Inflation: The Equity Swindler
This is the third in a series of posts reviewing literature on investing during inflation. In the first, we unpacked asset class performance under various inflationary regimes. In the second, we decomposed valuation methodologies which may have influenced stock market performance during the inflation of the 1970s. In this essay, we analyze the writing of a seminal investor and his views on equity investing during inflation.
In the second piece of this series, we delved into the expectations shock that 1970s inflation shock placed on equity investors. Many felt that equities, unlike bonds, would provide inflation protection with pass through price increases flowing into corporate revenues. If indeed passed through, inflation should result in little impact on net income. This idea was analyzed by Professors Modigliani and Cohn during the early 1980s. Their analysis suggested that markets were fundamentally undervaluing equities which generated negative real return during the 1970s.
An Investor’s Perspective
One investor plying his craft during the 70s was a certain Warren E. Buffett. Buffett began his professional investing career in the post war period, graduating from Columbia Business School in the early 1950s. He went on to work under his professor and early mentor Benjamin Graham, where he learned to apply a ‘cigar butt’ approach to a market still feeling the scars of the great depression.
Buffett ultimately went off on his own in the late 50s, forming the Buffett Partnerships, which he successfully managed for over a decade. He decided to close shop in the late 1960s when valuations were dear. He deemed the opportunity set depleted, returning capital to investors. A little over a decade later, firmly at the helm of a holding company qua investment vehicle (a certain Berkshire Hathaway), Buffett wrote a topical piece in Fortune titled How Inflation Swindles the Equity Investor[1]. It is one of this author’s favorite polemics on investing[2].
It's All in the Coupon
The piece’s fundamental observation is not dissimilar to that of Modigliani and Cohn, even though its conclusion is different. Like the academics, Buffett observed that the Return on Equity of broader US equities did not change fundamentally between the post war decade of 1945-1955 (12.8%), versus the ensuing decade of 1955-1965 (10.1%). Interestingly, it did not meaningfully change in the following decade of 1965-1975, including the go-go years of the late 60s heading into the inflationary shock of the early 70s (10.9%).
He quips, “as inflation has increased, the return on equity capital has not. Essentially, those who buy equities receives securities with an underlying fixed return.” Simply put, the return characteristics of domestic business as a whole (never mind their stock price) remained relatively stable, irrespective of inflationary condition. Buffett equates this stability to the coupon generated by a fixed income investment.
It is through this brilliant lens that an investor can better understand how inflation impacts the present value of equity investments, just as she intuitively understands how it impacts the value of a stream of fixed income coupons. From there, we can decompose the differences.
Equities (as a whole) are infinite in duration, while fixed income is not. Equities reinvest non-distributed earnings effectively at par, which can act as an accordion to valuation and of course require capital allocation discipline by management. Finally, as has been a consistent lens of Buffett’s worldview, par for equities should be equated to book value[3], with the market historically trading near that range. He cites book value for the Dow as averaging just above 1 during this three decade period, hitting a low of .84 (1974) and high of 2.32 (1965).
I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in the partnership. – WEB
Starting Points Matter
Is it any coincidence that Buffett wound down the partnerships in 1969 with such an elevated book value? The period was described by Richard Jenrette as “the great garbage market”, a time where price discipline was fleeting, transaction volumes exploding, and go-go stocks vogue[4]. Buffett saw a dearth of ripe opportunity (“the game is being played by the gullible, the self-hypnotized, and the cynical”, 1968).
As much as Buffett recoils from the notion of timing markets, we can view his capital allocation decision being influenced by the top-down environment, entirely driven through his bottom-up analysis. This ties back to the long-term return on equity dynamics of stocks and its relationship not only to book value but also to inflation.
A Triple Dip Please
Unpacking that in the 1977 essay, Buffett highlights the value of reinvestment of retained earnings at the long-term ROE yield. This conceptually is a very valuable asset when reinvestment occurs at par, especially so in an environment where bonds are yielding a low nominal yield (say 3-4%). As he wrote, “If, during this period, a high-grade, non callable, long term bond with a 12 percent coupon [his implied ROE] had existed, it would have sold far above par.”
Of course, this valuable instrument was available to investors in the form of generic US equities between 1955 and 1965. As a result, book values rose dramatically while (as we documented earlier) ROEs remained stable. Investors during this period profited from what Buffett called the "triple dip": (1) a strong relative yield from equities versus fixed income (12% vs 3%); (2) reinvestment of these elevated returns at par (the ‘equity coupon’ that isn’t returned to shareholders is reinvested in productive enterprise ‘at par’); and (3) book values of broader equities that subsequently rose (from 1.33 in 1946 to 2.2 in 1966). This was truly nirvana for owning equities. But this virtuous cycle can quickly unwind when rates rise. This is where Buffett’s views differ from that of Modigliani and Cohn.
What Goes Up Comes Down
As rates increase, the relative attractiveness of the 12% ROE vs, say, a 9% Fed Funds Rate (as it stood in 1973) is far less compelling. Paying 2.2x book value feels unreasonable. Investors unsurprisingly churn out of equities. This lens of thinking across asset classes is often called the Fed Model (comparing the nominal yield of stocks vs that of treasuries).
