Warren Buffett: How to Invest During High Inflation

Stocks sell at silly prices from time to time. It doesn't take a high IQ to figure out that they're cheap, but it does take a temperament that's willing to step up and actually act. That, there, as I'm sure you are all aware, is Mr. Warren Buffett, the 92-year-old Oracle of Omaha. He is the CEO of Berkshire Hathaway, one of the largest companies in the world. The reason most people know his name is because he is the world's best investor.

Every year, he releases a letter to his shareholders where he details the returns of Berkshire Hathaway stock since he took the reins back in 1965. And get this: from then to now, he's averaged 20.1% per year while the S&P 500, or the market, has only averaged 10.1-12%. Berkshire's total return over that time is $3.6 million versus $30,000 for the S&P 500.

So in this video, we're going to take the time to hear some of Warren Buffett's advice that specifically applies to the investing scenario that we all face coming into 2023. So what is that situation? Well, firstly, the market is falling; it fell 20% in 2022. We also have very high inflation, although thankfully that does seem to be trending down at least currently. Finally, we have rising interest rates which are likely going to continue in 2023 based on the FED reaffirming they want to get that inflation rate back down to 2%, and they won't stop raising rates until they get there.

So chuck that all together with the possibility of a decent-sized recession throughout the year, and well, for investors, there's a lot to think about. So let's start at the start: the first conundrum. What do we do as rational long-term value investors when the stock market is pretty solidly trending down? Let's talk a little bit about the fact that the market's down almost 800 points this morning.

"Yeah, concern for you?"

"Well, no, that's good for us actually. Um, we're a net buyer of stocks over time. Just like being a net buyer of food, I expect to buy food the rest of my life, and I hope that food goes down in price tomorrow. When stocks are down, we're going to be buying on balance, and who wouldn't rather buy at a lower price than a higher price? People are really strange on that. I mean, most people, most of your listeners are savers, and that means they'll be net buyers, and they should want the stock market to go down. They should want to buy at a lower price. And they have that feeling that they just feel better when stocks are going up."

Buffett's rational thinking really shines through in this clip. If you're a long-term investor trying to build wealth and you're under the age of about, you know, 55, you actually want the stock market to go down. The reason being is you should still be a net buyer of stocks. You know, if you're 70 or if you're 80, then you definitely want the stock market to stay really high because on the flip side, chances are you're in the stage of your life where you're a net seller of stocks.

And I like that Buffett touches on the fact that most people's reaction to a falling market is really emotional. People just feel better buying stocks when the market is going up, but in reality, you should actually feel better buying at times like right now when the stock market is down so much. And this goes back to a very famous investing quote, which says the stock market is the only place people run out of the store during a sale.

Think about that. When it's Black Friday, we're always buying, but how come we get scared when Black Friday happens in the stock market? For long-term investors, we should actually get excited by the stock market falling.

"Have a listen to these two clips. Some people should not own stocks at all because they just get too set with price fluctuations. If you're going to do dumb things because your stock goes down, you shouldn't own a stock at all. What are dumb things? Selling a stock? Yeah, selling a stock as it goes down. I mean, if you buy your house at $20,000, and somebody comes along the next day and says I'll pay you 15, you don't sell it because the quote's 15."

"But some people are not actually emotionally or psychologically fit to own stocks. But I think there are more of them would be if you get educated on what you're really buying, which is part of a business. If you worry about corrections, you shouldn't own stocks. I mean, if you can't take your stock going down, it's going to go down sometime if you own a stock. So why worry about it?"

"I mean, the point is to buy something that you like at a price you like, and then hold it for 20 years. And you should not look at it day to day. If you bought a farm or apartment house, you wouldn't get a quote on it every day or every week or every month. So it's a terrible mistake to think of stocks as something that bob up and down, and you should pay attention to what those bobs up and down."

So in summary, own great businesses and remember that market corrections are a normal part of investing, and they should actually make you happy, not scared. So that's investing during a bear market. But what about all this inflation we're seeing? Prices of materials are rising a lot at the moment, making everything more expensive for both us consumers and also for businesses.

So what do we need to consider during a period where prices across the board are inflating? Kane said it many years ago that it's an invisible tax that only one man in a million really understands. The best investment against it is to improve your own earning power. 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.

But it's interesting: in the United States, the value of the dollar since I was born has declined by 94%, to 6 cents. But things can work out pretty well even during inflationary times. I mean, if somebody told me when I was born, you know, that the dollar bill is going to go to 6 cents, I might have said, you know, let me go back. I'm not interested in emerging into that kind of a world, but actually, it's worked out pretty well, so I have no complaints.

So that advice is really interesting. There are a few concepts to unpack there. Firstly, the best thing you can do during high inflation is to actually improve your own earning power, aka make yourself more valuable to your employer or potential future employers, so that your income can actually rise alongside the inflation that you'll feel.

But beyond that, Buffett says the best passive strategy you can implement to nullify inflation is to find a really high-quality business and stay invested in it. Buffett wrote down exactly what he meant by this back in his 1981 shareholder letter. He said that the best businesses to own to combat inflation have, firstly, 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 then, two, he said they need to have an ability to take large dollar volume increases in business often produced more by inflation than by real growth, with only minor additional investment of capital. So to explain the second point first: Buffett is simply saying that businesses will fare better during inflation if they are scalable, aka they can accommodate a much higher dollar volume of business without needing to sink a lot of money into the company to increase that capacity.

