Governments and central banks around the world have reacted quickly to try and stem the economic fallout from the Covid-19 pandemic.
In many countries, including the U.S., crisis-era central bank policies have been revived, and governments have signed huge bailout packages for the private sector. These developments, while potentially necessary right now, greatly increase the chances of inflation at a later date.
Inflation has always been a risk for equity investors, but after these massive monetary and fiscal packages, it is now more of a threat than it has been in the past few decades.
Warren Buffett on inflation
Inflation is bad news, especially for bad businesses. Companies that lack pricing power are bound to suffer as input prices rise and they're forced to spend more and more money on the rising cost of equipment.
Warren Buffett (Trades, Portfolio) laid out the risks of inflation for investors in his 1981 letter to investors of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial).
"Inflation takes us through the looking glass into the upside-down world of Alice in Wonderland," the Oracle of Omaha wrote in his annual letter. "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."
Describing inflation acts as a "gigantic corporate tapeworm," the CEO of Berkshire told shareholders it "preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism," as no matter how much money a business is earning, more and more money will always be required to fund investment, working capital demands and wages.
In the early 1980s, inflation across the U.S. was more than 10%. This meant even businesses earning 10% on capital were struggling to keep up as the "tapeworm" demanded more and more funding to stay alive.
At the time, Berkshire was clearing this hurdle. It was reporting a 21% return on equity capital. As Buffett explained:
"Berkshire continues to retain its earnings for offensive, not defensive or obligatory, reasons. But in no way are we immune from the pressures that escalating passive returns exert on equity capital. We continue to clear the crossbar of after-tax passive return - but barely. Our historic 21% return - not at all assured for the future - still provides, after the current capital gain tax rate, a modest margin over current after-tax rates on passive money."
So, how do investors avoid falling into this trap? Like so many questions in investing, there's no one single answer to this query. Most businesses will be, in one way or another, impacted by inflation over the long-run. Nevertheless, there are some precautions investors can take to prepare for the worst.
Avoiding fixed income is an excellent place to start. Bonds with a coupon of 1% or 2% are not going to fare well in an inflationary environment. The yield on the 10-year Treasury now sits at 0.8%. If inflation hits a relatively conservative 3%, that implies a real yield of -2.8%. Over a 10-year horizon that suggests investors will see a real return of -25% over the term of the bond.
On the other hand, companies with pricing power and a robust competitive advantage should fare better. These businesses will likely be able to raise prices in line with inflation, maintain profit margins and enabled dividend growth to match rising prices. If you're looking to protect your portfolio from inflation, looking for these companies could be a great place to start.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- We Might Not Be at the Bottom, but There Are Bargains
- Warren Buffett's Rules for Investing in a Crisis
- Seth Klarman's Tips for Finding Deeply Valued Securities
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
