Hey everybody, welcome to invested. I'm Danielle Town. We're off this week. I'm going to play one from the vault for you and we'll be back next week with expert info. So enjoy your investing practice. Remember to be talking to friends and family and everybody around who might be complete experts on some random subject and just enjoy. Thanks everybody. Bye. Hey everybody and welcome to the invested podcast. I'm Danielle Town. My dad is out today and I thought it'd be a great opportunity to talk about something that I've been reading a ton about. I know I've mentioned it a couple of times on the podcast because I'm obsessed and that is the insane wisdom from the letters of Warren Buffett. So I'm not going to go through all the letters. Don't press stop on your podcast app. I promise not to go through all of them. If you want to know what they all say, of course, you can have access to that on the archive of my invested practice newsletter, which is at newsletter.DanielleTown.com. But today I'm going to talk about one particular piece of learning that I kept on over and over and over taking from these letters because it's so important to what's going on with our market today and that is inflation. So I started reading these letters and the first one I started with was 1977 simply because that's the first one that he offers on the Berkshire Hathaway website. Easy, simple, thought about starting earlier, but decided I wasn't going to torture myself or any of the other members of the invested practice too much and that we would just start with what Buffett wanted us to start with and that was 1977. So I got into 1977 and realized quickly that it was a much higher inflationary time than has really existed during my lifetime. Really, since I've been around, I mean, I was born in 1981, which had high inflation, but I was not terribly aware of it. So in my centi-ed years, I haven't really had inflation as an issue. And so starting back in '77 and reading, he didn't really mention it much in '77 or '78, but in '79, when inflation got up to 11.2%, he wrote most of his letter about inflation. And my take of it is that he didn't mention in '77 or '78, not because it wasn't important. Not because he wasn't dealing with it at Berkshire Hathaway. But because he was writing these letters in a public company as a new sort of out-there kind of public leader and I think he really wanted to just focus on what was happening in that company, which is what those letters are about there. What's happening in Berkshire Hathaway? He doesn't get into larger pronouncements, but then in '79, I think it was such a major world-changing potentially situation with inflation and the currency in the U.S. that he had to write about it. And in a funny way, because it's such a negative situation, but in a funny way, it gave us the buffet we know because that's the first time that he started writing about larger financial issues. And then that led to many letters about accounting and financial issues in the macroeconomic world and political issues then later on. He didn't get into political issues for a very long time, but eventually started talking about financial political issues. And then finally becoming kind of the oracle of Omaha that we know him to be. So it kind of in a way, I think, started with his comments on inflation in 1979's letter. I recommend going and reading if you're interested in really diving into his inflation comments from that time. '79, '80 and '81. Those are fantastic letters and then '83 also he talks a lot about inflation. So here are some things he said in the '79 letter, which were really just warnings to us. It was saying like, "This is a big problem, guys. Pay attention." And his warnings are not mild. His warnings are like out of the gate. Like never mentioned this before and all of a sudden he says, "Hello, this is affecting the stability of the American currency. This is a problem that potentially affects the stability of the future financial system." What he says is that inflation as it grows higher, and here it was at the time of this writing, it was probably a little bit higher than 11 percent. He says that runaway inflation on that level means severe doubt about the future of the financial instruments in that currency. So long-term fixed interest bonds that are in dollars may not continue to serve as a financial instrument at all. They may become obsolete. So he's sending these massive flare warnings out, saying to other investors and to people interested in Berkshire, "We don't know actually not only what's going to happen with the stock market. We don't know what's going to happen with the underlying currency here." And then he says, "There's no corporate solution to this problem. There's no corporate solution to the problem of growing inflation. As the currency becomes more and more worthless, companies do not have a method of dealing with that. They just have to deal with it. They have to do the best they can." That's what he says. And I'm going to redo a quote because this is actually from the 1981 letter. He says, "Inflation acts as a giant corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars, regardless of the health of the host organism. Whatever the level of reported profits, even if nil, more dollars for receivables, inventory, and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year in order to merely match. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm." Oh, it just gives me shivers. Okay, so what do we do about this? It's bad, right? And I'm not saying this is the situation we're in right now. But this is what he wrote back then in the late '70s, early '80s. And I think it's instructive because we keep hearing these giant warnings. So what do I do when I hear giant warnings? I try to educate myself. So here are his solutions. These are from the 1980 and '81 letters and then a little bit from the '83 letter. So three points here. I'm going to give you the three points and then I'm going to get into them. One is choose an investment that is indexed to inflation. Now, okay, I'll comment on that in a minute. So first choose an index that's indexed to inflation. Two, choose an investment that has a very little debt. Three, shift the measure of your success from earnings, which no longer mean anything, to actual gains in purchasing power. Okay, so let's go