
How inflation swindles the equity investor (1977) - mudil
http://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/
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csdreamer7
The main takeaway for me is that is Buffett encourages investors to invest in
companies that reinvest all earnings in resource saving capital investments.
He argues that is the proper way to increase standards of living, and not with
distributions of earnings to investors or redistribution to the government in
printing money. That is, stocks that don't pay dividends, and require the
government to have a balanced budget.

My argument against this, and is one he has made in later years, is the greed
of modern management discourages investors from long term investments in a
company. Specifically, outrageous salaries for subpar results, golden
parachutes, or acquisitions of questionable value. Wells Fargo's management
either lied or was not doing their job, and yet their CEO was paid
compensation of $20 million in 2014 (did a quick google search for a figure).
Meyer's spent Yahoo's money on acquisitions that people she knew owned,
enriching many friends in her network. I really don't feel like subsidizing a
connected person's cash grab.

Dividend stocks are a way to get some control over management that tries to
pocket the earnings for themselves. Investors flee a stock that even looks
like it could cut it's dividend which avoids some of the wasteful acquisitions
and compensation (management is forced to buy in as an investor to get the
dividends). If the stock goes down you can reinvest the dividends. If it goes
up you can sell the stock and reinvest in one that has a better yield.

~~~
pjc50
"Looting" of companies by their management is starting to look like an
increasing problem. Usually in failing companies, but one day it will turn a
success into a conspicuous failure.

UK examples: Jaguar Land Rover, BHS, Carillion.

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csdreamer7
> "Looting" of companies by their management is starting to look like an
> increasing problem.

I think it's been a problem since the 80's. When I look at management pay
issues and corporate raiding that was the era Buffett began talking about it
if I remember correctly. Futurama even made fun of it indirectly in an
episode.

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drharby
My only regret is that i have boneitis

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runeks
From Buffet’s explanation, it doesn’t sound like it’s inflation in and of
itself that swindles the equity investor, but _rising_ or _falling_ inflation.
I.e. if inflation were constant, the market would easily adjust, but when it
rises or falls slowly over decades, investors are bound to make decisions that
will turn out to be wrong in the future.

It seems to me that exactly the same is the case for interest rates: no rate
is “right”, but falling or rising rates will force market participants to make
wrong decisions:

* In a rising interest rate environment, all bond purchases will prove unwise, since the investor could have earned a higher rate by waiting a bit longer.

* In a falling interest rate environment, all bond _selling_ (issuance) will prove unwise, because the issuer could have paid a lower rate by waiting a bit longer.

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dantheman
Real interest rates - those set by banks based on demand for money, and not
set by central banks are a price signal. What we have now is straight market
manipulation which causes problems.

Interest rates should be a signal about consumption vs investment.

~~~
YPCrumble
Does a "real interest rate" per your definition actually exist? Googling the
term returns an inflation-adjusted interest rate.

In theory if we didn't have central banks this might be possible. However,
central banks "print" money to adjust short-term interest rates that are a
lever for influencing demand for money. It seems unlikely that it is possible
to decouple supply from demand in the real world.

~~~
nine_k
> Does a "real interest rate" per your definition actually exist? Googling the
> term returns an inflation-adjusted interest rate.

> In theory if we didn't have central banks this might be possible. However,
> central banks "print" money to adjust short-term interest rates that are a
> lever for influencing demand for money. It seems unlikely that it is
> possible to decouple supply from demand in the real world.

With gold standard, central banks could not directly print money. It was
abandoned by the US about 40 years ago, and by Europe, even earlier (because
world wars).

~~~
Retric
You can still manipulate a gold standard it just takes more effort. EX: This
coin represents 2% less gold every year.

~~~
nine_k
Then prices include the weight, not the nominal value. Also, it's a lot of
effort. You can also lower the content of gold in coins, but the process of
remaking existing coins would be quite expensive.

Paper money is much easier in this regard.

~~~
Retric
It may sound odd, but gold coins are not on the gold standard. The gold
content represented a value floor, but their value should exceed that, or they
would have just used bars not coins. If nothing else they where less likely to
be fake.

Gold standard only really refers to paper money which was used as a proxy for
actual gold. Arguably it's even preferable to physical coins as historicly
people would often clip them.

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simo7
There is an important aspect which is not well remarked in the article: high
fixed-costs businesses are the ones that really suffer inflation.

If every time you want to expand you need to make significant investments (and
there will always be a delay before it starts making money), inflation will
affect your costs way before it will affect your revenue.

