How does inflation affect stock owners?

Today's business news media is rife with articles suggesting inflation is here to stay. Were that to happen, what does it mean for equity holders? Upon first reflection, it would seem that in inflationary times, companies can charge more for their products, and thus should have a natural hedge against inflation. Unfortunately, companies in such times are forced to invest their profits in the companies JUST to keep returns at ordinary levels, resulting in real costs to equity holders.

Consider a numerical example for a given company. For simplicity, we will consider total assets (e.g. A/R, inventory, fixed assets) at $1000, and annual sales at $2000/year. Assuming profit margins of 5%, this level of annual sales translates to $100 in profits.

At zero inflation (to keep the example simple), that profit of $100 can pay shareholders, or can be re-invested in the company to generate further returns the following year.

At 10% inflation, presumably sales increase to $2200 / year. Margins stay at 5% since costs increase as well, resulting in profits of $110. Sounds fine, right? Profits have increased along with inflation, resulting in no loss for the equity holder. Unfortunately, this isn't the end of the story.

We've implicitly assumed asset turnover (sales / assets) will increase with inflation. But there is no reason to believe this. Inflationary increases in dollar amounts for assets such as A/R, inventories, and fixed assets will be required to service these inflationary increases in sales. We had assets at $1000. With our 10% inflation, asset requirements become $1100, eating up almost all of the $110 in profits. What's the value of a company that needs to re-invest all its profits just to maintain its earnings? Very little.

The numbers were made up, but the principle of this argument will persist no matter what numbers are chosen. Inflation eats up profits. If inflation is high, equity values will suffer.

Book Summaries

Constantly educating oneself is a neccessity for every value investor. Here are links to the book summaries we have discussed on this site. Enjoy!

Security Analysis by Graham and Dodd

Predictably Irrational by Dan Ariely
The Upside Of Irrationality by Dan Ariely
Super Crunchers by Ian Ayres
It's Not Rocket Science by Tom Bradley

The New Buffettology by Mary Buffett
Buffett Partnership Letters by Warren Buffett
The Innovator's Dilemma by Clayton Christensen

Influence by Robert Cialdini
The Little Book That Builds Wealth by Pat Dorsey

The New Contrarian Investment Strategy by David Dreman
Contrarian Investment Strategies - Next Generation by David Dreman
The Making Of A Market Guru by Ken Fisher
How To Smell A Rat by Ken Fisher

Common Stocks And Uncommon Profits by Philip Fisher

Conservative Investors Sleep Well by Philip Fisher

Developing An Investment Philosophy by Philip Fisher
A Short History Of Financial Euphoria by John Kenneth Galbraith
How We Know What Isn't So by Thomas Gilovich

The Intelligent Investor by Ben Graham

The Little Book That Beats The Market by Joel Greenblatt

You Can Be A Stock Market Genius by Joel Greenblatt
Competition Demystified by Bruce Greenwald

The Warren Buffett Way by Robert Hagstrom

Even Buffett Isn't Perfect by Vahan Janjigian

The Investment Zoo by Stephen Jarislowski
Thinking, Fast and Slow by Daniel Kahneman

Margin Of Safety by Seth Klarman

Freakonomics by Levitt and Dubner

SuperFreakonomics by Levitt and Dubner

Reminiscences Of A Stock Operator by Jesse Livermore

A Random Walk Down Wall Street by Burton Malkiel
Boombustology by Vikram Mansharamani
The Most Important Thing by Howard Marks

The Psychology Of Human Misjudgement by Charlie Munger
Quality of Earnings by Thornton O'Glove

The Dhandho Investor by Mohnish Pabrai
The Halo Effect by Phil Rosenzweig

The Snowball: Warren Buffett by Alice Schroeder

Irrational Exuberance by Robert Shiller
Fooled By Randomness by Nassim Taleb

New Era Value Investing by Nancy Tengler
The Aggressive Conservative Investor by Martin Whitman

Ben Graham's Intellectual Property Lives On

On what would have been Ben Graham's 100th birthday, a few of his former proteges (Buffett, Schloss and others) participated in an event titled "A Tribute to Ben Graham". They all agreed that Graham had changed their lives by teaching them the principles that were the foundation for their ultra-successful careers in investing.

Here's a summary of some of the wisdom they claimed they learned from Ben, with brackets around who said it:

1) Look at stocks as part ownership of a business (Buffett)

2) Make market fluctuations (Mr. Market) your friend...volatility is GOOD, not bad (Buffett)

3) Margin of safety - building a 15,000 pound bridge if you're going to be driving 10,000 pounds across it (Buffett)

4) You don't have to do anything ridiculously complicated to find undervalued companies...assets don't lie (Buffett)

5) Stocks are easier to deal with than people...they don't argue with you, they don't have emotional problems, you don't have to hold their hands (Schloss, who prefers not to talk to managements of the companies he buys, as he's not confident he can judge them accurately and without bias)

6) Companies with high debt get punished during bad times...the best companies to own aren't leveraged (Schloss)

7) Always have an open mind...that's what allowed Graham to build his great model (Irving Kahn)

Charles Brandes

Charles Brandes is yet another value investor who has broken the bank (so to speak), having market beating returns since 1978 with Brandes Investment Partners.

