Four Key Inflation Lessons from Warren Buffett

By: Keith Kaplan

Jul 14, 2021 | Educational

When it comes to inflation, take lessons from Warren Buffett.

Back in the late 1970s and early 1980s, inflation was very high.

At the time, Buffett dedicated a lot of his time in the annual Berkshire Hathaway shareholder letters to addressing inflation’s impact on his company.

Inflation levels are nowhere near where they were in the stagflation years.

Back then, inflation hit 14%, and mortgage rates surged as high as 20%.

On Tuesday, the Consumer Price Index (CPI) for June came in at 5.4%.

Whether it’s 5% or 14%, Buffett has always been wise enough to classify inflation as what it is: a tax.

In a famous 1977 column in Forbes, Buffett wrote: “The arithmetic clarifies that inflation is a far more devastating tax than anything that our legislatures have enacted. Moreover, the inflation tax has a fantastic ability to simply consume capital. … If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker – but not your partner.”

Buffett was saying that speculating on inflation is a fool’s errand. A broker would be more likely to make money on trades than an investor jumping in and out of different stocks.

The other thing that stood out was Buffett’s explanation that his company – Berkshire – had no solution to inflation. Simply put, “inflation does not improve our return on equity.”

Today, I want to discuss the recent inflation and highlight a few other lessons from Buffett on handling inflation.

Another Pop in the Inflation Tax

This morning, the CPI for June indicated that inflation continues to rise across the United States.

For a few months, the Federal Reserve has said that inflation will be “transitory,” or temporary.

But now economists around the country are starting to call the central bank’s bluff.

Inflation looks like it’s here to stay. A new survey by the Wall Street Journal surveyed economists about their expectations for economic recovery and the prospect of higher prices. The average forecast called for inflation (minus energy and food prices) to increase by 3.2% in the fourth quarter.

Expectations also call for annual inflation to hit 2.3% in 2022 and 2023. Keep in mind that the Fed has been desperate to get to and sustain its target for a decade.

As Federal Reserve Chairman Jerome Powell prepares to speak before Congress today, inflation will be top of mind in these meetings.

What does it say about a stock market that shrugs off a 5.4% increase in inflation, but sells off several of Wall Street’s largest banks after they beat earnings expectations and provided upbeat guidance?

Right now, inflation is running red hot. And if you need evidence of rising prices, check out this list of goods that have surged over the last year:

Year-Over-Year Changes (U.S. Statistics)

·      Car Rentals: +87.7%

·      Used Cars: +45.2%

·      Gasoline: +45.1%

·      Laundry Machines: +29.4%

·      Hotel Rooms: +16.9%

·      Furniture: +8.6%

·      TVs: +7.6%

·      Fruit: +7.3%

·      Shoes: +6.5%

·      Milk: +5.6%

And the one I can’t forgive – the one I won’t forgive…

The price of bacon is up 8.4% year-over-year.

But people forget about one other thing that is up significantly over the last year: stocks.

At a time when investors are increasingly wary about inflation, the markets largely shrugged off these moves. But that’s likely to change in the weeks ahead. After that, inflation will eat into the bottom line of companies.

And Buffett offers a roadmap on how to approach the challenge of investing when inflation rises.

How Does Inflation Impact Stocks?

Tuesday, we kicked off earnings season by releasing reports from banks such as JPMorgan Chase and Goldman Sachs. But unfortunately, those stocks sold off yesterday… despite beating profit expectations.

Will inflation concerns do the same for companies in other sectors this year? Buffett would suggest so.

“Earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner,” Buffett wrote in his 1980 Chairman letter.

Buffett also said during this period that “purchasing power” is what matters in periods of higher inflation.

Why? The purchasing power of a company’s cash on hand impacts its ability to invest, buy, hire, and put cash to work.

That’s Lesson No. 1: Purchasing power will be calculated and questioned during earnings calls.

Lesson No. 2 is equally important.

Buffett says investors should pay attention to the impact of inflation and taxation on a shareholder’s bottom line. The best metric for these two factors is known as the “misery index.”

The “misery index” combines an inflation rate with the income tax on dividends paid. But again, this is a similar measurement of purchasing power.

The more inflation starts to eat into the actual return on equity, the less attractive the investment will look.

Lesson No. 3: Buffett puts a significant focus on optimistic cash-flow businesses.

He likes companies that are making real hard cash every day and not consuming it. So, mature businesses that don’t need to pump a ton of money into research and development, or have turned to automation, might be more attractive investments.

Finally, and most importantly, Lesson No. 4. Look for cash-generating businesses that can pass the cost of inflation to their consumers.

Remember, when Congress talks about raising corporate taxes, I recommend that investors find companies that can pass those costs to customers.

Well, inflation, too, is a tax.

A company’s ability to increase prices quickly without fear of losing customers is essential. For these reasons, we’re always looking at companies that make must-own products and services.

Remember to think about companies in electricity generation, food and beverage manufacturing, military and defense, pharmaceuticals, and other must-own sectors.

I’ll be pulling together a large list of these inflation-proof, must-own companies and sectors in the week ahead.

For now, remember that we are entering a new period that many investors have not faced in the past. Priorities might change quickly for Wall Street, and we must remain vigilant.

Tomorrow, we’ll turn our attention back to earnings season.

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