Since we wrote The New Normal, we think it is fair to say we have gotten more right than wrong. But we don't believe in resting on our laurels. All investing is about the future and while it is nice to get some things correct, there is a long way to go.
Things change quickly, especially when there are several major conflicts happening. Any one country leader can change history and the future with a single announcement. Just look at the recent events surrounding the Straits of Hormuz and oil prices.
As we have said for the past 2 years, we are in a transition period where free markets and globalisation are dead, and we now return to a time when inflation was higher than expected (until economists get used to it and realise the 2-3% inflation target is dead).
A few weeks ago we gave a presentation about inflation and how we see it playing out. In terms of future stock returns, we see the 1964-1982 period as rhyming with current circumstances.
Here we want to present some thoughts about inflation and we will build on this theme over the coming months. Ultimately, we want to give you some information about that specific period to help you think about changing circumstances, how to position your portfolio, and what actions to take over the coming decade to protect your capital.
As we have been discussing on the podcast, we expect broadly higher inflation over the coming decade. The days of no or minimal price changes, thanks to less labour regulation, lower wages and interest rates, globalisation and China, are over.
We may have spoken about this Warren Buffett article previously, but it remains a good way to think about how inflation impacts your returns. Here is a highlighted copy of the paper:
"It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment."
"Over the years, and in the aggregate, the return on book value tends to keep coming back to a level around 12 percent. It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter)."
Buffett is highlighting that the returns on stocks have been fairly stable over the long term. Whether it was the decade ending in 1955 (12.8%), the 1960s (10.1%), or the 1970s (10.9%), the return on equity consistently gravitates back to around 12%. We should not expect any changes to that figure.
"Those who buy equities receive securities with an underlying fixed return, just like those who buy bonds."
1946-1966 were the golden years where investors received above average returns. However, as Buffett explains, when major investing institutions "discovered" equities in the mid-1960s, we entered an era of accelerating inflation and higher interest rates. Rising rates ruthlessly reduced the value of all existing fixed-coupon investments, and both the equity return of 12% and the reinvestment "privilege" began to look very different.
"The major claimants are labor, raw materials, energy, and various non-income taxes. The relative importance of these costs hardly seems likely to decline during an age of inflation."
Buffett is looking at the inputs to profits and determining that the costs of these inputs are rising, not falling. We cannot expect an increase in operating margins (allowing for competition) if costs are rising and cannot be handed on to the end consumer. Remember: demand should fall if prices rise.
Remember: this is for those who buy at book value. In CAPE terms, that means buying stocks when the CAPE is around 17.
"If my inflation assumption is close to correct, disappointing results will occur not because the market falls, but in spite of the fact that the market rises."
This is where we need to think about depreciation. If you have a company in a new or emerging sector like OpenAI, then you need to continue to buy the latest chips to keep up with technological advances. Inflation results in continuous price rises for chips and all other plant, property and equipment required to stay competitive. Your costs rise, and to maintain your operating margins you must be able to hand all those costs, plus additional costs, on to the end user.
Now think about Coke. Old machines that just pump out sugary water without any need to upgrade those machines. Or oil stocks that just pump that black gold out of the ground like they have for the past 100 years. Most of their costs have long been paid for, so they actually make more money thanks to stable costs. And being first in the supply chain, they can hand on additional costs if needed.
Older sectors and companies will most likely outperform technology stocks over the next decade. Businesses with long-depreciated assets, stable input costs, and supply-chain pricing power are better positioned in an inflationary environment than capital-hungry tech firms.
This is a good podcast on the future of commodities, and one we wholeheartedly support.
| Market | Index | 200-Day SMA | Status |
|---|---|---|---|
| Australia (ASX) | ^AORD | 9,045 | ▼ BELOW |
| United States | SPY | ~669 | ▼ BELOW |
Our 3 Wells portfolios have delivered a combined average return of ~30% across all three programs.
Past performance is not a reliable indicator of future performance.
Individual results may vary. Speak to your adviser before making investment decisions.
Essentially, Buffett is giving us a way to think about how stock returns will be delivered over the coming decade given high and rising inflation.