Good, which means demand increased as prices rise. This makes raising prices easier.
As I wrote in Financial Euphoria, the price of a wonderful business still matters. Investing is not as simple as buying the best businesses, regardless of price. If inflation materializes, interest rates will rise, which can compress P/E multiples.
Companies like ASML and WD40 are trading like bonds at 50-70x earnings because they exhibit stable cash flows that will likely withstand inflation. A 2% earnings yield might be palatable when interest rates are zero and inflation is naught, but that could change quickly. A re-rating from a 2% to 4% earnings yield means a 50% decline in price. Such a decline could take years, if not decades, of growth to claw back.
Conclusion
In the depths of the 2008 financial crisis, President George W. Bush had perhaps the most candid take on the economy ever when he said, “If money doesn’t loosen up, this sucker will go down.”
Today we’re in the opposite situation. Money is flowing like Niagara Falls. We don’t kid ourselves that we know where the economy is going, but we are vigilant of where we’re at today.
The present situation seems to favor inflation. Armed with that knowledge, our job remains the same: Buy good businesses. Don’t overpay. Avoid excessive leverage. Hold for a long time.
Ben Graham wrote that "The purpose of the margin of safety is to render the forecast unnecessary." If we’re right about our businesses’ quality, pay a reasonable price, and avoid leverage, we are likely to have enough of a margin of safety to weather any storm. That gives us the power to hold for long periods of time.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.