Inflation Continues to Sky Rocket: How Warren Buffett Says You Should be Investing

Everyone is talking about inflation, inflation, inflation, inflation. This pesky little thing called inflation has probably been the most talked-about topic in finance this year, and this is likely for a good reason. The cost of mostly everything, from houses to used cars to even food at your favorite restaurant, has gotten more expensive, and this has some people really afraid for what the future holds. Listen to these crazy stats: the median U.S. home price is up 20 percent from this time last year, the highest annual increase on record. The price of used vehicles is up more than 21 percent from last year, also the largest increase on record. Inflation in the overall U.S. economy, as measured by what is referred to as the personal consumption expenditures price gauge, is up 4.3 percent since last year, the largest annual increase since 1991, and more than double the 2 percent inflation rate that is considered to be a healthy and normal level of inflation.

Periods of inflation tend to be difficult times for investors. This has me asking the question: what can I be doing to benefit from this inflation in the economy and actually make money instead of losing it? To answer this question, I am turning to the greatest investor of all time, and someone who, at 91 years old, has lived through his fair share of inflation: Warren Buffett.

Fun fact about inflation: when Warren Buffett was born in 1930, the average rent in America was $25 per month. Talk about inflation! Real quick, make sure to like this video and subscribe to the channel if you aren't already, because it is my goal to make you a better investor by studying the world's greatest investors. Without further ado, let's listen to what Buffett has to say.

“Let's go to microphone number two please. Mr. Bob, Mr. Buffett, Mr. Munger, good morning. My name is Akis Sares, and I am from Athens, Greece. There is a widespread perception that we are heading towards an inflationary environment. What advice would you give to investors who need to preserve their capital and their purchasing power in such an environment?”

“The thing is to have a lot of earning power of your own. If you're the best brain surgeon in town, or even the best lawyer in town, you will retain purchasing power in terms of your income no matter what happens. You know, whether people are using seashells for money or whatever, as time goes by. But in the investment world, it's tougher. But Charlie and I think the best answer is to own fine businesses that will be able to price in inflationary terms and will not have huge capital investment that is required to handle the larger dollar volume of sales. Some years ago, I used C's Candy in our annual report as an example of the kind of business that more or less can handle an inflationary world and maintain investment in value no matter what happens to the currency.”

“Unfortunately, most businesses will 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 business is one that makes you put more money on the table all the time and doesn't give you greater earnings. So you really want a business that can have pricing that reflects inflation and does not have very much capital investment that reflects inflation. But inflation is the enemy of the investor in terms of real returns.”

“As you know, there are, in this country as well as a half a dozen other countries, what they call inflation-protective bonds. We call them TIPS in the United States, where the income is adjusted or the principal amount is adjusted to inflation, and that's not a bad investment for people that have worries about inflation heating up. I think, incidentally, we're starting to see it heat up in this country.”

“Charlie?”

“Yeah, most people are going to get a very small real return from investment after considering inflation and taxes. I think that's an iron law of the world. And if for a brief period some of us do better than that, we ought to be very thankful. One of the great defenses to being worried about inflation is not having a lot of silly needs in your life. In other words, if you haven't created a lot of artificial demand to drown in consumer goods, you have a considerable defense against the vicissitudes of life.”

“Charlie, we're selling consumer goods in the other room.” [Laughter]

“It's okay to talk that way at home, but [laughter] doesn’t do any good there.” [Laughter]

“I know the feeling. One of the things that was mentioned in the clip that I have never heard before on the topic of inflation is the importance of having strong earnings power of your own. Perhaps this is one of the reasons why Buffett always advises people to do what they love as a career so that you can really be good at the work that you're doing. Then you will have a competitive advantage over others and be able to increase how much you charge for work to keep up with inflation in the economy. If you are the best accountant, plumber, salesperson, barber, dentist, or software engineer, your skills and talent will always be in such high demand that you can essentially choose how much you charge for people to access your valuable skill.”

An example of the type of business and stock you want to buy during inflation is C's Candies. C's Candies is owned entirely by Warren Buffett and his company Berkshire Hathaway. For those of you who don't know, C's Candies is an American manufacturer of candy and is especially well-known for its chocolate, as well as Warren Buffett's personal favorite: peanut brittle.

