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The Coupon is Sticky
A Modern Look at Warren Buffett’s 1977 FORTUNE Article “How Inflation Swindles the Equity Investor”
“If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker - but not your partner.”
Inflation is like is like the weather: We all experience it simultaneously, but uniquely. Knowing the average temperature in America tells you little about the experience of any particular resident. Also like the weather, the vast majority of us can define its nature without really understanding how it works, and crucially, without grasping its long-term impacts.
Inflation’s impact on investment is especially troublesome. The sources of inflation and their effect on business is highly reflexive. Belief in which asset classes fare well during inflationary periods has religious-like adherents with some extolling (shilling?) the virtues of hard assets like gold, and others who claim that businesses with pricing power are actually the most effective hedge against declining purchasing power. One thing nearly everyone agrees on is that fixed income is the worst home for capital during periods of high inflation. “You hardly need a Ph.D. in economics to figure that one out,” Buffett says referring to the declining real value of fixed nominal coupon payments. What he argues in 1977 though, is that stocks and bonds are really as different as many investors believe.
“For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might. And why didn't it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds.”
Buffett’s main argument is that in aggregate, returns on equity are pretty stable — that with the exception of some outliers, return on the book value of equity tends to return to a level around 12%. Buffett’s observation period included the Dow Jones Industrial Average in the decade following World War 2 and the FORTUNE 500 from 1955 through 1975.
The article was timely as inflation had risen to a peak of 12.1% in 1975 and was trending back up to 9% in 1977. High inflation was surely appearing to be a structural phenomenon prior to the aggressive actions that came with Paul Volcker’s appointment as Fed Chair 1979. As historical analogs go, our current environment rhymes even if it is not an exact repeat. Inflation has steadily trended towards 8%, a 30 year high, and the modern era has seen a slightly higher return on equity but with similar stability with an average since 1990 of 13.25%
Source: Bloomberg, LP
That 12% (or 13%) is not really that different than a bond coupon if the “yield,” as measured by return on equity, stays stable. That is had the owners been able to acquire them at book value. As nice as it would be to buy equities at book value (or less!), the gyrations of the market rarely make it possible.
“Instead, many try to outwit their fellow investors in order to maximize their own proportions of corporate earnings. This thrashing about, obviously fruitless in aggregate, has no impact on the equity coupon but reduces the investor's portion of it, because he incurs substantial frictional costs, such as advisory fees and brokerage charges. Throw in an active options market, which adds nothing to the productivity of American enterprise but requires a cast of thousands to man the casino, and frictional costs rise further.”
Just as you can’t pay much above par and expect to earn the coupon rate on bonds, such is true for paying high multiples of book value and earn your “equity coupon.” Because equities are perpetual in nature, that is they don’t have a contractual maturity like bonds, investors rightly demand their equity coupon be a good bit higher than bonds to account for the risk. Buffett argued that while there is undeniably a lot of turnover driven by the spread between bonds and equites there is no special level where risk is abolished.
“Stocks are also riskier because they come equipped with infinite maturities. (Even your friendly broker wouldn't have the nerve to peddle a 100-year bond, if he had any available, as "safe.")
Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return - and 12 percent on equity versus, say, 10 percent on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.
But, of course, as a group they can't get out. All they can achieve is a lot of movement, substantial frictional costs, and a new, much lower level of valuation, reflecting the lessened attractiveness of the 12 percent equity coupon under inflationary conditions. Bond investors have had a succession of shocks over the past decade in the course of discovering that there is no magic attached to any given coupon level - at 6 percent, or 8 percent, or 10 percent, bonds can still collapse in price. Stock investors, who are in general not aware that they too have a "coupon," are still receiving their education on this point.”
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But do we really believe the 13% equity coupon is immutable? First off, it’s important to remember the bondholder gets their coupon in cash, while the equity holder will only get a portion of their coupon in cash with the remainder being reinvested at “whatever rates the company happens to be earning.” This reinvestment privilege is part of what drives equity prices up and away from book value. Returning however to the underlying return on book value, Buffett identifies five, and exclusively five, levers that could cause a company to earn higher returns on equity during an inflationary period:
An increase in total asset turnover.
Lower Income Taxes.
Wider Operating Margins.
“And that's it. There simply are no other ways to increase returns on common equity. Let's see what can be done with these.”1
Buffet argues the returns from increased turnover are likely be both illusory and small. Of course, turnover is due to increase some during an inflationary period as the result of rising prices. Inventories accounted for under LIFO for example will show rising sales against a smaller inventory balance for at least a period of time. On a longer timeline, the increased turnover on fixed assets is also, in some sense, borrowed from the future. As those assets age and are retired they will need to be replaced at then current, higher prices. In essence, increased turnover during inflationary periods is an arbitrage that closes either quickly or gradually, but regardless not in a way that ultimately benefits the long-term investors’ average “equity coupon.”
More and Cheaper Leverage
Cheaper leverage is unlikely to be available during an inflationary period. There is the obvious reason that lenders want to earn a real rate of return, but Buffett points to a demand for capital impact as well.
“Galloping rates of inflation create galloping capital needs; and lenders, as they become increasingly distrustful of long-term contracts, become more demanding.”
The possibility of using greater leverage to juice equity returns presents a few challenges during inflationary periods; one is that of adverse selection:
“An irony of inflation-induced financial requirements is that the highly profitable companies - generally the best credits - require relatively little debt capital. But the laggards in profitability never can get enough. Lenders understand this problem much better than they did a decade ago - and are correspondingly less willing to let capital-hungry low-profitability enterprises leverage themselves to the sky.”