Even worse, because fixed assets need to be replaced due to obsolescence every
once in a while, you'll end up increasing your costs way more than you're
increasing your revenue just to maintain the current production level.

TL;DR: The more the delay between investment and revenue generation and the
more capital intensive it is, the worst.

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tomjohnneill
Depends how you fund the investments.

If you fund them by taking on more debt, then higher inflation is a benefit -
it reduces the value of your debt compared to your product.

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fwdpropaganda
The article says just the opposite.

> Cheaper leverage? Not likely. High rates of inflation generally cause
> borrowing to become dearer, not cheaper. Galloping rates of inflation create
> galloping capital needs; and lenders, as they become increasingly
> distrustful of long-term contracts, become more demanding. But even if there
> is no further rise in interest rates, leverage will be getting more
> expensive because the average cost of the debt now on corporate books is
> less than would be the cost of replacing it. And replacement will be
> required as the existing debt matures. Overall, then, future changes in the
> cost of leverage seem likely to have a mildly depressing effect on the
> return on equity.

To be honest my intuiton is like yours. I still haven't managed to
reconciliate my intuition with the above quote. I guess it would be something
like this: It is true that inflation means that the stream of cash you will
pay back is worth less, but the costs of keeping your business running (which
in turn is what generate those stream of cash) also goes up. When this
happened, lenders become more strict.

You can read further down:

> Nevertheless, given inflationary conditions, many corporations seem sure in
> the future to turn to still more leverage as a means of shoring up equity
> returns. Their managements will make that move because they will need
> enormous amounts of capital — often merely to do the same physical volume of
> business

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HillaryBriss
In this light, it's interesting as a counterpoint to look at inflation's
systemic effects.

After the 2008 real estate loan bust, many economists hoped for _more_
inflation so that the existing pool of loans would be a little more manageable
for the debtors. (In Japan, they've been trying to increase inflation for
decades). Even today, on financial news feeds and Bloomberg, when economic
observers talk about "good news on inflation" they usually mean inflation
going up, not down.

I guess, overall, there's a sweet spot for inflation. Or what's good for
corporate profits and banks is sort of opposed to what's good for the overall
collection of people in the economy.

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fwdpropaganda
> Even today, on financial news feeds and Bloomberg, when economic observers
> talk about "good news on inflation" they usually mean inflation going up,
> not down.

Indeed, the sweet spot is believed to be 2%. It's good news because we've been
under that for so long, not because the more the better.

> After the 2008 real estate loan bust, many economists hoped for more
> inflation so that the existing pool of loans would be a little more
> manageable for the debtors.

I'm not an expert, but I'll just point out that debt from a loan that you've
put into a house probably doesn't have the same mechanics as debt from a
company trying to fund its capital requirements. Not saying I agree or
disagree with those economists, just pointing out maybe they're different.

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exHFguy2
Regarding business debt ---- > It is usually floating rate and has a shorter
term. You will have to roll the debt more often as you refinance. Thus, you
will pay the higher inflation costs. And if inflation costs are unpredictable,
then lenders will require a higher risk premium on the inflation piece.

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ikeboy
>Virtually every corporate treasurer in America would recoil at the idea of
issuing a “cost-of-living” bond — a noncallable obligation with coupons tied
to a price index. But through the private pension system, corporate America
has in fact taken on a fantastic amount of debt that is the equivalent of such
a bond.

[https://www.treasurydirect.gov/indiv/products/prod_tips_glan...](https://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm)

So do any companies use tips to fund their pension obligations?

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misnamed
I assume so these days, but TIPS didn't exist when this article was written.
And probably not exclusively TIPS in any case (but perhaps combined with
equities, etc.).

