The document linked below is a compilation that I put
together of Warren Buffett’s comments on inflation and some of the types of
businesses he thinks do well in inflationary times. These comments were
compiled from his 1977 Fortune
article “How Inflation Swindles the Equity Investor”, his annual letters, and
also include other commentary that is not inflation specific, but that I
thought was useful to review in this context. Any misspellings or misstatements
throughout this document are probably from errors I made in the transfer
process, and not those of Mr. Buffett.
Link to: Buffett inflation file
Mr. Buffett has occasionally quoted the Noah principle:
predicting rain doesn’t count, building arks does. It is to be hoped that by
reading Mr. Buffett’s own words over the years, one can get a little direction
in the ark-building process, whether or not the storm turns out to be severe,
non-existent, or just a sprinkle.
…..
Excerpts:
From Warren Buffett’s 1981 Letter to Shareholders:
In fairness, we should acknowledge that some acquisition
records have been dazzling. Two major categories stand out.
The first involves companies that, through design or accident,
have purchased only businesses that are particularly well adapted to an
inflationary environment. Such favored business must have two characteristics:
(1) an ability to increase prices rather easily (even when product demand is
flat and capacity is not fully utilized) without fear of significant loss of
either market share or unit volume, and (2) an ability to accommodate large
dollar volume increases in business (often produced more by inflation than by
real growth) with only minor additional investment of capital. Managers of
ordinary ability, focusing solely on acquisition possibilities meeting these
tests, have achieved excellent results in recent decades. However, very few
enterprises possess both characteristics, and competition to buy those that do
has now become fierce to the point of being self-defeating.
The second category involves the managerial superstars - men
who can recognize that rare prince who is disguised as a toad, and who have
managerial abilities that enable them to peel away the disguise. We salute such
managers as Ben Heineman at Northwest Industries, Henry Singleton at Teledyne,
Erwin Zaban at National Service Industries, and especially Tom Murphy at
Capital Cities Communications (a real managerial “twofer”, whose acquisition efforts
have been properly focused in Category 1 and whose operating talents also make
him a leader of Category 2). From both direct and vicarious experience, we
recognize the difficulty and rarity of these executives’ achievements. (So do
they; these champs have made very few deals in recent years, and often have
found repurchase of their own shares to be the most sensible employment of
corporate capital.)
From the Appendix of Warren Buffett’s 1983 Letter to Shareholders:
But what are the economic realities? One reality is that the
amortization charges that have been deducted as costs in the earnings statement
each year since acquisition of See’s were not true economic costs. We know that
because See’s last year earned $13 million after taxes on about $20 million of
net tangible assets – a performance indicating the existence of economic
Goodwill far larger than the total original cost of our accounting Goodwill. In
other words, while accounting Goodwill regularly decreased from the moment of
purchase, economic Goodwill increased in irregular but very substantial
fashion.
Another reality is that annual amortization charges in the
future will not correspond to economic costs. It is possible, of course, that
See’s economic Goodwill will disappear. But it won’t shrink in even decrements
or anything remotely resembling them. What is more likely is that the Goodwill
will increase – in current, if not in constant, dollars – because of inflation.
That probability exists because true economic Goodwill tends
to rise in nominal value proportionally with inflation. To illustrate how this
works, let’s contrast a See’s kind of business with a more mundane business.
When we purchased See’s in 1972, it will be recalled, it was earning about $2
million on $8 million of net tangible assets. Let us assume that our
hypothetical mundane business then had $2 million of earnings also, but needed
$18 million in net tangible assets for normal operations. Earning only 11% on
required tangible assets, that mundane business would possess little or no
economic Goodwill.
A business like that, therefore, might well have sold for
the value of its net tangible assets, or for $18 million. In contrast, we paid
$25 million for See’s, even though it had no more in earnings and less than
half as much in "honest-to-God" assets. Could less really have been
more, as our purchase price implied? The answer is "yes" – even if both businesses were expected to
have flat unit volume – as long as you anticipated, as we did in 1972, a
world of continuous inflation.
