Inflation: Raising the stakes

The first half of 2021 has provided no shortage of ‘big picture’ topics to be concerned about: take your pick between the pace of vaccine-rollouts, ongoing border closures, geopolitical sabre-rattling, the risk of personal and corporate tax increases, or fears of rapidly increasing inflation requiring an offsetting rise in interest rates.

If you cast your mind back, the topic du jour this time last year was the ‘shape’ of the economic recovery following the COVID-induced global recession, which was endlessly debated at the time. Would we have a V-, U-, L-, J-, or K-shaped recovery? (Or our favourite: the ‘Nike swoosh’-shaped recovery, which is really just a J-shaped recovery with better branding.) This topic is hardly mentioned these days, despite the vast amount of energy expended on predicting it last year.

To our thinking, the lesson is not that the macro-economic backdrop does not matter, but rather that long-term investors are better served in trying to understand how the businesses they own (or might look to own, should they go on sale) are positioned to navigate periods of distress and subsequent recovery. Given that we favour well-capitalised and cash-generative businesses with deep economic moats, we believe that most of our holdings took the opportunity presented by the pandemic to a) take market share, b) allocate capital to attractive acquisition opportunities, or c) permanently reduce costs without reducing their capability to service their clients, which will lead to sustainably higher margins. 

We remain focused on the fundamentals of the businesses we own and understanding their long-term destination, rather than trying to predict short-term macro-economic outcomes in which we have very little edge. 

In recent engagements with our investors, the topic that comes up most frequently relates to fears of higher inflation.

These concerns are valid. We have essentially had an entire generation of consumers never having had to live through a high-inflation period. Historically, inflation peaked in the early ‘80s in the US, meaning that a person would have to be in their mid-to-late 40’s (at the very least) to even remember it, and more likely in their 60’s to have felt the experience of seeing their purchasing power erode at double-digit rates year-over-year. As such, the risk of inflation is top of mind for us as an investment team, and has been since last year.

We think a few perspectives around the potential effects of inflation (both near term and long term) are worth highlighting. 

We distinguish between what could be called ‘transitory’ inflation (which is affecting near-term sentiment and making news headlines on an almost-daily basis) and potential 'structural' inflation (i.e. where prices go up, and then keep going higher).

If we go back 15 months to when the COVID outbreak began to materially impact economic data, demand for goods and services were artificially depressed, as many consumers were confined to their homes for long periods of time. What we are seeing now is that the reopening of the global economy and the related pent-up demand for goods and services (i.e. the demand-side of the inflation equation) has to an extent overwhelmed the pace at which the supply-side can respond and normalise by producing/delivering a sufficient quantity of goods/services. This demand/supply imbalance has resulted in temporarily higher inflation as there are relatively more people chasing the same (or fewer) amount of goods and services. 

We expect that as supply chains work through the disconnections (typically it takes several months to ramp up production capacity) and the imbalances normalise, this type of ‘demand-pull’ inflation will moderate. At present, the combination of ‘demand-pull’ inflation and a relatively weak comparative base for the period March to July 2020 is pushing up the reported inflation numbers, which is what you are seeing in the headlines on a day-to-day basis.

More of our focus as an investment team is spent on whether or not these temporary inflation trends can become more structural in nature. By way of example, in May, McDonalds in the US announced that they would be increasing the wages of over 36,000 workers by 10% over the next several months. Similarly, Amazon is offering $1000 sign-on bonuses to new employees at starting salaries higher than minimum wage rates (and what would likely have been the going hourly rate otherwise). To us, these are indicators that the labour shortages in the US may manifest in structurally higher wages in time. Given the strong demand levels for goods and services in the near-term, we would expect them to get passed through to the end consumer in higher prices. Essentially, once McDonalds has increased staff wages, we would expect wages to remain at those levels and not to revert lower. The risk here is that this type of wage increase leads to an upwards adjustment in the cost of production/services, leading to cost-push inflation. 

This dynamic could lead to inflation taking a step-change higher and not be merely ‘transitory’ in nature (though in time it could be offset by greater automation). As you might suspect, we are watching developments on the wage front closely.

Importantly, while the nature of inflation (transitory or structural) and the rate of inflationary increases remain uncertain at present, we have worked to position our Fund to take advantage of this current environment. As we wrote last year in The critical question to ask in 2021, we invest in businesses with strong balance sheets and considerable pricing power. 

By and large, our businesses have utilized the past year to remove costs from their operations without sacrificing the capacity to service their customers. We expect this will translate into sustainably higher margins over the medium term, a point that seems to be ignored by the broader market at present (which seems very focused on the inflation print from now to December 2021). Given the nature of the unique products they sell/services they deliver and their strong market position, our businesses are using the current inflationary environment to not only pass on rising input costs, but in many instances raise prices above inflation. In short, these businesses prefer to operate in the current environment where demand for their goods is strong and they can more easily pass on price increases. We expect this inflationary period to be a tailwind for several businesses we own.

However, business fundamentals are often not reflected in the market (at least, in the short run). Should the inflationary outlook result in central banks globally raising interest rates materially, this will very likely negatively impact valuations across all asset classes (equities, bonds & property) as the ‘risk-free’ rate of return (achieved through owning a government bond or placing money on deposit) will move higher, meaning investors’ will reassess how much risk they need to take to generate a specific level of return. Stated more simply, if interest rates are 0% (and inflation remains contained), you’d pay up a lot more for a business that can grow earnings at 15% p.a. for the next five years than if interest rates were 5% and inflation at 4%, (at which point you might well consider having some money on cash deposit). 

If inflation REALLY takes off, prices might need to come down quite some way. Stocks at the hyper-growth end of the market (think very, very expensive tech names with no demonstrable cash flows) will be disproportionately hurt in such a scenario, which is why we have reduced our overall tech weight since September 2020.

One common theme shared by our businesses is that they are run by management teams who have a demonstrated ability to allocate capital wisely; combined with the fact that they approach the creation of shareholder value (return on capital > cost of capital) the same way we do, they are very sensitive to the acquisition price paid. We believe owning a portfolio of cashed-up businesses with good capital allocators, strong cash flows and little debt is exactly what one would want to do in such a scenario, as it would give CEO’s such as Mark Leonard (Constellation), Messrs. Buffet and Munger (Berkshire), the Mendelson family (HEICO), etc. the opportunity to deploy their balance sheets in a meaningful way. Seen in this light, we would argue our ability to actively back superior capital allocators places us at an advantage to the major indices through such a period, as our businesses have the ability to ‘create’ value in a shareholder friendly manner (whereas our opinion of the capital allocation skills of the average business in the index is not nearly as benign.) Superior capital allocation is often an underpriced vein of 'quality' investment opportunities, in our experience.

There is a school of thought that says commodities and commodity producers are a good inflation hedge. This may work for a period of time, but in the long run, doesn’t actually hold true. To quote from the 1983 letter to Berkshire Hathaway shareholders (written just as inflation was subsiding):

Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.

And that fact, of course, has been hard for many people to grasp. 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.

In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.

The whole piece written by Mr. Buffett on the type of business to own during periods of inflation is worth reading, though it is quite lengthy. (Those readers who are interested can find it here: (VIEW LINK) - simply search for the phrase ‘Goodwill and its Amortization: The Rules and The Realities’ to skip to the relevant part.)

While the uncertainties around inflation in the near term persist, we believe the businesses we own on behalf of our investors are well positioned to capitalise on a range of outcomes that may unfold.