Words of Wisdom with Warren Buffett

February 27, 2018
Posted in Insights
February 27, 2018 DCT Capital Fund

Warren Buffett, chairman, and CEO of Berkshire Hathaway, one of the largest investment companies in the United States, has long regarded as an expert on inflation. He was able to predict and navigate through high inflationary periods in the ’70s and ’80s and warned about central banking policy affecting stocks. Inflation is on the rise again, making it a good time to look back on Buffett’s wise words before getting into stocks or real estate investment.

1. Don’t get too comfortable.

While success is important Buffett reminded his company success that “the inflation rate, coupled with individual tax rates, will be the ultimate determinant as to whether our internal operating performance produces successful investment results.”

Even if you acquire funds, success is not guaranteed.

2. Investors shouldn’t look just at earnings

Because the value of money will change with inflation, Buffett reminds us that gains in purchasing power are the only real way to determine earnings. Just because people are investing in a company doesn’t mean the owners are getting richer.

3. The ‘Misery Index.’

Buffett stated, “The inflation rate plus the percentage of capital that must be paid by the owner to transfer into his pocket the annual earnings achieved by the business can be thought of as an ‘investor’s misery index.’ When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.”

One’s misery index must be lower than one’s income.

4. Inflation makes running a business hard

To keep operating, a business must hold on to their earnings, but inflation makes this difficult to do. “Bad businesses” spend all their earnings and have no purchasing power as a result.

Buffett compared inflation to a tapeworm saying, ” 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 to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.”

5. Look to companies that make more than they spend

Inflation makes companies spend more just to stay in business. However, the numbers aren’t the important part. What matters is if it is less or more than the incoming revenue.

6. Invest in companies that can handle inflation and more business, while keeping expenses low.

Investing in companies that will adapt well to an “inflationary environment ” is the only way to go. Buffett describes these businesses as having ” (1) an ability to increase prices rather easily without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business with the only minor additional investment of capital.”

7. Focus on the Future

We see the past as the glory days even in finance. We look back fondly at what businesses did well in the past, but instead of looking at the past success of a business look towards how well these companies will meet future needs.

8. Corporations submit to government control

Buffett was able to recognize the limitations of his own company and others. A company may be doing well, but never have more purchasing power, because of the inflation caused by the government. This means corporations are always subservient to the government.

9. Take Heart

While inflation is almost inevitable in society, it is not the death nail for businesses or investors. Following Buffets words and building up your financial literacy can make investing less daunting in periods of inflation.