Warren Buffett: how to invest during high inflation?

As inflation is a very hot topic in the mid of 2021, we've seen the FED saying, ‘this inflation we're seeing now is short term, and there is nothing to worry about’, on the other hand we've seen Warren Buffett talking about how he's seeing big inflation throughout Berkshire Hathaway's businesses. We've also got Michael Burry making a new big-short on bonds.

So how does high inflation affect the investors and what's the best way to deal with a period of high inflation?

All the investors want to do is - commit a certain amount of money to an investment and get more money back at some point in the future. But when we talk about inflation and investing it's more helpful to think of investing like - giving up a certain amount of buying power now, to have more buying power in the future. Like  giving up the purchasing power to buy 100 apples now in the hope that we have the purchasing power to buy 150 in the future

While you may make a 20% gain on an investment on paper over a few years if inflation is running rampant, there's a potential that your real return is zero. E.g. you could buy 100 apples before, then you make 20% on your, investment then you sell it, but after that you can still only buy 100 apples now. You've had no gain in purchasing power.

This is what Warren Buffett talked about in 1979. He said that a business with per-share net worth compounded at 20% annually, would have guaranteed its owners a highly successful real investment return, but now such an outcome seems less certain for the inflation rate coupled with individual tax rates will be the ultimate determinant as to whether our internal operating performance produces successful investment results.

It is just as the original 3% savings bond, a 5% passbook savings account, or even an 8% US treasury note have in turn been transformed by inflation into financial instruments that chew up, rather than enhance purchasing power over their investment lives

A business earning 20 on capital can produce a negative real return for its owners under inflationary conditions not much more severe than what presently prevail. And this was in 1979 and the inflation rate was 11%.

Buffett says the combination of the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business, i.e ordinary income tax on dividends and capital gains tax on retained earnings - can be thought of as an investor's misery index when this exceeds the rate of return earned on equity by the business the investors purchasing power real capital shrinks even though he consumes nothing at all.

Inflation is a crummy time for investors because when you take into account its rate - you can think about the annual percentage loss of purchasing power. If you couple that with either taxes you have to pay on income received through dividends and the capital tax the capital gains tax you have to pay when you sell then your real return on your investment could be negative even if the business is going well.

In 1980 Warren Buffett made the following analogy ‘the average tax paying investor is now running up a down escalator which pace is accelerated to the point where his upward progress is nil.’

And even if you are not an investor inflation can be a crappy time for businesses as well. Inflation eats away at the purchasing power as well and businesses generally need to buy a lot of stuff to keep operating. And if this stuff is now all of a sudden more expensive, they're trapped in a dilemma either they pay the higher price to operate, therefore making less profit or they raise the prices (produce more inflation) and hope that their sales volume doesn't shrink.

Inflation can also put upward pressure on interest rates which can make it harder for companies to access loans or make pre-existing loans more expensive to pay off, and this makes it much harder for the investor to pick great stocks that are going to compound money over time.

Warren Buffett explains what type of businesses tend to do well even in periods of high inflation. Such favored business must have two characteristics:

1. An ability to increase prices rather easily even when product demand is flat and capacity is not fully utilized, without fear of significant loss of either market share or unit volume

2. An ability to accommodate large dollar volume increases in business often produced more by inflation than real growth with only minor additional investment of capital

So, on the first one - an ability to increase prices and face no consequences. The business is feeling higher costs which hurt their margins so why not push those extra costs onto the customer if they can.

And you may think –‘ that is ridiculous, no company could do that, and the customers would just go and buy the cheaper product elsewhere, but not if the company has a moat.

If you're a small production company you've spent money to train all 50 of your employees to use Photoshop and Premiere pro and After effects - that took time, and it took money. Adobe suddenly decides to up the subscriptions ten dollars more per month.

Your company management might be thinking – ‘let's switch to a cheaper alternative, maybe you find a cheaper alternative, twenty dollars a month cheaper, great but it doesn't have all the same features as what the team's already using. Plus, it's going to cost two hundred dollars per employee to train them on the new software, not to mention the downtime your business will experience to get that training done and to switch everybody over.

If you think about the clients - they are already stressing you out, they're trying to get their productions finished, and at the end of the day it's just not worth switching. So, what can you do? You just pay the increased subscription, and you stick with Adobe, and pay more.

Another example: Apple has such a strong brand mode and a strong ecosystem that it's completely normal for them to squeeze a little bit more, and a little bit more out of all their customers each year.

In 2012 iPhone average selling price was just over $600. At the end of 2018, it was almost $800. Nowadays, it's even higher, and that's not even considering the plethora of add-on subscriptions. Apple will somehow force upon you whether it be AppleCare or iCloud or Apple Music, there's no escape and that's the point. So, during inflationary times look to the companies with very strong moats which can raise prices without consequences.

