Business that can pass inflation

[beerbaron]

Since there is a lot of talk about upcoming inflation I tough it would be a good idea to have a discussion about which businesses valuations could resist the most to high inflation.  I have listed a few of my toughs out of 10. A grade of 10 means a business that profits from inflation, 5 will absorb high inflation at par and 1 will decrease in value with high inflation.

 

Gold & luxury metals  9

Oil & Gas                  7

Non luxury metals      7

Money management    6

Restaurant                2

Cars and trucks        3

Semiconductors/tech  1

Military                    2

Infrastructure            2

Retail                      3

Restaurant                3

Computer science      2

Advertisement          3

Agriculture                6

Insurance                4

Health Care services  4

Banks                      4

Pharmaceuticals        4

Entertainment            3

Real estate                5

Distributors                4

 

This is only my own thoughts and I have not made an intense study about each sector just my feel. I'd be interested to know what everybody thinks. Feel free to add industry sectors as I probably forgot lots of them.

 

 

 

 

[Uccmal]

Not a business in and of itself but any company that has extremely long bonds and perpetual preferreds.  The money is borrowed in todays dollars and never really paid back. 

 

Power Financial, Bell Canada in Canada are good examples. 

 

Other :Utilities in regulated industries:  Pipeline companies such as Enbridge, TCP in Canada. 

 

Real estate companies with long leases and mortgages

 

Your own mortgage - with a long amortization

[returnonmycapital]

I would suggest that in periods of high inflation all businesses lose real value.  The ones that lose less are those that have pricing power and low capital/re-investment needs.  Tobacco springs to mind, so does pharma; as do other high margin, moat-protected, low capital requirement businesses.

[niels12think]

Even if the business looses real value, then the nominal market price per share might rise with inflation, catapulting far out of the money leap call options;

For some companies, the price of out-of-the-money leap call options seems to include only extremely low probability of share price increases due to high inflation and/or devalued USD.

 

I.e. it seems to me, that while underlying common stocks may increase in price only to keep pace with inflation and USD devaluation, then the leap calls might at the same time increase very significantly both in price and in real value in the case of significant inflation and/or devaluation of USD...

 

Therefore such leap calls could serve as a hedge not only for the return of exuberant times, but also against inflation and USD devaluation.

 

cheers

 

[ERICOPOLY]

Lets say inflation wipes out debts.  Some people are going to get hurt along the way (consumers who don't get raises in step with inflation).

 

But after the dust settles (inflation subsides), there is going to be a lot of room for growth in consumer spending as consumers won't have meaningful mortgages anymore.

 

Is that what happened in the later 80s/90s?

 

[netnet]

Some general ideas on businesses and inflation.  You could do worse than look to Buffett's deeds and words, i.e. the annuals, during the inflationary pre-Volker US economy( 70's).  He refuted the general notion of asset heavy companies being the place to be during inflation; companies with pricing power was the place to be.

 

Comments on the discussion so far:

Semiconductors/tech 1 The thriving software and tech companies have far, far outpaced inflation--that said you still have to pick the next winner, good luck on that.  A mature tech company is a different animal than a young Intel or Microsoft.

 

Utilities in regulated industries:  Pipeline companies such as Enbridge, TCP in Canada. The asset heavy companies did not protect your money during the last inflationary era.  See above. (Geez, quoting myself, that's kind of pompous ;)

 

I would suggest that in periods of high inflation all businesses lose real value. Really? That is kind of a blanket statement.  In a terrible environment, Zimbabwe or Wiemar Germany, I would have to agree.  Still, if your business is not expropriated, it is still a better bet to protect to your net worth than the average job or any bank account.  The last time I looked, this is not Zimbabwe so do you think your statement is true in all cases in North America with say 12% inflation?  Suppose you have some kind of asset light, toll business that has pricing power?  And then of course you have the sterling example of BRK; it didn't lose value during the 70's.

 

[ERICOPOLY]

Suppose you started your own "business" where you merely used conforming 30 yr loans at today's low fixed rates and bought 4-plex apartments?  If you do this with a certain amount of leverage, you can structure it so that your rental income roughly covers maintenance/repairs/expenses+taxes+interest (cash flow neutral).  Initiallly, because you used a lot of leverage your interest payments are the dominant form of your outgoing cash flow.

 

Now, suppose this inflation comes along that pushes rents up at 10% a year.  Your interest payments remain flat so you now become cash positive.

 

This business benefits from inflation.  Deflation is pretty bad though.

 

[returnonmycapital]

Netnet,

 

Let's suggest that long-term nominal ROE has been 14%/yr for the S&P 500.  In a period of inflation/deflation/stability, that nominal rate will typically not change (this statement taken from one of the 1970s BRK annual letters you mentioned).  Real ROE declines by whatever the rate of inflation, it eats away at the real value of that return on capital.  The higher inflation, the lower real ROE (and this doesn't stop at 0% real ROE, it can go negative).  So, as I state, for every increase in the rate of inflation, real value is lost on business as a whole.

[Uccmal]

Netnet, I disagree that pipelines such as Enbridge or TransCanada would not do well in an inflation environment.  Rather than being asset heavy they are debt heavy, and their debt is long term in nature giving them interest rate stability. 

 

Enbridge for example doesn't sell gas.  They transport it for a fee.  Every quarter or so they renegotiate the rates they charge consumers.  This protects them on the pricing end.  The assets rest in the form of bonds and preferred debt are backed by the pipe itself.  At the end of an inflationary cycle their earning power will have grown with inflation - basically expenses plus regulated profit.  The debt will be less since it was issued in old dollars.  Maintenance capex on the pipe will rise but is handled in lockstep with the rising transport fees and inflation.  Not the best bet but probably better than cash.

