w w w . t i c o n l i n e . c o m

THE EVILS OF INFLATION

The common view is that inflation is an economic phenomenon governed by money supply and consumer spending. In part, this is true. However, Warren Buffett maintains that inflation is a political factor, not an economical one because there is no limit to government spending.

The American government has to deal with two primary deficits - the budget deficit and the trade deficit. Because the U.S. is an economically wealthy country, Buffett believes that budget deficits can be controlled. However, it is the trade deficit that often gives the American government trouble.

During strong economic periods, Americans tend to consume more goods than the country can produce. This causes Americans to look outside the country to consume foreign products. In order to pay for these foreign products, the government issues various claim checks in the form of US government and corporate bonds. As the boom continues, the number of claim checks begins to pile up (ie the trade deficit).

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it."
Warren Buffett, 1993 Chairman’s Letters to Shareholders

Due to the economic strength of the country, it may be some time before this deficit is noticed. Realizing that claim checks will be redeemed for American assets (cash, land, buildings), the government will decide to debase these claims by increasing inflation. In essence, the government attempts to screw foreigners over by paying off pre-inflated debts with inflated dollars. Although this results in decreasing the strength of claims against American assets, it also takes its toll on American business.

As inflation rises, American claim checks decrease in value and consumer spending begins to slow. This, in turn, decreases the number of claim checks the government has to issue. As the economic landscape slows to a crawl the government will try to stimulate growth by dropping inflation rates (reducing their careless spending habits) and the entire cycle begins anew.

High inflation puts pressure on companies to produce a real return for their investors. Thus, a company's return on equity must exceed the combination of taxes (income tax on dividends and capital gains tax on retained earnings) and inflation. Companies with high returns on equity are therefore more able to withstand the ravages of inflation by providing more 'padding'.

How does a company increase it's return on equity?

"...a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics...We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?"
Warren Buffett, 1993 Chairman's Letters to Shareholders

RETURN ON EQUITY

Return on equity is simply one years earnings divided by shareholder equity. There are 5 ways to increase return on equity:

• increase operating margins
• increase asset turnover (ratio of sales to assets)
• pay less tax
• use leverage
• use cheaper leverage

PROFITABILITY

Operating margins result from the excess of sales over fixed costs. Many companies have 3 major costs that they have to deal with: raw materials, energy and labor. In order to increase the return on equity the company will either need to cut down on these costs or sell more product. During inflationary periods fixed costs are usually on the rise and companies with a dependency on fixed costs are squeezed. Due to the rising of costs, loan demands also increase. Knowing this, Buffett tends to stay away from companies that are adversely affected by high inflation and invests in those with very few fixed assets or those with large amounts of economic goodwill (eg: extremely strong brand name franchises).

"In the short-run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long-run, the market is a weighing machine."
Benjamin Graham

ASSET TURNOVER

Asset turnover is the ratio of sales to total assets. In general a company wants to sell more product per amount of asset it employs to make the product.

There are 3 types of assets that are important to look at:

1. accounts receivable
2. inventories
3. fixed assets.

When sales increase, accounts receivable will virtually always increase in sympathy. Thus, we can't affect return on equity here.

In addition, as sales increase inventory turnover will increase only marginally. Buffett pointed out that ratios increased from 1.2:1 to 1.7:1 during the 10 year period ending in 1975. Thus we can affect return on equity here, but only slightly.

As sales increase, the fixed assets used to make the product will not need replacing right away. Once the fixed assets are changed it will eventually make up for the extra sales. It is important to make sure that earnings created from extra sales are enough to 'cover' the annualized cost of these capital expenditures by a significant margin, otherwise the earnings will not represent the company accurately. This is especially important in industries where high capital spending is required to keep businesses competitive such as mining and high-tech.

LEVERAGE

I won't get into using leverage and/or cheaper leverage since increasing return on equity by loading up on debt is neither impressive nor desirable. Suffice to say that corporate borrowings should be in the form of bonds as opposed to callable debt and the operation that the debt is funding should produce a return greater than the cost of capital. Investors should keep in mind that companies that depend on debt to maintain their returns on equity will be extremely hard hit during inflationary periods as costs of capital increase.

With a better understanding of how return on equity we can see how it provides a cushion of safety for investors during periods of rising inflation.

Cheers,
Jim Chuong