In this second of the series of articles on teachings of Warren Buffett we look at how inflation has a negative impact even on equity investor. Buffett says that it is no secret that stocks, like bond perform badly in high inflationary environments. For holders of fixed income securities, it is no surprise that they have fared poorly in high inflationary environments since as the value of the dollar deteriorates, a security with interest and principal payments denominationed in this currency will be highly unattractive.
Stocks, however, were supposed to be a different matter since it is was assumed that assets like stocks and real estate were a hedge against inflation. This proposition was based on the fact that stocks are not fixed dollar claims but represent ownership in productive facilities which are expected to retain value irrespective of how aggressively politicians print money. Buffett says that stocks have some similarities to bonds since the returns on equity have remained relatively constant over a long period of time. He says that over several years and in aggregate the return on year-end equity (or net book value) has remained around the 12 percent level for listed companies in the U.S.
If we assume that shareholders of these companies acquired them at book value, then their return will be around 12 percent. In reality, investors in stocks sometimes make acquisitions below book but most times they pay more than book value further lowering their return to below 12 percent. The reason why Warren Buffett believes that inflation swindles equity investor is that as inflation has increased, the return on equity capital has not increased to compensate investors. He says that essentially those who buy equities receive securities with an underlying fixed return – just like those who buy bonds.
He cites some major distinctions between stocks and bonds. The first is that bonds will eventually mature and need to be repaid so bond holders will eventually be able to renegotiate interest rates. Stocks, however, are perpetual. They have no maturity date and investors are stuck with whatever return American companies as a whole happen to earn. Therefore, if corporate America is destined to earn 12 percent, then that is the level investors must learn to live with. As a group, stock investors can neither opt out nor renegotiate.
Buffett says that in an environment where inflation and interest rates are low, the differential between the 12 percent return on equity and interest rates on bonds is enough of an incentive for investors to hold perpetual securities like equities. Another difference between a fixed income security and stocks is that the investor in fixed income securities receives all the returns in cash with nothing left for reinvestment.
On the other hand, the investor in stocks receives part of the returns as cash dividends and the rest is reinvested at whatever rate the company happens to earn. So part of the 12 percent earned annually is paid out in dividends and the remainder is reinvested to be compounded at 12 percent also. The reinvestment of part of the returns in the case of stocks can be good or bad depending on the relative attractiveness of the 12 percent. When bonds were yielding only 3-4 percent in the 1950s, the right to reinvest automatically a portion of the equity coupon at 12 percent was of enormous value. This happened in an environment where stocks were selling above book value, meaning that earnings reinvestment allowed investors to buy part of an enterprise at a price well below what it was selling in the market for.
Buffett says that stocks are also thought of as riskier than bonds because although return on equity is more or less fixed over long periods of time, they fluctuate significantly from one year to another. Investors attitudes are affected tremendously by those fluctuations. Stocks are also riskier because they have infinite maturities. As a result of this additional risk, investors will require an equity return much higher than a bond return. Therefore, a 12 percent return on equity versus a 10 percent return on bonds is not considered an adequate incentive to move from bonds to equities. In high inflationary environments, the 12 percent equity return is not seen as very attractive.
Warren Buffett poses the questions “Must we view the 12 percent equity return as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation”?
He answers by saying that there is no such law but for corporate America to increase its return on equity, it needs to do at least one of the following: (1) increase turnover ratio i.e. The ratio between sales and total assets employed in the business; (2) borrow cheaper; (3) take on more debt (greater leverage); (4) lower the tax rates; and (5) achieve wider operating margins on sales.
Inflation tends to produce some gains in turnover ratios initially because sales immediately reflect new prices, while the fixed assets will reflect the change only gradually as existing assets are retired and replaced at new price levels. The more slowly a company goes about the replacement process, the higher the rate of increase of the turnover ratios. Buffett believes that these gains are modest and do not produce any substantial improvement in the return on equity.
Cheaper borrowing is not likely in higher inflation environments. High rates of inflation tend to lead to more expensive rates of borrowing. Galloping rates of inflation creates galloping capital needs and lenders become more demanding as they become increasingly distrustful of long term contracts. Therefore, higher inflation causes more expensive borrowing which tends to reduce return on equity.
The room to maneuver in terms of increasing the level of borrowing will be limited by the debt to equity ratio. Buffett says that in the twenty-year period ending in 1975, equity as a percentage of total assets declined from 63 percent to just under 50 percent. The irony of high inflationary environments is that the highly profitable companies which are generally the best credits require little debt capital. It is normally the less profitable companies who can never get enough debt. Lenders have wisened up to this and are less willing to let capital-hungry, low-profitability companies leverage themselves to the hilt. Also, increasing debt at high levels of interest rates will do very little to enhance return on equity. Thus the higher cost of borrowing in high inflationary environment is likely to offset any benefit of greater leverage.
With the propensity of governments to spend and their reluctance to cut the cost and size of government, it is unwise to expect lower corporate income tax ratios in the future. It will be unwise to expect government to vote to reduce the income it receives. We should therefore not budget on lowering corporate tax rates.
It is in the area of improving operating margin that Buffett says most optimists hope to achieve major gains. He says although there is no proof that they are wrong, the demands on sales from other sources is huge. The major claimants are labour, raw material, energy and various other costs. The relative importance of these cost are very unlikely to decline in eras of high inflation.
In determining whether a 12 percent return on equity is adequate, one must make certain forecast of future inflation levels. Buffett says that inflation levels tend to be a political problem and not an economic problem. He says human behavior, not monetary behavior is the key. Buffett says that when very human politicians have to choose between the next elections and the next generation, it is very clear what usually happens.
Buffett says that inflation is a far more devastating tax than anything that has been enacted by the legislative and that the inflation tax has a fantastic ability to consume capital. When inflation is high disappointing results occur and not because the market falls, but in spite of the fact that the market rises. He says that in 1977 even though the Dow Jones Average was at 920 and fifty–five points more than where it was ten years ago, it was down almost 345 points when adjusted for inflation.
Many investors will react to this prognosis by indicating that in spite of the challenges of a higher inflationary environment, they will be adept in moving in and out of securities to produce superior results for themselves. Warren Buffett says this is unlikely and even impossible for equity investors to achieve in aggregate. He says that if you feel you can dance in and out of securities in a way that defeats the inflation tax, he would like to be your broker – but not your partner.
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This article first appeared in the B&FT newspaper