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Inflation and the Asset Heavy Business


Rod
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I know that Buffett has long stated that asset heavy companies are hurt particularly hard by inflation, but to be honest I am having a hard time understanding why. The only major way I see this happening is that they tend to pay higher tax rates because the depreciation charges they take are much smaller than the cost of replacing assets, so accounting profits overstate cash earnings and lead to higher income taxes. But my impression is that Buffett is making a claim that there are economic reasons beyond this tax effect. And yes, I have read "How Inflation Swindles the Equity Investor" by Buffett and find it rather unclear. Does anyone understand why inflation affects capital heavy businesses badly beyond the income tax effect that I mentioned above?

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I'll give it a shot.

 

Mr. Buffett has defined some assumptions:

 

-ROE and inflation are not proportional and not even sticky

-Higher inflation periods are typically associated with poorer general economic conditions with +/- lower demand and higher partial fixed capital utilization

 

His take seems to be that firms with stronger pricing power would be relatively less punished (or swindled) versus capital intensive firms which, typically under these circumstances, would have delayed and partial pricing power and would have a relatively higher amount of capital sitting idle (so lower ROEs).

 

The reinvestment of retained earnings question remains open but Mr. Buffett has shown the ability to deal with that specific question over time. Given BH's huge size now, this would also explain his interest for large utilities with contractual indexing and pretty much guaranteed capacity utilization.

 

If you like to think along multiple dimensions, here's an unrelated example. I'm into cycling and sometimes do racing. Conditions vary but the best time to "attack" or to differentiate, in general, is not when going downhill or on rolling terrain, it is when going uphill, at a time when your relative competitive advantage or power/weight "moat" may grow larger with gravity working against you.

 

If you have time or interest, here's a collection of what Mr. Buffett has said about inflationary conditions. A lot of the comments have to do with the effect on reserves but a lot of it has to do with your question.

http://csinvesting.org/wp-content/uploads/2015/01/Buffett-inflation-file.pdf

 

 

 

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Such earnings are stated after depreciation, which presumably will allow replacement of

present productive capacity - if that plant and equipment can be purchased in the future at

prices similar to their original cost.

 

I think this is the key here. Since depreciation lags capex by at least one year, earnings of capital intensive businesses are overstated, because they have to reinvest more than deprication in the future to maintain the status quo.

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I'll give it a shot.

 

Mr. Buffett has defined some assumptions:

 

-ROE and inflation are not proportional and not even sticky

-Higher inflation periods are typically associated with poorer general economic conditions with +/- lower demand and higher partial fixed capital utilization

 

His take seems to be that firms with stronger pricing power would be relatively less punished (or swindled) versus capital intensive firms which, typically under these circumstances, would have delayed and partial pricing power and would have a relatively higher amount of capital sitting idle (so lower ROEs).

 

The reinvestment of retained earnings question remains open but Mr. Buffett has shown the ability to deal with that specific question over time. Given BH's huge size now, this would also explain his interest for large utilities with contractual indexing and pretty much guaranteed capacity utilization.

 

If you like to think along multiple dimensions, here's an unrelated example. I'm into cycling and sometimes do racing. Conditions vary but the best time to "attack" or to differentiate, in general, is not when going downhill or on rolling terrain, it is when going uphill, at a time when your relative competitive advantage or power/weight "moat" may grow larger with gravity working against you.

 

If you have time or interest, here's a collection of what Mr. Buffett has said about inflationary conditions. A lot of the comments have to do with the effect on reserves but a lot of it has to do with your question.

http://csinvesting.org/wp-content/uploads/2015/01/Buffett-inflation-file.pdf

 

Great stuff.  Thank you.

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