 

 

 

 

[SharperDingaan]

 

Keep in mind that there is (1) before inflation, & (2) after inflation.

 

(1) If you know your accounting, & are fairly sophisticated, look at long out-of-the-money LEAPS on USD denominated Balance Sheets, that are investment coys  and/or exporters. When the UK Pound lost its reserve status in 1967 the net devaluation over a 1 year period was around 25%; the devaluation alone will drive the LEAP into the money, subsequent FX acquisitions &/or export sales will push it further in-the-money.

 

(2) When nominal interest rates are in the teens, long-dated zero coupon treasury bond strips are pretty hard to beat. They are dirt cheap to buy, there is no credit risk, inflation does eventually normalize, & you walk away with a healthy gain - for doing little more than sit on your ass!

 

SD

 

[ragnarisapirate]

it seems to me, that in the midst of inflation, real estate would do badly, as the main way to curtail rising consumer prices is to raise interest rates; as a lot of real estate values can be determined by interest rates, it seems that housing would do terribly when we 'take our medicine'.

 

Say that primary residence mortgage interest rates double from 5%-10%... a $100K house suddenly becomes $5K a year more unaffordable, JUST IN INTEREST! Furthermore, if you go conventionally on the mortgage, then a person effectivly has to make another $15K a year, since the debt/income ratio that HUD likes to see is about 1/3.

 

Obviously there are other issues that will effect the real estate market; stimulus, tax credits, population migration, the supply of housing, etc. BUT, it seems to me that inflation would be good for the debtors of the real estate, provided that they don't leave their homes, and continue to pay their fixed rate mortgage with cheaper dollars.

[finetrader]

What about an insurance company that is well managed (combined ratio <= 100) that have their float invested in short term bond. When a bond comes to maturity they can invest the cash at a higher yield as  interest rates are going higher to fight inflation.

 

 

 

 

[ERICOPOLY]

What about an insurance company that is well managed (combined ratio <= 100) that have their float invested in short term bond. When a bond comes to maturity they can invest the cash at a higher yield as  interest rates are going higher to fight inflation.

 

Are there any insurers buying TIPS?  3:1 leverage insurer, CPI jumps 10%, 30% pre-tax return on CPI adjustment (plus interest income).  Presumably combined ratio takes somewhat of a hit from higher nominal claims.

 

[netnet]

Let's suggest that long-term nominal ROE has been 14%/yr for the S&P 500.  In a period of inflation/deflation/stability, that nominal rate will typically not change (this statement taken from one of the 1970s BRK annual letters you mentioned).  Real ROE declines by whatever the rate of inflation, it eats away at the real value of that return on capital.  The higher inflation, the lower real ROE (and this doesn't stop at 0% real ROE, it can go negative).  So, as I state, for every increase in the rate of inflation, real value is lost on business as a whole.

 

Not to quibble or go on at length, but by your the terms you use  the nominal ROE on the S&P your argument holds.  But you said  ALL businesses lose value.  Ericopoly shows that a pipeline company, that has "tolling" i.e. pricing power will gain in value in a high inflation.  Are you saying that BRK lost value in the 70's?

 

Ericopoly, I don't know the pipeline business, but a business with pricing power, here a toll for distillates instead of cars, should be fine in an inflationary environment, given your assumptions--longterm debt at fixed rate and pricing flexibility.

 

SD--Did the stock price of the U.K. exporters and investment manager go up in response to the devaluation?

[ERICOPOLY]

Personally I like the insurance co with TIPS idea quite a bit because the TIPS pose no risk whatsoever from deflation -- it benefits from deflation because you are guaranteed to get back the original principle of the bond at par (so long as that's what you paid for it, you get your money back).  Now, if you have out-of-control deflation the value of your guaranteed principle rises in real terms.

 

And then if the CPI rises you earn (pre tax) a leveraged multiple of the CPI.  So you benefit from inflation.

 

High inflation -- good.

High deflation -- good.

Price stability -- very mediocre (unless your insurance company has a terrific combined ratio).

 

 

 

 

 

 

 

[jberkshire01]

I compiled some of Buffett's writings on this topic here if you haven't seen it yet: http://tinyurl.com/y92sbzb

 

The shortened version is that Buffett recommends businesses:

 

- that have 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

- that have 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

- that generate cash, not consume it

- that are high return businesses that still have free cash flow after working capital needs

- and that are preferably run by guys who understand the above (i.e. Warren Buffett, Tom Murphy, Henry Singleton, etc.)

[SharperDingaan]

 

Results were as you might expect but were slow to occur, & they were very much a function of the BS currency and coy’s client/trade structure. In today’s wired world it would happen much quicker.

 

If your books were denominated in sterling you took a hit as P/E ratios collapsed as soon as the announcement was made. If you were a UK exporting multinational with BS assets & liabilities both denominated in sterling there wasn’t much BS effect (offsetting MTM gain/loss), but higher future earnings because you sold more (Vickers, Leyland, etc.) – but it took a while for markets to correct.

 

UK multi-nationals with a UK denominated BS, US denominated assets & UK liabilities did extremely well (BP, Asian, ME, & African ‘charter’ coy’s, etc.). Share prices initially fell, then rose quickly as foreign (US) buyers realized they could both extract the BS impact & buy at an even deeper discount to the market.

 

In US terms:

1) US markets take a hit as soon as the ‘reserve’ change is announced. 2) Look for US denominated BS with foreign denominated assets and US denominated liabilities

 

SD

 

 

[beerbaron]

Judging from what Buffett states I would say that money management firms would do fine in inflation. Their pool of money grows at the same pace as inflation but they still keep their 1%.

 

So putting it all together, a money management firm that has lots of preferred shares an free cash flow would be a good buy. Maybe there is still some of these available at an affordable price.

 

BeerBaron

 

BeerBaron