through those three. First of all, as I scroll up here, number one, choose an investment that's indexed to inflation. Okay, I mean, yes, like this is like every buffet and monger thing ever. It's like, thank you for that piece of information. How simple but not easy. And then he says, so after saying that he says very few investments are indexed to inflation. So here's what he gives in detail to look for here. By the way, I do not have a list of companies that meet this criteria. I wish I did. I don't know if he has a list of companies. He did not give one at the time. I think he says over and over these kinds of companies are very hard to find. But I think knowing what we're looking for is important. So he says that this kind of investment is one that has its earnings increase consistently with raised prices. And here's the key without adding any additional capital. So it's earnings increase in proportion with its raised prices. So it can raise prices. It still makes money on those raised prices. And it does all of that without adding in additional capital. And then he says Berkshire Hathaway is not a company that falls into this category, which I think is funny. And again, I'm saying this is from the early 80s letters. So it's not a comment on Berkshire Hathaway right now. So he's looking for companies that essentially convert earnings into cash without putting any more of that cash back into the business. And over and over in the letters, he repeats this point that it's a company that can continue to make money, can continue to raise prices, but can do so without putting its cash back into the business because it's going to need that cash just to survive. So as inflation gets bigger, as it intensifies, he says this is a quote. More and more companies find that they must spend all the funds they generate internally just to maintain their existing physical volume of business. There's a certain mirage like quality to such operations. However, attractive, those earning numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no strings attached cash. So again, the more money they're putting back into the business just to maintain their volume, the less well they're going to do as that money becomes worth less, which is what inflation is. By the way, the irony of me talking about inflation in such detail is not lost on me when I started my entire investing education saying, what the heck is inflation? I don't get it at all. So we've come a long way, baby, in five years. Yeah, it's kind of wild to sit here and do this actually. It's a good moment, though. We need to celebrate our small wins. And maybe for me, this is a small win, especially considering how hard this year has been. So to get back to inflation, now he goes further into what a inflation-favored business would be. So not just that it can continue to make money and raise prices as inflation grows. But it also has to be able to accommodate a large dollar volume increase in business. And that actually he says is produced by inflation rather than real growth. And again, only with minor investment of capital. He calls this an inflation adapted company. And so with those increased prices, they then can handle the larger volume without again, without putting the extra money in. And he says that, quote, managers of ordinary ability, focusing solely on acquisition possibilities, meeting these tests, have achieved excellent results in recent decades, end quote. So he's saying that non superstars have been able to do this again before the early 1980s. I don't know if you would still say that today. And so he's saying like this, first of all, it's happened. Companies have been able to do it. We can find these companies. Then he says there's another level. This is level two. Level two is that exact same kind of company, but then it's run by a superstar manager, which is my favorite thing, because finding a superstar manager who has a great company is just perfect. So these companies cannot only survive inflation, but he says that they actually can then use small amounts of their incremental capital at very high rates of return, and can actually do, and he doesn't say exactly, but I'm going to say decently well during an inflationary period. There is a section, which I don't have in my notes right here, but there is a section where he talks about companies, again, without naming them irritatingly, that have done so well during inflationary times that they are now at the time of his writing the letter, the companies of note. And I mean, of course that makes sense. If we're going to have an extraordinary company that I'm going to own for 10 years, 20 years, 30 years, of course that company is going to go through an inflationary period. It's part of the economic cycle. So it has to be a company that I'm going to be confident, has the ability to raise prices with inflation, and do so without putting a huge amount of money back into the business, thus negating the good effects. I will also add, and I'm going to put this for invested practice members, so if you guys want to join, it'll be in the next issue, and it'll always be on the archive, a whole section on his discussion of economic goodwill in the 1983 letter. If you go read the 1983 letter at the end, there's an appendix entirely about economic goodwill, and that essentially is how he thinks about an inflation adapted company. It's very interesting. Okay, two, very little debt. Now, this is something that I have extrapolated from his comments. I have not found a spot where he specifically said a company to get through inflation needs to have very little debt. However, I think it's an easily discernible belief of his because over and over, he does say that a well run company has very little debt, and that the dangers of debt will sink a company in bad economic circumstances in the 2010 letter. So way after those other letters, 30 years after those other letters, he says companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job. Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that's all that is noticed. Even a short absence of credit can bring a company to its knees. So that's from relatively recent 2010 and quote, and it's not specifically about an inflation-adapted company. But considering how many companies we see these days that do carry debt and that use financing to meet many of its obligations, yes, but also to grow. And remember that one of the points of his inflation-adapted company is that it does not need additional capital to grow. I think that that is an extremely important point for us to look at, to determine whether or not a company is going to be able to make it through a tough inflationary period, does it have to refinance its debt? Does it expect to refinance its debt in order to continue to do well? Does it depend on refinancing its debt in order to continue to do well? And if so, how is that going to work in an inflationary environment when interest rates are going up? So I think to me that's a key point. It's not explicitly said by Buffett, but one that I'm going to put in there. And then three, to shift the measure of success from earnings, which he says no longer mean anything on their own to the gains in purchasing power. And that's because, so this is like essentially a mental shift for us investors. But it's also an accounting shift. We got to look at what this money actually buys. Inflation creates a hurdle rate over which a company needs to make a return on equity in order to make any real return for its shareholders. So he describes it as running up a down escalator. In 1980, the inflation rate or the hurdle rate was 13%. I mean, 13%, that is, it's just unheard of to us in this world of ours, or in our low inflation world for so many years. When we see a company right now that's making a 13% return on equity, I think like that's pretty good. But in a world of high inflation, that's not even keeping up. So he says, in a world of 12% inflation, a business earning 20% on equity and putting it out is chewing up their capital, not enhancing it. And he goes on to explain that some of it will go to tax, some of it will give the business, the owners of the business some percentage of the purchasing power they possessed at the beginning of the year, even though they have not spent a penny of their quote unquote earnings. So making that shift in our investing calculations of frankly, going from a calculation and accounting point of view, a calculating point of view, that has not really included a lot of inflation numbers or inflation discussion even to one where, okay, inflation is actually a hurdle that we need to get over before we even see any money. And then that money that we do end up getting, what is it going to be worth? What can it actually buy? Is it enough to sustain this business? Is the bottom line of what Buffett is saying? So those are the three points. One, find an inflation adapted business and index an investment that's indexed to inflation. Very hard to find. I'm not saying it's easy, but that's the goal. Two, find one that has very little debt so that it's not dragged down as it needs to refinance with much, much higher rates. And then three, shift to the measure of success from straight earnings to actual gains in purchasing power and maybe even run some simulations of what that would look like in a high inflation environment. I think with those three elements will be not protected. I'm not going to say that, but decently well positioned for an inflating currency situation. I'm going to leave you finally just with this deep dive into whether equity really adds any value against what he describes as the headwind of inflation. He wrote this comment on change, quote, "It is much easier for investors to utilize historic PE ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable. It achieves little and slows response time. But when change is great, yesterday's assumptions can be retained only at great cost. And the pace of economic change has become breathtaking." And remember, this is from a number of years ago, but I think it applies to today. Oh, sorry, end quote. I always forget the end quote part of it. The pace of economic change has become breathtaking is the end of that. And that yesterday's assumptions can be retained only at great cost tells us we need to be ready to shift. We need to be ready to adapt to a new kind of market, to a new kind of economic situation, which may or may not happen, I don't know. But to be ready makes us more agile, makes us more anti-fragile, regardless of what happens. I mean, those kinds of companies just described as the inflation adapted companies. Those are fantastic companies, regardless. I don't care if inflation is happening or not. That's a great company. So it's a company that's anti-fragile in that it'll do fine, maybe even really well, maybe even better than a lot of other companies in an inflationary environment. And it will also do really well in a lower inflation environment. I'll leave you with one more thing. He also says, "The Noah principle several times in his letters." I think he likes it a lot. He says, "The Noah principle is that predicting rain doesn't count, building arcs does." Predicting rain doesn't count, building arcs does. And he often says that in the letters, alluding to how he did not build an arc, how he neglected to take action on an idea that he had. So he's always poking fun at himself. But it always strikes me as, "Yeah, it's easy to come up with the ideas. It's hard to actually put them into effect." So I feel this one. And with that, I wish you a wonderful investing practice. Again, if you want more of this kind of content, you can join the invested practice at newsletter.danieltown.com, where all of my summaries of all of the letters since 1977, we've been doing an investing intensive, are up on the archive. And we do calls and it's fun. And it's nerdy stuff like this, so I love it. Thanks, everybody, and enjoy. Hi, guys. Thanks for listening to Invested. If you enjoyed this episode and you want more information or to listen to additional episodes, visit our website at InvestedPodcast.com and sign up for my virtual workshop right there. Spots are definitely limited for this event. I'm not kidding. They really are. They sell out very quickly. So everything discussed on this podcast, by the way, is either my opinion or it's Danielle's opinion. And it's really important. It's not to be taken as investing advice because I am not your financial advisor, nor have I considered you a personal situation as your fiduciary. So remember that. You're on your own here. This podcast is for your entertainment and education only and I really hope you enjoyed it.
