Category Archives: inflation

I read a lot on a daily basis. Nothing gets me more excited than to see a new editorial by great investors such as Bill Gross of PIMCO and Warren Buffett of Berkshire Hathaway. I've learn a great deal from these investors on many subjects but nothing confuse me more than the subject of deflation and inflation. We are hearing these terms on a regular basis because of the recent turn of events in our economy. Misunderstand the two and how to invest during such time can be costly.

I turned to one of the greatest investor of our time, Warren Buffett, for advice on how to invest during inflationary period. What I found confused me rather than enlightened me. Back in 1977, Buffett wrote an article titled "How Inflation Swindles the Equity Investor" (Fortune, May, 1977) which implicitly suggest that investors stay away from stock (equity) during inflationary time. The quote below was taken from the context of that article.

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.

He stated that the problem is that the return on capital hasn't risen with inflation and seems to be stuck at 12 percents. He wasn't too excited about stock during inflation. Fast forward to our current bear market. On October 16, 2008, Buffett wrote an op-ed piece in NY Times titled "Buy American. I Am." The except below was taken from the context of that article.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later.

Interesting! It appears that Buffett now favors stocks as a hedge against inflation.

My personal view is that any tangible assets, whether it be gold, silver, corn, sugar, or beans, will do just fine during inflation. Equity holder also is protected by having exposure to the underlying assets that company hold. You can find this under the balance sheet in current assets or inventory.

I had an investment in Heinz not long ago and wrote that "We were told to have gold in our portfolio for inflation hedge. The good news is that can of beans will do just that." Things were probably different in 1977 or maybe I misinterpret his article, but any investors who took his advice without educating himself may have missed the greatest bull run from 1982 to 2000. Please see the chart below. Related article.

As an investor who has to take responsibility for my actions, I seek out as much information as I can. Although I am willing to take in as much information as possible, I attempt to discern quality from the junk, critically analyze the information and questioning my assumption along with the author that I’m reading. For this reason it did not go unnoticed when I read the October 16, 2008 New York Times op-ed piece written by Warren Buffett titled “Buy American. I Am.”

It turns out that in my zeal for seeking quality information, I found that Mr. Buffett had written an article in Fortune Magazine back in May of 1977 titled “How Inflation Swindles The Equity Investor.” If you didn’t know who the author was you’d probably think that the articles were written by two entirely different people.

In the article “How Inflation Swindles The Equity Investor,” Warren Buffett states in significant detail many reasons why and how inflation is the bane of equity investors. One such reason is that in order for companies to get through an inflationary period they are forced to issue new shares to service liabilities that had been accrued in prior years. This method of dealing with inflation was used to offset the payment of dividends.

In essence, a company would pay a dividend “…of $3.3 billion and asked investors to return $3.4 billion” (in the issuance of new stock). According to Mr. Buffett, the act of paying dividends and then issuing new stock exceeding the value dividend payments is among the problems that are part of the equity swindle. It should be known that Mr. Buffett’s article was extensive and left no doubt about the impact that inflation has on corporations.

Fast forward 31 years later, Mr. Buffett writes a concise op-ed piece in the New York Times titled “Buy American. I Am.” Published in the throes of a banking crisis, Mr. Buffett’s words were intended to provide assurance to a public that couldn’t trust either the banks, the government or regulators assigned to ensure stability in the financial system. Mr. Buffett points out that government policy to deal with the financial crisis “…will probably prove inflationary and therefore accelerate declines in the real value of cash…” Mr. Buffett goes on to suggest that individuals would be wise to invest in stocks.

I begin to wonder how an investor is supposed to make sense of the two articles. In the one case, Mr. Buffett offers an elaborate explanation for why equity investors are getting "swindled" during inflationary periods. In the other case, Mr. Buffett suggests that over the next ten years stocks will beat cash in a high inflation environment.

Is the only distinction that Mr. Buffett is making is the comparison between cash and stocks during inflation? If this is the case then we have to wonder which is the bigger swindle, cash that is being debased or stocks, where the management of a company can arbitrarily increase the number of shares denominated in a debased currency.

As far as I can tell, the last several months have had the largest increase in the issuance of secondary offerings (new stock) from major corporations. You'd think that Mr. Buffett would be speaking out about this based on his writings from the 1970's. I believe that I know which of the two articles is correct however, what is a person supposed to think when they hear the most successful investor in the world seemingly speak out of both sides of his mouth? I'm guessing that Mr. Buffett isn't expecting us to remember what he said 31 years ago.

“A patriot wraps himself around the flag to defend it; a scoundrel wraps it around himself to defend himself”

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