Thoughtfully and humbly.
We need to recognize that inflation in the long-term is a probability but not a certainty. Macroeconomics is a voodoo science; it appropriately belongs in the liberal arts department. The economy is an incredibly complex and unpredictable system.
Here is an example: Japan is the most indebted developed nation in the world (its debt-to-GDP exceeds 260%, while ours is 130% or so). Its population is shrinking, and thus its level of indebtedness per capita is going up at a much faster rate than the absolute level of debt. Anyone, including yours truly, would have thought that this forest full of dry wood was one lightning strike away from a disastrous conflagration. And yet Japanese interest rates are lower than ours and the country has been mired in a deflationary environment for decades.
Admittedly, Japan has a lot of unique economic and cultural issues: Companies are primarily run for the benefit of employees, not shareholders (unproductive employees are never let go); there are a lot of zombie companies that should have been allowed to fail decades ago; and the Japanese asset bubble burst in 1991, when debt-to-GDP was only 60%. The point still stands: Long-term forecasting of inflation and deflation is an incredibly difficult and humbling exercise.
As investors we have to think not in binary terms but in probabilities. The acceleration of our debt issuance and our government’s seeming indifference to it and to ballooning budget deficits raise the probability and the likely severity of inflation. At the same time, we have to accept the possibility that the economic gods are playing cruel games with us gullible humans and have deflation in store for us instead.
Inflation and higher interest rates are joined at the hip. The expectation of higher inflation will raise interest rates, as bond investors will demand a higher return. This in turn will result in larger budget deficits and more money printing and thus more borrowing and even higher interest rates.
Here is how we are positioning our portfolio for the risk – the possibility, not the certainty – of long-term inflation:
Valuation matters more than ever. Higher interest rates are an inconvenience to short-duration assets whose cash flows are near the present and devastating to long-duration assets. Here is a very simple example: When interest rates rise 1%, a bond with a maturity of 3 years will decline about 2.5%, while one with a maturity of 30 years will decline 25% or so.
The same applies to companies whose cash flows lie far in the future and who are thus very sensitive to increases in the discount rate (interest rates and inflation). Until recently they have disproportionally benefited from low interest rates. They are the ones that you will most likely find trading in the bubble territory today. But their high valuations (high price-to-earnings ratio) will revert downward. Value stocks will be back in vogue again. We have started seeing the rotation from growth to value recently.
Inflation will benefit some companies, be indifferent to others, and hurt the rest. To understand what separates winners from losers, we need to understand the physics of how inflation flows through a company’s income statement and balance sheet.
Let’s start with revenue. Higher prices across the economy are a main feature of inflation. We want to own companies that have pricing power. Pricing power is the ability to raise prices without suffering a decline in revenue that comes from customers’ inability to afford higher prices or from the loss of customers to competitors.
Companies that have strong brands, monopolies, or products that represent a very small portion of customer budgets usually have pricing power.
If Apple raises prices on the iPhone, you’ll curse Steve Jobs and pay the higher price. (A friend of mine curses him every time the iPhone frustrates him. I keep reminding him that Steve is no longer with us. Doesn’t help.) Of course, if Apple raises iPhone prices too much and its products become unaffordable, consumers may just start buying iThings less often.
Tobacco companies have pricing power. I lived through a hyperinflation in Russia in the late 1980s and early 1990s, I was a smoker then. One day cigarette prices doubled. I experienced a price shock. I cursed at tobacco companies; cigarettes did not get any cheaper. A day later I was paying double again for my cigarettes. Smokers are very loyal to their brands, and cigarettes are an addictive product. We own plenty of these stocks, too. The same applies to beer and especially hard liquor. (If you think tobacco stocks are socially irresponsible investing choices, you are … just read my thoughts on this topic here).
What the pandemic showed us is that humans are adaptable creatures – you throw adversity at us, we’ll indulge in angry outbursts but we’ll adapt. The rate of change of inflation matters even more than absolute rate of inflation. If inflation remains predictable, even at a higher level, then businesses will plan for and price it into their products. If the rate of growth is highly variable, then there is going to be a war of pricing powers for shrinking purchasing ability of the end customer. We want to own companies that are on the winning side of that war.
