In light of the sustained high inflation we are seeing today, I thought it would be great to read over and summarize the writing of Warren Buffett from his experience with high levels of inflation in the 70s. In 1977, Buffett wrote for Fortune magazine on “How Inflation Swindles the Equity Investor”, a time where most believed equity investing was a ‘hedge’ against inflation. No one knows how this period of inflation will unfold today but it should be interesting to learn what Buffett made of a period where inflation ruled the land.

Effects of Inflation

Buffett begins by explaining how there is no secret that stocks and bonds perform poorly in inflationary environments. With bonds, it is axiomatic that a fixed income investment will perform poorly when the dollar value in which it is denominated in continues to deteriorate. Back then, many had believed stocks to be a hedge against inflation, which proved to be misguided. The reason as Buffett puts it, at their economic substance, a stock is very similar to a bond. The main difference between bonds and stock is the unpredictability of their cash flows, a stock varies from year to year, a bond has set coupon payments.

Through the 50s, the market had an annual average year-end return on equity of 12.8%. Into the 60s &70s the average sat at around 10.8%. While the return on equity could jump around yearly, over long periods of time it was quite stable, this is where Buffett believes it would be okay to refer to corporate earnings as an “equity coupon”. A key difference between bonds and stock is when the cash ins received by the investor, usually a bond coupon is handed straight to the investor to reinvest wherever they see fit. As for stocks, earnings withheld are reinvested at whatever rates the company happens to earn. Part of this earnings can be paid out in dividends, the rest will match the company’s rate of return. This ability to reinvest earnings at high rates allowed for investors to buy interests in enterprises for a price at book value, which was far below the actual value of the business.

When inflation rises and interest rates follow, the equity return starts to be looked at differently by investors. Although, Buffett claims that over the long term, the equity coupon is more or less fixed, the short term fluctuations can sway investor attitude about the future far more than warranted. Since stocks have no maturity and carry additional risk to bonds, investors need a return above that of a bond and when this spreads narrows too much, the exit is the option for most investors.

The Inflation Tax

Further into the article, Buffett breaks down the mathematics of the inflation tax. Had an investor been earning 12% pretax they were expected to earn 7% aftertax using tax rates from that time. When inflation runs at or above that 7% rate, the real return becomes zero. Another example Buffett uses, is a widow earning 5% on her savings. Had the widow been taxed 100% on interest income she would lose her 5%, had there been no interest tax but inflation ran at 5% she would lose her interest income all the same. In both cases the widow walks out with no real income.

Conclusion

In sum, inflation works as a silent tax that swindles everyone including the equity investor. The effect on inflation can affect aftertax returns. When you boil it down, investing at its core is the commitment to give out your purchasing power today in the hopes of increasing your purchasing power later a much higher rate. Periods of sustained high inflation are not able to guarantee the return an investor receives after frictional costs will actually see them make real returns. So it should also follow, that periods of deflation are more favourable to equity investors, where the real return on their investments would increase due to future higher purchasing power of their dollar invested. Many people attempt to guess the inflation or interest numbers, and work off that, but those numbers move in a way that could never be predicted, not even by those with access to the necessary information. Inflation is a tax investors must familiarise themselves with and beat or they end up earning zero real returns if the rate of inflation is high enough.

You can read Buffett’s article here: http://csinvesting.org/wp-content/uploads/2017/04/Inflation-Swindles-the-Equity-Investor.pdf