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Which stock will be most affected by inflation?
I believe Berkshire HathawayNYSE:BRK.B) is the best single stock you can buy to outpace inflation. This is not a new thought.Berkshire can be bought by almost any case. Berkshire has high pricing power in its businesses and a low cost capital. It also has a lower P/E ratio than the market, when you consider the investment value. These traits are reminiscent of Buffett’s ideas from the 1980s regarding the best investments in an inflationary environment.
I became more concerned about inflation when Texas was experiencing shortages of goods. These were made worse by the 2021 freeze. I warned my readers about the impending inflation spike due to the large amount of stimulus given to the economy. This was something anyone who has ever taken an intermediate-level economic class without conflict of interest could see coming.
In my quest for understanding which investments performed best in inflationary environments I came across Warren Buffett’s work. It was based on his experience investing in the inflationary 1970s. You can read the article for interested readers For guidance in these crazy times, here are Buffett’s thoughts on inflation.
Inflation doesn’t always occur in the fullness of time. Stocks should rise in real terms. Inflation is good for increasing revenue but does not make companies more profitable. Stimulus was a good thing for the market and made everyone wealthy, but now the bills are coming due. Inflation will not be sheltered by low-quality stocks, so investors will be subject to the double whammy – nominal losses as well as a loss of purchasing ability due to inflation.
Buffett pointed out in 1970s pieces that even though stocks rise in nominal terms, investors are often crushed by federal and state capital gain taxes. These taxes can lead to investors losing purchasing power. However, they also mean that investors are not getting richer if their “gains” are actually just keeping up with price increases. This is what the investor experience in 2022 shows – inflation continues to rise, but stocks are falling. Investors are losing purchasing power in nominal terms and even more in real terms.
In Buffett’s 1977 FortuneArticleInflation investing:
The main problem with the stock market is the fact that the return on capital hasn’t increased with inflation.It is no secret that stocks and bonds perform poorly in an inflationary climate.
Buffett also shared some wisdom about the best stocks to inflation in his 1981 annual letter. He called it a “tapeworm”, which forces companies to keep earnings and/or to sell stock to continue operating, which slows down valuations over time.
I have found that many things that appear to be good investments in inflationary situations may not be. It is clear from Buffett’s work and the 1970s that companies with a lot of inventory and other physical assets don’t perform well in inflationary situations. Companies that are heavily encumbered do not perform well in inflationary situations. This is because when rates rise to combat inflation, it becomes more expensive for them and their return of equity does not improve.
Buffett stated that the inflationary 1970s were the best years to invest in stocks.
The first includes companies that have bought businesses that are especially well adapted to an inflationary environment, either by accident or design. These favored businesses must possess two characteristics: (1) The ability to increase prices quickly (even when product demand and capacity are low) without fear of loss of market share or unit volumes; and (2) the ability to handle large dollar volume increases in business (often caused more by inflation than real growth) with minimal capital investment.
This is what we need to do when searching for stocks that will perform well in an inflationary climate. In an inflationary environment, the ideal stock is one that has strong pricing power and is not too capital- or financing intensive.
Why Berkshire Hathaway is the Right Stock For An Inflationary Climate
Berkshire is an excellent investment relative to the overall market. Investors agree with me, as Berkshire has the lowest short interest in the stock market. Today, Berkshire is well-positioned to follow Buffett’s advice about how to succeed in an inflationary climate, 40 years later.
1. Pricing power
Berkshire Hathaway is a high-quality business investor and has a significant number of investments made in companies with strong pricing power. Berkshire Hathaway shares Apple (AAPL), which accounts for about 25% of the company’s market cap, and has a lot of pricing power through its services business. Although I don’t like Apple due to its valuation and exuberant earnings estimates (but buying Berkshire is basically a free Apple), I do not consider it a great investment. The correlation between Apple, Berkshire and relative value is well-known and regularly mentioned by some the brighter minds. Looking for Alpha(“The backdoor way to own Apple”) I believe that Apple is a great business to own long-term, despite its valuation being far ahead of its actual value. This is where the backdoor trade comes in.
American Express (AXP), and Bank of America BAC (BAC) are other large holdings. These businesses are great for rising rates and inflation, respectively. Coca-Cola (KO) has a similar pricing power story to Apple. The valuation is a little too high compared with the business. This problem can be solved by buying Berkshire stock.
