Excerpt 2022 interim letter

“In stocks, it's the only place where when things go on sale, people get unhappy.

If I like a business, then it makes sense to buy more at 20 than at 30.” [Warren Buffett]


How to invest in a highly inflationary environment


Inflation is one of the most discussed topics of our time. I believe it is also one of the most misunderstood.


When inflation rates rise, as is the case in the current environment, people focus on how everything is becoming more expensive and market pundits are obsessed with publishing inflation and interest rate forecasts. The agitation is driven by people’s fear of losing wealth and forced selling by leveraged market participants responding to higher interest rates (central banks’ typically raise interest rates in response to higher inflation).

Ironically, many of those now complaining about loose monetary and fiscal policies didn’t criticize last years’ speculative excesses caused by unwarranted monetary and fiscal spending (a key driver of inflation), higher asset prices and higher nominal wages. It seems they were blinded by what was going up and are now scared by what is going down. This is the nature of greed and fear.


The timing of the sudden monetary tightening is peculiar, though. Why are central banks suddenly so keen to raise rates, after more than a decade of overly loose policies in what was an exceptionally benign environment, when our system has now become dependent on and addicted to cheap debt, when minimum wages finally started to rise after at least a decade of stagnation? Why raise rates now, when we are fighting an incredibly expensive proxy war with Russia, and Europe is facing a winter without sufficient physical supply of energy (leading to yet another round of record bailouts and economic distress)?


When discussing inflation, it is incredibly difficult to come up with a meaningful inflation number, as inflation means very different things to different people, depending on their level of wealth, level of income, place of residence, and individual spending patterns. Any official inflation rate is always a political estimate and likely understated. Whatever the number, most economies suffer from a continuous devaluation of their currencies over time, as it’s easier for leaders and bureaucrats to procrastinate difficult economic decisions by diluting currencies than to implement necessary but painful measures with immediate impact.


It should also be noted that trying to predict inflation rates has historically been futile. Yet, many market participants are obsessed with those rather meaningless forecasts and they are keen to bet on inflation expectations in one way or another.


Instead of adding to the rather misguided and overly excited public debate often driven by fear and anger, let’s focus on how inflation is impacting different investment styles and asset classes. Warren Buffett has elegantly shown how to exploit structural inflation to generate outsized returns without taking on undue risk, by creating what is commonly called structural alpha in multiple ways. While many of his followers are focused on what he buys, it may be more important to pay attention to how he finances his purchases. For example, in the past, he took on smart leverage by using the float (essentially negative cost, long duration, and non-recourse debt / negative working capital) of his reinsurance operations to fund the acquisition of businesses with tailwinds and pricing power such as Coca Cola, McDonald’s and Walmart. This is a very intelligent, leveraged spread-trade in addition to just going long solid names at reasonable valuations. In a similar move, he recently issued long dated, low yielding Japanese bonds and used the proceeds to buy shares of Japanese trading houses well positioned to pass on inflation, at single digit price to earnings ratios.


Cash


Holding cash has never been a good way to maintain purchasing power but is a good way to maintain optionality and to remain solvent in times of market distress. It provides peace of mind and protects from having to liquidate assets at inopportune times. The trick of the game is to determine what level of cash is appropriate and what currency to own.


Debt


Loans can be divided into variable and fixed rate instruments of various durations and levels of safety.


A loan with a high probability of the issuer defaulting will yield higher rates than one almost guaranteed to be redeemed in full at the end of its term, to compensate for the higher risk of loss of principal. A bond of long duration will yield a higher rate than one of short duration, to compensate for the loss of optionality and the risk of higher market rates in the future.


Historically, safe credit instruments of short duration (deposits, treasuries, AAA bonds, etc.) tend to only pay at or below inflation levels but are a good way to park money temporarily. A lucrative way to invest in debt instruments (without taking on leverage) is buying bonds with long durations when interest rates are high but likely to fall, or when the issuer quality is bad but likely to improve, as the impact of changes in base rates or issuer quality are leveraged by the bond’s distant maturity date.


From a borrower’s perspective, the best way to benefit from inflation is to lock in interest rates when they are low for a long period of time, as this allows the borrower to deleverage when inflation picks up without having to put more money on the table.


Equity (ownership stakes) in businesses and real estate


Historically, one of the best ways to maintain purchasing power over time is to own durable businesses or rental properties with pricing power. This is perfectly illustrated by many countries that have experienced periods of high inflation, including currency resets after periods of hyperinflation, such as Weimar Germany and Zimbabwe.