A key takeaway is that the accordion of valuation, which pulled forward returns in the triple dip years, can snap back with rising rates, acting as a headwind in the inflationary period. And so, our previous piece’s decomposition of returns during different regimes can be more holistically understood through Buffett’s framework. His framework also addresses one of the key blind spots of the Modigliani Cohn framework, namely the initial conditions. As the accordion snaps back, valuations begin to tilt in the investor’s favor. The book value of the Dow fell to its .84x nadir in 1974.
Buffett also warns about inflation’s impact on corporate wellbeing. Companies with comparatively poor ROE will have diminished ability to make sustainable reinvestment, the ultimate engine of economic prosperity. It is perhaps unsurprising that many macreoconomic charts began to go sideways in the early 1970s.
Assuming that return on equity is not compensated for during inflation, then real returns will diminish. Factoring in static tax rates, the amount of earnings available for “real growth” is negligible. Corporations will have to either halt their return of capital in the form of dividends (and more recently buybacks), or delay reinvestment.[5]
The Tapeworm
Which brings us to the most salient inflationary metaphor Buffett provides in the piece (and returns to in future Berkshire annual meetings): the tapeworm.
“Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume or the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm. A business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or ‘real’ dividends. The tapeworm of inflation simply cleans the plate.”
It is unsurprising that, when asked about inflation in the 2015 annual meeting (linked above), Buffett cites capital light businesses as those that are resilient. This is parallel to the notion cited by Terry Smith in his 2Q22 letter to shareholders. He explains with an illustrative comparison: a business with lower gross margins (say 30%) facing some nominal increase in input cost (say 5%) suffers a larger relative decline in earnings, as compared to the same nominal cost increase (5%) for a higher gross margin business (say 60%). It’s a simple denominator effect.
Fear & Greed
Having unloaded much of his equity exposure in the late 1960s for lack of opportunity, it is unsurprising that Buffett was aggressively buying in the throes of 1973-1974, as the inflationary shock felt by the Yom Kippur War sent oil hurtling and equity valuations down to their lows. During this period, Buffett strengthened his balance sheet and increased buying power by taking out relatively low-cost debt[6]. We all of course attribute the maxim of being greedy when others are fearful (and the inverse) to Buffett. He subsequently went on a buying spree.
As Lowenstein cites, Buffett made his first major purchase of Washington Post in 1973, becoming the largest outside holder by October. Perhaps one of the reasons he fetishized the Post was its brand-led pricing power and high gross margin. The core business (newspaper advertisements) was vital for lower margin businesses in maintaining customers in a period of economic tumult.
At the time, newspapers also enjoyed regional monopolies/duopolies, a pattern Buffett understood from his early days as a delivery boy, up to his contentious feuds involving local Buffalo newspapers in the late 1970s. In 1973, being able to purchase the Post for well below the go-go valuations of the late 60s meant that he would be the long-term benefactor of the “triple scoop” of expanding book value, relative spread of earnings vs nominal rates (as they subsided), and high ROE reinvestment compounded over time. The Washington Post was unsurprisingly a home run investment.[7]
Rhyme or Reason
Fast forward to today, and WEB is back at it, deploying vast amounts of capital. According to fund manager Christopher Bloomstran, who kindly shares his expert knowledge of Berkshire Hathaway through Twitter and his investor letters, the company made $45 billion of net purchases in the first half of the year, in addition to buying back nearly $5 billion worth of its own stock.
Of note, many of these net buys were directed towards energy companies such as Occidental and Chevron. We’ll have more visibility into fulller transactions next week with updated 13F data. Given energy was one of the - if not the - best performing asset class from 1973-1981, Mr. Buffett is perhaps switching gears from what he did in the early 1970s, where he focused on quality / compounder purchases like The Post.
Perhaps the analogous hypothetical purchase today would have been buying Google, which traded into relatively sanguine valuations during the low periods of May 2022. Energy investments are not without their attendant risks, but it is a notable evolution in his thinking and capital allocation when compared to the 70s. Ultimately, through his writing and his actions, Buffett is providing a masterclass in navigating inflation through the potent mental model of the infinite duration coupon.
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[1] For a far more comprehensive explication of Buffett’s essay, we suggest the following piece: https://lewisenterprises.substack.com/p/the-coupon-is-sticky
[2] For a more complete Buffett history, we suggest reading Lowenstein, citing the book herein.
[3] Let us set aside the role of intangibles, which complicates the matter. Buffett wrote this in 1977, a different landscape for intangibles. We wrote about this here.
[4] See Howard Marks’ writing on the NIFTY 50 for more color. The parallels to the last few years, are self-evident.
[5] For the author, this is the great dilemma of Buffett’s reasoning vs Modigliani Cohn. Buffett observers that ROE does not change and thus poorer business will be impaired by inflation. But this is somewhat tautological. He addresses this somewhat anecdotally with the following paragraph:
“If business was able to base its prices on replacement costs, margins would widen in inflationary periods. But the simple fact is that most large businesses, despite a widespread belief in their market power, just don’t manage to pull it off. Replacement cost accounting almost always shows that corporate earnings have declined significantly in the past decade. If such major industries as oil, steel, and aluminum really have the oligopolistic muscle imputed to them, one can only conclude that their pricing policies have been remarkably restrained.”
[6] Bemusingly, something he has done recently.
[7] An interesting ‘deconstruction’ of the investment thesis can be found here: https://futureblind.com/2006/12/12/warren-buffett-washington-post/