Here’s more miscellany on 100-baggers and how to get them.
Investing abroad. Investing abroad is a way to expand the menu. How-ever, if you are investing abroad to flee risks at home, I’d check that impulse.
I know some Americans are interested in investing abroad because they are so down on US politics or the US economy or whatever.
Phelps made a good point in his book that I will repeat here. He said when we invest abroad we often trade risks we see for risks we can’t see or are not aware of. Be mindful of this. Many investors have had their heads handed to them in far-off lands that seemed alluring. It’s happened to me more than once.
Having said that, the principles in this book are universal and timeless and apply to all markets everywhere.
Inflation. Throughout this book, I’ve dealt in nominal dollars, unad-justed for inflation. This doesn’t mean inflation isn’t real, of course. Odds are, if you stick US dollars under a mattress for 10 years, you’re going to lose purchasing power. Put another way, $20 may get you a haircut today, but it probably won’t in 10 years.
My main message to you is to not obsess over it. Again, I speak from ex-perience. I know many who get so hung up on worrying about the US dollar that they confine themselves to investing in gold stocks and natural-resource companies as they worry about the end of the world.
This is extremely costly. The best inflation fighters are 100-baggers.
They are so good at beating inflation that I can talk about inflation in a few paragraphs.
I’ve taken to reading Warren Buffett’s annual letters—50 of them—
from first to last, something I’ve never done. What’s interesting about the early letters is the amount of time given to discussing inflation and its effects on investors.
Inflation has not been a serious problem for years now. But inves-tors tend to prepare for yesterday’s battles, which Buffett acknowledges.
“While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past,” Buf-fett wrote in 1981.
This reminds me of Peter Lynch’s example from Mayan mythology. A great flood destroyed the world. So, the Mayans moved to higher ground in the woods. Then fire destroyed the world. So they moved away from the woods and built houses of stone. Then came an earthquake. . . .
Inflation was high in the late 1970s and was a real problem for busi-nesses and investors. It was something new, and people were slow to take in what it meant.
What it meant was that a 20 percent return was not really a 20 per-cent return, but could actually be negative after inflation and taxes—the
“investor’s misery index,” as Buffett called it.
Buffett gave an analogy:
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.
He does not mince words about what those high inflation rates did to the returns of Berkshire. In the 1981 letter, he wrote about how inflation made Berkshire’s “apparently satisfactory results . . . illusory as a measure of true investment results for our owners.”
In the 1979 letter he wrote this:
One friendly but sharp-eyed commentator on Berkshire has point-ed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce.
A similar comparison could be drawn with Middle Eastern oil.
The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.
Keeping up with inflation was a triumph. Most American businesses chewed up capital and left owners with less purchasing power than they started with.
In 1981, Buffett pointed out that tax-exempt bonds paid 14 percent.
And that 14 percent went right into the investor’s pocket. American busi-ness also earned 14 percent that year. But that did not go directly into the investor’s pocket. Even if a business earning 14 percent paid out all of its earnings in dividends, taxes would reduce your return below inflation.
How can you value such a business in such an environment?
Buffett uses the analogy of a bond. Let’s say you had a tax-exempt bond issued in prior years that paid you 7 percent. Such a bond would be worth 50 percent of its par value in an environment where tax-exempt bonds pay 14 percent.
And so it is with stocks.
“Thus,” Buffett wrote, “with interest rates on passive investments at late 1981 levels, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals.” (italics in the original)
The year 1982 was the last year of that kind of inflation, which di-minished thereafter. No wonder it proved to be such a great bottom in the stock market. As rates fell, businesses became more and more valuable.
This explains why interest rates are a big deal and why people are so keen on what the Fed is going to do. Interest rates on passive, tax-exempt securities set the crossbar for stocks.
Here’s Buffett summing it up well:
Inflationary experience and expectations will be major (but not the only) factors affecting the height of the crossbar in future years. If the causes of long-term inflation can be tempered, pas-sive returns are likely to fall and the intrinsic position of American equity capital should significantly improve. Many businesses that
now must be classified as economically “bad” would be restored to the “good” category under such circumstances.
Inflation did abate. Rates fell. Stocks soared.
While on the topic of Buffett and inflation, it’s worth clearing up another misconception about what kinds of businesses do better in infla-tionary environments.
As much as the big-picture crowd likes to hammer away at stocks, they do have a soft spot for stocks with tangible assets—such as gold miners and oil stocks. The usual belief is these stocks will protect you when the dollar loses value.
Not really true.
I always think about Warren Buffett’s example from his 1983 letter, when inflation was still high on everyone’s list of concerns. Buffett ran through an example of See’s Candies versus a hypothetical business with lots of tangible assets—let’s call the latter Gold-Oil Co.
Both businesses earn $2 million in profits. See’s has little in the way of tangible assets—about $4 million worth. The stock goes for $25 million.
Gold-Oil Co, by contrast, has $18 million in net tangible assets supporting its operations. Since it earns a lower return on its asset base, the stock goes for $18 million (basically the value of its net tangible assets).
Now, let’s roll forward and say inflation doubles prices. Both need to double their earnings just to keep pace with inflation. As Buffett writes,
“this would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.”
But here’s the kicker: both businesses will need to double their invest-ment in tangible assets, too. As Buffett writes,
Both businesses probably would have to double their nominal in-vestment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad . . . and all of this inflation-required investment will produce no improvement in rate of return. The motivation for
this investment is the survival of the business, not the prosperity of the owner.
For See’s, this means $8 million in additional investment. For Gold-Oil Co., this means $18 million in additional investment.
Buffett paid $25 million to own See’s. After this round of inflation, See’s “might be worth $50 million if valued (as it logically would be) on the same basis is [sic] was at the time of our purchase.”
Thus, See’s would have gained $25 million in nominal value on $8 million of additional investment. That’s more than three to one. As for Gold-Oil Co., it might be still be worth the value of its net tangible assets, now $36 million. That’s an $18 million rise in value on $18 million of additional investment. That’s 1 to 1.
Note that inflation was bad for both. But it was less bad for See’s, which owned little in tangible assets. This idea has been hard for many people to grasp, as Buffett notes:
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 re-turn—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.
This idea is critical. If you don’t understand this, you should read through the example again. Work it out on paper for yourself. Change the numbers around if you wish. It’s important to understand the dynamics.
In a world of monetary depreciation, the asset-light company wins. Or put another way, monetary depreciation favors the asset light.
The irony for the big-picture crowd is though they tend to shun stocks, when they do get involved they favor the worst kinds.
To quote another great investor, John Maynard Keynes: “The difficulty lies not in the new ideas but in escaping from the old ones.” The ideal business during an inflationary time is one that can (a) raise prices easily and (b) doesn’t require investment in a lot of assets.