Warren Buffett: How to Make Money During Inflation

Are you seeing signs of inflation beginning to increase? We're seeing very substantial inflation. It's very interesting. I mean, we're raising prices, people are raising prices to us; it's being accepted. I mean, inflation is a big concern for everyone right now: individuals, companies, investors, politicians. Inflation has been a big worry and topic of conversation for the last year to 18 months or so.

In this video, we're going to be going through a hierarchy of different investing categories and how they rank in periods of inflation, all of this according to Warren Buffett, who at 91 years old knows a thing or two about inflation because he's lived through it. I went through hours of interviews with Warren Buffett when researching for this video. All I ask in exchange is for you to hit that like button. Seriously, that's all. Okay, and maybe subscribing to the channel if you aren't already. Now, let's get into the video.

The worst investment to have during a period of inflation is cash. Warren Buffett isn't the only investor that doesn't like holding cash during inflation. Fellow billionaire Ray Dalio has also been vocal about his dislike of cash with a very memorable and kind of catchy quote: "Cash is trash." This is because during times of inflation, cash that you have sitting in a savings account or in your dresser drawer at home is becoming worth less and less every day, every week, every month, and every year.

One of the biggest takeaways I want you to have from this video is that you, as an investor, need to think about your investment returns and what is referred to as real terms. The math behind calculating your real return on an investment is simple. Let's say your investments returned you 10% a year—that's great, right? Not so fast. It really depends on what the inflation rate is. In order to calculate the real return on your investments, you need to subtract out the impact of inflation. So if inflation is seven percent and your investments return 10% that year, your real return is only 3%. Not nearly as exciting, right?

This is why cash is at the bottom of this hierarchy, because your return on holding cash is essentially zero. Holding cash over a long period of time allows the impacts of inflation to work against you. Above cash on the hierarchy is fixed interest rate bonds. These investments are generally considered very safe by conventional investing wisdom, but Buffett would make the argument that these investments aren't really all that safe when you factor in the impact of inflation.

Let me explain what I mean. The current yield on a 10-year U.S. government bond is around 1.8% as of the making of this video. This means that if you were to purchase a 10-year government bond today, you would effectively lock in a 1.8% annual return every year for the next decade. Let's say that inflation averages four percent over the next decade, which isn't necessarily a stretch given that the most recent inflation report had inflation at seven percent. With four percent inflation, this means you would have an annual real return of negative 2.2% after you factor in the impact of inflation on your return.

Now, this is still better than just holding cash, but it is still a long way from the best. You know, if we dropped a million dollars of cash into every household in the United States today, everybody would feel very good, except the people that invested in things that were denominated in dollars. It's important to note that people who own fixed-rate debt, like government bonds, lose during times of inflation. On the flip side, people who borrow money in a long-term structure at a fixed rate are winners during inflation.

An example of this would be people that use a mortgage to buy a property. In December 2020, I purchased a house. I was able to lock in a 30-year fixed-rate mortgage at 2.8%. This means that my interest rate is going to stay the same for the next 30 years. My mortgage payment is also going to be the exact same for 30 years. This is a great place to be in during times of inflation. This is because inflation eats away at the value of the mortgage debt month after month and year after year. As inflation makes each dollar worth less and less, I get to repay my mortgage debt with devalued dollars.

If you own a home though with a very large mortgage, and you have incredible inflation that wipes out the mortgage, then you've still got the home. I mean, just in Weimar, Germany, they gave you the mortgage back at the end. That was very interesting; that's the one thing they did right. Next up on this hierarchy is what Buffett refers to as unproductive assets. These are things like gold, silver, and other precious metals. Now, these aren't terrible to own during a period of inflation because, all else being equal, as the price for everything else rises, these things should at least keep up with inflation in theory.

However, these unproductive assets also won't likely increase your purchasing power either. Let's listen to Warren Buffett explain this: "I will say this about gold. If you took all of the gold in the world, it would roughly make a cube 67 feet on a side. So if you took all of the gold in the world, we could have a cube that went down there 67 feet, 67 feet high, and that would be the whole thing. Now for that same cube of gold, it would be worth, at today's market prices, about seven trillion dollars. That's probably about a third of the value of all the stocks in the United States.