Think, for example, a social media company versus a car company. You know, it costs Facebook nothing really to show you three ads instead of two, but for Ford or for Tesla to increase their output by 50%, well, that would cost a lot in capex and it would take a lot of time to spin up. So that's the second point.

But it's Buffett's first point that is really critical when it comes to investing during inflation, and that is that the business needs to have an ability to increase prices without losing market share or unit volume. And this simply means that the company has a competitive advantage or moat that gives them pricing power.

When you go into a drugstore, 7-Eleven, or something, and you say, "I would like a Snickers bar," and the owner says, "Oh, I've got something, the Musk bar, at 10 cents off the Snickers bar," you say, "Give me the Snickers," and if he doesn't give you the Snickers, you go across the street and buy the Snickers.

It's probably easier to develop a new card just to compete with Snickers. But some products have terrific moats, and probably Elmer's Glue does. You know, WD-40. People that have an iPhone, they want to continue with a product that they've got. They want the new version. It's just easier for them; they learned how to do everything, and their lives built around it, and all of that.

And moats are very useful. Costco has a moat in people's mind. I mean, Amazon can raise the price of Prime, you know, 20%, and you can't do that unless you've built something within that image of the Amazon Prime that's based on reality, that you're going to get a lot for your money and you're going to want to use it.

Then you can raise prices $20. But if you're selling, you know, some commodity product, you can't do that; you need a moat. So there are many different types of moats out there. For example, a patent could give a company a moat. Anytime you have to pay a toll, that toll-collecting company has a moat.

As Buffett said, powerful brands like Coca-Cola or Apple or Louis Vuitton, they all have moats. Costco has built a moat around always having the best prices. There are a lot of different ways companies can form a competitive advantage, and if it gives them the ability to dictate prices, aka pricing power, then they're the best bets to come out on top during an inflationary period.

As inflation raises their costs and lowers their profits, they can simply raise the prices of their end products, and their moat should protect them from suffering a drop in sales. In fact, last year, as Coca-Cola raised their prices, their sales actually went up. So there's some good proof for you.

So that's how to handle the inflation side of investing in 2023. But finally, we also need to talk about the third big challenge of investing this year: interest rates. What can we do when interest rates just keep rising?

Interest rates, you know, basically are to the value of assets what gravity is to matter, you know, essentially. And if I could reduce gravity's pull by about 80%, I mean, I'd be in the Tokyo Olympics jumping. That's really the way to view interest rates: like gravity to the stock market. When interest rates are very low, money is cheap and easy to access for both consumers and businesses.

And this means more spending, more profits, and more growth, and that's what we've had basically over the past 10 years or so. But now, on the flip side, we're starting to see rising interest rates. This means, of course, borrowed money is more expensive to access, so business debts become harder to pay off and consumers generally have a lot less to spend.

So this is a tough environment for businesses to operate and thrive in, and it often shows in their financial results, which then affect their stock prices. Have a look at this graphic of the past 5 years. As you can see, interest rates went up in 2018, and the stock market didn't do much at all. In 2019, rates started coming down and the market went up, and then when COVID struck, the FED lowered the interest rate to zero, and the market basically boomed for two years.

However, in 2022, interest rates went up a lot and the market dropped by 20%. So when rates go up, stocks generally suffer. And this is half caused by businesses performing poorly and their stock value falling. But the other factor to consider with interest rates is, of course, government bonds.

So U.S. Treasury Bills or Treasury Bonds are generally considered the risk-free return. So you give the U.S. Treasury a loan, and then they'll pay you back at some point in the future plus interest. So when interest rates are low, the government honestly, they give you bugger all interest. But when interest rates rise, if you buy the new bonds that they're issuing, well, those ones will give you a higher interest payment.

Now, this this is all very boring to us, but it is very interesting to the 80% of the market who are just institutional money managers trying to get a good return for their clients with as little risk as possible.

So what you find is that when rates rise, a lot of professional money flows out of the risky stock market and back into the safety of Treasury bills. And that selling out of the stock market by the big players causes stock prices to fall.

This is Buffett talking about exactly this idea in 1982 or '83 when the long government bond got to 15%. "A company that was earning 15% on equity was worth no more than book value under those circumstances because you could buy a 30-year strip of bonds and guarantee yourself for 15% a year. A business that earned 12% was a subpar business then, but a business that earns 12% when the government bond is 3% is one hell of a business now, and that's why they sell for very fancy prices."

So if a business is giving you 10% returns per year, that's pretty good. But the closer that risk-free rate gets to 10%, the more professional money will sell the business and just buy the government bond, causing the business's stock price to fall.

So what do we take away from all this? Well, it's again that we need to be laser-focused on our selected business's performance, and we need to stay focused on the long term because history tells us stocks are generally a better place to be than bonds over a very long period of time; that's just the reality.

But for short periods of time, well, occasionally they're not, so we, as stock market investors, need to stay focused on the long term so that we can use the depressed stock prices on high-quality businesses as opportunities for long-term returns.

We need to acknowledge that we can't do anything about the Federal Reserve; they'll do whatever. So instead, let's just play the long game and pick up great businesses at great prices while interest rates are really high.

That's how we tackle a high-interest rate environment. And overall, guys, that is Warren Buffett's wisdom around tackling the three big investing issues that we are all going to face in 2023: stock market correction, high inflation, and rising interest rates.

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