Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 185

Buffett on inflation and equity investing

US Senate Majority Leader Mitch McConnell (the Turtle to fans of The Daily Show) has been largely responsible for one of the least productive periods of recent US law enactment. Stagnancy in the Senate was the weapon used against President Obama. McConnell has also stated that some of President-elect Trump’s proposals, including a trillion dollars in new infrastructure spending, are not priorities for Senate Republicans. Regardless, the market currently only has infrastructure spending in its sights.

Rates rising on inflation expectations

US stocks experienced an historically high intra-day move on the night of the US election. US futures at one point were almost ‘limit down’ (a market rule of a maximum of -5%). However, it took just 49 minutes of morning trading for stocks to move positive before finishing over 1% higher for the day. What happened? The perceived wisdom prior to the election was that stocks would fall heavily if Trump was elected, but in hindsight maybe traders had their ‘Brexit’ hedge on this time. They weren’t going to get caught short again.

So stocks are now higher and bonds are selling off as the market now believes Trump’s investment plan can create growth. But a closer inspection of bond yields reveals that it’s not so much growth the market is expecting but inflation (and a slightly higher default risk as Trump has had six companies go bankrupt); 30-year bond yields are spiking, delivering the largest percentage rise in yields ever.

With all this market volatility it’s easy to get caught up in the emotion of the moment. The smart investors, however, are looking at the fundamentals, which are the ultimate driver over the medium to long term.

Inflation and share prices

If the market is right and inflation is due to rise, how should this affect stock prices? Intuitively one might think stocks should be protected from inflation’s taxing effects because companies own real productive assets, but Warren Buffett delivered an important lesson on this topic almost 40 years ago.

In 1977, Fortune magazine published an article by Buffett titled ‘How inflation swindles the equity investor’. In summary, the article highlights the following points:

  • conventional wisdom that stocks would retain their real value despite inflation didn’t eventuate
  • stocks, actually, are similar to bonds in economic substance in that they pay what turns out to be a ‘sticky’ coupon
  • share returns on capital have averaged 13% over 10-year periods since the end of WW2, regardless of the inflation rate
  • this 13% return on equity has historically translated into about a 10% annual return for investors as stocks tend to trade at 1.7x equity value
  • while the yearly high and low over this period was 14.1% and 9.5%, average returns showed no signs of moving higher than average in inflationary years
  • stocks are still riskier than bonds as the ‘13%’ return moves around a little year to year
  • stocks are also riskier as they are ‘perpetual’ instruments – meaning there is no future maturity date where your capital is repaid to allow a renegotiation of your return
  • the only way to earn better returns over time is via five earnings levers: (1) turnover, the ratio of sales to total assets employed (2) cheaper leverage, (3) more leverage, (4) lower taxes and (5) wider margins
  • there is no fundamental reason for return on capital to rise in response to higher inflation.

I’d urge you to read this article for its invaluable lessons in clear and understandable terms. It will also put you one up on many professional investment managers who are still to learn Buffett’s inflation and stocks message. While stocks remain preferable to bonds in a higher-inflation environment, they are still negatively impacted. Higher inflation hurts all investment returns, it’s just a matter of to what degree.

 

Stephen Ross is a Portfolio Manager at OwnersAdvisory by Macquarie, a do-it-yourself investment platform. Owners Advisory is a division of Macquarie Equities Limited. Important disclosure information about any research contained in this document is available at www.macquarie.com/disclosures. Owners Advisory is a sponsor of Cuffelinks.

 

3 Comments
Ashley
December 08, 2016

When Buffett wrote that story in 1977, CPI inflation was running at 7%, having been 12% a couple of years prior (and it rose to 14% a couple of years later). Now inflation is barely 1%. So it might rise back to mid-single digits – but is anyone seriously expecting double digit inflation any time soon?

stefy
December 09, 2016

Do you really believe inflation is barely 1%? Perhaps by our trusted and beloved ABS reckoning. What about the real world!

Warren Bird
December 10, 2016

Not this old chestnut. Sure, any estimate of average inflation is going to misrepresent any one individual's or group's particular experience. But the economic universe doesn't revolve around any one individual or group. The CPI is based upon the data for what all Australians spend their money on, over the whole year, rebased every 5 years. It isn't just your food bill or your interest expenses or your private school fees, it's everything. It isn't a pensioners, or over 65's price index; nor is it a young, first home owner price index; it is the average for all Australians.

The ABS humbly says that you can't call the CPI the 'best' measure of inflation, because there is no such thing. But it is comprehensive, checked by a team of experts on an on-going basis, based on actual prices, collected by people who walk into stores all around the country and look at the items for sale as well as from lots of other sources. If you can do better than that then by all means go to town and produce an alternative.

Private sector groups like Toronto Dominion do a cut down version to try to predict what each CPI will come out at. Over time it gives pretty much the same measure of inflation as the ABS does.

So the inflation rate over the last 12 months is in my view the best estimated at 1.3%, which is the all groups CPI produced by the ABS.

 

Leave a Comment:

     

RELATED ARTICLES

Three all-time best tables for every adviser and investor

Why it's a frothy market but not a bubble

The coiled spring: markets are primed for the year ahead

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.