“We neglected the Noah principle: predicting rain doesn’t count, building arks does.” - Buffett, 1981 Letter to Shareholders
Last week we discussed how Buffett discerns whether a business is going through a short-term, solvable problem, or is structurally impaired. The answer, according to Buffett, is to judge whether a company’s fundamental economic advantage is in jeopardy or not.
This week (1981 letter) we turn our attention to a topic that’s on everybody’s mind: inflation.
The Inflation Hurdle
Similar to today, inflation was a central focus for investors in the late ‘70s/early ‘80s, with annual inflation peaking in 1980 at a staggering 13.5%:
While the inflation we’re seeing today is more tempered1, the challenge for investors remains the same: a higher hurdle rate. The hurdle rate is the rate of return on equity required to generate positive real return for equity owners. The aim of any investor is to preserve and ultimately grow starting capital. This must incorporate the effects of taxes and inflation, because at the end of the day, the purpose of growing capital is to increase purchasing power, not to grow a nominal dollar amount.
For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer. (1980 letter)
The investor’s mandate, then, can be summarized in the following equation:
[Rate of return * (1-tax rate) - inflation rate] must be ≥ 0%
Let’s say you invest in an instrument that returns 10% for the year (could be a fixed yield or appreciation in equity value). The tax rate is 30% and inflation is 7%. Plugging the numbers into the equation yields:
10% * (1-30%) - 7% = 0% real return.
Thus, in a 7% inflationary environment your hurdle rate is 10%.
Here is Buffett summarizing:
High rates of inflation create a tax on capital that makes much corporate investment unwise - at least if measured by the criterion of a positive real investment return to owners. This “hurdle rate” the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners - has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil. (1980)
Finding refuge in inflationary environments
The desirable assets in an inflationary environment are those that are insulated from its eroding effect. Buffett’s criteria for businesses that fit this description are asset-light businesses with pricing power:
Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades. However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.
There is a subtle point in the above quote that deserves closer attention. Buffett says an ability to increase prices without fear of significant loss of either market share or unit volume. Raising prices without losing market share means the business is not at risk of losing customers to competitors; in other words, it has no viable substitutes or the cost to switch is prohibitive. Google search is probably the hallmark example of a product with no close substitutes. I would even argue Zoom doesn’t have a viable substitute - Google Meet is bad, Teams is better but still mediocre at best (let me know if you disagree!).
I think of the cloud providers (AWS, Azure, and Google Cloud), along with “systems of record” like Intuit and Salesforce as checking the “prohibitive switching cost” box because they contain crucial business data.
Raising prices without a significant loss in unit volume means the product or service is a necessity, not a luxury. In other words, it’s untenable for survival to stop consuming said product or service. On the individual consumer side, there is a hierarchy of these goods: water, food, shelter, energy, transportation, entertainment, and so on.
On the enterprise side, any product or service that is mission-critical for business operations will fall into this camp. I think the list given above (the cloud providers, systems of record, even Zoom), would fall into this camp as well.
The challenge for investors, as Buffett highlights at the end of his quote, is that “very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.”
Happy hunting.
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At least on paper; we won’t discuss changes to inflation calculation methodology that have transpired since the ‘80s.