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Buffett on Inflation and Stocks (Part 1)


Munger
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Fascinating to watch the lemmings pile into the stock market to "protect" against inflation or even worse, believing inflation will benefit their equity investments...and when the stock market implodes, all of the fools that are giddy today will cry and blame someone else for their ignorance.

 

 

Here is Buffett in 1977 (Fortune Magazine) on the topic.  In my humble opinion, his best piece ever.  Enjoy.

 

 

 

How Inflation Swindles the Equity Investor

 

http://www.valueinvesting.de/en/inflation-equity-investor-by-warren-buffett.htm

 

 

 

 

 

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"And why does a man who is gloomy about stocks own so much stock? "Partly, it's habit," he admits. "Partly, it's just that stocks mean business, and owning businesses is much more interesting than owning gold or farmland. Besides, stocks are probably still the best of all the poor alternatives in an era of inflation - at least they are if you buy in at appropriate prices."

 

Depends on your view of current prices but the implosion isn't necessarily a given (at least not in nominal terms).

 

 

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Thats my issue with your assessment Munger - you appear to be saying hold cash during a period of rising inflation which seems a bit nutty. The world is full of crappy choices sometimes we have to pick the least crappiest one.

 

Please lay out your investment advice. We all know the world economy sucks and will suck for a while. Honestly I think Bernanke might be doing the right thing, given the hand he was dealt.

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Thanks for sharing this link Munger - it is a timely one.

 

Fascinating to watch the lemmings pile into the stock market to "protect" against inflation or even worse, believing inflation will benefit their equity investments...and when the stock market implodes, all of the fools that are giddy today will cry and blame someone else for their ignorance.

 

The real point of this article (for me, anyhow) is this: "Besides, stocks are probably still the best of all the poor alternatives in an era of inflation - at least they are if you buy in at appropriate prices."

 

If you look at what Buffett has *done*, it is exactly that. He has purchased businesses and/ or stocks at bargain prices and held on to the them for a long, long time. I don't think that Buffett's point was to criticize the "lemmings", but instead to highlight the precarious investment environment that inflation creates and to point out the folly of trading in and out of the market in equities with a mind to outwit inflation, which is near impossible.

 

His actions since have advocated buy and holding equities (aka businesses) at the right price, which is the positive counterpoint to this cautionary tale. To me, that is a more useful focus since it is something that can be *done*, and not something simply to be feared (fear is not actionable).

 

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Obviously Munger you didn't read the article you posted  What is important is not only what Buffet says but what he doesn't say. He says inflation swindles the equity investor but that is only because it swindles the cash holder, bond holder, gold holder, property holder EVEN MORE!

 

Steel1 noted the important qualification to the simplified nonsense posted above -- at least they are if you buy in at appropriate prices

 

Couple of observations:  

The best approach is always and will always be to wait for Mr. Market to sell you great companies at bargain prices -- margin of safety.

When the margin of safety is high, buy hand over fist.

Inflation is not a problem today and will not be any time soon -- so holding cash has not resulted in a loss of value.  

If inflation truly rears its ugly head, the stock market will tumble more than the loss of value for cash, given current multiples -- see the 1970s.

If hyperinflation truly took hold, the allocation between cash and stocks won't matter -- society will collapse.  Always has and always will in hyperinflationary periods.

If deflation takes hold, which is still entirely possible (see Japan), equity prices will tumble and cash will be king.

 

Holding cash at the current time does take some strong internal fortitude when the rest of the world is shouting cash is trash, but be patient and wait for the fat pitch -- it will come...and most of all don't panic and follow the crowd.

 

 

 

 

 

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"Inflation is not a problem today and will not be any time soon -- so holding cash has not resulted in a loss of value."

 

I'd argue that asset inflation will precede physical inflation such that holding cash can result in substantial loss of value in asset terms. The actual damage to purchasing power in terms of physical goods will come more slowly. I believe the current ratio of stock market capitalization to GNP is around 94% (got to 83% in June). Not Buffett's ~80% and you'll do quite well but hardly massively overvalued either, especially relative to alternatives.

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but hardly massively overvalued either, especially relative to alternatives.

 

Be clear -- this may work for a trade but completely irrelevant from an investment perspective.  In terms of valuation, the only consideration that matters for the economic return an investor will realize on his/her capital outlay is absolute value not relative value.

 

I'd argue that asset inflation will precede physical inflation such that holding cash can result in substantial loss of value in asset terms.

This would be called an asset bubble fueled by artificial low interest rates manipulated by the Fed -- these bubbles always have and always will pop.  So there will be no real loss of purchasing power in this scenario.  If you held cash during the housing bubble and bought after the burst, you did fantastically well.  Note holding cash when everyone else appears to be making easy money, riding the bubble is not easy to do.

 

current ratio of stock market capitalization to GNP is around 94%

On your comparison of market capitalization to GDP, note that GDP is clearly artificially inflated by artificially low interest rates and 10% budget deficits.  At normalized interest rates and 3% budget deficit, GDP is a helluva lot lower.

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QE2 won't bring high inflation unless people start borrowing and spending again. The Fed is increasing the monetary base at the moment but it cannot force banks and people to lend and borrow which is how money truly gets created in our system. Of course it could print trillions and trillions and trillions but all that would bring is hyperinflation and it would not have any support in the political arena to do that as things are not sufficiently bad yet (maybe in the future).

 

The real issue is: are we facing a secular change or only a cyclical one?