Secondly, you want the business to have an ability to accommodate large dollar volume increases in business with only minor additional investment of capital. So, if your business is not just able to pass on extra costs to the consumer, that means that you're going to have to cope with those costs, which means lower margins to generate your profit. It means you need to be able to increase the amount of business you're doing.

Essentially, what Buffett is saying here is - you want companies that are growing and are also easily scalable. For example - a shipbuilding company would struggle on this point. It costs a lot to build a big ship, you're not going to make huge margins doing it, but it's also very hard to increase the number of ships you're delivering each year. That would take enormous investment, into new shipyards and it'll be slow to wind up.

And if you consider a company like Facebook on the other hand if they can’t pass on the extra cost to their customers (which are the advertisers),  they could just choose to bump up the frequency of sponsored posts or of other ads. When a user is scrolling Instagram or Facebook they see three ads, instead of seeing two, and Facebook could do that very easily, and very quickly.

3. And Buffett has one more piece of advice for those seeking the best strategy during a time of inflation. Invest in yourself!

Sometimes there's just no escaping. Stock market investing in these times can be hard, so and given the fact that we're dealing with fairly high levels of inflation what can we do?

To improve your own earning power, know your own talents. Very few people maximize their talents and if you increase your talents, they can't tax it while you're doing it, they can't take it away from you. If you become more useful in your activities your profession - doctor, lawyer, auto repair, etc… - that’s the best protection against a currency that might decline at a rapid rate and the best investment.

And a good passive investment – is an investment in a good business. If you own an interest in a good business, you're very likely to maintain purchasing power no matter what happens to the currency.

Warren Buffett is indirectly acknowledging that it's hard to do well as a stock market investor when inflation just keeps ramping up. It's a bad time and your real return can be zero, so probably a better thing to do is invest in yourself, up-skill so that you can achieve a higher level of income. And your personal buying power would not fall - make yourself more valuable.

Overall, Warren Buffet gives us those 3 invaluable points. Those just come back down to the competitive advantage of you and your business – have a moat, be able to scale quickly and cheaply, and the last one is to invest in yourself.

How to make competitors irrelevant

Nowadays many business owners struggle to impress the consumers with their products in the endless sea of competition. Renee Mauborgne and W Chan Kim bring salvation to all of those businesses, experiencing frustration and inability to outcompete the other players on the market.

The book we are going to discuss today is Blue Ocean Strategy, Expanded Edition and we highly recommend it as the ideas and examples are mandatory knowledge for everyone doing business in nowadays oversaturated markets.

An overall belief is: if a business owner wants to be successful the business needs to beat the competition. But Renee Mauborgne and W Chan Kim believe that striving to beat the competition in an established market is a very unwise business strategy, especially if your business tries to compete over an established market (e.g. fast food, health & beauty, fitness markets).

If your business is trying to outperform the competition you are adopting what the authors call “Red ocean business strategy”. Nowadays, thanks to globalization, the widespread access to information, and the major improvements in technology it is very easy for business owners to try their luck into an established market. The consequences are vastly oversaturated markets, and the only business strategy for success in such markets is to compete with the other businesses for market share. Those battles (metaphorically) turn the waters bloody and this is where the term “Red ocean” comes from.

The alternative for the business owners is to sail past the “red oceans” and focus on searching and creating a “Blue ocean business strategy” for untapped market potential. According to the authors, this will greatly increase the new business’ chances of survival and profitability. The authors studied about 110 new businesses, across more than 30 different industries. About 100 out of those businesses adopted “Red ocean business strategy” and only a small number of businesses dared to adopt “Blue ocean strategy” to avoid competition. They searched for (and created) new markets to dominate. After some time, the authors measured the collective profits of all the companies and found out, that the “Red ocean” businesses only accounted for about 40% of the total profits, while the “Blue ocean” businesses managed to generate 60% of the total profits.

Renee Mauborgne and W Chan Kim studied the companies extensively for years and discovered that the “Blue ocean” businesses dominated their respective markets for 10 to 15 years after their initial launch, while many of the “Red ocean” businesses run out of business after a couple of years (or sooner).

As a business owner, you are probably asking “Ok, how could my business use blue ocean strategy and make competitors irrelevant?”. We will provide some examples of companies and how they did it.

Casella wines
They used a “Blue ocean strategy” to find an uncontested ocean of opportunity and dominate the market for over a decade, by creating a new category of wine, and become the best-selling wine in Australian and United States history.

Casella wines set out to create a successful new wine product. They knew the market is oversaturated and competing with existing wine brands in the traditional manner would be extremely difficult. If they have chosen a “Red ocean strategy” they would need to establish the brand over the span of several years and hope to win several awards along the way, hoping to gain the favor of existing wine drinkers. Those should have been a lot of investments leading to some very uncertain results.

