The cash-eating parasite we forget about
Let’s begin with the complex reality of investing and money- it doesn’t grow on trees and everybody wants a piece of yours. There are parties (or parasites) that chip away from your hard-earned cash: some brokers charging ridiculous fees, fund managers doing the same, or the government collecting taxes.
However, there is one “charge” most people forget about- sometimes because it is insignificant, but most of the time because it eats away your cash much more covertly. Any idea what I’m talking about? Yes, it’s the dreaded inflation.
Imagine you have $100k in cash, and you can choose to either invest it in a public company returning 10% a year or buy a 3-bedroom house for $100k. Assuming you would like to buy the house, but, you would also like to have extra $10k for renovation; thus, your best decision will be to invest in the public company to earn the 10%.
After a year, you have $110k (earning the 10%), eagerly going to the realtor to buy the house, only to discover the current price of the house is $110k, which is 10% higher because of inflation.
Therefore, even though you have more money than a year before, your purchasing power remained the same, or in other words, your 110k today are equivalent in purchasing power to last year’s 100k due to inflation. Hence, that’s why inflation is a silent parasite – it doesn’t diminish your returns by literally taking away your money, but rather by making the stuff you would buy more expensive, making you able to buy less.
“Inflation is taxation without legislation” — Milton Friedman
What if inflation was 5% or higher?
Then we might encounter considerable problems down the road. Why? Imagine you earn 10% a year, net of fees and taxes (that is quite a lot already) but have inflation of, say 6%. Your real return would suddenly be (1 + return) / (1 + inflation rate) - 1, thus only 3.77% (before tax!). That is a massive difference from the initial 10%.
Can we hedge it?
In 1977, Fortune magazine published a fascinating article, “How Inflation Swindles The Equity Investors” written by the legendary investor Warren Buffett. The article was published during the years of high inflation 1973-1981 when inflation was averaging at 10.4% and a peak of 13.3%.
Mr. Buffett begins by saying that it was conventional wisdom or a rule of thumb if you wish that stocks were a hedge against inflation. That would mean all we needed to do in order to avoid inflation was to invest in stocks, because it was thought stocks would not only earn standard returns without inflation, but also the extra returns equal to the rate of inflation, off-setting its effect.
So ... do stocks really off-set inflation?
This proposition is not completely unreasonable if you think about it: you invest in a business, which earns some profits and their returns on book value is your return. Should inflation arise, it would also increase the prices of goods and services the business sells, thus earning more in profits (and earning you more in return, off-setting the inflation).
This explanation is missing an important piece of the puzzle though. Inflation generally means an increase of all prices: including materials, labor, energy costs etc. Thus, even though the prices (and thus sales) would increase, so would the costs of the business, earning more-or-less the same nominal profits and the same return on book value. However, now we are in hypothetical inflation scenario, meaning the same nominal return on book value would be lower in real terms.
Can this be empirically proven? Actually, yes. Warren Buffett goes on to state that from the period 1945-1975, the average return on book value of FORTUNE 500 companies averaged around 12% with very little deviations. During this period, the U.S. experienced various inflation rates, even negative in some years. Nevertheless, even with rising inflation rates, the return on book value stayed almost constant, proving that stocks in general don’t provide much protection against inflation.
It gets worse
Why, you might be asking? Inflation isn’t all bad, don’t get me wrong. But just like fire, it’s a great servant but a terrible master. If it’s controlled at around 2%, all is good, working like a clock-work. However, when it starts getting out of hand to levels of 5% and higher, we’re in trouble. The governments try to avoid this, but when it happens, their tool number one is moving the interest rates up– by a lot.
What that does is that it slows down the economy by making money and debt more expensive, thus hindering inflation. What that also does is that it slashes down the valuation of the stock market because of the discounting effect. Put simply, stocks have to reprice if new interest rates are introduced.
Is high inflation real?
I would reply with a counter question: why wouldn’t it be?
We are very much used to periods of inflation close to zero. Most of today’s investors have not even experienced a high-inflation environment. However, double-digit inflation has occurred several times during history as I wrote above, even in such developed markets as the U.S. We cannot assume that simply because we haven’t experienced high inflation for a long time that it will stay that way.
Moreover, we have all the reasons to see inflation spike in the coming years: primarily because of QE (quantitative easing), which is basically pumping money (in a rate never seen before) into the economy and the Covid-19 pandemic certainly doesn’t help, mainly because all the social stimulus and economic relief for business is financed by, yes you guessed it, more money printing.
There is a big debate on Wall Street about high inflation possibly coming, which might or might not materialize. It’s a feisty debate: there are economists who are sure it will be at 10%, there are economists who think it will stay basically at zero and then everything in between.
One thing is for sure: nobody can forecast inflation – not Warren Buffet, not economists, not oracles with a crystal ball and certainly not me. But that doesn’t matter; the important thing is that it has happened a few times in history and it definitely can happen again.
Inflation diminishes your returns by making everything more expensive, thus making you able to buy less (decreasing your purchasing power/wealth)
Stocks don’t offer much hedge against inflation: return on book value is more-or-less constant around 12% (from 1945-1975, FORTUNE 500 companies)
Overvalued companies (by book-to-market) earn you lower returns
If inflation comes, not only it makes your real returns smaller, but the government's reaction of rising rates makes the stock prices go down (making you lose even more money)
We cannot exclude the possibility of high inflation in the future
Nobody can predict inflation, we can only speculate and prepare