So you can have a choice of owning a third of all the stocks in the United States, or you can have a choice of owning a little block of gold, which can't do anything but kind of shine there and make you feel like Midas or Creases or something of the sort. Now for seven trillion dollars, there are roughly a billion farm acres of farmland in the United States that are valued at about two and a half trillion dollars. It's about half the continental United States is farmland. You could have all of the farmland in the United States; you could have about seven Exxon Mobils, and you could have a trillion dollars of walking around money.

And if you offered me the choice of looking at some 67-foot cube of gold and looking at it all day—I mean, I'm not touching it, fondling it occasionally, you know—then saying, you know, 'Do something for me,' and it says, 'I don’t do anything; I just stand here and look pretty.' And the alternative to that was to have all the farmland in the country; everything—cotton, corn, soybeans; seven Exxon Mobils—just think of that. Add a trillion dollars of walking-around money. I, you know, maybe call me crazy, but I'll take the farmland or the Exxon Mobils."

Let's move on to the next category of investments in our inflation hierarchy. Now, these investors don't just want to keep up with inflation; we want investments that can outperform inflation and that produce a real return for us. Here's where what Warren Buffett refers to as productive assets enters the picture. Now, we all know that Warren Buffett made his fortune buying stocks and entire businesses, but according to Buffett, not all businesses are created equal.

Next up in the inflation hierarchy is productive assets—average businesses. Average businesses have a couple of characteristics, one of which is that these types of businesses require a ton of additional capital, which is just a fancy word for cash, to keep operating. Unfortunately, most businesses do not come out well in real terms during inflation. Their earnings may go up a fair amount over time, but they're compelled to put more and more dollars into the business just to stay in the same place. And you know, the worst kind of a business is one that makes you put more money on the table all the time and doesn't give you greater earnings.

So here's a simplified example using a real company that will hopefully prove the point: United Rentals, ticker symbol URI, is the world's largest equipment rental company. They have a pretty simple business model. United Rentals buys equipment typically used in construction projects, so things like bulldozers, portable restrooms, and heavy-duty trucks. United Rentals then turns around and rents out that equipment to construction projects over the short term, usually the length of the project.

Obviously, this equipment that the company United Rentals rents to its customers doesn't last forever and needs to be replaced every few years or so. Let's say, for simplicity purposes, each bulldozer the company buys costs one million dollars to purchase, and let's say over the lifetime of that bulldozer it can be rented out to customers and generate 1.2 million dollars in sales for the company. That's a nice two hundred thousand dollar profit. But let's just say, for the sake of this example, inflation is twenty percent.

This means that the next time the company goes to buy another bulldozer to replace the existing one, the company has to spend 1.2 million dollars. See what's happening here? The company isn't able to take any money from the business in the form of profits; all the money that United Rentals is earning in profits has to be poured right back into the business in order to purchase new equipment to replace the old equipment. Now, I don't expect inflation to be anywhere near 20%, hopefully, and United Rentals is a great company, but this example demonstrates the challenge that capital-intensive businesses face during periods of inflation.

One quick story before we move to the next characteristic of businesses that you want to avoid during inflation: Warren Buffett's partner and friend Charlie Munger had this quote that sums up what I explained pretty well: "There are two categories of good businesses. One is the business where the whole reported profit just sits there in surplus cash at the end of the year, and you can take it out of the business, and the business will do just as well without the cash as it would have if it stayed in the business. The second business is one that reports a profit, but there's never any cash."

It reminds me of the used construction equipment business of my old friend, and he used to say, "In my business, every year you make a profit, and there it is sitting in the yard." There are an awful lot of businesses like that where to just keep going, to stay in place, there's never any cash. The next trade of average businesses that you want to avoid are businesses that don't have what is referred to as pricing power. The best way to explain what I mean by companies that don't have pricing power is to talk a little bit about a company that does have pricing power.

