Warren Buffett Explains How To Invest During High Inflation

Well, inflation it's a really hot topic right now. We've seen the Fed saying this inflation we're seeing now is short term, you know, nothing to worry about. Then, on the other hand, we've seen Warren Buffett talking about how he's seeing big inflation throughout Berkshire Hathaway's businesses. We've got Michael Burry making a new big short on bonds, so it's something to watch for sure. But how does it actually affect us as investors, and what's the best way to negotiate a period of high inflation?

Well, in this video, we're going to dive into some past annual letters from the world's best investor, Warren Buffett, to see how he suggests we go about investing during inflationary periods.

So as investors, what we want to do is commit a certain amount of money to an investment and get more money back at some point in the future. But when we talk about inflation and investing, it's more helpful to think of investing like this: we're giving up a certain amount of buying power now in order to have more buying power in the future, aka, we're giving up the purchasing power to buy a hundred meatball subs now in the hope that we have the purchasing power to buy 150 in the future.

Now, when you think about it like that, you're thinking about your real return. While you may make, say, a 20% gain on an investment on paper over a few years, if inflation is running rampant, there's a potential that your real return is zero. You could buy a hundred meatball subs before; then, you make 20% on your investment, then you sell it, but after that, you can still only buy a hundred meatball subs. Now you've had no gain in purchasing power.

This is Warren Buffett talking to that point. In 1979, he said, "A few years ago, a business whose per share net worth compounded at 20 percent annually would have guaranteed its owners a highly successful real investment return. Now such an outcome seems less certain, for the inflation rate coupled with individual tax rates will be the ultimate determinant as to whether our internal operating performance produces successful investment results, i.e., a reasonable gain in purchasing power from funds committed for you as shareholders."

Just as the original three percent savings bond, a five percent passbook savings account, or an eight percent U.S. Treasury note have, in turn, been transformed by inflation into financial instruments that chew up rather than enhance purchasing power over their investment lives, a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than what presently prevail.

So this was in 1979, and the inflation rate was 11%. So, it's crazy that when you think about investments from a purchasing power point of view, you know, the three percent savings bond, the high-interest bank accounts, and even, you know, an 8% guaranteed treasury bond, obviously we're not getting that now, but back then that was still giving investors a loss of purchasing power.

Buffett says the combination of the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business, i.e., ordinary income tax on dividends and capital gains tax on retained earnings, that can be thought of as an investor's misery index. When this exceeds the rate of return earned on equity by the business, the investor's purchasing power, real capital shrinks even though he consumes nothing at all.

So inflation is a crummy time for investors because when you take into account the rate of inflation, or we can think about the annual percentage loss of purchasing power, and you couple that with either taxes you have to pay on income received through dividends and the capital gains tax you have to pay when you sell, then your real return on your investment could be negative even if the business does well.

In 1980, Buffett made this analogy, which I really like. He said, "The average tax-paying investor is now running up a down escalator whose pace is accelerated to the point where his upward progress is nil." But beyond being an investor, inflation can be a crappy time for businesses as well. Obviously, inflation eats away at their purchasing power as well.

Now, businesses generally need to buy a lot of stuff to keep operating. If this stuff is now all of a sudden more expensive, they're trapped in a dilemma: either they pay the higher price to operate and therefore make less profit, or they try and raise the prices and hope that their sales volume doesn't shrink because of it. Inflation can also put upward pressure on interest rates, which can make it harder for companies to access loans or make pre-existing loans more expensive to pay off.

And this makes it much harder for the investor, you and me, to pick really great stocks that are going to compound our money over time. So, what do we do? Well, this is Warren Buffett's explanation of what type of businesses tend to do well even in periods of high inflation.

He says such favored businesses must have two characteristics: one, 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. And two, an ability to accommodate large dollar volume increases in business, often produced more by inflation than real growth, with only minor additional investment of capital.

So, number one, an ability to increase prices and cop no consequences. That makes sense, right? The business is feeling higher costs, which hurt their margins, so why not push those extra costs onto the customer if you can? "Whoa, that is ridiculous! No company could do that! You know, people would just go and buy the cheaper product elsewhere."

Ah, but not if the company has a moat. Say you're a small production company. You've spent money to train all 50 of your employees to use Photoshop and Premiere Pro and After Effects. That took time and it took money. Adobe suddenly says subscriptions now ten dollars more per month. "Cop it!" And you say, "That's it! Let's switch to a cheaper alternative." Maybe you find a cheaper alternative 20 dollars a month cheaper. Great! But it doesn't have all the same features as what the team's already using. Plus, it's going to cost 200 dollars per employee to train them on the new software, not to mention the downtime your business will experience to get that training done and to switch everybody over.

