Benjamin Graham And Inflation's Impact on Stocks

With the generous liquidity central banks are providing, inflation has become a key concern. Unfortunately there has been scant clarity of inflation’s impact on stocks. Benjamin Graham has written an article about inflation simply titled “Common Stocks and Inflation” that sheds some light on the topic.

Graham explains his rationale for buying stocks, “This is a good reason—and there are others—not to be enthusiastic about equities at every market level. This caution is part of my long-held investment philosophy. But what about the current situation? Should inflation prospects dissuade an investor from buying strong companies on a 15 percent earnings return? My answer would be ‘no.’”

He makes clear the need to detach macro concerns if stocks are undervalued. He seemed to feel confident about prospects for stocks at the time he wrote this; I don’t know if he’d feel the same way today.

Of interesting note, he does caution against investing in commodities: “The first is that it is impossible for any really large sums of money—say billions of dollars—to be invested in such tangibles, [‘real estate, gold, commodities, valuable pictures and the like’] other than real property, without creating a huge advance in the price level, thus creating a typical speculative cycle ending in the inevitable crash.”

Graham doesn’t define “strong” companies, but I imagine it wouldn’t be too far off from Warren Buffett’s definition, and in “strong” he would include pricing power. The ability to pass on cost increases to consumers is critical for any business to survive in an inflationary market.

Oil refiners are currently in a precarious situation. Elevated oil prices mean their underlying costs have gone up. The price they receive is that of gasoline which they haven’t raised as much as the underlying cost of oil. The Wall Street Journal described the situation in an article 1-2 months ago. Some U.S. refiners have considered the option of shutting down refining capacity if they aren’t able to improve their margins. The Exxons and Chevrons, which have done well of late, are a more upstream operation. Exxon specializes in oil extraction and their profits are generally contingent on the price of oil.

Moving to a different industry, branded food products, Kraft has not blinked in their intent to raise prices. Higher food costs have squeezed their margins of late. The company is responding by reducing the amount of food in some products in addition to raising prices. Not surprisingly, very strong brands comprise the top of Warren Buffett’s holdings. Coca-Cola, Proctor and Gamble and Johnson and Johnson among others should be able to increase prices should inflation manifest itself.

The question then becomes: Are these stocks trading at prices that would yield 15% as Benjamin Graham specifies? My answer would be I don’t know.

Disclosure: Long JNJ, BRK.B, KFT

Josh Zachariah

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