When I think of pricing power, the first company I think of is Apple. Apple has such a loyal customer base that many Apple customers will pay whatever the company wants to charge for its iPhone product. If someone wants a new iPhone, they aren't going to buy a competitor's product just because it's cheaper. Contrast this to a company with little to no pricing power, where pretty much the only thing the customer cares about is price. Let's say a company manufactures plain white t-shirts; that is all the company makes—just plain white t-shirts, no design or branding.

This company has no pricing power because someone is just going to buy the cheapest white t-shirt they can find. This t-shirt manufacturer also has no ability to raise prices higher than its competitors because the second its prices are higher than its competitors, people are just going to choose to buy the white t-shirts of this company's competitors. An inflationary environment is going to be tough for this company. The cost of materials to make the shirts are increasing, the cost to pay workers to make the shirts are increasing, and the cost to ship the shirts to customers are also increasing. The only thing that isn't really increasing is the price the company can charge for shirts.

Now do you see why inflation is so challenging for companies without pricing power? Now, let's move on to the next investment category on the hierarchy. Let's call these investments productive assets—great businesses. I know, very clever name. Here's another example for you: Remember how in the earlier example we had the business that spent one million dollars buying a bulldozer? Let's say instead that our friend John here uses that same one million dollars developing a software product that does something like make it easier for creators on YouTube to make videos.

Just like in the earlier example, let's say that John makes 1.2 million dollars his first year from that product—a 200,000 dollar profit, great. But wait, it gets even better. Let's say there is also 20% inflation. In this example, this means that John is able to charge 20% more for his software this year than last year. This means that the 1.2 million dollars John had in sales last year turns into 1.44 million dollars due to the 20% inflation.

But the great news with this software business is that John doesn't have to reinvest any more money back into the business. He already has the software, and while he may have to spend some money upgrading it and maintaining it, it would be a very minimal amount. This is the opposite of a capital-intensive business. In the earlier example, this software business of John's would be what is called a capital-light business because the amount of cash John will have to keep reinvesting in the business just to maintain the operations and product of the business is very minimal.

This means that John can actually take his profits out of the business and doesn't have to constantly reinvest his profits back into maintaining the business like in the earlier example of the equipment rental company. In order to find a business that performs well during inflation, you want to find pretty much the exact opposite of the mediocre business that we talked about earlier. You want to find a business with low capital requirements.

These are businesses that don't have to constantly be reinvesting large sums of money back into the business to grow. A lot of times, these are businesses with very strong brands: businesses such as Apple, Coca-Cola, or Buffett's very own See's Candies. Other examples of the kind of businesses that have low capital requirements are businesses that don't rely on owning a ton of physical assets, like factories or physical inventory. So think of companies like Microsoft, Facebook, or other technology-focused companies. Pretty much any software company falls into this category, as once the software is created and the money is spent in building it, the reinvestment back in the business is relatively minimal compared to most businesses.

The other key element of a company you want to own during times of inflation is pricing power. Now, I'll be the first one to admit evaluating a company's pricing power is more of an art than a science, but here are some helpful things to think about. One exercise that I think is helpful is to think about how a customer would react if the company were to raise its prices by 10%. There are a few different reactions customers would have that fall on a spectrum ranging from "Don't care about the price increase, take my money please" to "No way, I’m not paying that!"

During times of inflation, when prices are rising, you want to own stock in companies that are able to easily increase prices for their goods. You want to avoid investing in companies in commoditized industries that struggle to raise prices, even during normal times. I want to end this video with some important advice from Warren Buffett, and you know the best investment of all? I mean, if you're the leading brain surgeon in town, or the leading lawyer in town, or whatever it may be, you don't have to keep re-educating yourself to be that in current terms. You bought your expertise when you went to medical school or law school in old dollars, and you don't have to keep reinvesting, and you retain your earning power in current dollars.

The best protection against inflation is to invest in yourself. If you are the best at what you do—whether you are the best mechanic, lawyer, dentist, plumber, or accountant—you make yourself immensely valuable to other people. The benefit of being immensely valued in a marketplace economy is that you essentially get to charge whatever you want for your services, and your customers will be happy to pay it. So there we have it.

I hope you enjoyed the video. As always, make sure to like this video and subscribe to the Investor Center, because it is my goal to make you a better investor by studying the world's greatest investors. Talk to you soon.