Common academic gospel says valuation multiples of businesses should decline in highly inflationary environments because the cost of capital is increasing. Such gospel is based on concepts like WACC (weighted average cost of capital) or DCF (discounted cash flow). Indeed, at least in the short run, rising interest rates typically lead share prices to decline given forced selling by leveraged market participants and as capital is being shifted from equities (uncertain cash yields) to debt instruments (“guaranteed” cash payments).


Nevertheless, this way of thinking too narrowly focuses on the denominator of the equation and ignores higher nominal earnings generated by those assets able to pass on inflationary cost pressures. In an inflationary environment, the intrinsic nominal value of equities is in fact increasing, given higher future earnings, as corporations pass on higher costs to consumers – and not falling as is the case with cash and fixed rate bonds who see their value eroding. Technically speaking, ownership interests in the right businesses and properties can be looked at as inflation-protected perpetual bonds. In a highly inflationary environment, it therefore makes sense to pay up (i.e. a higher multiple on earnings power) for businesses and properties that are striving and surviving.


As always, the difficulty in investing comes down to picking the right assets. Let’s explore a few nuances about how different businesses respond to inflation and what’s best to own.

  • Speculative valuations: Over the last few years, the market’s focus went from paying low multiples on cash flow (= value-based investing) to high multiples on often unprofitable growth and exciting stories (= speculative investing). The abundance of cheap capital made it easy to bid up prices, and higher prices attracted further capital to support increasingly unreasonable valuations. As we can clearly see now, such a self-reinforcing, Ponzi scheme-like momentum breaks once the cost of capital increases and the flow of capital required to prop up sky-high valuations dries up. If too many market participants took on excessive levels of leverage on the way up, the inevitable bear market is likely to overshoot on the downside as well given the lack of technical support.

  • Pricing power: Whether a business can easily increase prices in an inflationary environment depends on many factors, such as how essential its products are to a customer’s life, how price sensitive customers are, whether a brand carries pricing power, or the strength of general competitive pressures. When analyzing pricing power and price elasticity, it should be noted that it is common in many industries for prices to be stuck in certain ranges for long periods of time until suddenly step changes are triggered. While demand elasticity is important for some businesses, it’s less important for others. Especially merchant businesses and platforms built around taking a stable margin on a diverse range of goods traded (such as eBay or Costco) are in a sweet spot in an inflationary environment, as they clip the same margin on an overall higher value of goods sold.

  • Capital light businesses: It’s no secret that capital light businesses, those able to scale up without having to heavily invest in new capacities, are amongst the most attractive. These businesses also tend to do well in inflationary environments, as they have more room to maneuver when costs increase and capital becomes more expensive. Intangible assets, such as brands, distribution networks, or patents, can provide an additional shield of protection, as inflationary environments make it more difficult for competitors to enter the market given higher upfront investment requirements when capital is tight.

  • Capital intensive businesses: Businesses that require high levels of capital to produce and grow are traditionally seen to be in difficult spots in inflationary environments. However, there is a very important distinguishment to be made: (1) the remaining life of the assets owned and (2) the expenditure required to maintain current production levels. If a business has short-life asset or is in constant need of spending high sums to maintain its competitive edge (such as semiconductor factories, car manufacturers, or mines with short lives), its real value deteriorates quickly when inflation picks up, as a large part of cash generated will have to be spent to just maintain market share. In these cases, EBIT (earnings before interest and tax) tends to overstate profitability, as maintenance capital expenditure is higher than depreciation. However, if a company owns long-life assets that don’t require much maintenance, the story is very different. These businesses are capital light in nature, despite high levels of initial capital spent. If inflation and interest rates pick up, it becomes difficult to bring on additional supply, which protects incumbent players and allows them to harvest high returns on capital spent in the past.

  • Real estate: Rental properties tend to behave very similarly to equities as described above, with the location and the condition of a building determining a property’s pricing power and capital requirements. Run-down properties can be considered capital intensive, while those in good shape and built to last, capital light. Basic housing is often protected from inflationary pressures, as governments tend to buy votes by providing low-income earners with sufficient means to pay bills for basic necessities such as food, housing, and electricity. The biggest advantage landowners have is that they own assets almost guaranteed to appreciate over time given structural inflation.

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