How to Make Money During Inflation? Warren Buffett's Billionaire Secret

In this article, we are going to discuss How to make money during inflation: warren Buffett’s billionaire secrets.

Warren Buffett has long been a fervent believer that keeping investing in stocks is the only course.

If anything, Buffett, the chairman, and CEO of Berkshire Hathaway is famed for the ultimate remark on dip buying: Be frightened when others are greedy and greedy when others are fearful.

But these Buffett-isms may obscure the fact that, throughout his life, Buffett has delivered many smart words on just how much inflation may hurt stocks. Now that inflation is back in the crosshairs of the markets, as investors try to comprehend what has caused such a fast decline in stocks, it’s interesting looking back at what Buffett has said about inflation in the past.

Buffett devoted substantial amounts of Berkshire annual letters in the late 1970s and early 1980s — amid strong inflation in the United States — to outlining what rising prices entail for stocks, company balance sheets, and investors. Buffett lived and invested through a period when inflation touched 14 percent and mortgage rates climbed as high as 20 percent — amid what some dubbed the greatest American macroeconomic failure of the post-World War II period.

He never lost that concentration on — or fear of — inflation, either.

In June 2008, as the price of gas climbed past $4, Buffett claimed “exploding” inflation was the biggest risk to the economy. “I think inflation is picking up,” Buffett stated on CNBC. “It’s massive right now, whether it’s steel or oil,” he continued. “It's everywhere.”

Do you recall what occurred next?

In 2010, Buffett sent the government a “thank you note” (in the form of an op-ed) for its efforts rather than stagnation or politicking after the crisis. “We are implementing policies that unless reversed will eventually lead to plenty of inflation,” he warned that same year.

“We are on a bad path,” he added.

As the markets fell in recent weeks, stories suggested the end of central bank easy money was near. Buffett had previously cautioned that “QE is like watching a fantastic movie since I don't know how it will end.” Anyone who owns stocks will rapidly reassess their position.”

According to Buffett, “the arithmetic shows that inflation is a far more damaging tax than anything done by our legislatures.” The inflation tax can easily eat capital. I'd like to be your broker, but not your partner if you think you can avoid the inflation tax by trading equities.

The world and economy have changed dramatically since Buffett addressed inflation and investing in his annual shareholder letters. Tax rates have shifted. Bond yields and savings rates were substantially higher back then. And these are only the early indicators of inflation. The last nonfarm payroll report's surge in wages shook markets. A surprise jump in the Consumer Price Index was reported on Wednesday, Feb. 14.

Other economic issues are eerily similar. During the Vietnam War, the federal deficit grew rapidly, causing inflation that peaked in the late 1970s. The tax cuts and recently enacted spending package are estimated to quadruple the annual deficit from $600 million to $1.2 trillion in 2019.

Il convient de rappeler that the worst stock performance of the 1970s occurred when inflation first soared dramatically. Inflation doubled from 1972 to 1973 to over 6%. By 1974, it was 11%. The S& P 500 fell 40% in those two years. Inflation peaked at 13.5 percent in 1979 and 1980, when the S& P 500 had long returned to positive performance, but adjusted for inflation. Stocks had a bad decade.

So who better than Buffett to illustrate how equities become inflationary? “Berkshire has no business solution to the problem,” Buffett remarked in one of his inflationary era letters. (We'll say it next year.) It does not boost our equity return.”

Here are Buffett's other opinions on investing during inflationary times.

#1. When you are doing great, it is the time to remember inflation.

Before we drown in a sea of self-congratulation, a further — and critical — point must be made, Buffett said. Until recently, a company's net worth multiplied at 20% yearly would have guaranteed a profitable actual investment return. Now it's less certain. If our internal operating performance does not yield successful investment results — i.e., a real gain in purchasing power from money committed — then our internal operating performance will fail.

Under current inflationary conditions, a business earning 20% on capital can yield a negative real return for its owners.

