Market Musings - February 21, 2018
We continue our blog series: Market Musings, Volume 2, Edition 11, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Buffett on Inflation".
Back in May 1977 Warren Buffett wrote an article for Fortune magazine (full article linked here) entitled "How Inflation Swindles the Equity Investor". Given that we now appear to be heading into an era of higher inflation, it pays to take a look back at Buffett's thoughts on the subject from 41 years ago.
First we should note that the 30-year Treasury bond yield has jumped up recently, appreciating about 40 bps over the past 6 months to the ~3.16% level (source):
Granted, we are not even remotely close today to the ~15% level of the early 1980s, however for equity investors we appear to be moving in the "wrong" direction, at least if you buy in to Buffett's thesis, explained further below. But first the long, long-term bond view, showing that the ~35-year bond bull market may finally be ending (source):
So how does Buffett view the relationship between inflation and equities? First, he refutes the previously accepted view that equities act as a hedge against inflation:
There is no mystery at all about the problems of bondholders in an era of inflation. When the value of the dollar deteriorates month after month, a security with income and principal payments denominated in those dollars isn’t going to be a big winner. You hardly need a Ph.D. in economics to figure that one out. It was long assumed that stocks were something else. For many years, the conventional wisdom insisted that stocks were a hedge against inflation. The proposition was rooted in the fact that stocks are not claims against dollars, as bonds are, but represent ownership of companies with productive facilities. These, investors believed, would retain their value in real terms, let the politicians print money as they might. And why didn’t it turn out that way? The main reason, I believe, is that stocks, in economic substance, are really very similar to bonds. I know that this belief will seem eccentric to many investors. They will immediately observe that the return on a bond (the coupon) is fixed, while the return on an equity investment (the company’s earnings) can vary substantially from one year to another. True enough. But anyone who examines the aggregate returns that have been earned by companies during the postwar years will discover something extraordinary: the returns on equity have in fact not varied much at all.
Basically, Buffett takes the view that equities are disguised bonds that pay around 12% on par value (i.e., book value, or shareholders' equity). Thus, stocks are hurt just as much as bonds when inflation rises because the price-to-book ratio for stocks must decrease just as a bond's price decreases in inflationary times. Conversely, the lower the relative level of inflation, the higher bond prices rise and the more P/E multiples expand (all other things being equal).
We can see this evidenced currently, as stocks trade around 3.4X book value (source). Recently, however, S&P 500 companies have averaged around a 14% return on equity, which looks to have been bumped up by the recent tax cuts to perhaps 16% (source). At a 16% ROE, this means that investors are receiving an earnings "coupon" of 4.7% (16/3.4) on the S&P 500, or about 1.5% higher than the risk-free 30-year Treasury rate (note that this equates to a trailing P/E ratio of about 21X). However, if the 30-year bond rate were to increase to, for example, 7%, then one would expect the earnings yield on the S&P 500 to rise from 4.7% to about 8.5%, implying a P/E ratio of around 12X. With investors anticipating around $150/share in 2018 S&P earnings (source), this would mean that the S&P should drop to the 1830 level or so (12X150), which is about 33% lower than the current trading level. Obviously, we are nowhere near a 7% long bond rate, but it is interesting to see how things would likely shake out in such a scenario.
Buffett goes on to identify a key characteristic of low inflationary environments: they favor companies that reinvest their earnings (versus paying them out via dividends). Why? Because when stocks are trading at 3.4X book value, every $1 of cash from operations that gets reinvested in said book value should translate into an incremental $3.40 in market value for the shareholder (versus worth just $1 when paid out as a dividend, or even less after payment of taxes thereon). Buffett explains further:
This characteristic of stocks — the reinvestment of part of the coupon — can be good or bad news, depending on the relative attractiveness of that 12%. The news was very good indeed in the 1950s and early 1960s. With bonds yielding only 3 or 4%, the right to reinvest automatically a portion of the equity coupon at 12% was of enormous value. Note that investors could not just invest their own money and get that 12% return. Stock prices in this period ranged far above book value, and investors were prevented by the premium prices they had to pay from directly extracting out of the underlying corporate universe whatever rate that universe was earning. You can’t pay far above par for a 12% bond and earn 12% for yourself.
But on their retained earnings, investors could earn 12%. In effect, earnings retention allowed investors to buy at book value part of an enterprise that, in the economic environment then existing, was worth a great deal more than book value.
It was a situation that left very little to be said for cash dividends and a lot to be said for earnings retention. Indeed, the more money that investors thought likely to be reinvested at the 12% rate, the more valuable they considered their reinvestment privilege, and the more they were willing to pay for it. In the early 1960s, investors eagerly paid top-scale prices for electric utilities situated in growth areas, knowing that these companies had the ability to re-invest very large proportions of their earnings. Utilities whose operating environment dictated a larger cash payout rated lower prices.
No wonder investors recently have been in love with so-called "growth" companies--they tend not to pay dividends, but rather reinvest all their cashflows into existing or new operating businesses. Think about Amazon (AMZN) for a moment. All operating cashflow is plowed back by Jeff Bezos either into the existing retail business or in new businesses such as AWS. Unfortunately, the higher interest rates rise, the lower the relatively benefit of the reinvested dollar for shareholders, and the less attractive "growth" stocks will look relative to stodgy dividend payers like AT&T (T) or General Motors (GM) (again, other things being equal). Buffett notes that this exact "reversal" phenomenon took hold in the mid-to-late 1960s just after major institutional investors had stampeded into growth stocks at nosebleed valuations:
This heaven-on-earth situation finally was “discovered” in the mid-1960s by many major investing institutions. But just as these financial elephants began trampling on one another in their rush to equities, we entered an era of accelerating inflation and higher interest rates. Quite logically, the marking-up process began to reverse itself. Rising interest rates ruthlessly reduced the value of all existing fixed-coupon investments. And as long-term corporate bond rates began moving up (eventually reaching the 10% area), both the equity return of 12% and the reinvestment “privilege” began to look different.
Buffett goes on to note that there are 5 ways companies can increase their ROE, namely (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. Obviously, #4 has recently come into play with the cut in the domestic corporate tax rate from 35% to 21%. However, tax cuts leads to higher deficits, which logically would lead to higher inflation and higher interest rates (so, regarding #2, leverage should become more expensive, rather than cheaper). What the tax cut giveth, higher interest rates may take away. Note also that higher interest rates may lead companies or their lenders to reduce leverage (see #3). So, overall, the recent corporate tax cut package might be a wash as far as equity valuations are concerned (although no doubt CEOs across the country will bonus themselves to the hilt in the aftermath of it). But those who have been happily long certain "profitless growth", high price-to-book companies during the current bull market may be in for a rude surprise if rates continue to rise.
DISCLOSURE: Long GM.