Where does the bail out path lead?

Inflation has been the topic of a few of the previous articles on this site. One article talked about how inflation is a manufactured phenomenon, and that deflation is the reality. Another article talked about ways we can deal with inflation, like by trying to out run it. And still another article mentioned Buffett’s comments on inflation in his 1983 Chairman’s Letter, but didn’t go in to the idea too far.

Buffett’s ideas on inflation

Let’s remedy that last one. Buffett’s idea is that he assumes that inflation will continue, so he’s looking to make investments in companies that will benefit from inflation.

Consider two different investments [1].

One company, a candy maker, needs $8 million in machinery to produce its goods and earns $2 million a year in profits. That’s a 25% return on invested capital.

Another company, a screw maker, needs $20 million in machinery to produce its goods and earns $2 million a year in profits. That’s a 10% return on invested capital.

Now consider what these companies would sell for. For a buyer, the first company looks more attractive if the buyer can just buy the machinery. If the buyer pays $8 million, the buyer can make a 25% return on the invested money. Even if the owner of the candy company raises the price to $15 million, the candy company is still a better deal. Only when the candy company costs $20 million does the return on the new buyer’s invested capital become the same for the two businesses. In this case that return is 10% in both cases.

However, now consider that we believe inflation will continue and that the costs to these companies will also increase. Let’s say that costs double.

For the screw maker, that means that the $20 million in machinery is now $40 million. But they are also able to sell the screws for twice as much, so they make $4 million a year in profits. The return on invested capital is still 10%.

For the candy maker, that means that the $8 million is now $16 million. And they too are also able to sell their candy for twice as much, so they make $4 million a year. So the original purchase price of $20 million, plus the new $8 million in inflated costs means that the total invested capital is $28 million. With a profit of $4 million, that means that the return on invested capital is ($4 / $28) about 14%. That’s much better than the 10% of the screw maker.

If the buyer now decides to sell the candy maker, the buyer should expect to get $40 million for it, since that’s how much someone would pay for the screw maker. But the candy maker buyer only paid $28 million total as opposed to the screw maker buyer who paid $40 million total. The screw maker buyer can break even. The candy maker buyer gets a ($40 – $28) $12 million profit.

So in an inflationary environment, a business that can make a higher return on its assets is worth more than a business that cannot.

Why bring up inflation now?

The solution being proposed by Congress is to buy our way out of the current problems in the financial sector. The proposal is to buy the bad loans from the banks that have them with $700 billion. That money is basically going to come from nowhere. It will be printed up and given to the banks in exchange for something that is not worth $700 billion. The way we know it’s not worth $700 billion is because there isn’t anyone else willing to buy these things at that price right now.

This is basically the engine of inflation at work. If you add $700 billion dollars to the money sloshing around in the economy, then the prices of everything rise to account for the extra money that people can now use to bid on stuff.

Unintended consequences

There’s a further problem caused by this bail out though. The government has now tipped their hand. Now an investor believes that any scenario that results in a blow up of the financial sector can count on a bail out from the government. So the investors have an incentive to risk more because they benefit from all the gains, but don’t have to suffer all the pains.

The more investors believe this, the more they are going to rely on it. The more they rely on it, the more real risk they ignore because they expect the government to bail them out. Until finally the real problems are so big that the government won’t be able to paper over them with printed money and the full force of the pain will fall on the investors, and probably everyone else as well.

This problem comes from the government trying to subvert natural laws. These would be things that go against the laws of physics. For example, the law of conservation of matter and energy says that you can’t create matter out of thin air. It has to come from somewhere. So if you try to create money or value out of thin air, eventually that’s going to come back to bite you.

Natural consequences

When I was a kid my brother and I would horse around sometimes. Eventually we’d knock heads or something and go crying to mom. She’d give us hugs of course, but then ask us if we were horsing around like we knew we shouldn’t be. We’d guiltily acknowledge and she’d sagely intone “Natural consequences”.

Mom was basically telling us that it was our own fault we got hurt and that the way of the world was that if you knew something was wrong, and you kept doing it, eventually you were going to get hurt.

Summing up

We’ve got the fact that deflation is the natural way of things, and that inflation is a manufactured phenomenon. We’ve got a way to profit from inflation by buying companies that make a higher return on their invested capital. We’ve got a government that is determined to use inflation as a problem solver until it no longer works. And we’ve got a reality that likes to knock our heads around to a harsher and harsher degree the longer we try to subvert it.

All that leads me to think that at some point the government is going to push inflation one step too far and prices are going to collapse and bring deflation back with a vengeance. I don’t have any insight into when that might happen. But if I follow my No Lose Stocks strategy then I should be able to benefit from the rise in prices due to inflation, and maybe even bet on the companies more likely to benefit from inflation (capital efficient companies). And if the prices do fall due to deflation, the Puts in the strategy will help me to keep my gains while other investors are scrambling to sell their investments.

[1] This example is basically the same example in Buffet’s 1983 Chairman’s Letter from the section called “Goodwill and its Amortization: The Rules and The Realities”, but you may find his version better, so consider taking a look at it. Do a search on the page for that title to find it. It’s in the appendix of the letter at the bottom.

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