Inflation Hurts Stocks Too

The massive amount of liquidity that has been pumped into the economy lately in order to battle a depression has left us vulnerable to severe inflation in the near future. Whether we will be able to withdraw these monetary injections has yet to be seen, however the risk of inflation poses risks to all types of investors. In 1977 when our country was in the midst of crippling stagflation, Warren Buffett wrote an article for Fortune called How Inflation Swindles the Equity Investor. In it, he details how inflation not only harms bondholders, but also stockholders.

It is commonly known that bond prices decrease with inflation because the fixed coupon payments quickly lose their purchasing power. People sometimes believe that stocks are a hedge against inflation since they do not have fixed payments but rather have earnings that can rise with inflation. The truth is that over periods of both high inflation and no inflation, the return on equity for stocks, like the coupons on bonds, hasn't really moved from its historical level of about 12%. This essentially leaves us with infinite, 12% bonds that pay out some of the coupon and reinvest the rest. Of course, investors only see these 12% returns if they purchase the stock at book value, however this is rarely the case. Overall, the market prices trade at a premium to book values.

So let's look to see if earnings can increase in periods of inflation. Buffett has identified five ways that earnings can rise:

• Higher asset turnover
• Cheaper leverage
• More leverage
• Lower taxes
• Wider operating margins

Now let's see if these scenarios come true during periods of inflation. As far as asset turnover, you won't see any change in inventory or accounts receivable turnover since they move proportionately to sales, regardless if the sales increase due to inflated prices or more volume. Fixed asset costs, however, will rise slower than sales because they have to be replaced less often. So we may see modest gains due to asset turnover at best.

Cheaper leverage is certainly not going to occur since the cost of borrowing rises with inflation. More leverage seems unlikely as well as American corporations are already heavily burdened by debt, and more debt would likely cause a drop in credit ratings, thus pushing borrowing costs up even higher.

Lower taxes seem unlikely as well. Federal, state, and local governments have a claim on the earnings of corporations that are both retained by the companies as well as those paid out to shareholders. They have the power to unilaterally change the size of their claim on these earnings whenever they wish, so why would they choose to lower it over the long term regardless of inflation?

Lastly, we come to operating margins. This is where many see the opportunity for earnings to outpace inflation. In real life the idea that large companies have pricing power in the market simply doesn't hold true in the aggregate, despite what theoretical models might show. Furthermore, the majority of their costs, namely labor and raw materials, will most certainly rise during periods of inflation.

So we can then conclude that as a whole, earnings can't really beat inflation. Thus, assuming the market trades on average at book value, the average investor can expect, after taxes, about 7% returns. In 1977, Buffett was expecting 7% inflation "in the future." For eight years following the article's writing, inflation did in fact average 7%, bringing real returns down to nothing.

While time has shown that historical inflation over long periods is actually lower than 7%, Warren Buffett indicated a few months ago that inflation might be coming again. It would be wise to heed his warnings and think twice before blindly rushing into the stock market if inflation is indeed on the horizon.