Then you think about the clients. Oh, the clients are already stressing you out. They're trying to get their productions finished, and at the end of the day, it's just not worth switching. So what do you do? You just pay more. You stick with Adobe. You just pay more.

Or, another real-world example: Apple has such a strong brand moat and a strong ecosystem that it's completely normal for them to squeeze a little bit more and a little bit more out of all of their customers each year. In 2012, the iPhone's average selling price was just over six hundred dollars. At the end of 2018, it was almost 800. I'm sure now, it's even higher. And that's not even considering the plethora of add-on subscriptions Apple will more or less force upon you, whether it be Apple Care or iCloud or Apple Music. There's no escape, and that's the point.

So during inflationary times, look to the companies with very strong moats that can raise prices without consequences. But then secondly, you want the business to have an ability to accommodate large dollar volume increases in business with only minor additional investment of capital.

So if you're not just able to pass on extra costs to the consumer, that means that you're going to have to cop those costs, which means lower margins. So to generate the same or more profit with lower margins, well, it means you need to be able to increase the amount of business you're doing. Essentially, what Buffett is saying here is you want companies that are growing and are also pretty scalable.

For example, a shipbuilding company would struggle on this point. It costs a lot to build a big ship. You're not going to make huge margins doing it, but it's also very hard to increase the number of ships you're churning out each year. That would take a huge, enormous investment, you know, into new shipyards, and it'll be really slow to wind up.

But then if you consider a company like Facebook, on the other hand, if they aren't able to pass on the extra cost to their customers, which are the advertisers, they could just choose to bump up the frequency of sponsored posts or other ads. So when you're scrolling Instagram, you see three ads instead of seeing two, and they could do that very, very easily and very quickly as well.

So that's the second characteristic that really helps your business thrive, even through periods of inflation: the ability to ramp up their business so the lower margins actually don't have an impact on the financials.

But Buffett has one more piece of advice for those seeking the best strategy during a time of inflation because sometimes there's just no escaping that stock market. Investing in these times can be really hard. So have a listen to this: "But given the fact that we're dealing with fairly high levels of inflation in India, what would your advice be to people who are investing? What should they change? What should they do?"

"Yeah, well, inflation," Kane said many years ago, "that it's an invisible tax that only one man in a million really understands, and it's a tax on people that have had faith in their currency that the government’s issued. The best protection, the best investment against inflation is to improve your own earning power, you know, your own talents. Very few people maximize their talents, and if you'd, if you increase your talents, they can't tax it while you're doing it. They can't take it away from you. So if you become more useful in your activities, your profession, you know, doctor, lawyer, whatever it may be, that is the best protection against a currency that might decline at a rapid rate. And the best passive investment, I think, is a good business. If you own an interest in a good business, you're very likely to maintain purchasing power no matter what happens to the currency."

In this clip, Buffett is indirectly acknowledging that it's hard to do well as a stock market investor when inflation just keeps ramping up. It's a shitty time, and your real return can be zero, so probably a better thing to do is invest in yourself, upskill so that you can achieve a higher level of income so that your personal buying power doesn't fall. Make yourself more valuable. You know, if you can maintain your own personal buying power, then once inflation settles, you're still going to be in a great position to invest and you'll likely be able to snap up some cheap stocks as well.

So overall, that is how the great man Warren Buffett hints that we should be investing during inflationary times. Really, it does just come back down to the competitive advantage. If your business has a moat and can increase prices and suffer no negative consequences, then those businesses actually come out on top during inflationary periods. And the reason they come out on top is, unfortunately, because everybody else loses.

So overall, it's an annoying time, but hopefully that helps you understand a little bit more how to negotiate it as an investor. So overall, guys, I hope you enjoyed the video. Leave a like on the video if you did enjoy it or if you found it useful. I really appreciate it. Subscribe to the channel as well if you have not done so already. A lot of my views come from people that aren't subscribed, so if you're still here, please feel free to subscribe. It's, of course, completely free to do. And if you're interested in learning how I go about my investing strategies, passive investing, and active investing, then you can check out Profitful. Links to two in-depth courses are down in the description below, one for obviously passive investing and one for active investing. If you want to check those out, that’d be awesome, but no stress if you don't want to.

Overall, guys, thank you very much for watching. That is it from me for today, and I'll see you guys in the next video.