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Quote of the Day
“The central problem in the stock market is that the return on capital hasn’t risen with inflation. It seems to be stuck at 12%.
It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment. We have been in such an environment for most of the past decade, and it has indeed been a time of troubles for stocks. But the reasons for the stock market’s problems in this period are still imperfectly understood.
There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that one out.
It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might.
And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.”
-Warren Buffett in his classic 1977 article in Forbes, “How Inflation Swindles the Equity Investor“. Buffett published the article in 1977, but inflation was heating up years earlier, as we see from the events below on August 16th, 1971:
August 16th- This Day in Stock Market History
August 16th, 1945 – Stock markets closed for a second day to celebrate end of WW2. Stocks would resume trading the next day with muted returns, the Dow would fall 0.25% on the day.
August 16th, 1971 – Nixon’s announced freeze on wages, prices, and rents goes into effect. In response, a record volume on Wall Street as 31.7 million shares trade. Stock market soars as the Dow Jones Industrial Average rises 3.85%, or 32.93 points.
Source: Wall Street and Stock Markets: A Chronology
1970 saw inflation of nearly 7%, and 1971 saw inflation of nearly 6%. As Nixon worried that the economy was overheating he began implementing price controls throughout the economy. In a nationally televised address, President Nixon announced a 90 day freeze of “all prices and wages in the U.S.”
However, the freeze would not work. By 1975 inflation is running at over 11% and after a slight drop in the late 70s hits 13% and 12% in 1980 and 1981.
August 16th, 1987 – Bill Gates sends out a message to all Microsoft employees congratulating them on their work. Gates had just received data showing Microsoft had passed Lotus software in sales and profits for the year.
Lotus had outsold Microsoft since 1985, after this day – Microsoft would never look back.
Best August 16th in Dow Jones Industrial Average History
1971 – Up 3.85%, 32.93 points.
Worst August 16 in Dow Jones Industrial Average History
1990 – Down 2.43%, 66.83 points.
Read of the Day
How should you invest in times of high inflation?
Of course Buffett speaks to the issue in his annual letters. His 1981 letter offers this advice:
“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.”
You can find Buffett’s letter by clicking the link above, and also in the book Berkshire Hathaway Letter to Shareholders which consists of a collection of all annual letters written by Buffett, including ones not available on the Berkshire Hathaway site.
Also, for those looking for further reading. The book, The New Buffettology gives an example from one of company that meets the above criteria. Hershey’s.
“Yet the most interesting aspect of the durable competitive advantage and inflation is that this increase in product price has also caused an increase in earnings, which led to an increase in the underlying value of the business. Let me explain.
Say that every year, like clockwork, Hershey’s sell ten million chocolate bars. In 1980 it cost Hershey’s 20 cents to manufacture each bar, which it then sold for 40 cents. This gives Hershey’s a 20 cent profit on each bar. To calculate what Hershey’s earned selling chocolate bars in 1980, all you have to do is multiply the number sold, 10 million, by the 20 cent profit that each produced, which equals $2 million.
So in 1980 Hershey’s made $2 million. If Hershey’s had 4 million shares outstanding in 1980, then you could calculate earnings per share of $0.50. If in 1980 Hershey’s stock was trading at a multiple of 15 (a P/E multiple that is), it would have been trading at $7.50 a share.
Jump ahead to the year 2000, when everything has doubled in price because of inflation. Now Hershey’s chocolate bars cost 40 cents to manufacture and they sell for 80 cents. This equates to a profit of 40 cents per bar. If Hershey’s sells 10 million bars in 2000 (the same amount as 1980!), we can calculate that Hershey’s will earn $4 million, or double what it earning in 1980.
(Now you are about to see a really interesting thing happen). If Hershey’s still has 4 million shares outstanding, it will post a profit of $1 per share. If you multiply the Hershey’s per share earnings of $1 by 15, you come up with a stock price of $15 per share….Hershey’s didn’t have to manufacture any more bars in 2000 than it did in 1980.”
The book goes through many great examples like this, covering a wide range of topics that Buffett uses to analyze a potential investment. If you have not read it yet, add it to your list!
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