Warren Buffett: How To Profit From Inflation (feat. Mohnish Pabrai)

We're seeing very substantial inflation. It's very interesting. I mean, we're raising prices, people are raising prices to us, and it's being accepted. Take home building. I mean, you know, the cost of—we've got nine home builders and, in addition to our manufactured housing, and then operation, which is the largest in the country. So we really do a lot of housing. The costs are just up, up. Steel costs, you know, just every day they're going up.

As I've covered extensively on the channel across the past year, we're currently seeing record levels of inflation. In fact, the latest inflation data came out the other week, and it's yet another 40-year high, this time 8.6. When inflation gets really high like this, the Federal Reserve raises interest rates to put the brakes on the economy. For example, just last week, the Fed announced a 0.75 interest rate hike, with more to come. Just like that, a $500,000 mortgage got about $4,000 more expensive each year. Ouch, right?

But inflation doesn't just hurt homeowners; it also hurts businesses. Businesses take out loans, too. Debt becomes more expensive, and if you couple that with consumers that no longer have a lot of spare money to buy iPhones and Teslas and Disney Plus subscriptions—because now they're so focused on paying down their mortgage and their credit cards—suddenly sales drop at these businesses and stock prices fall.

So the question is: how do we, as stock market investors, best protect ourselves from suffering at the hands of inflation? Well, instead of rambling on myself, let's turn to the 91-year-old oracle of Omaha, Warren Edward Buffett, to explain how to invest in these conditions.

There are really two key factors that need to be considered, and they're both covered in this next clip. So let's have a listen, and then we'll take the time to break down each point.

The businesses that will perform the best are the ones that require little capital investment to facilitate inflationary growth, that have strong positions that allow them to increase prices with inflation. We have a candy business, for example, and the value of the dollar since we bought that candy business has probably fallen at least 85 percent I would say. And that candy business sells 75 percent more pounds of candy than it did when we bought it, but it has 10 times the revenues, and it doesn't take a lot more capital.

So that kind of a business—any business that has enough freedom to price to offset inflation and doesn't require huge investment to support it—will do well. So point number one: the business has enough power to raise prices to mitigate the effects of inflation.

Point number two: the business doesn't require a huge amount of capital to support inflationary growth—both extremely important factors. So we will discuss both, but let's start with point number one, the idea of pricing power. Pricing power simply means the company has the ability to raise prices without reducing demand for their products.

Companies that have pricing power have some form of competitive advantage, an intrinsic characteristic of their business that sets them apart from their competitors: Apple's ecosystem, Facebook's network, Costco's low prices. Buffett wrote this back in 1982, just after the U.S. had gone through a crippling spike of inflation. He described two key factors to look for to reduce the effect of inflation, and the first, you must find companies that have, quote, "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."

These are businesses that have wide moats. But here's the thing: it can't be any old moat. There are lots of companies with competitive advantages that will actually suffer during inflationary periods, so it must be a competitive advantage that gives the business pricing power.

Usually, what happens when you have inflation is, usually wages don't keep up. So if inflation is running ten percent, maybe wages might be going up five percent or seven percent. Usually, there's a lag, and so purchasing power is declining. In economies like India, where food and energy can be a huge part of the pie for most lower middle class and poor people, then I think even strong brands will be challenged to raise prices.

On the other hand, if you're Louis Vuitton, you know you're at the top end. You will have a very strong ability to raise prices regardless of inflation because you know the rich are getting richer, and they've got limited places they can spend their money, etc. So I think that inflation hits these different companies and products in very different ways.

It can be a very strong headwind for some businesses, and it can be a much lighter headwind for others. I find that really interesting. You can have a competitive advantage and still struggle, so really you need to focus on pricing power. You know, if you're a business that's, say, the most popular makeup brand in a poor country—you know, big brand moat—well, in an inflationary period, your sales might still struggle due to unaffordability.

Netflix is a small luxury bought by the masses, and they have a competitive advantage, but as consumers whittle away their savings, they may look to cut their subscription spending altogether to save money. Whereas, on the flip side, a brand like Louis Vuitton or Ferrari probably won't suffer the same effect because their customers are all at the top end of the spectrum. They're the people that are rich no matter what's happening.

I find that point very interesting from Monish—go beyond the fact that they have a wide moat and also ask who’s buying these products. That is the important question to find businesses that will genuinely suffer no consequences from inflation.