To understand why, imagine the effect that a doubling of the
price level would subsequently have on the two businesses. Both would need to
double their nominal earnings to $4 million to keep themselves even with
inflation. This would seem to be no great trick: just sell the same number of
units at double earlier prices and, assuming profit margins remain unchanged,
profits also must double.
But, crucially, to bring that about, both businesses
probably would have to double their nominal investment in net tangible assets,
since that is the kind of economic requirement that inflation usually imposes
on businesses, both good and bad. A doubling of dollar sales means
correspondingly more dollars must be employed immediately in receivables and
inventories. Dollars employed in fixed assets will respond more slowly to
inflation, but probably just as surely. And all of this inflation-required
investment will produce no improvement in rate of return. The motivation for
this investment is the survival of the business, not the prosperity of the
owner.
Remember, however, that See’s had net tangible assets of
only $8 million. So it would only have had to commit an additional $8 million
to finance the capital needs imposed by inflation. The mundane business,
meanwhile, had a burden over twice as large – a need for $18 million of
additional capital.
After the dust had settled, the mundane business, now
earning $4 million annually, might still be worth the value of its tangible
assets, or $36 million. That means its owners would have gained only a dollar
of nominal value for every new dollar invested. (This is the same
dollar-for-dollar result they would have achieved if they had added money to a
savings account.)
See’s, however, also earning $4 million, might be worth $50
million if valued (as it logically would be) on the same basis as it was at the
time of our purchase. So it would have gained $25 million in nominal value
while the owners were putting up only $8 million in additional capital – over
$3 of nominal value gained for each $1 invested.
Remember, even so, that the owners of the See’s kind of
business were forced by inflation to ante up $8 million in additional capital
just to stay even in real profits. Any unleveraged business that requires some
net tangible assets to operate (and almost all do) is hurt by inflation.
Businesses needing little in the way of tangible assets simply are hurt the
least.
And that fact, of course, has been hard for many people to
grasp. 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.
In contrast, 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. In such cases earnings have bounded upward in
nominal dollars, and these dollars have been largely available for the acquisition
of additional businesses. This phenomenon has been particularly evident in the
communications business. That business has required little in the way of
tangible investment – yet its franchises have endured. During inflation,
Goodwill is the gift that keeps giving.
But that statement applies, naturally, only to true economic
Goodwill. Spurious accounting Goodwill – and there is plenty of it around – is
another matter. When an overexcited management purchases a business at a silly
price, the same accounting niceties described earlier are observed. Because it
can’t go anywhere else, the silliness ends up in the Goodwill account.
Considering the lack of managerial discipline that created the account, under
such circumstances it might better be labeled "No-Will". Whatever the
term, the 40-year ritual typically is observed and the adrenalin so capitalized
remains on the books as an "asset" just as if the acquisition had
been a sensible one.
From Warren Buffett’s 1984 Letter to Shareholders:
While there is not much to choose between bonds and stocks
(as a class) when annual inflation is in the 5%-10% range, runaway inflation is
a different story. In that circumstance, a diversified stock portfolio would
almost surely suffer an enormous loss in real value. But bonds already
outstanding would suffer far more. Thus, we think an all-bond portfolio carries
a small but unacceptable “wipe out” risk, and we require any purchase of
long-term bonds to clear a special hurdle. Only when bond purchases appear
decidedly superior to other business opportunities will we engage in them.
Those occasions are likely to be few and far between.
From Warren Buffett’s 2008 Letter to Shareholders:
This debilitating spiral has spurred our government to take
massive action. In poker terms, the Treasury and the Fed have gone “all in.”
Economic medicine that was previously meted out by the cupful has recently been
dispensed by the barrel. These once-unthinkable dosages will almost certainly
bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though
one likely consequence is an onslaught of inflation. Moreover, major industries
have become dependent on Federal assistance, and they will be followed by
cities and states bearing mind-boggling requests. Weaning these entities from
the public teat will be a political challenge. They won’t leave willingly.