A great article from Ben at The Inoculated Investor blog.
So, with all of the issues with gold, I guess that leaves ownership stakes in businesses as the best inflation hedge, right? Bruce Greenwald thinks so:
“The assets that are most attractive are the franchise businesses that have pricing power, because you can pass along inflationary price increases and you are not subject to competition from excess capacity, the way you are in industries like autos and steel. You have much more control on the downside.”
I never had any reason to doubt that rationale until I picked up the December 2009 edition of Value Investor Insight. In this issue Colin Moran and Geoff Gentile of Abdiel Capital discuss their study of the impact of inflation on stocks:
’s last stretch of high inflation was between 1973 and 1981. In the early 1970s many equity investors, as they do now, imagined generally rising prices would make earnings grow faster, sending stock prices higher and giving investors a good real rate of return. U.S.
It didn’t work out that way. Inflation turned out to be a kind of neutron bomb that left revenues and profits standing while decimating the free cash flow available to owners. Even if a company’s GAAP earnings kept pace with the general level of prices, higher working capital needs and increased prices for capital spending meant that free cash flows failed to keep up with the price level.
Overall, inflation and taxes together stripped public-company owners of more than 100% of their reported profits from 1973 to 1981. We measured that by tracking the book value per share of companies in the Fortune 500, which compounded at 10% per year over that period, adjusting for share repurchases and including the after-tax value of dividends paid out. Someone who bought a business in 1973 and sold it in 1981, in both cases for book value, would have actually lost ground. After capital-gains taxes, the investment would have doubled, but over the same period the overall price level more than doubled.
And most owners would probably have done worse. Having for years failed to produce real returns, businesses traded in 1981 for less relative to book value than they did in 1973. As a result, stock prices grew more slowly than book values. The S&P 500 added only 3% annually during this stretch – again including the after-tax value of dividends – but since inflation compounded at 9% per year, stocks’ real value declined 40%.”
Wow. A 40% decline is pretty ugly and seems to fly in the face of the often quoted benefit of stock ownership as espoused by Buffett and Greenwald. If stocks didn’t protect purchasing power, then what about bonds?
“Treasury bills, reinvested every three months from 1973 to 1981, compounded at 8% per year. Long-term government bonds bought in 1973 and held to maturity delivered less. Assuming total state and federal taxes consumed a third of the interest income, Treasury bills ended up delivering a 5% after-tax yield. Cumulatively, these “risk-free” Treasury bills lost 30% of their real value. It's worth emphasizing that tax-paying investors need to compound way above the rate of inflation just to maintain purchasing power. If prices are stable, any positive return gives you a positive real after-tax return. But if inflation is 10%, a investor paying taxes needs 15-20% returns to keep wealth from losing its purchasing power.”
Yikes. A 30% loss in real value is better than the 40% loss that stocks experienced, but neither did the job of protecting purchasing power. Did anything do well over this period?
Gold and oil compounded in the low-20% range in the period. Residential real estate also rose slightly faster than the general price level; and the equity of homeowners with mortgage rates set in the early part of the decade obviously rose faster than the assets themselves. Not all stocks are losers in an inflationary environment. The 25 highest-ROE companies in the Fortune 500 compounded book value at 15% annually from 1973 to 1981. Warren Buffett compounded Berkshire Hathaway's book value at around 20%. In general, businesses that could support a fair amount of leverage, had decent pricing power and had limited capital needs did well. We expect the same to hold true if inflation rekindles in the future.
It comes as no surprise to me that an investment strategy focused on high quality, high return companies served as a reasonable form of protection. It comes as even less of a surprise that value investing as practiced by The Oracle of Omaha was the best of all the strategies.
What should investors conclude from all of this data? Well, at first blush it looks as though gold and oil could potentially be viable inflation hedges, given that the current price does not already reflect future inflation expectations. The problem with both is that there is almost no way to know what is embedded in the current price. Inflation concerns? Supply-demand imbalances? Geo-political fears? Irrational speculation? Accordingly, I think the data corroborates what Buffett and Greenwald have been stressing recently. But that does not mean that blindly owning a stock index is going to be a saving grace. Instead, investors need to focus on buying shares of companies with conservative management teams that are prudent capital allocators and that have sustainable competitive advantages. It is my belief that such stocks purchased below their intrinsic values and with a sufficient margin of safety will always offer investors the best opportunity to compound their wealth irrespective of the inflation rate.
Related previous post: Warren Buffett’s Comments on Inflation