Buffet also brings up an interesting point about pension liabilities as being hidden, mispriced leverage:
“Besides, there is already far more debt in corporate America than is conveyed by conventional balance sheets. Many companies have massive pension obligations geared to whatever pay levels will be in effect when present workers retire. At the low inflation rates of 1955-65, the liabilities arising from such plans were reasonably predictable. Today, nobody can really know the company's ultimate obligation. But if the inflation rate averages 7 percent in the future, a twenty-five-year-old employee who is now earning $12,000, and whose raises do no more than match increases in living costs, will be making $180,000 when he retires at sixty-five.
Of course, there is a marvellously [sic] precise figure in many annual reports each year, purporting to be the unfunded pension liability. If that figure were really believable, a corporation could simply ante up that sum, add to it the existing pension-fund assets, turn the total amount over to an insurance company, and have it assume all the corporation's present pension liabilities. In the real world, alas, it is impossible to find an insurance company willing even to listen to such a deal.”
Lower Income Taxes
It has been said that every business has the Government as a silent partner, in Buffett’s words:
“Investors in American corporations already own what might be thought of as a Class D stock. The class A, B and C stocks are represented by the income-tax claims of the federal, state, and municipal governments. It is true that these "investors" have no claim on the corporation's assets; however, they get a major share of the earnings, including earnings generated by the equity buildup resulting from retention of part of the earnings owned by the Class D shareholders.”
Higher Operating Margins
This is perhaps the thinnest reed on which to hang equity return hopes. Rising costs impact companies at nearly every level from raw materials, to labor, to energy costs. The outlook for margins may be even bleaker than when Buffett wrote in 1977. Corporate margins have experienced a variety of one-time tailwinds in the modern era. Productivity gains from new technology paired with sticky median wages have accrued enormous benefit to corporate bottom lines. Globalized supply chains and a domestic shale boom that provided cheap energy have both contributed to a decade or more of expanding corporate profit margins. From nearly all sides those secular trends are under attack. Companies will need to find a new foothold to continue squeezing more out of the “100 cents in the sales dollar”.
The Number Nobody Knows
“Forecasts usually tell us more of the forecaster than of the future”
Buffett suffers no fools when it comes to predicting the future of inflation, but he also feels like it is not the monetary phenomena it is presented as:
“But many signs seem negative for stable prices: the fact that inflation is now worldwide; the propensity of major groups in our society to utilize their electoral muscle to shift, rather than solve, economic problems; the demonstrated unwillingness to tackle even the most vital problems (e.g., energy and nuclear proliferation) if they can be postponed; and a political system that rewards legislators with re-election if their actions appear to produce short-term benefits even though their ultimate imprint will be to compound long-term pain.”
“…at the source, peacetime inflation is a political problem, not an economic problem. Human behavior, not monetary behavior, is the key. And when very human politicians choose between the next election and the next generation, it's clear what usually happens.”
The Social Equation
Jim Grant was recently interviewed by Morningstar about our current bout with inflation. He had a particularly poignant quote that has stuck with me.
“Inflation is unfair. It's like a certain bug we know. It attacks vulnerable people. It distorts things; it distorts the value we attach to money. It poisons relationships between classes, between employers and employees. It institutes jealousy and envy of those who have somehow managed to sidestep it by the part of those who have not. It empowers clever and cunning people as against the trusting souls who save. It's a social plight, as well as the financial one.”
His words now seem partially inspired by Buffett for whom the social cost of inflation was not lost on either.
“Unfortunately, the major problems from high inflation rates flow not to investors but to society as a whole. Investment income is a small portion of national income, and if per capita real income could grow at a healthy rate alongside zero real investment returns, social justice might well be advanced.
A market economy creates some lopsided payoffs to participants. The right endowment of vocal chords, anatomical structure, physical strength, or mental powers can produce enormous piles of claim checks (stocks, bonds, and other forms of capital) on future national output. Proper selection of ancestors similarly can result in lifetime supplies of such tickets upon birth. If zero real investment returns diverted a bit greater portion of the national output from such stockholders to equally worthy and hardworking citizens lacking jackpot-producing talents, it would seem unlikely to pose such an insult to an equitable world as to risk Divine Intervention.
But the potential for real improvement in the welfare of workers at the expense of affluent stockholders is not significant.”
The article Buffett wrote for Forbes didn’t end with this quote but had I been the editor I may have suggested that it did. In all of our hand-wringing about the impact on equity returns it is easy to forget that inflation is not simply an assumption plugged into a model, it is a malfunction of political economy. It is, as Grant suggests, more akin to a disease. “Hangover” is apt too, a natural reaction to excess. It necessarily leads to recession as prices rise to a level where demand is impacted. That too, like the weather, is not experienced equally be either citizens or the businesses in the economy. The rising tide indeed lifts all boats, but some make it far enough out not to notice the inevitable fall of the shoreline.
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It’s probably worth mentioning here the work of Michael Mauboussin, Jonathan Haskel & Stian Westlake on the role of intangible assets in the modern economy and their impact on both book values and earnings. The role of inflation on those investments is probably worthy of a study all its own, but for the purposes of this analysis it’s fair to say that companies are able to make more durable investments that are less impacted by inflation than what Buffett could have envisioned in 1977. Go off in the comments.