The Nixon Penny and What You Need to Know About Inflation

The Nixon penny. A product of the early 1970’s. I’m old enough to remember it. The incredible shrinking pocket book. Inflation was running wild. The cost of everything was going up. Gas, bread, housing, you name it.

Are we returning to the 1970’s? It almost seems like it. Lumber and steel has skyrocketed. Meat is up 25%, and to exacerbate the situation there’s a labor shortage driving up costs even more.

As many of you know I’ve been talking about the possibility of inflation for a long time. There are some things that are inevitable but might not be imminent. In other words, you know it’s coming but getting the timing right is anyone’s guess. So is the case with inflation.

Today’s version of inflation seems to be event driven. Covid-19 came along and accelerated many trends, including the inflation I’ve been speaking of for several years. Supply chain and labor disruptions have driven up the cost of inputs for many businesses.

We all know that inflation affects our pocketbooks, but how does it affect your investments?

Some people claim that stocks do well in an inflationary environment, but I don’t agree with that. The market is made up of thousands of different stocks, all with different characteristics, funding requirements, etc. Just like people. People have different traits, habits and characteristics. Stocks are like people in that sense.

The reality is that not all stocks perform well in an inflationary world. Take restaurants for example. Increased labor and food costs lead to higher prices for the diner and smaller portions. It can be difficult for a local franchise chain to pass on all those costs to the consumer, so they have to eat them. (Sorry for the pun…I can’t help myself sometimes!)

There are very few businesses (stocks) that can pass all those inflationary costs on to the consumer. The result is usually lower profitability and lower profits for shareholders. Of course, not every business is totally impervious to the costs of inflation, but some have the ability to pass on those costs without their clients noticing. And that, dear reader, is the type of company/stock you want to own.

A typical example is Coca-Cola. During the inflation of the 1970’s, Coke was able to raise prices without it affecting their profitability. If you’re used to paying $2.00 for a bottle of Coke and it’s now $2.14 you’ll still buy it. 14 cents isn’t much to a thirsty customer, but as a percentage it’s 7%. That’s huge. But not huge enough to change your behavior. Coke passes the inflation on to the customer and most people are none the wiser.

Think about Microsoft. Microsoft’s Azure cloud computing platform is huge and still growing 30-50% a year. Its customers are large multinational corporations such as Samsung and GE. Microsoft is so dominant, and switching costs so high, they can easily pass on any inflationary costs.

Think about Google. Their Free Cash Flow (FCF) has exploded the last 2 years from $22B in 2018 to $42B. Their Android phone has 129M users in the U.S alone. Currently, Google doesn’t charge their users for Android or for their apps, but charging clients a small nominal fee of $8 a month would produce another $13B in free cash flow with very little incremental cost. In other words, almost all of that would fall to the bottom line. Google has lots of other costs like this it could pass on if it wanted to. You get the point — whatever inflation comes down the pike certain companies can handle it very well.

Inflation resistant companies share the following traits:

  • They all are extremely capital efficient.
  • They don’t require a lot of reinvestment to produce more returns.

For example, Microsoft doesn’t have to build a new factory every time their business grows, so most of the cash generated by their Azure business gets reinvested into the business.

You can identify these companies by their high returns on capital and steady profit margins. If you are researching investments and see both of those traits, you’re probably on to something.

Fortunately, those are the very businesses that we seek at CSH. We obsess over high returns on capital. It might just be the most important metric in investing. Not just in inflationary times but all the time. Amazon, Berkshire Hathaway, and Microsoft will do quite well in any environment short of an apocalypse. (Read more about how we work here.)

What about gold during inflation?

I’ve talked about owning gold for a long time. Gold has unique characteristics that other elements do not have. If I place 1 ounce of gold under a waterfall in 100 years I’ll still have 1 ounce of gold. I can melt it and as soon as it solidifies I’ll still have 1oz. Many pundits including Warren Buffet say gold doesn’t do anything — it just sits there. But that’s actually the point, Warren. No matter what you do to it, it still retains its original structure. No other element does that, and that is its store of value.

I think Mr. Buffett was emphasizing the fact that he’d rather own great businesses than gold, and I totally agree with him on that. Over time, a great business with a protective moat will outperform gold — probably by a wide margin. However, in the short to intermediate term gold can be an excellent hedge against inflation.

“Hey, what about bonds? My broker has me 40% in bond funds.”

Unfortunately, bonds perform very poorly in such a strained environment of inflation. This makes sense because their coupon, or interest rate, is fixed. In a world of rising prices, bonds lose ground every day. And if interest rates rise, bond investors can lose even more money. Bonds could face huge headwinds in the coming years.

A better fixed income option is TIPS or Treasury Inflation Protected Securities. TIPS are a low risk way to earn a little income and not worry about eroding coupons.

Another great hedge against inflation is commodities. In 2020 I talked about how disruptions in the oil supply would soon drive energy prices higher, maybe much higher. I would expect demand to accelerate going into summer as consumers can’t wait to leave home. OPEC is holding supplies tight and I would expect the supply demand imbalance to take time to resolve. In 2020 we established positions in certain oil and gas assets that are proving to be great investments.

Will the inflation of the 1970’s return? Will there be a Biden nickel? Over the last 12 months the inflation rate has spiked to 4.2% — the highest number since September 2008. As supply chains and the business world normalize I would expect that number to stabilize. But realistically, we just don’t know for sure. A major world disruption could change the equation at any time.

So here’s what you need to remember. In an inflationary world…

  1. Most stocks are OK, but many will suffer.
  2. Stocks with competitive moats that are highly capital efficient are the BEST choice.
  3. Bonds are bad in almost all scenarios.
  4. TIPS are good, but don’t count on big gains.
  5. Gold is the second best option. Gold royalty stocks will do well. Mining firms with low costs will do even better.
  6. Commodities will also do very well against inflation. But be careful — if you stay at the party too long you can give back all your gains.

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