A multi-decade inflection point
By definition, a multi-decade inflection point doesn’t happen very often. We have had 40 years of falling interest rates, a fabulous tailwind for most assets and for the use of leverage. Interest rates cannot rise that much because of huge government indebtedness, hence the case for financial repression where rates are kept low and government debt is inflated away. Even if you don’t believe in the financial repression argument, it’s arithmetically impossible to have another 40-year tailwind from falling rates. (Unless you believe that rates can go to -5%; I would have thought that impossible at one time, but I am more imaginative now, having seen too many impossible things happen in markets over the past decade).
Inflation is here to stay
Of course, I don’t know this for sure. There are three main reasons why inflation will be a theme for at least the next decade:
- Globalisation has been a key driver of disinflation for probably the past 30-odd years. Even if relations with China were not strained and Covid had not opened our eyes to the supply chain risks, there would be a limit to how much disinflation further outsourcing to Bangladesh or Vietnam would bring. But the onshoring drive to make supply chains less vulnerable and to reduce our reliance on China will clearly be inflationary.
- The demographics are unfavourable – the baby boomers are retiring and the dependency ratio (effectively the ratio of retired people to people of working age) will rise in many Western countries. There will be fewer workers and although increasing numbers of robots will alleviate the worker shortage, this looks likely to be an inflationary pressure (although it hasn’t created inflation in Japan).
- Measures to combat climate change will be expensive – we could end up with electricity that is very cheap to produce and will bring us some relief from inflationary pressures, but that appears over a decade away. In the meantime, additional capacity will be built, often duplicating existing plant, and this greener capacity is likely to be a burden on consumers.
Why this is central to investment strategies
Inflation is a wealth tax. It hits the poorest in society most but it also hits the rich, if they have not invested to defend their capital. Bonds are a disaster in an inflationary environment. In the 1970s, the last period in which we had persistently high inflation, equity indices did not always keep pace and only select groups of stocks managed to deliver a real return.
Most importantly, I doubt that there are many professional fund managers around today who were investing in that period and who have hands-on experience of coping with the impact of inflation on their portfolios. . This is likely to be a very different environment from the ones we have become used to, particularly recently. The terminal value for a growth stock in 20 years might look quite different from today in an inflationary environment, unless it has inflation-linked revenues. We shall need to change our thinking.
David Einhorn’s approach to inflation
I recently talked to hedge fund manager David Einhorn, the founder of Greenlight Capital, whose portfolio is heavy on inflation protection. I am not sure if it was assembled with that objective in mind, rather these stocks are more likely to be ones he liked and where there is an inflation-protection overlay.
The first type of inflation protection is fee-based revenues. Brokerages come in different forms, but the commonality between a stockbroker and an insurance broker (or even a travel agent – remember them?) is that their revenues are a percentage of the clients’ transactions. So as prices go up, their fees are linked, and there should be a good element of inflation protection. They are people-intensive businesses, so they are inflation-protected rather than inflation-proof. David Einhorn has a position in a payments processor which, similarly, has percentage fee-based revenues.
The second type of inflation protection is sunk costs. Those readers who are old enough to remember the 1970s and sad enough to have an interest in accounting may recall something called CCA – Current Cost Accounting. Yes, even back then the accountants were dreaming up ever more marvellous ways of reporting, mainly it seems to give themselves more work and more fees. Under CCA, if you were in manufacturing, as most of the economy was then, you had two sets of accounts – the historical cost accounts were drawn up on the same basis as they are today. The current cost accounts purported to show what your profits would be if you had bought your fixed assets in today’s money.
It was more complicated, but the basics were something like this. There was a massive book of indices where you could find out what inflation had done to the cost of your assets. Say you had a press which cost you £10,000 15 years ago and had a life of 30 years. Today, because of inflation it would cost, say, £30,000.
The historic cost accounts had the asset sitting at cost £10,000, depreciation £5,000 and net book value of £5,000. The current cost accounts would have the asset at cost £30,000, depreciation £15,000 and net book value of £15,000. You get the picture – the asset used to produce your widgets had gone up massively in value. This confers an important advantage on you, as a new entrant wanting to compete with you using a similar press would have an entry cost of £30,000 and would have to charge prices commensurate with making a return on that investment. Your returns on a £10,000 cost are going to look pretty special in that environment.
Einhorn has two types of asset that seek to exploit such a situation. One is a housebuilder with an extra long land bank. This is exactly the type of situation to look for. Land is scarce in the UK and has been subject to inflation for many years, so smart investors have always looked to own builders with longer land banks. The valuation differential between builders with short and long land banks is only going to increase in the UK and it will also become more significant in the US. But this applies to any type of sunk cost.
This has a profound implication – for the past 40 years we have favoured capital-light businesses that enjoy high returns. Low-return businesses have been less attractive. The reason is that high-return businesses have delivered long-term returns to shareholders that have been close to their returns on capital; they have therefore been more attractive than their ugly low-return cousins. This relationship may not exactly be broken – a high-return business with pricing power will still be a good asset to own in an inflationary environment. But there will likely also be jewels among those ugly low-return businesses, which requires quite a change in thinking.
The second type of asset that Greenlight owns to exploit this situation is one where there has been a historic lack of investment, preferably with a long construction lead time – mining is the classic example. Again, there is a sunk-cost element which will play out with inflation, but here the capital cycle is also at work.
Those of you who have read Edward Chancellor’s books Capital Account or Capital Returns will be familiar with the concept – it’s usually very profitable to buy stocks in industries where capital is exiting. When the industry starts to ration capital and to be more disciplined in adding supply, or where it is closing capacity, returns usually improve significantly. This is true today of many mining and energy investments, and again this strategy is an effective hedge against inflation.
I shall return to the subject of inflation many times in this Substack and will explore the Capital Cycle in an Age of Financial Repression soon. I talk about the capital cycle in chapter 4 of my course How To Pick Winning Stocks.