I wrote this sometime in May 2021. It helps me learn by writing these things, I learned and clarified a lot writing this one. Hope you enjoy!
Me writing this note correctly implies that I am fearful of inflation. But let me take a brief moment and say that when it comes to making macroeconomic predictions, the hall of fame worthy economists have stats similar to hitting in baseball, .300 is really good. Take the inverse of that, 70% of the time even the best batters do exactly what I would do standing at the plate...strike out and sit down. So don’t be totally surprised if many are wrong about inflation or any macroeconomic prediction for that matter.
What we do know, is when politicians borrow and spend money, that is a force in the direction of inflation. When the federal reserve keeps interest rates low and prints new money to buy assets, that is a force in the direction of inflation. In a big way, congress and the federal reserve has been pushing toward inflation.
When inflation rates are high, it acts as the largest expense investors pay. A steady figure in American business has been the roughly 12% return on equity capital earned by corporations. Read Warren Buffett writing in a 1977 Fortune article:
But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.
The coupon is sticky
In the first ten years after the war - the decade ending in 1955 - the Dow Jones industrials had an average annual return on year-end equity of 12.8 percent. In the second decade, the figure was 10.1 percent. In the third decade it was 10.9 percent. Data for a larger universe, the FORTUNE 500 (whose history goes back only to the mid-1950's), indicate somewhat similar results: 11.2 percent in the decade ending in 1965, 11.8 percent in the decade through 1975. The figures for a few exceptional years have been substantially higher (the high for the 500 was 14.1 percent in 1974) or lower (9.5 percent in 1958 and 1970), but over the years, and in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter).
The problem is, that figure has been remarkably steady, even when inflation rates hit 4, 5, 6+%. We have roughly $10 trillion dollars worth of equity capital among the S&P 500 companies. That means you can reasonably expect the net earnings of them all to be around $1.2 trillion in 2021. Some of that money will be retained by the corporation, adding to the total amount of equity capital, and some of it will be returned to shareholders via dividends and stock buybacks. If companies across the board are going to earn something around 12% ROE regardless of inflation, that means if we have 6% inflation, $600 billion, or half, of those earnings must be plowed back into the business simply to maintain current production volumes. Inflation is the largest expense corporations pay.
In the coming months if the fears of inflation rise, I can assure you with complete confidence you will be introduced to many “solutions” to inflation. The truth is debt borrowed at rates below inflation is the only investment that thrives in an inflationary environment. If you borrow money at 5% and inflation runs 10%, essentially you have a -5% interest rate loan. Before you call your banker, remember the bank issues that loan because banks know we may or may not get high inflation rates over the next 30 years. Only time will tell.
Those who own a home, carrying a long mortgage at the going low rates makes more sense when you have good reason to be fearful of inflation than when you don’t.
To find stocks that can survive in an inflationary environment you want to look for two qualities: (1) the ability to raise prices without a decrease in market share or unit volume (2) an ability to increase large dollar volume increases in business with only minor additional capital spending. Keep in mind, these companies will only provide satisfactory returns if purchased at appropriate prices. Alas, companies that meet both of our criteria typically are widely recognized and frequently sell for high prices.
There is however one kernel of good news. While our economists might hope to get on base once every 4 or so times they make their inflationary predictions, it should not drastically change your investment behavior. We always should invest with respect boarding on fear of inflation. Companies with both pricing power and the ability to grow sales with only relatively small additional investments in the business, purchased at appropriate prices, are always a smart investment. Attempting to select companies that meet these characteristics, knowing that we may or may not run into inflation, wisely adheres to Ben Franklin’s maxim: “An ounce of prevention is worth a pound of cure”.
Think about pricing power. Let’s start with a bad example.
The perfect example of a company with poor pricing power might be auto manufacturers.
2021 Pickup Truck
msrp (per google search)
Dodge Ram 1500
$28,855
Ford F 150
$28,940
(GM’s) Chevy Silverado
$29,300
Look how closely they are all priced. If we get 10% inflation, you now have to buy materials that cost roughly 10% more to build your next truck. Dodge, Ford, and GM all deal with this issue. Here’s the problem. Think about being in management at Dodge, if you increase the price of the RAM 10%:
2021 Pickup Truck
msrp (per google search)
Dodge Ram 1500
$28,855 $31,740
Ford F 150
$28,940
(GM’s) Chevy Silverado
$29,300
How many buyers will buy the Ram over the F 150 or Silverado? You might have some people that choose the Ram for it’s brand, but you have to expect a significant drop in sales volume. As you get drops in sales volume, you get worse purchasing prices on raw materials. You might start to have plants that cost 10% more to maintain, and are sitting there underutilized, do you invest in them? As these costs rise you might want to further increase your price, which could lower your market share even more.