Now let's talk about the second key factor, which is finding businesses that don't need huge capital investment to keep humming. If you have a business where most of the capex has already happened in the past, they would be deriving the benefits of that capex in the future.

Let's say, for example, I own a hotel, and I've already built the hotel, and it's up and running, and I don't plan to build another hotel, etc. If we had strong inflation, assuming there weren't, you know, changes in many more hotels being built around me, the odds are high that if it's in a good area, the nightly rates might go up in lockstep with inflation. That's possible because you did the capex in yesterday's dollars.

Inflation actually is not going to hurt if you have to use those dollars to build another hotel; it's going to cost you a lot more to build the next hotel, and so in that case, it becomes difficult. But if you are milking the cow, so to speak, on old capex that you've done in old rupees or dollars, then it's an advantage.

We are best off in a world where there's no inflation because that makes the analysis easier. But when we have an inflationary environment, it is important to try to understand which businesses will do well in that environment and which businesses will struggle in that environment.

I think it relates a lot to the capital expenses the business has to do in the future. So that's the second point: businesses that are well shielded from the effects of inflation and can actually benefit from it are those that have already completed major capital expenditures in yesterday's dollars.

Think about this: Coca-Cola has been around since 1892. In its first year, they sold 25 bottles of Coke. Today, they sell 1.9 billion bottles per day. Over time, Coca-Cola's had to invest significantly in making more and more product to be able to keep up with demand. But they did that investment, and they did it in yesterday's dollars.

So today, they don't need to invest tens of billions of new production plants to be able to, you know, keep up with demand and grow their market share. They've done that investment already, and because they have a competitive advantage that gives them pricing power, as inflation runs, they can raise their prices without consequences, making them even more profitable, which actually puts them further ahead compared to the up-and-coming drinks brands that are having to invest significantly in new production plants and whatnot in a time where everything is more expensive.

So Monish’s tip is to look for companies that have already done the bulk of their capital investment. Companies that need to invest heavily to maintain their competitive position are the ones that are going to struggle right now.

Businesses like our utilities, which get, in effect, a bond-like return, but require—if you're going to build a generating plant that costs twice as much per kilowatt hour of capacity—all you're going to get is a fixed return. Yields on bonds go up, perhaps dramatically, to get high inflation is not going to do that well in an inflationary period.

Just because it has certain aspects of a bond-like investment doesn’t mean bonds generally are going to do well in inflation. So there you go: let's look for companies that don't need to invest large sums on an ongoing basis to maintain their competitive position. We're better off looking for those businesses that, as Monish says, are just milking the cow.

These are really the two key factors to consider when it comes to investing during inflation. However, I just wanted to include one last point from Warren Buffett, which is very important to remember during these times—maybe even most important—and that is to remember that, unfortunately, there is no true silver bullet in inflationary times.

There is no way you can completely sidestep the issue. It's an annoying time to be an investor, and you need to understand that over the next few years, investing will be a lot harder. Of course, bonds can swindle the equity investor, too. Everything, and inflation, I should say, swindles the bond investor, too. It swindles the person who keeps their cash under their mattress. It swindles almost everybody.

If you really could have a totally stable unit of monetary use in the next hundred years, it would be better for business and investors in general. So I really just want to put that in there to show that these conditions are not ideal. Investing will get tougher because business will slow down as rates rise, but that's the point.

So we, as investors, need to be prepared for that. We want to have our emergency funds ready. We don’t want to be investing money that we might need to cover our expenses across the next few years. We don’t want to be speculating and chasing higher returns of yesteryear. We need to stay rational, keep buying solid businesses with low capital requirements and with obvious pricing power when we get the opportunity, and we need to stay focused on the long run.

But that's it, guys. Let me know what you think. You know, is there something else that you'd add to this Buffett investing checklist during times of inflation? Definitely let me know down in the comment section below. Of course, leave a like on the video if you did enjoy, subscribe to the channel if you'd like to see more.

But guys, that will just about say thank you very much for watching, and I'll see you guys next time. This video is brought to you by Sharesight. Sick of tracking your performance manually? Track capital gains, dividends, and currency fluctuations easily.

And when it comes to tax time, have everything you need ready to go with just a click of a button. Try Sharesight for free or use the referral link in the description to get four months free when you sign up to an annual plan.