About the Author: Jacques Caesar is a former managing partner at Oliver Wyman who now works on market assessment for the company.
Stock market investors have benefited from about three decades of reprieve from the dreaded “i” word, inflation. It could change. Investors should exercise caution.
Inflation is currently about twice as high as the Federal Reserve would like to see. The question is whether this surge in inflation is only temporary or the early stages of a longer-term trend. In its statement today, the Federal Open Market Committee noted “significant price increases in some areas” and announced its intention to begin reducing asset purchases this month.
There are some obvious and well-documented ways that inflation hurts equity investors. When inflation rises, the Fed typically tightens financial conditions to slow the economy. This puts pressure on earnings and also increases the “equity risk premium,” or the extra return an investor demands to take on the risk of holding stocks rather than a risk-free asset. Of course, not all businesses are affected in the same way; those with pricing power and less reliance on commodities will fare better than their less fortunate counterparts.
But there is another, more insidious way that chronic inflation affects equity investors: It wreaks havoc on anyone trying to assign values to individual companies. This is because accounting standards require that most businesses during times of inflation actually overestimate their true economic benefits, while forcing a smaller subset of others to underestimate them. Corporate profits essentially become a fun mirror.
The good news is that Warren Buffett knows how to spot these distortions, and by following his lead, investors will have a much better idea of what companies are really worth when inflation soars.
Buffett, the chairman of the Berkshire Hathaway conglomerate and perhaps the most influential investor of all time, can teach investors how to get through the fog. In his 1986 annual letter to Berkshire shareholders, he presented an antidote to inflation-tainted earnings which he called “owner’s earnings,” which he defined as a company’s cash flow minus everything. money spent to maintain the business. These represent the real economic benefits of the company.
Let’s say you own a bakery. You get money from customers, you pay vendors, employees, an owner, etc., and you keep the business in shape by repainting the walls every few years, etc. Let’s say you don’t grow the business or deal with it. What remains after all are the owner’s earnings.
If there is no inflation, there is no problem: the companies’ earnings report accurately reflects the profits of the owners.
In high inflation environments, however, most companies are required to overstate their profits. There are two main reasons for this. It gets complicated, but it boils down to how companies account for depreciation and inventory.
Depreciation is a deduction that allows businesses to spread the cost of a long-lived asset over its useful life, say 20 years, rather than charging it in full at the time of purchase. If there is inflation, replacing the asset at the end of its useful life would cost the company more than what the company took into account in its earnings reports. The result is illusory profit.
The same idea applies to inventory: Companies with large inventories tend to underestimate the cost of goods sold and, as a result, overestimate the income of their owners. This is because companies have a choice of which accounting method to use, and many decide to charge what they initially spent on inventory much earlier, and not its replacement cost today.
The distorting effects of inflation came under scrutiny in the late 1970s and early 1980s. A 1981 study, for example, found that after adjusting for these factors, Profits of 111 companies were 53% lower than the figures reported by the companies. At the time, large state-owned enterprises were required to file certain replacement cost estimates as supplements to their tax returns. But as inflation fell, investors became less worried and companies were no longer required to provide these estimates.
Even more confusing, inflation can have a positive effect on the financial position of companies that owe a lot of money, be it to bondholders, banks, suppliers or even the tax authorities. When it comes to repaying, these companies use inflated dollars, reducing the true economic cost of debt. When inflation is raging, the burden of debts such as loans, debts, and taxes becomes much more manageable, and the homeowner’s income can be greater than the reported income.
The problem for investors is now twofold.
First, the recent rise in inflation makes it more difficult to determine the true value of individual firms.
Second, inflation is a hash of general market measures such as the S&P 500. Oliver Wyman recently corrected the impact of inflation going back to 1871. The gap between owner profits and reported profits was particularly large. as a result of the great period of inflation, but persists. For example, on a rolling 10-year basis, homeowners’ incomes were 33% lower than reported income in 1992 and are still 9% lower today.
The recent rise in inflation is therefore worrisome: it will make most companies ‘profits look better than they actually are, and some companies’ profits will look worse. If the situation persists, investors would be wise to apply some Buffett-style skepticism to corporate earnings reports before making buy or sell decisions.
Guest comments like this are written by authors outside of the Barron’s and MarketWatch newsroom. They reflect the views and opinions of the authors. Submit comments and other comments to [email protected]