An Eye On Inflation
With a clear bias from central bankers towards loose monetary policy, global inflationary pressures are building. We don’t see dangerously high inflation as a certainty - a period of prolonged low inflation or even deflation is still possible. But given how much damage periods of high inflation have done to real investment returns and personal wealth historically, the risk demands some careful thought.
So what are the best assets to own in a period of high inflation? Warren Buffett wrote an excellent piece on this dilemma in his 1983 Berkshire Hathaway shareholder letter. His conclusions were learnt the hard way as he navigated through the investment world of the 1970s, and are not necessarily as you would expect. In short, you are better off owning asset-light businesses (i.e. those that generate high returns on capital) than asset-heavy businesses.
In the words of Buffett “for years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.”
Based on this insight, is the market's current obsession with commodity producers as a hedge against inflation really sensible? We're not convinced. Buffett notes that the earnings of commodity businesses declined significantly in real terms during the 1970s, despite rampant inflation. The positive impact of rising sales is quickly offset by escalating spend on costs, capital expenditure, and acquisitions to replace depleting resource bases. Look no further than Rio Tinto’s 2007 Alcan acquisition for a case study. Surplus cash flow, rather than returning to shareholders, was channelled into new resources at inflated prices. As a result, the only shareholder reward for years of strong commodity inflation was a dividend cut and a rights issue. If you fear monetary debasement , history has shown you are better off owning physical commodities directly than buying shares in the commodity producers. The risk of this approach is, clearly, that the anticipated inflation fails to materialise.
Our preferred inflation protection, like Buffett, is to invest in businesses with high returns on capital. Our preference is not simply a bet on inflation - we prefer to hold such businesses anyway - but it is an extra benefit of this investment strategy. As inflation takes hold, they are far less exposed to replacement spend on rapidly escalating asset bases. As a result, shareholder cash-flow emerges relatively unscathed. Ideally, we would like them to exhibit pricing power too - retaining a real share of their customer’s wallet as the price level escalates. Happily, this tends to be the case -a consistently high return on capital tends to indicate the existence of durable competitive advantages and therefore pricing power. One of our largest holdings, Diageo, is a good case in point. The strength of its brand portfolio is key - we are confident that products such as Guinness and Johnnie Walker will do a good job of retaining their share of disposal income over the next five to ten years, whatever happens to the price level. Overall, companies in our portfolio generate a cash return on assets of more than 20%, compared to the market average of 7%. This return is generated using substantially less debt than the overall market.
These businesses should also - unlike commodities stocks or commodities - do well in a deflationary environment. Typically they possess pricing power, strong cash flow and critically, don't rely on leverage to produce attractive returns on equity. If the zeitgeist shifts back to worries over a protracted balance sheet recession, these factors would be much sought after. History provides the evidence. Asset-light businesses outperformed strongly in the stockmarkets of both the US in the 1930s and Japan in the1990s. In many cases these stocks not only outperformed, but actually rose strongly in price.
Hugh Yarrow
November 2009
Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st November 2009 and does not constitute investment advice.