Similar to Berkshire, Berkshire private holdings also have high pricing power and quality, such as Burlington Northern Santa Fe and Berkshire Energy. Lastly, Berkshire’s investment arm is very powerful, as evidenced by its smart preferred and warrant deal, which it has with Occidental Petroleum, another inflationary winner.
2. Capital at a low cost
Berkshire Hathaway’s capital cost is one of its most coveted “secrets”. Berkshire Hathaway has the best capital cost. Insurance floatThe company continually takes in cash in the way of insurance premiums. They can then invest the money until they have to pay claims. One Famous study on BuffettBerkshire achieved a leverage of 1.7x (with no potential margin calls) mainly by using its insurance float at a cost that was 3.6% lower than the average LIBOR during the study period. The study also shows that Buffett has made a profit over time from an asset pricing anomaly called quality minus junk. This could be a very useful hedge against the Nasdaq’s (QQQQ) reeling.
Berkshire is unique because it can take up capital at rates much lower than inflation and then invest them. Berkshire’s operations are able to benefit from a rising rate environment and a falling stock exchange, as well as inflationary pressures resulting from the company’s genius design.
Berkshire can continue to increase rates and invest the capital in money markets or in bonds at a higher rate than they will likely have to pay in insurance claims. And if they can’t, Berkshire has always been willing stop writing insurance in unprofitable market, a key difference from its competitors. Berkshire’s ownership of companies that have strong pricing power will help to keep rates down. Investing in BRK.B stock will not hurt your pocketbook.
3. Reasonable valuation
Berkshire trades for approximately 26x earnings at the current price. Berkshire trades for approximately half of this amount. It likely trades between 10x-20x earnings depending on how you calculate its cash balances and investment portfolio. You can do a lot of detailed analysis on this topic as well as Berkshire’s book value and intrinsic values. But the main point is that Berkshire’s P/E ratio is lower than other companies because of the unique nature its business. Berkshire has A-class shares and B-class shares. This is because there is very little difference in practical value. It is easy to confirmYou can run a backtest. The main reason Buffett introduced B shares in 1990 was Wall Street is to be stoppedFrom making funds that only followed Berkshire and then selling them at a premium to investors who couldn’t afford the high share prices.
Moderate Risks
1. Key man risk
Without addressing the inevitable, no discussion about Berkshire investment is complete. Warren Buffett is currently 91 years old, while Charlie Munger was 98 at the time that this article was written. They won’t be around forever. Like the Queen they have outlived many of their critics but their succession will still be of great interest. Berkshire is similar to a monarchy in that they have managed to institutionalize a culture around work ethic and responsible risk-taking. They also invest for the long-term. Berkshire has always been a highly decentralized company. Decisions are delegated more to managers than is the case with other large corporations. It would be nearly impossible to run. This risk is something I cannot ignore, but it’s manageable. Buffett’s long-term experience has made it easier to plan for the company.
2. Macro risk
Berkshire is a highly-run company. However it isn’t immune from macro risk. Berkshire should outperform the market. However, the macro backdrop isn’t great right now. If we enter a recession or bear market, it’s unlikely that BRK.B stock would be up when the market is down. Berkshire’s strong financial position has proven over the years that it can buy back stock and make acquisitions, creating long-term value.
Honorable Mentions: Best Investments for Inflation
1. I-Bonds. While you get only $10,000 per taxpayer per annum, it’s still a great way to hedge against inflation risk. The current annualized rate is about 8%. You can buy through the U.S. Treasury. They must be held for a minimum of one year. Although our article series is focused on individual stocks, these bonds are worth knowing.
2. Vanguard Commodity Fund VCMDX Vanguard’s quantitative equity group has a really thoughtful commodity fund that combines commodity futures, awareness of contango/backwardation, and TIPs into one product with a 20 basis point annual fee. This is the best inflation hedge, aside from I bonds. However, they only have a $50,000 minimum. This means that you’d need to have about 10-20x as much assets to make this a useful hedge.
Bottom Line
There are stocks that perform better in certain inflationary environments than BRK.B. For example, if you knew in advance that oil would rise in price you could purchase something that is exposed to that. Berkshire Hathaway is the best stock for inflationary environments. The stock also has the bonus of not requiring you to accurately forecast the macro environment in order to profit.