The best way to demonstrate why C's Candies is such a great business is to compare it to an average business. In this example, let's call the average business Business A. When Buffett purchased C's in 1972, it was earning about $2 million in profit on $8 million of net tangible assets. Net tangible assets simply refer to the equipment, factories, and retail locations needed to run a business. In the case of C's, it would be the factory and all the equipment needed to manufacture the candy, any ingredients that they have purchased but not yet turned into candy, any candy that has been made but not yet sold, and any of the store locations that they own.

This introduces an important concept that you, as an investor, need to know: return on assets. Don't worry; it's a super easy calculation and lets you compare different businesses of varying sizes with each other. The math is simple: just divide the profit—in this case, $2 million—by the assets that were needed to generate that profit—in this case, $8 million. So, if we divide $2 million by $8 million, we get a return on assets, or ROA for short, of 25%.

A question you may be asking yourself is, "So okay, is that good or what?" Well, to answer that question, let's compare it to Company A, representative of an average company. Keep in mind, as we compare the two companies, that a higher return on assets is generally considered a good thing, especially during inflation. You will see why shortly.

Business A also made $2 million in profit, but needed $18 million in net tangible assets to produce that profit. Again, think $18 million worth of things such as equipment, real estate, raw materials, and finished products waiting to be sold. Using the same ROA calculation as C's Candies, we take the $2 million in profit Company A earned and divide that by the $18 million in assets needed to generate those profits. This leaves us with a return on assets, or ROA, of around 11%.

A business like that, therefore, might as well have sold for the value of its net tangible assets or for $18 million. In contrast, Buffett paid $25 million for C's, even though it had no more in earnings and less than half as much assets. In fact, Buffett actually paid around three times the value of C's Candies tangible assets for the company.

The answer for why Buffett paid more for C's than what he would have paid for the average business is due to the fact that the company generated a much higher return on assets, and he expected a world of continuous inflation. Generally, businesses with higher-than-average return on assets are more valuable because they can produce the same or more profit using fewer assets; they command a premium in the marketplace.

Now let's throw inflation into the mix. In this example, let's say over the course of some years inflation causes the overall price level of things to double. This isn't a stretch by any means. Remember how monthly rent was $25 in 1930 when Warren Buffett was born? Yeah, the average rent in America is now $1,100 for a one-bedroom apartment, more than 40 times what it was when Buffett was born.

Now back to our example: let's see how the two businesses perform when the cost of things doubles due to inflation. Both of the businesses would need to double their earnings to $4 million to keep their profit margins unchanged. Even with inflation, this wouldn't be all that difficult—just sell the same number of units at double the earlier prices. But to bring that about, both businesses would probably have to double their investment in net tangible assets since that is the kind of requirement that inflation usually imposes on businesses.

A doubling of dollar sales means more dollars must be employed immediately in running the day-to-day operations of the business, such as buying ingredients, and all this inflation-required investment will produce no improvement in the rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.

Remember, however, that C's had net tangible assets of only $8 million, so it would only have to commit an additional $8 million to finance the capital needs imposed by inflation. The business now has total assets of $16 million. Assuming the business is still worth three times its net tangible asset value, C's Candies would be worth $48 million in this inflationary environment.

As a reminder, Buffett was willing to pay this three-times multiple because of C's higher-than-average return on assets. The average business, meanwhile, had a burden over twice as large—a need for $18 million of additional capital. This business now has total assets worth $36 million, but because of the company's low return on assets, the company is still only worth the value of its assets.

That means its owners would have gained only a dollar for every new dollar invested. This is the same dollar-for-dollar result they would have achieved if they had left that money sitting underneath their mattress at home. Compare that to C's, where $8 million in additional dollars had to be put into the business while at the same time the value of the business increased by $24 million. That means for every dollar put into C's, the overall value of the business increased by three dollars—a three-for-one return.

This example demonstrates the power of what is referred to as asset-light businesses. These businesses are the type of businesses that don't require a lot of tangible assets such as factories, equipment, inventory, raw materials, and real estate to run the business. Examples of asset-light businesses today would be technology and software companies: think Amazon, Microsoft, Shopify, Apple, Square, PayPal, etc.

So there we have it. If you found this video interesting, make sure to check out the other videos on the channel here and subscribe to the Investor Center because it will make you a better investor. Talk to you soon!