Brandes doesn't worry about short term returns, as long as the underlying value of the business hasn't changed. He cites Freddie Mac who he bought in at $100, saw it go to $30, and finally sold when it had turned around up to $160. He's seen many 50%+ drops in many good companies that he has purchased. But beware, if you bought into a too rosy outlook, a 50% drop might reflect the real value of a company!

He also doesn't subscribe to market timing, another common theme among value investors we've looked at. "As long as you're prepared for declines and don't sell into them, they can't hurt you," he says.

Brandes tends to put little emphasis on earnings, but instead focus on cash flows. This strategy served him well with Latin American telecom companies. In 1994, Telebras (Brazil) was one of his favourites. It had lines in ground, which were hurting earnings due to their depreciation. But it traded at only five times cash flow, as the company benefitted from having infrastructure already in the ground. There are numerous examples of other industries where earnings can look bad because of fixed cost purchases in the past...but those purchases that have already been made can now generate cash flows in excess of earnings as a result!

How Much Is Inventory Worth?

Sometimes a company's inventory can be a large component of its assets. Therefore, when valuing a company, determining how much the inventory is worth becomes an important issue.

Companies will list their inventory at the lower of:

1) what they think they can sell it for

2) what it cost them to make it

What it cost them (#2) can include the raw materials they required, the labour costs, energy costs, and anything else that might have contributed to the end product.

But this listing of the lower of these two components is a little bit conservative. Sometimes, inventory is worth a whole lot more than what is shown on the financials.

Consider an oil company currently pumping oil out of the ground. It may not be costing them much to pull the oil out (resulting in a low inventory value on their balance sheet), but the value of their inventory could be astronomical. So where prices fluctuate (common for commodities), you have to keep an eye out and make sure you understand the underlying value of the inventory.

Another example where inventory is understated is when a company has particularly high gross profits. Consider Harley-Davidson throughout the late 90's. They had waiting lists for their vehicles, resulting in people willing to pay a lot more for the vehicles than the raw materials and labour required to put them together. As a result, the value of their inventory was actually a lot more than you would think if you just looked at the balance sheet.

When comparing inventories across companies, you also have to keep in mind different methods companies use to calculate their ending inventories. The two most common methods are FIFO and LIFO; a good article describing them is listed here, therefore I won't get into it here.

GDP not negative, but GDP per capita is

Lately there has been a lot of banter about the state of the US economy. Many (including Warren Buffett) have argued that for all intents and purposes, we're in a recession. Officially, however, a recession is defined as two consecutive quarters of negative, real (i.e. inflation adjusted) GDP growth. When you consider the fact that GDP is not adjusted for population growth, you realize this definition is pretty meaningless.

Consider country Happy, with a population of 1 million and GDP of $1 billion. If next year their GDP grows by 2.5%, pundits in the media will proclaim the economy is strong. During that same year, if the population increases by 5%, GDP per capita will have actually dropped from $1000 to $976. The standard of living of the average Happonian drop as a result, while the official numbers tell them growth is strong!

What is it we're trying to measure when it comes to GDP? Currently, the government and media seem most interested in how much the country as a whole produces (see some arguments here about why we're not in a recession). I would argue that what we should be interested in is how the people within that country are doing, to truly understand what is occurring in a given economy.

In the US, population growth is expected to be 1.2% in 2008. This suggests that if GDP growth for the country as a whole is below this, the standard of living of the average American will be lower this year. Real US GDP for the last two quarters has been (annualized) .6% and .9%. This IS a recession for all intents and purposes. The GDP for the entire country as a whole is useless without thinking about it and applying it to the population within that country.

XHB: Not A Real-Estate Play

We've seen here that certain home builders are showing large discounts to their book values right now. But some of these companies might actually be in trouble. For those who don't have the time to dig through each individual builder's finances, or for those who prefer a diversification strategy, a home builder ETF exists called XHB that tracks a whole slew of builders.

However, a closer examination of the underlying securities of XHB reveals this ETF not to be exactly what it purports to be.

First of all, it has quite a bit of exposure to retail. Home Depot and Lowe's make up almost 10% of its portfolio! Another problem is that three of the companies in XHB (Standard Pac, MDC, and Ryland) are heavily involved in mortgage financing. So you thought you were making a play on real-estate, but you end up owning mortgages you know nothing about, for another 10% of your portfolio!

Third, this ETF has another 25% of its holdings not in homebuilders, but in home accessories! With companies like Tempur-pedic (mattresses!), Sherwin-Williams (paint!), and other companies involved in furniture, carpets, and interior decorating, beware! I'm not saying that these companies don't have some correlations to the housing market, but by no means are these real-estate plays!

Finally, the builders we looked at which have the largest discounts to their book values (rankings here), do not even appear in XHB. It's possible they're too small for the ETF to hold without affecting their values.

In any case, if you're looking to benefit from the discounts to book values that home builders are trading at, XHB is not for you. Its exposure to retail, mortgage financing and various other sectors (adding up to almost half the portfolio) combined with the fact that even its home builders are not the cheapest ones out there, mean that if you want to take advantage of the discount to book values that are out there, the best strategy is to buy the individual securities yourself!