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It's no secret that inflation is a major topic for investors right now. With prices for housing, lumber, copper, steel, and a host of other commodities rising at the fastest pace in years, it's natural for an investor to wonder how inflation might affect the stock market and the economy. This raised two very important questions for me that I need to learn more about.
First, how will inflation affect future stock market returns? And second, how will inflation affect the stocks I own in my portfolio? To learn more about this, I turn to two investors who have weathered countless economic cycles and periods of high inflation. The legends themselves, Warren Buffett and Charlie Mayer.
Now let's take a look at these two clips of Warren Buffett and Charlie Munger from 2003 and 2019 explaining how inflation affects the stock market, as they are as relevant now as ever . Be sure to like this video and subscribe to the channel if you haven't already , because my goal is to help you learn about investing and the stock market by studying the best investors in the world.
Enjoy the video . Good morning. Good morning. My name is Matt Sauer and I'm from Durham, North Carolina. In a 1977 Fortune magazine article titled “How Inflation Cheats the Stock Investor,” you argued that corporate earnings in the aggregate act like a coupon on bonds and are therefore negatively affected by high inflation.
Due to high inflation at the time, you postulated a world where the 12% return on corporate stocks would decline to 7% after taxes and settle at 0% in real terms. You've been speaking out about the stock's outlook for several years now, and we suspect a significant part of that is due to extreme initial valuations .
If inflation was a decisive bad thing for investors in 1977, isn't its relative absence in today's economy at least one plus for stockholders? Is there also a component of expectations of future inflation in your warnings that investors are likely to be disappointed with stock performance? Well, I would...there's no doubt that the lack of inflation is a plus for owners.
I mean, the real return that you would get, I think, from owning an American business, if you bought it at similar prices, would be higher if we had long periods of low or...or almost no inflation, than if we had long periods of high inflation. I don't think there is any doubt about this, because this article further explained how nominal income and fictitious income are taxed in real terms.
So your question is , what is the best period for investors? A period of low inflation over any long period is better, um, for investors. Um, and the problem, as you pointed out, was also that the starting point for predicting modest returns for equity investors. Incomes were not necessarily so modest.
I predicted that they were just modest compared to what people began to think about income during that long bull market from 1982 to 1999. At that time, there were polls conducted by Gallup, which collaborated, it seems, with Payne Weber. Now they took it to UBS Warberg, who showed people's expectations in the stock market, and the return that people expected was 14 or 15%, as I recall, and they thought they would get 14 or 15% in a low inflation environment.
Well, it was, you know, a dream. And, uh, in a low inflation environment, there's nothing wrong with earning, you know, six or seven percent. This is probably as good as it should be, because in a low inflation environment, how much will GDP grow? Well, GDP, you know, if you have 2% inflation and even 3% real growth, you're talking about 5% GDP growth in nominal terms if GDP grows at that rate.
Over time, corporate profits will grow at more or less the same rate . And if corporate profits grow at 5% per year, the value of those corporate profits, the capitalized value, is likely to grow at about the same rate over any long-term horizon with a normal starting point. And add that to dividends and you get six or 7% to frictional costs.
Investors bear a lot of frictional costs. They don't have to, but they do it. And this is often one and a half, 2% of their investment. So, the math is not bad. It's just bad for ...those people who were used to or expected very high returns, looking in the rearview mirror back in 1998 or 1999. Charlie, my overall attitude is a little more negative than Warren's.
You heard it, people. This is not the end of the world. I mean, essentially, if the people who own American businesses get five to 6% of the pie, a $10 trillion economy, and now someday a $20 trillion economy. If we get, if we get five or 6% of the pie, those of us who invest our capital in producing goods and services for American businesses, former American consumers, the American population, that's, you know, I don't know if that's exactly what the designer of the universe would have thought of, but it does n't seem crazy to me in any way.
You know, I think that, uh , that's a lot of goods and services for people to invest capital in, but you have, you know, over 100 million people in the workforce working to transform that for you, using your capital. And it provides what I consider a pretty decent real return if you have low inflation.
If you have high inflation , as I wrote back in '77, you can easily have very, very low real returns for investors, possibly negative. I mean, inflation can fool a stock investor, as I wrote back then, and I use 7,000 words to explain why. And we'd be happy to send you a copy of this article if anyone else is interested.
But inflation is the only thing that can turn investors' aggregate returns into negative territory over an extended period of time, and it is the investor's enemy. Charlie, does this prompt any further thoughts? I don't think you'll get ideal help on these issues from the economics profession. Uh, they have some standard formulas for an economist, when a manufacturing job goes to China, it's just a certain increase in productivity, and if you ask someone, well, let's say all the manufacturing jobs in America went to China, wouldn't that be too much of an efficiency gain, and the answer would be no to that question.
comes from Mark Jordan of Charleston, South Carolina. He writes: “In a period of high inflation, which Berkshire Hathaway businesses will perform best and which will perform worst, and why?” “Well, the best performers will be those that require little capital investment to support inflationary growth and have strong positions that allow them to raise prices with inflation.
And, uh, uh, you know, we have, for example, a candy business , and the value of the dollar since we bought that candy business has probably fallen at least 85 %, I would say 80-85%, and that candy business sells 75% more pounds of candy than when we bought it, but it has 10 times the revenue and doesn't require much more capital.
So any business that has enough pricing freedom to compensate for inflation and does not require matching or huge investments to support itself will succeed. Uh, businesses like our utilities, which actually get a yield similar to bonds, but require, you know, if you're going to build a power plant, it's going to cost twice as much per kilowatt- hour of capacity.
Uh- huh, and all you get is fixed income, and bond yields will go up. maybe sharply to get high inflation, uh, won't work as well, uh, in an inflationary period, because it has certain aspects of being a bond-like investment, and bonds in general won't do well , uh, in an inflationary environment. Charlie.
Well, but like our insurance operations, uh , our capital-intensive rail business is certainly one of the best rail businesses in the world, and our utilities operations are certainly one of the best utilities operations in the world. So it's not so bad to be world-class in your core business. Our railroad, uh, the government has been talking about building a high-speed rail system in California.
I think they're talking about 800 miles of track, and their estimated cost was, uh, about 43 billion. And the estimated costs of building such things increase dramatically much more often than they decrease even by a small amount. And of course, we paid off 43 billion, including the debt we took on for the rail system, which has 22,000 miles of main track, over 6,000 locomotives, and, er , 13,000 bridges, if you ever want to buy a bridge.
Uh, so that the replacement cost of this asset during inflation is already huge, and it will grow sharply, and the world, our country will always need rail transport. Uh, so it's a great asset to own. I'll just leave it as is .
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