Inflation continued

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When The Student Is Ready…

A week ago I wrote about inflation, and my closing remarks were that I wasn’t sure how to beat it, but that I thought your best bet was to just try to out run it with returns in stocks. Throughout the week that bugged me. I didn’t like that answer because no matter how fast you make gains, the government can just print more money.

About the middle of the week I picked up an out of print book (from the library) called “Paths to Wealth through Common Stocks”, by Phillip A. Fisher. So far I’m only through the first chapter, but it just happened to be that the first chapter was called “Adjusting to Key Influences of the 1960s”, and that the first “Key Influence” was “A. Inflation”. He writes about 21 pages on inflation in general and comes out with the following conclusion:

“From the standpoint of the common stockholder, there is only one protection against all this inflationary produced financial attrition. This is a management of such ability that it can produce a steadily increasing stream of profits.”

In his previous book, “Common Stocks and Uncommon Profits”, he extols the virtues of choosing a stock by paying attention to the management’s ability to steadily increase profits, so he’s not exactly stating a new idea here. He eventually concludes that you should ignore inflation and just pick good stocks, by his definition. But that got me to thinking about this topic again.

A Second Teacher Appears

Then Friday, I read an article from Stansberry and Associates. As an aside, we don’t have any affiliation with these guys other than that we use their products and we think they are quite insightful. They put out two free daily email services www.dailywealth.com and www.growthstockwire.com, which I highly recommend.

In that article, there was mention of an article by Chris Mayer of “The Rude Awakening”. The article is on his observations of the Berkshire Hathaway annual shareholders meeting. The part of the article I found interesting was a paraphrasing of Buffett:

“The best protection against inflation is your own earnings power. The second best is to own a wonderful business.”

That got me to thinking. Why would the best protection against inflation be your own earnings power? And how does that compare to owning a wonderful business? In my observation, Buffett agrees with Fisher, that a “wonderful business” is one where the management can continually grow the earnings. So it seems that at least in their opinion the answer here centers on earnings, whether that is from a company or from you and not on assets (like gold).

So what are earnings?

Earnings seem to be the value that society places on what a person does for society relative to what everyone else does for society. So if a person is a highly paid baseball player, then that person is seen to add more value to society than a minimum wage paid grocery sacker. I don’t watch baseball, but most likely someone that does watch, also produces something that I do find valuable. So I would hazard the hypothesis that we are all paid in relation to each other based on the value that we provide to everyone else, either directly or indirectly.

So let’s look at that in the context of inflation due to the Fed increasing the money supply, since that’s the only way that it happens. If the Fed increases the number of dollars available by printing more or by lowering the borrowing rates, then there are more dollars chasing the same amount of goods. This will naturally increase the number of dollars it takes to procure any of those goods because you are now bidding against others who need those goods and the producers are being charged more for their raw materials as well. So in a nutshell that’s where inflation comes from.

But if we are all paid in relation to everyone else, then when the money supply is increased, the same people or companies that were paid more than everyone else before, will still be the same people or companies that will be paid more now. Their earnings will inflate to match the amount of inflation because it has already been decided by society that they add more value to society than other producers.

A Mental Experiment

Now let’s do a mental experiment. If you gave every person the sum of one quadrillion dollars, you would do a few important things.

First you would destroy any savings in dollars that anyone had before because the amount that a person had saved before would be miniscule compared to what they had now. All of a sudden, everyone would be at the same level of wealth in terms of dollars. So any previous savings stored in dollars would be meaningless.

Second you would eliminate basically all dollar denominated debts. The amounts owed would become so small that they would be insignificant compared to how much money the lender now had, and how much money the borrower now had. Even the debts of the government could be paid off by one person. So immediately now no one would owe anyone else any appreciable amount of money.

Then finally all the things that had value, like land, food, water, etc, would all cost significantly more because everyone could pay more for them and the competition for these goods would drive the prices up to where people were spending relatively the same percentage of their wealth on these items as they were before.

But very quickly the people and companies that earned more in relation to others in society before would pull ahead and again (as they had before) earn more and amass more savings than the rest of society. These people and companies know how to provide more value to society and thus are rewarded with a claim on a higher share of the goods that society produces.

So from that experiment we can deduce a few things. The first is not to hold a large percentage of your wealth in cash. The second is not to hold a large percentage of your wealth in debt instruments like bonds or loans to others. And the third is that we want to own those companies that are already deemed to be worth more to society in terms of what they produce than other members of society.

So I would have to agree with Buffett and Fisher that the best way to beat inflation is to buy the stocks of companies who are already increasing their earnings. And as I’ve read before, earnings statements can be fudged, but when the company is paying a steadily increasing dividend, then they have to have the earnings to back it up. So by buying the stocks of these companies you are actually putting inflation in your favor. You’ll be swimming with the current rather than against it.

Inflatable Dividends Real Time Example Trades

Last week I picked a few Inflatable Dividend trades to follow. So let’s do an update and see where we are.

The first was SPG. We wanted to pay ($113.35 – $4.20) $109.15 for the buy write combo. On that Monday, the stock ranged from $113.51 to $114.95. The option ranged from $4.50 to $5.20. If we take the lowest combination there (assuming that the stock and the option tracked each other pretty well) we get ($113.51 – $4.5) $109.01, which is below our desired buy in price of $109.15. So I’m going to say our trade was executed and that we were in the trade at that point.

Our stop loss position is a stock price of $109.15. The price range for this week for that stock has been $114.95 down to $111.25. So we have not hit our stop loss yet. The expiration for this position’s option is on Thursday, so we should have a resolution to this trade this next weekend.

The second trade was ALSK. We wanted to pay $14.45 for the buy write combo. On that Monday, the stock ranged from $15.96 to $16.27. The option stuck at $1.75. The trade time was 1:59 PM ET. Looking at the data on Yahoo’s charts, the price from 1:55 to 2:00 PM was a high of $16.02, and a low of $15.96. So the worst case of buying at $16.02 and selling at $1.75, ($16.02 – $1.75) gives a price of $14.27. That’s below our desired buy in price of $14.45, so I’m going to say our trade was executed and that we were in that trade at that point.

Our stop loss position is a stock price of $14.45. The price range for this week for that stock has been $16.27 down to $15.46, so we are still in this trade and have not hit our stop loss yet.

The third trade was AEE. We wanted to pay $44.31 for the combo. Monday’s range for the stock was $54.02 to $54.60. For the option, there were no trades executed on that option since May 1st, but the bid was $10.00 at close and the close of the stock was $54.44. That comes out to ($54.44 – $10.00) $44.44, which is above our buy in price. This position might have actually been entered at some point during the day or even at another time during the week, but I don’t have enough data and I can’t say it was with a high degree of certainty, so I’m going to say we have passed on this one so far. I’ll check it again on Monday and try to keep closer track of it during the week.

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