Warren Buffett explains how to invest in stocks when inflation hits markets - CNBC News

Warren Buffett explains how to invest in stocks when inflation hits markets
Warren Buffett has been vocal on the subject of inflation in past periods of rising prices.
In the late 1970s and early 1980s, he devoted significant portions of the Berkshire Hathaway annual letter to investing in stocks during inflationary periods.
He warned before the financial crisis that inflation would cause a shock, and after the crisis that central banking policy would ultimately force a reckoning in stocks.
Eric Rosenbaum | @erprose
Published 8:31 AM ET Mon, 12 Feb 2018  Updated 2:23 PM ET Wed, 14 Feb 2018
CNBC.com
Warren Buffett has always been a firm believer that staying invested in stocks is the only course.

If anything, Buffett, the chairman and CEO of Berkshire Hathaway, is famous for the ultimate statement on dip buying: Be fearful when others are greedy and greedy when others are fearful.

But these Buffett-isms may mask the fact that, throughout his life, Buffett has offered many wise words on just how much inflation can ding stocks. Now that inflation is back in the crosshairs of the markets, as investors try to understand what has caused such a swift correction in stocks, it's worth looking back at what Buffett has said about inflation in the past.

Buffett devoted significant portions of Berkshire annual letters in the late 1970s and early 1980s — amid high inflation in the United States — to discussing what rising prices mean for stocks, corporate balance sheets and investors. Buffett lived and invested through a period when inflation hit 14 percent and mortgage rates spiked as high as 20 percent — amid what some called the greatest American macroeconomic failure of the post-World War II period.

He never lost that focus on — or fear of — inflation, either.

In June 2008, as the price of gas went above $4, Buffett said "exploding" inflation was the biggest risk to the economy. "I think inflation is really picking up," Buffett said on CNBC. "It's huge right now, whether it's steel or oil," he continued. "We see it everywhere."

Do you remember what happened after that?

In 2010, as the Federal Reserve continued its quantitative easing program, Buffett sent the government a "thank you note" (in the form of an op-ed) for its actions, rather than its paralysis or politicking, after the crisis. But he also warned that same year, "We are following policies that unless changed will eventually lead to lots of inflation down the road."

He added, "We have started down a path you don't want to go down."

As the markets sank in the past two weeks, headlines suggested that the end of the central bank easy money era was finally "sinking in." At the 2013 Berkshire Hathaway annual meeting, Buffett had already warned, "QE is like watching a good movie, because I don't know how it will end. Anyone who owns stocks will reevaluate his hand when it happens, and that will happen very quickly."

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In a classic piece for Fortune magazine in 1977, Buffett outlined his views on inflation: "The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. ... If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker — but not your partner."

The world, and economy, are very different places now than when Buffett's annual letters to Berkshire Hathaway shareholders took up inflation and investing. Income-tax rates have changed. Back then, bond yields were much, much higher, as were savings rates. And it's just the first signs of inflation that now have been spotted. It was the rise in wages in the last nonfarm payroll report that first rattled markets. And the Consumer Price Index did rise more than expected in the latest data, released on Wednesday, Feb. 14.

Other economic factors are eerily, or at least partially, similar. In the Vietnam War era the government's rapid increase of the federal deficit began the inflation cycle that peaked in the late '70s. The latest projections from a government budget watchdog forecasts that the annual deficit will double from what was expected just two and half years ago ($600 million), to $1.2 trillion in 2019, due to the tax cuts and just-approved spending package.

It's worth remembering that the worst stock performance of the 1970s came not when inflation peaked but when it first spiked rapidly. From 1972 to 1973, inflation doubled to more than 6 percent. By 1974 it was 11 percent. In those two years, the S&P 500 declined by a combined 40 percent. Inflation was higher in 1979 and 1980, topping out at 13.5 percent, by which time the S&P 500 had long returned to positive performance, though on an inflation-adjusted base. It was a lost decade for stocks.

So who better than Buffett to explain some of the basic mechanisms at work when stocks run into inflation? As Buffett stated in one of his inflationary era letters, when it comes to inflation and stocks, there is one unsolvable problem: "Berkshire has no corporate solution to the problem. (We'll say it again next year, too.) Inflation does not improve our return on equity."

Here are some other thoughts from Buffett on investing during inflationary periods.

1. When you are doing great, it is the time to remember inflation.
Buffett wrote at a moment of good performance for Berkshire, "Before we drown in a sea of self congratulation, a further — and crucial — observation must be made. A few years ago, a business whose per-share net worth compounded at 20 percent 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.

"A business earning 20 percent on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail."

2. During high inflation, earnings are not the dominant variable for investors.
"Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego 10 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 your investment, no matter how much it appreciated in dollars. You may feel richer, but you won't eat richer.

"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 'hurdle rate' the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners — has increased dramatically in recent years. The average tax paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil."

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3. Understand the math of the 'Misery Index.'
"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."

4. Inflation is a 'tapeworm' that makes bad businesses even worse for shareholders.
"A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the 'bad' business. To continue operating in its present mode, such a low-return business usually must retain much of its earnings — no matter what penalty such a policy produces for shareholders.

"... Inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the 'bad' business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past — and most entities, including businesses, do — it simply has no choice.

"For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

... The tapeworm of inflation simply cleans the plate."

5. Focus on companies that generate rather than consume cash.
"Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their existing physical volume of business. There is a certain mirage-like quality to such operations. However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings attached cash."

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6. Look for companies that can increase prices and handle a lot more business without having to spend a lot.
Of course, most of us are not billionaire buyers of corporations outright, but Buffett's words on what makes for a great acquisition in the 1981 letter touch on inflation as one of two key factors that make a great acquisition candidate:

"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: (1) 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, and (2) 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."

7. Always be thinking about tomorrow, especially when the pace of change picks up.
"Several decades back, a return on equity of as little as 10 percent enabled a corporation to be classified as a 'good' business — i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at more than 100 cents. For, with long-term taxable bonds yielding 5 percent and long-term tax-exempt bonds 3 percent, a business operation that could utilize equity capital at 10 percent clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10 percent earned by the corporation to perhaps 6 percent to 8 percent in the hands of the individual investor.

"Investment markets recognized this truth. During that earlier period, American business earned an average of 11 percent or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were "good" businesses because they earned far more than their keep (the return on long-term passive money). The value-added produced by equity investment, in aggregate, was substantial

"That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday's assumptions can be retained only at great cost. And the pace of economic change has become breathtaking."

8. Corporations cannot out-manage government.
"One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, 15 years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.

"We intend to continue to do as well as we can in managing the internal affairs of the business. But you should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway."

9. There is no solution to inflation, but there's reason (maybe just a little) for hope.
Buffett wrote in 1980, "The chances for very low rates of inflation are not nil. Inflation is man made; perhaps it can be man-mastered. The threat which alarms us may also alarm legislators and other powerful groups, prompting some appropriate response."

The recent action in stocks does not suggest faith in that response being adequate, but the chance that it's adequate isn't "nil," either.