Let’s go to the expenses side of the income statement. Companies whose expenses are impacted the least by rising prices do well, too. Generally, companies with larger fixed costs do better.
It is important to differentiate whether the capital intensity of a business lies in the past or in the future. A business whose high capital intensity is in the past benefits from inflation. Think of a pipeline company, for instance (we own plenty of those). Most of its costs are fixed, and they have been incurred in yesterday’s pre-inflation dollars. The cost of maintaining pipelines will go up, but in relation to the total cost of constructing pipelines these costs are small. However, companies that operate pipelines have debt-heavy balance sheets, which can become a source of higher costs. Pipeline companies we own have debt maturities that go out many decades into the future. They’ll be paying off these debts with inflated cash flows.
I’ve seen studies that looked at asset prices over the last few decades and declared “These assets have done the best in past inflations.” Most of these studies missed a small but incredibly important detail: The price you pay for the asset matters. If we are entering into an inflationary environment today, it is happening when asset prices are at the highest valuation in over a century. (This was not always the case during the period covered by these studies.)
For instance, one study showed that REITs have done well during past inflations. This may not be the case going forward. Aside from its being a very broad and general statement (not all REITs are created equal), low interest rates brought a lot of capital into this space and inflated valuations. Investors were attracted to current income, which was better than from bonds, and they paid little attention to the valuations of the underlying assets. Buying REIT ETFs may do more harm than good.
I cannot stress this point enough: Whatever landscape is ahead of us, we are entering into it with very high valuations and an economy addicted to low interest rates.
We have to be very careful about relying on generalized comments about past inflations. We need to be nuanced in our thinking.
We get asked about gold and cash
Gold: We don’t have a great love for gold. We have a position through options as a hedge. We discussed it in the past in great depth, so I won’t bore you with it here.
Cash: I am basically referring to short-term bonds, which seem like the most comfortable asset to be in today. However, their ability to keep up with inflation has been spotty in the past. It is okay in the short term but likely to be value-destructive in the long term. Our view on cash has not changed: In a portfolio context cash should be a residual on other investment decisions. In our portfolios cash is what is left when we run out of investment ideas.
Investing Outside of the US
The US government was not the only one borrowing and paying people to stay at home. But the US has done it to a much greater degree than others. Most importantly, we are not slowing down our spending (and thus borrowing), which will likely lead to a weaker dollar. If nothing else, a declining dollar makes foreign securities more valuable in US dollars. The probability of a stronger dollar is low.
But there is more.
The next decade will likely belong to ex-US investing. If you invested outside the US over the last decade, your returns were overshadowed by the gigantic outperformance of the US markets. Today the US is the most expensive developed market. Take Europe, for instance; most European stocks are still trading below 2007 highs. UK stocks trade at a half of the valuation of US stocks.
Our approach to investing is very simple: We are diehard value investors looking for high-quality companies that are significantly undervalued and run by great management. We do not change into flamboyant value-indifferent investors when we cross the border. International investing just gives us a greater palette with which to paint our investing canvas.
We’ve been doing ex-US investing for a long time. Today, about a third of our portfolio is in international stocks. In a few months we are going to roll out a new ex-US portfolio (some stocks from this portfolio will spill into our core value and dividend portfolios, but not all).
If you thought we had a silver bullet and easy answers, we don’t. I know what I am about to say is going to fall on deaf ears, especially since we are in an apparently never-ending bull market. But as steward of our clients’ capital, our most important objective is survival (avoiding permanent loss of capital and maintaining purchasing power) in both inflationary and deflationary environments.
Last decade this did not matter. Risks were only figments of our imagination, as money printing by the Fed, which was trying to fix a lot of sins and became the biggest sin of all – significantly distorting the price of money and thus the economy. But as Charlie Munger said, “If you are not confused about the global economy, you don’t understand it.”
A suddenly appearing iceberg is life-threatening to a speedboat (or cruise liner), but it is just an unpleasant inconvenience for an icebreaker. Our goal is to have a portfolio of icebreakers. We are playing a different game – we are not racing against the speedboats. We take comfort in knowing that, while the speedboats may outrace us for some time, they are bound to eventually hit an iceberg and sink. One iceberg that we have an eye on today is inflation (though we are prepared for deflation, too.)