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zaroth
Inflation is one of the primary justifications for a lower capital gains rate,
because getting taxed on inflation is quite the slap in the face.

~~~
gridaphobe
Why are you singling out capital gains? Your argument works equally well for
labor-based income, but capital gains are already taxed much less than labor.

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njarboe
Labor is taxed year-by-year so inflation does not have much influence on it.
Capital gains tax taxes the sales of things (capital) that might have been
held for decades. Buy a piece of land and hold it for 20 years. If inflation
is 3% then the dollar value will go up by a factor of 1.8 without any real
increase in value but if you sell it you will get taxed on that inflation
created gain. Some see that is not "fair". That is the spin, anyway.

I think the way to mitigate this problem is to index capital gains to the CPI
and then tax gains like income. This cleans up the tax code quite a bit, stops
favoring capital over labor, and balances out the pressure on the CPI with
having a powerful group of people wanting to have it go up. At the moment CPI
is probably under-reported and keeping social security and other inflation
adjusted things lower than they would be otherwise.

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lotsofpulp
I don’t think CPI needs to be used to mitigate the problem of taxing inflation
on assets. It would just increase the politicization of CPI, which is already
not realistic.

The market can easily adjust prices for assets to factor in the cost of
inflation and taxes.

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CPLX
He certainly has a fair point.

The problem, however, these days, is the way a monetary policy hyper-focused
on eliminating inflation swindles the wage-earner.

~~~
ergothus
I'm by no means well-educated on finance. However, it seems like inflation has
been the boogeyman of every major policy decision in the US for the decades
I've been watching. So far, the dire predictions haven't come true, but we've
faced growing wage inequality for 30 years.

I've read that the Fed has a dual mission - keep inflation/deflation in check
and unemployment at healthy levels, but I only ever hear their concern for
inflation risks.

As a result I tend to discount concerns over inflation, assuming that the
major problem will be the issue we aren't addressing...is my reaction
reasonable?

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sidibe
All central banks have been focused on the other issue since 2008. No one has
been very worried about inflation until very recently.

~~~
ergothus
Banks, perhaps. Everyone else (conservative pundits, fiscal pundits) seem to
be declaring imminent crippling inflation on a regular basis, yet it never
seems to happen, even when the banks/govt take the action (or don't take the
remedy) to this threat.

Qe1 and Qe2 in the US were both accompanied by much hand wringing and
doomsaying (for example), but the logic of the fear never made sense to me.

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pjc50
A very different time when equity returns were 12% and inflation was in the
5-10% region.

~~~
outside1234
we are probably on the verge of at least the inflation part of this - there is
no way we are going to be able to do $1T deficits for long.

~~~
mdemare
People have been saying that for ten years now.

If inflation ticks up, the Fed will raise rates, which will dampen inflation
but increase the interest on new treasuries, which will presumably compel the
administration to cut spending and raise taxes, and borrow less.

~~~
monob
Ten years?

People have been saying that since before Clinton got in office.

Catastrophic inflation from government spending has been just around the
corner for 40 years now. The 1970s were an odd time for many reasons, and they
won't repeat again. But for some reason too many people base their predictions
of the future from what happened between 1974 to 1984.

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zimbatm
Is it still common to get 12% return on the market?

My layman impression is that with ETFs, ~6% is the current average return.

~~~
gdubs
Important to remember that they’re averaging over a decade to get that annual
return figure. I still hear 10% thrown around as a rough estimate (if you
believe anyone is capable of making such a prediction) — though Jack Boggle
has been cautioning that we should expect much lower returns over the next
twenty years (more like 3-4%).

~~~
mancerayder
But if that's true, isn't that just keeping, just barely, with inflationary
predictions? Especially given the new tax bill increases the deficit wildly,
which will lead to a bond glut / money printing exercise?

If so, what's the market going to do, if not reallocate capital from the stock
market to a less risky asset?

~~~
gdubs
I mean, I honestly have no idea. The concerns about inflation are real; we
have high employment, and a relatively strong economy. Stocks (and Real Estate
in certain areas) are at high valuations already. The tax bill is stimulus at
a time when we don’t really need it - and it doesn’t address inequality, which
economists like Robert Gordon consider one of the major headwinds against
lifting productivity.

I think it’s the Dutch who have a saying that the point of investing isn’t to
make money - it’s to not lose what you already have.

Buffet has said something like, “I’d rather have a lumpy 12% than a smooth
10%”. Higher risk can mean higher reward.

I’m not offering investment advice; but for myself, I still think being
invested in stocks for the long haul is smart. As they say, if it isn’t, then
there are bigger problems to worry about. Doesn’t hurt to hedge against some
“black swan” events too.

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dnautics
Just be wary about advice from buffet. He's rich enough that he can basically
buffer swings in the market. For the rest of us, employment might be market-
procyclical: We lose the ability to buy in at the bottom of the market because
we're at employment risk and maintaining personal cash reserves is critical
and it's more likely that we have to sell off to stay afloat.

~~~
gdubs
For sure. That’s why a safety net is a core of so many strategies. And again,
amateur opinions here - not offering investment advice.

