Nothing Costs a Nickel Anymore

By Ben Ferris, CFA

The 1960s was a terrific decade for America. Neil Armstrong & Buzz Aldrin were moon walking, Beatlemania was sweeping the nation, and 2001: A Space Odyssey hit the theaters for the first time in 1968. That same year, the average price of a movie ticket was $1.31. Parents handing out money to their children were probably shocked at the monumental price tag. Who can blame them? Movie tickets 50 years before that were about $0.07.

In the last half century, the value of the dollar has declined a whopping 86%, or at an annual rate of about 4%. This annual “tax” on our spending power is commonly known as inflation. It is generally known that bondholders are directly subject to the inflation tax as the real value of their dollar deteriorates in an inflationary environment, given the nature of a bond’s fixed income and principal payments. Unadventurous knowledge presumes that stocks are different than bonds. The thought goes that stocks don’t lay claim to fixed payments, like bonds, but instead represent an ownership stake in an enterprise with real assets, and those assets should retain their real value over time. A closer look at the data tells a different story.

In 1977, Warren Buffett wrote a brilliant article entitled “How Inflation Swindles the Equity Investor” that I will attempt to summarize in the following three paragraphs.

According to data compiled by the NYU Stern School of Business, publicly traded U.S. companies have averaged an annual return on equity of roughly 12% over the last two decades. Longer term data also puts this figure at about 12%. Let’s think of these companies not as publicly traded stocks, but instead as privately-owned businesses. Let’s also assume that the owners acquired the assets of these businesses at book value, meaning they bought the business for what it cost to purchase the productive assets employed, such as factories and inventory. Since the longer-term data suggest that the return on equity is about 12%, the owners of these businesses would receive $12 of annual earnings for every $100 they invested in the business.

This 12% return on equity can be thought of like a fixed bond coupon received every year, regardless of what inflation has been or will be.

There are many factors that can influence return on equity in any given year, but if we assume the 12% “equity coupon” is here to stay, future investing results are primarily driven by a few factors, the most significant being: inflation, the Taxman (unfortunately for investors, the one by the Beatles is far more cheerful), and the relationship between market and book value. A thorough discussion about market and book value is beyond the scope of this writing, but the concept of Buffett’s 12% equity coupon is important and should be well understood by owners of stock (If I did a poor job explaining, please feel free to call me).

Just as bondholders face the inflation tax, so do stockholders. In times of high inflation, owners of all assets are worse off because the return from the assets you owned is lower in a real sense. And that’s why nothing costs a nickel anymore. This inflation tax is pervasive and often goes unnoticed, especially when compared to Uncle Sam’s doings. If $100 is invested in a bond yielding 5%, and the $5 of income is taxed at 20%, the after-tax return for the investor is 4%. However, if inflation is 4%, as it has averaged over the last half century, the real return after the inflation tax is 0%. This would be the equivalent to an income tax of 100% in periods of 0% inflation. I’d imagine far more outcries against the latter example.

So, are we all as doomed by inflation as Dr. Poole was by HAL 9000? Fear not! We simply must find and own companies (at reasonable prices) that have terrific economic characteristics and are able to increase prices in periods of inflation. An example should illustrate the point.

Let’s imagine we own shares of a wonderful bakery that produces the best cookies in Vermont and our brand is widely known and admired. Let’s call this company Delightful Treats. Delightful Treats competes against a poorly run bakery across town named Yummy Uncooked Cookie Kompany (YUCK). Both companies earn $20 million in annual operating profit after taxes, but Delightful only had to invest $100 million in tangible assets such as ovens, cooking ware, and inventory. YUCK, on the
other hand, had to invest $200 million in tangible assets just to earn the same amount of operating profit. The key distinction is that Delightful has far more economic goodwill than YUCK because our company has a fabulous brand and an untarnished reputation. Delightful earns 20% on invested capital while our competitor earns just 10%. Let’s also assume that both companies are constantly valued by the market at 10 times after-tax operating profit, or $200 million, initially.

Now, consider the effect that 10% inflation would have on these two businesses. Both companies would now need to earn $22 million in after-tax operating profit to keep up with inflation. This would simply require increasing prices by 10% for the same number of goods sold. To bring about this increased level of profitability, both companies would have to invest 10% more tangible capital in the business because prices for machine parts, inventories, and receivables would also increase by 10%. YUCK would need to deploy an additional $20m of incremental capital (10% of $200 million) to increase after-tax operating profit by $2 million and would then generate $22 million of after- tax operating earnings, and the market would value the company at $220 million (10x $22 million). This means that it took YUCK $20 million of capital to create $20 million of market value, a mediocre result. On the other hand, Delightful Treats would only have to invest an additional $10 million of capital (10% of $100 million) to increase after-tax operating profits by $2 million, and the market value of the company would also increase from $200 million to $220 million. Thus, Delightful was able to invest just $10 million of capital to create $20 million of market value.

This is why companies that have intangible assets such as brands are so valuable in an inflationary world. While no one can escape the inflation taxman, we can mitigate, and sometimes more than offset the tax, by searching for companies with wonderful economic characteristics and purchasing them at an equally wonderful price.