re: Interesting Business, Econ and Finance Links

Fitting for today. Warren Buffet's 1977 article for Fortune Magazine, "How Inflation Swindles the Equity Investor."

His primary thesis is that "stocks, in economic substance, are really very similar to bonds." And we all know what inflation does to bonds denominated in the currency losing purchasing power.

Why does he say that? A few reasons:

1. He showed that in the 30 years after WW2 the return on book value of equity was effectively stuck at 12%. Sure, it was somewhat higher and somewhat lower in any particular year, but in each of those three decades, it was effectively 12% with little significant variation. He also noted this 12% figure changed very little whether during the post-WW2 decade (where annual inflation regularly hit double digits) or in a period of very low inflation (such as 1955-1965, where it averaged about 1-2%).

2. Given #1, he viewed equities as having a fixed "coupon," just like bonds and, to reiterate a point made in #1, he found ROEs did not increase in an inflationary environment. In his words, "Essentially, those who buy equities receive securities with an underlying fixed return - just like those who buy bonds."

3. Given the fixed nature of the "equity coupon" described in #2, and given equities are effectively "perpetual bonds," they have much greater duration than bonds, particularly when valuations are stretched (given how much longer it will take for an equity investor to be repaid by the underlying issue's cash flows).

4. In the mid-1960s, as bond yields were rising, the greater duration of equities (i.e. higher risk) and rising interest rate environment simply made them unattractive vs. bonds on a risk-adjusted basis as rising interest rates compressed the spread between bond yields and the fixed 12% "equity yield."

5. Some may argue companies should be able to increase this 12% yield in an inflationary environment. After all, the book value of equity is tied to older less inflated dollars while the earnings, theoretically, could be increasing in light of higher price levels. That said, there are only 5 ways in which corporations can increase ROEs: (a) higher asset turnover ratio, (b) cheaper leverage, (c) more leverage, (d) lower income taxes and (e) higher operating margins. Buffett took each in turn:

(a) Regarding the asset turnover ratio, there may be some temporary increase if inflation is able to be passed through on a 1:1 basis to consumers. But ultimately, the denominator of the equation will also increase, as companies are forced to replace accounts receivable, inventory and fixed assets at higher prices due to the same inflation that is increasing sales. For example, in the decade ending in 1975, despite an inflationary environment, the asset turnover ratio only increased by 9%, which only added 100bps of temporary improvement to reported ROEs.

(b) Don't expect cheaper leverage in an inflationary environment, unless banks are simply willing to take on lower real returns (which they typically aren't). Not much to say on this one. Moreover, even if interest rates stay the same, the overall amount of interest paid increases as debt-financed assets become more expensive to replace in an inflationary environment.

(c) More leverage is one possibility, but Buffett concluded companies were already overlevered by the time he wrote the article (1977). For context, it was about 30% of GDP then; it's now about 50%. Moreover, as inflation causes interest rates to increase, credit ratings tend to be downgraded, which mitigates the positive ROE effect of greater leverage. In addition, in Buffett's view, higher leverage levels made the fixed 12% "equity coupon" less attractive in the first place (on a risk-adjusted basis, given the greater possibility of bankruptcy).

(d) Lower taxes Buffett assumed was a fool's bet at the time. Do we even need to address this one in today's context?

(e) Higher operating margins is the one area Buffett admitted inflationistas were most likely to hang their hats. Yet, when going from the relatively low inflation decade ending in 1965 to the higher inflation decade ending in 1975, pretax profit margins actually contracted by 60 basis points, meaning companies weren't actually able to pass through inflation on a 1:1 basis, on average.

6. Given (a)-(e), it's more likely than not that profitability will actually decrease during inflationary periods, and that spells bad news both in its own right but even moreso during periods of peak valuations. Even worse, during periods of higher inflation, the real value of that 12% fixed "equity coupon" Buffett calculated (which, remember, he argues would be less at best in an inflationary environment) is even lower.

7. As a final point (and this one is from me), remember one of the causes of potential future inflation to begin with: massive debt accumulation. As inflation rises, and interest rates rise in tandem, that means interest expense as a percent of our government's budget will also increase. This, of course, will lead to higher taxes, putting even further pressure on stocks in an inflationary environment. While tax revenue might increase some as inflation kicks investors into higher tax brackets, it will no doubt be more than offset by higher interest expense on the immense amount of debt that has recently by issued by our elites in Washington.

/end

Read more here (note, the actual article is on pp. 2-15; everything else is lagniappe from other Buffett writings):

LINK

One of the better reads I’ve come across recently:

LINK