How Inflation Still Swindles the Equity Investor and How to Protect Yourself Against It

Warren Buffett wrote an article in 1977 that was published in Fortune Magazine that was entitled, "How Inflation Swindles the Equity Investor". Before this article was written, it was often thought that equities were a hedge against inflation. But the experience of the 1970s seemed to disprove this notion.

High Inflation Can Often Have Poor Performing Stocks

In the 1970s inflation was very high, and stock markets wilted under the strain of such high inflation. The key insight of Buffett's article was that when there is high inflation, stocks often perform poorly just like bonds do. But why was this the case? It stands to reason that if I own a business and there is high inflation, I will simply raise my prices and charge more to offset my higher costs. If I raise prices at a rate equal to inflation I should be left in the same position as I was before, with the same exact purchasing power. Shouldn't I?

The problem with this premise is that equities are not all created equal. A stock in a business is a share of whatever that business owns. So it's not useful to say equities perform better or worse in a high inflationary environment. Some will perform very well, and some will not, depending on what the business owns. Let me give you an extreme example which demonstrates this.

An Extreme Example to Demonstrate

Let's say I owned a company whose sole business is to own government bonds. 100% of the assets on the company's balance sheet are long term fixed rate bonds. In this scenario my equity shares in this company are not really 'equity' at all. The business of the company is fixed rate bonds, and effectively by owning the equity in the business I own fixed rate bonds. Fixed rate bonds do not do well in a high inflationary environment as the amounts you get paid are fixed, and inflation is devaluing the purchasing power of those fixed payments rapidly.

This is not as far fetched as it sounds. The business model of many banks, credit unions, savings and loans, and insurance companies is to essentially borrow money short term (from depositors with accounts) and invest that money in long term bonds. As a result, these types of financial companies often have big challenges in a high inflation type of environment, and that's why you saw the collapse of the savings and loan industry in the US during the 1980s.

Losing Customers to Competition

Another issue with owning equities in a high inflationary environment is that some businesses are not able to raise their prices because their customers will either switch to a lower cost product or service, or they will just stop using it altogether. I have an 8 month old child, and she makes a lot of messes. We go through a lot of paper towels in our house. If I have a favourite brand of paper towel, I will choose that brand as long as it's not a significantly different price then its competitors.

But if the price gets raised even a little bit, I would probably switch to a different brand. Or I might even buy reusable cloths or choose some other method of cleaning up messes in my house (this would be good for the environment as well). So paper towel companies don't have the luxury of raising their prices too much because they will lose their customers to their competition.

Disaster for a Business

The same can be said for many industries and services. Many simply don't have the capacity to raise prices significantly when inflation is high. So the value of their stocks suffer. If a business is unable to raise prices, that doesn't mean their costs are also staying the same. In an inflationary environment, their costs will be going up. Their suppliers could be charging more, their employees will be demanding more for wages because of the higher cost of living, and investors and lenders will be demanding a higher rate of return because of the higher inflation. If a business is caught with stagnant or sinking revenues and rising costs, that can spell disaster for the business.

This is particularly true for businesses with high capital requirements and high depreciation. If a business owned a lot of assets that were long lived and saleable, then theoretically those assets would rise in value when there is high inflation. That doesn't necessarily help the business in the short term because those assets are likely needed in the business, but at least it does provide some assets which can be used as collateral for loans and could be sold if there was a need.

However for business with high capital requirements and who own assets that are not long lived, this can be a very problematic scenario in a high inflationary environment. That's because the business is constantly forced to re-invest in new capital assets, the costs of which are rising rapidly. On the flip side their assets are being used up very quickly so they're not really retaining any advantages of the higher inflation. If the business is unable to raise prices for their products or services, this could mean extreme financial hardship for the business.

One Homogenous Monolithic Group

So we've proven that some equities will definitely do poorly in a high inflationary environment. In fact, according to Buffett, most equities will behave like a bond and will do poorly. But that's not the end of the story. As we mentioned above, in this article Buffett treated equities as one homogeneous monolithic group. We know they are not. So if that's the case, could there be equities that will perform better in an inflationary environment? Absolutely there can be.

Extreme Example Number Two

If we take another extreme example we can see what I mean. Gold is often used as a hedge for inflation. That's because gold has historically been used as a currency and because it can only be produced by digging it out of the ground, it's not possible for anyone to manufacture or create more of it out of thin air, like we can with paper money. So if I owned shares in a corporation whose only business was owning gold, then that would be a pretty good hedge against inflation, because effectively I would own gold, and that gold would rise in value with inflation.

Incidentally a business that was solely in the business of owning gold would not be a very good business at all, as there are storage costs to holding gold and gold itself doesn't produce anything. However there are businesses which are somewhat analogous to a business that owns gold. These are of course, gold mining companies. They are in the business of digging gold up out of the ground and selling it. When gold prices go up, gold miners tend to do well. Now anyone who has ever owned a gold company knows that owning a stock of a gold miner is a very different experience then owning gold itself. But it is still true that in a high inflationary environment, gold miners should do well.

Toll Roads

I think there are businesses that will do even better in a high inflationary environment. These are businesses that have such a strong moat around their business that they retain a very significant pricing power. Essentially they can become something like a toll road. A toll road is often essential for people to use. They have no other choice, and they will be forced to pay whatever price that is charged because they are at the mercy of the operator. There are businesses in real life that function as toll roads in effect and they are tremendously valuable businesses.

One good example would be Google. Google is of course a search tool that often functions as the gateway to the internet for the vast majority of people around the world. There is a flywheel effect where more users mean more searches, more searches mean more and better data for Google, more and better data for Google means more accurate search results, and more accurate search results means more users will want to use Google, and around the flywheel we go. At this point it would be very difficult for any company to challenge Google's dominance in internet search. As a result, Google essentially owns a toll road on the internet.

But they don't charge users directly, instead they charge advertisers for the opportunity to market directly to their users. It would be like a road with no tolls but the owner of the road charges advertisers for roadside signs. That is understating the power of Google's model though because on Google's road, the roadside signs are customized to each individual driver and they offer immediate turnoffs to go and buy that product or service. It's a tremendously powerful business model if you think about it. Because Google is essential for internet users, it is also essential for businesses who want to advertise to those users. As a result they are willing to pay very high prices to get the exposure they need for their business because they know it will be worth it to them.

In a high inflationary environment, Google can raise prices for advertising, and because they have relatively small needs for capital re-investment, their business will do very well in an inflationary environment. Essentially Google (through it's parent company Alphabet) is a fantastic hedge against inflation. This doesn't mean it's a good investment mind you. Even a really great company can be a bad investment if you pay too much. But Google's business is definitely a great hedge against inflation.

Asymmetric Bet

When you find a business that has both a great moat around it like Google, as well as a great price, you get a powerful combination that I call an Asymmetric Bet. In my next post I'm going to dive into what an Asymmetric Bet is and why I prefer to think of investments like an Asymmetric Bet rather than an Equity Bond. Stay tuned!

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.