“For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ('In Goods We Trust'). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.” - Warren Buffett (Trades, Portfolio)
In his 1983 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholder letter, Warren Buffett (Trades, Portfolio) gave a vital lesson against the prevailing “wisdom” that capital-rich businesses help hedge inflation. He illustrated this point by comparing See’s Candy, which mainly depended on intangible assets to operate and grow, and a hypothetical mundane business earning a low return on tangible assets. The former generates far more shareholder value per every dollar of capital invested during an inflationary environment.
“A disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets,” Buffett wrote.
In light of the central bank-led money-printing initiatives around the globe, we think that investors should prepare themselves in protecting purchasing power. In the equity space, many would intuitively go with natural resources businesses. But Buffett appears not to think it necessary to worry too much about the pricing of business output in the face of declining currency value. Instead, he assumes that most businesses can raise prices sooner or later. After all, companies that fail to maintain a necessary degree of pricing power could lose to competitiors even without inflation and, therefore, would not be the target for him anyways.
Many would also imagine that the nominal value of tangible assets could go up through an inflationary environment. This is true, but intangible assets can increase in value as well – and probably even more, according to Buffett. Rather than showing up on the accounting book, an “inflating” economic goodwill can be reflected through a higher return on tangible assets. This is because asset-light businesses spend way less on capital expenditures than their asset-heavy counterparts. Inflation just adds to the economic cost of the latter and helps the former gain more competitive advantages.
So look for capital-light businesses to hedge inflation. To gauge how much a business needs to consume new capital, investors can look at the historical CapEx as a percentage of sales, operating cash flow or net income – the lower the better, but the figure should be put into the context of business growth. For instance, the U.K.'s top property portal site, Rightmove (LSE:RMV, Financial), spent less than 1% of its sales or less than 2% of its earnings on CapEx every year over the last five years. In the meantime, the company’s top line and bottom line both grew by nearly 12% annually, which is a remarkable record of shareholder value creation, in our view. Rightmove raised prices a couple of times for the past few years. The actions invoked anger among its customers, but the business still maintains its market-dominating position with an astonishing over 80% market share. The largest network connecting estate agents and buyers and renters in the U.K. builds a valuable intangible asset for Rightmove. It helps generate a super-normal return on capital (i.e., 437% as of fiscal 2019) and just requires very little capital to maintain and grow. As a result, it should be reasonable to expect the economic profit to easily increase as inflation takes the reins.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Rightmove.
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