 

- If it is a cyclical one, when some jobs come back and people start borrowing and consuming again, there will very probably be much higher inflation with all those reserves bank now have on their balance sheets to loan to people. The fed will have a hard time reversing the process and interest rates will rise. There could be stagflation as Sanjeev suggested. Some businesses already looked priced cheap enough to be of some interest. Having cash in reserve seems proper also as there will be some volatility along the road and opportunities will be there for very profitable value investing.

 

- If it is a secular one then this is a different game. This is what most of us do not want to consider because it is frightening. The Fed wants to do anything in its power to avert that but I do not think it can do it by itself. The first ingredient of this is the change of psychology and behavior of the consumer. People's balance sheets are weak at best in the average and the housing mess is not correcting fast: it is just too big. Many indicators point to a repeat of the contraction phase and that is outright deflationary. I tend to believe at this point that we are facing a secular change. The country's finances are going to look increasingly dubious in the future and the same for most western nations (excess leverage). And then we will go from one crisis to the next as dominos fall. In this case it makes sense to have a lot of cash reserves and be very cool and patient and require a high margin of safety.

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Anyone seen coffee prices lately?  Sugar?  Gold?  Steel?  You name it!  Other than pretty much orange juice, we've already encountered some inflation at the raw materials and commodities level, and that will probably continue for the next year.  In the short-term (1-2 years out), I don't see deflation as a possible scenario.  

 

We had this discussion a month or so ago, and I mentioned that when the market turns it turns hard.  September was the largest September gain since 1939!  Investors are reaching for yield and they will continue to do so for the next six months to year.  Is it to their detriment long-term?  Probably.  But the fact remains that investors are slowly piling into other assets because fixed income instrument yields are so low.  Why do you think there is such a huge revival in the junk bond market?  That will probably also continue for at least another year or so.  Cheers!

 

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Do you remember what happened before the last crash: commodities were flying high and people were chasing yield everywhere.

Pension funds are trapped  because bond yields are so low and they have to make around 8%. So they go to hedge funds and chase yields everywhere they can find it. M&A deals replace organic growth and are possible because companies can borrow so cheap.

But why is that changing the real issue in the first place: the ability and the will to consume and borrow. This whole reflation thing may actually make things worse by:

- increasing the price of necessities which is what people truly consume at the moment.

- increasing frictions among countries (currency wars, relative buying power, trade wars etc...).

- increasing governments' future financing issues: they get addicted to low yields and increase debt dramatically. What is next?

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September was the largest September gain since 1939!

 

Please tell us what happened in the months following 1939.

 

Investors are reaching for yield and they will continue to do so for the next six months to year.

 

This is simply the greater fool theory at work and has no relevance to value investing in the spirit of Buffett, Munger, and BG.  This scheme ends terribly -- always has, always will... I am always entertained by those that convince themselves they can sell right before the music stops.    

 

Other than pretty much orange juice, we've already encountered some inflation at the raw materials and commodities level, and that will probably continue for the next year.

 

We have not seen any of these increases passed on to the consumer in any material way.  Where is the price of oil relative to pre-recession highs?  What is the price of real estate relative to pre-recesssion highs?

 

 

 

 

 

 

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Other than pretty much orange juice, we've already encountered some inflation at the raw materials and commodities level, and that will probably continue for the next year.

 

And if these costs do get passed on, what do you think happens to consumer spending, the economy, and the stock market?

 

And if costs continue to rise but don't get passed on, how is that remotely good for corporate earnings?

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This is simply the greater fool theory at work and has no relevance to value investing in the spirit of Buffett, Munger, and BG.

 

You keep saying this, but Buffett keeps contradicting you in every presentation or interview he's given in the last six months.

 

We have not seen any of these increases passed on to the consumer in any material way.

 

I'm guessing you don't buy the groceries in the house.  Have you seen produce prices lately?  There is a lag between when raw material prices increase and then the final product prices.  I expect to see some continued inflation in consumer prices in the next year.

 

And if costs continue to rise but don't get passed on, how is that remotely good for corporate earnings?

 

They do get passed on.  And for businesses with branding power, they will be able to pass those prices on while maintaining much, if not all of their sales.  I never said to buy all stocks.  I said to buy high quality businesses, that had good dividend yields, and were reasonably priced at the time.  They will do far better than bonds or cash over the next few years.  Cheers!

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You keep saying this, but Buffett keeps contradicting you in every presentation or interview he's given in the last six months.

 

Are you that naive?  Please.

 

In this environment, if Buffett told the masses to get out of stocks, the system could literally come down.  Buffett knows full well how fragile the current environment is... And both Buffett and Munger dodge the question on expected returns by simply saying stocks will do better than current yields on long term government bonds over the very long term -- not a very high hurdle over a 30-40 year period.  Buffett has always said the masses should put a small amount of their income into an index fund every month, regardless of valuation -- he is talking to the masses, who he doesn't believe have the ability and/or time to invest.

 

You need a refresher from BG.

 

In recent months, Buffett has frequently repeated that current government policies are unsustainable because they will lead to US becoming a banana republic.

 

 

 

 

 

 

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Please tell us what happened in the months following 1939.

 

You had a 33% correction over the next two years and then the market doubled over the next four years.  Even if you had invested in the general market at the top of 1939, you would have been ahead versus holding cash six years later.  If you averaged down as the market went down, you would have done even better!  In the meantime, you were also reaping dividends that would have increased your average investment return.  Cheers!

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Munger, I wonder if you could answer my earlier question. Or let me rephrase it, so that an answer can be a simple number -- what is your current cash allocation percentage?

 

The reason I'm asking is that you're talking in general terms, but I want to get some perspective. Thanks!

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