The problem is all three car makers know this and it becomes an inflation fueled game of pricing chicken. And meanwhile, it’s really the investors profit margins that pay the price.
Think about it the other way too. If GM and Ford raise prices and Dodge doesn’t, Dodge might pick up market share.
2021 Pickup Truck
msrp (per google search)
Dodge Ram 1500
$28,855
Ford F 150
$28,940 $31,834
(GM’s) Chevy Silverado
$29,300 $32,230
The issue is, to meet that market share growth Dodge will have to invest in plant capacity to make all the new trucks it has been selling for reduced profit. With inflation, maintaining your old plants gets more and more expensive, and building that new plant will take even more capital to build. Accounting rules require that when you build your plant you write off that expense via depreciation over time. So not only do you have to shell out large amounts of money today in order to build it, but the value of your write-offs goes down as inflation rises. If it costs you $10 million to build the new plant, and you write off $2 million a year for 5 years, if inflation rates average 6% over that time, 25% of the cost of building your plant will be a taxable event, your write-offs don’t rise with inflation. Regardless of how this game plays out, at some point Dodge will have to increase prices and if that causes a drop in sales volume, the new plant might prove to be purely an unneeded expense.
Investors might be told that cost savings can offset these inflationary induced cost increases, and perhaps that proves true, but you have to be skeptical if the company waits until inflation hits to make these improvements. Last I checked cost savings are a fairly high priority item during non inflationary times too.
The much more likely scenario is all three auto manufactures slowly raise prices with their profit margins taking the hit. It’s not the type of situation you want to find yourself in.
On the opposite end of the spectrum take Soda.
Price (per amazon)
Coca Cola 12 Pack
$5.19 (+10% = $5.71)
Pepsi 12 Pack
$4.99 (+10% = $5.49)
If you get 10% inflation and Coca Cola raises prices to $5.71, do you really think the Coke drinkers will switch to Pepsi? Go ask a coke drinker if they would pay up $0.52 cents for a 12 pack of the soda they prefer. So the pricing game of chicken doesn’t work in soda. You don’t have the same problem. If Pepsi is slow to raise prices (at the expense of their own margin) Coke will simply raise theirs and know that unit volumes won’t drop by any meaningful amount. Pepsi keeping prices low likely won’t meaningfully increase market share, so they probably won’t do it. There is no game of pricing chicken, both brands will likely just raise prices.
And while for Pepsi and Coke they might be able to handle inflation well, sometimes one player in an industry can prosper while the industry as a whole suffers.
When you go shopping for smartphones, how many people do you know have never even considered buying anything but an iPhone? In my experience Android users sometimes have loyalty to a specific brand, particularly Pixel or Samsung, but I also know lots of Android users that are very open to other phones running Android, whether it be Samsung, Google’s Pixel, LG you name it. If Apple raises prices, the debate is typically between buying a new iPhone now or in a year. Rarely does it push them to Android. The smartphone industry might experience the pricing game of chicken, but Apple probably won’t have to play.
So when picking stocks, you have to ask yourself if the company has a brand that can easily raise prices without losing business. The other consideration is if you increase production volume will the business need heavy capital investment. Google can take on new business with next to no increase in cost. A company like Verizon or AT&T, might have some pricing power, but if they wish to expand, they will have to build lots of expensive new infrastructure. In an inflationary environment, not only are all the costs of keeping their legacy customers rising, but all the costs of building new capacity substantially rise as well. How much more can Verizon charge you before you switch to AT&T? The pricing game of chicken is very likely to happen in telecoms. Worse yet, 5G, might eventually allow each provider to raise prices, but before they find out it certainly will require billions in capital investment that they have no choice but to pay. If Verizon builds 5G and AT&T doesn’t, think how that would impact AT&T subscriber-ship. AT&T has no choice but to make the investment, there’s nothing strategic about it. If I was in the cell phone service provider business the numbers 6, 7, and 8 spoken near anything that rhymes with G would be banned from my household.
I hope I illustrated that some equities are better positioned for inflationary environments, but certainly not all companies can thrive. Unfortunately saying equities are a hedge against inflation is an often said, yet oversimplified rule. More accurately, equities are your best of many bad choices when it comes to hedging against inflation. The bond markets are fine when they accurately price in the inflation risk, however, today’s 30 year yields certainly do not anticipate any meaningful rise in inflation. Even if we do get high inflation rates, politicians and borrowers will be heavily incentivized to downplay the likelihood that it will last long. That downplaying will make the pricing decisions at all firms very difficult. Back to our car example if you think inflation will decrease next year maybe you don’t raise prices now, that further extends the duration of our game of pricing chicken. If you’re Coca-Cola, you do whatever you want.
Now that I’ve put on paper that I’m worried about inflation, the odds of any meaningful inflation happening surely have dropped at least 20%.