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November 7, 2008

What about the principal?

How Inflation Swindles the Equity Investor
Warren E. Buffett, FORTUNE May 1977

In the article he suggests that stock is fairly accurately modeled by treating equity as a bond with a 12% interest rate.

For many years, the conventional wisdom insisted that stocks were a hedge against inflation.
...
Must we really view that 12 percent equity coupon as immutable? Is there any law that says the corporate return on equity capital cannot adjust itself upward in response to a permanently higher average rate of inflation?

There is no such law, of course. On the other hand, corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes, (5) wider operating margins on sales.

Buffet knows more about accounting than I ever will, but I think he's missed the ramifications of the fact that bonds have a fixed principle, while equity does not. I wonder if he still agrees with this 30 year old analysis.

When there is inflation it means that on average everything is more expensive than it was before. That includes raw materials, inventory, machines, intellectual property, and land the things that firms own as well as labor and skills. We don't know the mix of price rises without more detail, but just looking at the headline inflation number just tells us something about the amount that average prices increased. If you own a diversified pool of investments, you are going to end up owning a fractional share of practically every sort of asset their is (from the prior list and then some). So the assets of the firms you invest in should increase in price, because if they didn't then inflation wouldn't have happened. For the same reason, the price of the things the firms sell must too have gone up on average. I certainly buy his argument that this should have had no influence on the 12% asset return of equity, because both the numerator and the denominator must on average have increased by the rate of inflation. But if we treat the stock as the value of the firm less the value of all the bond, we see that the price of the stock should have increased by at least the rate of inflation.

Why?
Lets say that in the old world the firm had an equal mixture of all the productive assets in the economy and was worth $200. The firm has $100 in equity and $100 bond. Now we are in a new world where inflation has doubled the average price level. It must be that the price of all the firm's assets is $400, because it is an equal weighting of the economy's assets. The bond is not indexed to inflation. It remains worth $100. Note that the bond holder has suffered terribly, they have lost half their bond's value. The equity holder gets the remainder $400-$100= $300. They still get the average 12% return, but they also get an adjustment to their principle that modifies their return even if all the financial variable above are unchanged. In fact, it is only the case that there was no debt (or all debt were somehow indexed to inflation) that inflation would increase equity by the same amount as inflation. In all other circumstances it should be more.

It is true that inflation causes waste and dislocations, and this represents a dead weight loss for the economy. That money is gone forever but at least for the stable levels of inflation we typically see, that's modest, and equities should go up in response to inflation. The fixed principal of the bond holder and the appreciating assets of the firm combine to require this. Sure, some firms can win or lose depending on how their assets and prices respond to inflation, but on average this has to hold. It follows directly from the concept of inflation as a general rise in the price level.

Posted by OneEyedMan at November 7, 2008 7:59 AM

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