Casella wines decided to take a different approach instead, and not only focusing on wine drinkers like most wine businesses. They mainly focused on beer and cocktail drinkers’ consumers in adjacent markets of other alcoholic beverages, who either infrequently drank wine or avoided wine altogether. They approached these non-wine-customers and ask them a few questions. E.g.: why did they avoid drinking wine and what was specifically discouraging them from drinking wine. These non-wine-customers shared many of the same reasons for avoiding wine. One of the most important reasons was that purchasing wine is intimidating, and having to choose from such a large variety of wines makes the process of purchasing wine overwhelming and time-consuming. Another important business discovery was that most non-wine-drinkers find wine unpleasant to drink – as it is either too bitter, harsh, or too sweet. Another reason was that those non-consumers believed wine is simply not so much fun to drink, compared to beer, cocktails, and other beverages. The wine seemed too fancy, traditional, and elitist.

Casella wines business accepted the challenge and set out to make a wine that would appeal to
these frustrated consumers of non-wine-drinkers. At the same time, they kept producing a wine that would be considered high quality to most wine drinkers.

The newborn wine product was called ‘Yellowtail’. The non-wine-drinkers found it very easy to purchase, drink, and enjoy. It was sweet enough to keep their palates fresh and keep them wanting more but not too sweet as to be associated with cheap and low-quality wine.

Casella wines had created a new category of wine that was fun, easy to drink, and relatively high
quality and ultimately caused a large portion of the non-wine-consumers to embrace the new category of wine. The new product provided incredible value; ‘Yellowtail’ was a high-quality innovative product at an incredibly good price. A price that was comparable with most beers and much cheaper than most of the cocktails.

The business strategy to create an innovative new product, while the same keeping costs low is what Renee Mauborgne and W Chan Kim call “value innovation” and it's at the heart of every “Blue ocean business”. To achieve value innovation and discover blue oceans of opportunity Casella wines adjusted four levers during the development of the ‘Yellowtail’ (eliminate, reduce raise, and create).
1. Eliminated the aging process of the ‘Yellowtail’ wine and saved money on oak barrels and storage costs.
2. Reduced the inventory to just two wines. They offered just a white Chardonnay and a red Shiraz. Operating at minimum inventory reduced the cost of their product, while simultaneously increasing the appeal to infrequent or non-wine-drinkers who valued something much simpler.
3. Casella wines raised the freshness and drinkability of their ‘Yellowtail’ wine, so it was easy on the palate like beer and cocktails.
4. Incorporating practices from adjacent markets like the beer industry Casella wines created a new wine label that was simple and somewhat adventurous like many beer labels. The label just had a picture of a kangaroo and stated that the product was from Australia. Casella wines removed information about the age of the wine and there was not any fancy terminology that stressed the art and science of winemaking and confusing the consumers. Casella wines also came up with a bottle that could be used by both white and red wine. The first of its kind, but it was something that the beer industry had been doing for years.

Playing with these four levers allowed Casella wines to create its own wine category of fun, unintimidating, easy-drinking wine and it attracted a whole new group of customers to the wine market in an area of the market that Casella wines could dominate for years to come and due to their “Blue ocean business strategy” they created the category of fun, easy-drinking wine they had a huge head start on the competition, making it extremely hard for competitors to steal any market share from Casella wines.

--
This is the power of “Blue ocean strategy” and there are several businesses which have used the strategy to dominate their market.

Another blue ocean business example is ‘5-hour energy’ (or the alternative Moose Juice Energy Shots)

It is a mini energy drink that you see on the counters of almost every convenience store in the US. ‘5-hour energy’ created the new energy drink market of two bottles, and it maintained a 93% market share of that market category despite competition from major competitors like Coke and Red Bull. Because the business owner created the category and got out to a huge lead on future competitors ‘5-hour energy’ continued to dominate that category nowadays.

if you, as a business owner are interested in finding blue waters for your next business idea and try dominating a market niche for years start by focusing on 1. the frustrations of customers outside of your current market space and 2. look at existing products or services within the market and ask yourself:
1. What can my business eliminate?
2. What can my business reduce?
3. What can my business raise?
4. What can my business incorporate?
… to create something new and attract infrequent or non-current customers.

By pulling these four levers any business owner can gradually develop a product that defies the status quo and creates a new product category that the business will dominate for years. As a business owner, you should stop focusing on how you could beat the competition and start focusing on how you can make the competition irrelevant. That’s what every business owner should learn from the “Blue ocean business strategies”, described in the book Blue Ocean Strategy, Expanded Edition

p.s. As usual, if you would like to support the 'Money Questions' blog - please buy the book and other linked products, using our affiliate links.