#2. During high inflation, earnings are not the dominant variable for investors.

The owner's true income is not determined by earnings disclosed in company financial statements. For only increases in purchasing power reflect actual returns. Your investment yielded no actual income if you (a) forewent 10 hamburgers to buy it; (b) received dividends that bought two hamburgers after taxes, and (c) sold your assets for after-tax gains that bought eight hamburgers. But you won't eat richer. Inflation creates a tax on capital, making much business investment foolish, at least in terms of a positive real return to owners.

A corporation's return on equity (ROE) must exceed a certain threshold to create a real return for its owners. The average tax-paying investor is now jogging up a down escalator at a snail's pace.

#3. Understand the math of the ‘Misery Index.’

For example, ordinary income tax on dividends and capital gains tax on retained earnings can be viewed as an ‘investor's suffering index.' When this index surpasses the business's rate of return on equity, the investor's purchasing power (real capital) declines even if he consumes nothing. High inflation rates will not help us generate higher rates of return on equity.”

#4. Inflation is a ‘tapeworm’ that makes bad businesses even worse for shareholders.

“An inflationary climate punishes the owners of ‘bad' businesses in a particularly ironic way. A low-return business must retain much of its earnings to continue running, regardless of the cost to shareholders. ... Inflation transports us to the world of Alice in Wonderland. When prices keep rising, the ‘bad' business must keep every penny. Because it is undesirable as a depository for equity capital, the low-return business must have a high retention policy. It has no choice except to continue operating as it has in the past – and most organizations, including corporations, do. Inflation is a corporate tapeworm. Regardless of the host's health, the tapeworm consumes its daily feed of investment funds. Regardless of stated earnings (even if none), the corporation needs more funds for receivables, inventories, and fixed assets to simply match last year's unit volume. The tapeworm claims a larger share of available food when the firm is less lucrative.

... Inflation's tapeworm cleans the plate.”

#5. Focus on companies that generate rather than consume cash.

“We prefer businesses that make cash over those that consume it. As inflation rises, many businesses find themselves forced to spend all internal finances merely to keep up with physical demand. Such processes have a mirage-like aspect. We are wary of companies who can't seem to turn pretty figures into free cash.”

#6. Look for companies that can increase prices and handle a lot more business without having to spend a lot.

Inflation is one of two important criteria Buffett mentions in his 1981 letter on what makes an excellent acquisition candidate:

“Companies that have purchased only businesses that are well suited to an inflationary climate. The preferred business must be able to increase prices easily (even when product demand is flat and capacity is underutilized) without significant loss of market share or unit volume, and accommodate large dollar volume increases (often caused by inflation rather than real growth) with only minor additional capital investment. Managers of average skill have excelled in recent decades by focusing entirely on acquisition opportunities meeting these requirements. But few businesses have both, and the competition to buy them has become self-defeating.”

#7. Always be thinking about tomorrow, especially when the pace of change picks up.

‘Good' businesses were defined as those in which a dollar reinvested in the business logically might be expected to be valued by the market at more than 100 cents. With long-term taxable bonds producing 5% and long-term tax-exempt bonds yielding 3%, a business operation that could deploy equity capital at 10% warranted a premium to investors. That was true even if combining dividend and capital gains taxes would lower the 10% gained by the firm to probably 6%-8% by the individual investor. The financial markets realized this. During that period, American businesses earned an average of around 11% on equity capital and stocks sold for an average of over 150 cents on the dollar. Most firms were “good” because they made money (the return on long-term passive money). Overall, equity investment brought significant value. That was then. But its lessons are hard to forget. While investors and managers must look forward, their memories and neurological systems are often stuck in the past. In the absence of daily rethinking, investors and managers can use historical p/e ratios and corporate valuation yardsticks. Constant pondering achieves nothing and slows response time when change is sluggish. But when change is rapid, holding on to old notions is costly. And the velocity of change is breathtaking.”

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