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 protect yourself from hyperinflation

And another question from the FB page. Jane is asking ‘with all this money printing that's been happening already, how can we make sure that we are protected from inflation or even worse – hyperinflation?’

And we will be presenting a couple of points to help you guys be protected from hyperinflation.

1. Put yourself close to the raw materials
Stay close to land or anything that could be transformed like lumber. If you look at lumber - you need to have land, you need to cut down the tree it goes through a process and is transformed into standardized logs. Then it goes into producing furniture, then into storage and then you buy the final product at your store.

If you look at it there's a lot of added value that goes through the process of just taking lumber and selling it. And if you can get closer to the lumber then hyperinflation will have less of an impact on you because what you will do essentially is you will cut your own trees down, you will buy the machinery to cut it and make it and you'll learn how to process.

You'll get it at a lot cheaper price and it's the same with everything other raw material. If you can get closer to land transform it, sell it - you can protect yourself from hyperinflation. It's an easier way to protect yourself. The same goes for agriculture, forest, oil commodities, etc.

2. Learn new skills in high demand
In case of hyperinflation - all service in high demand will increase quickly. For example, the maintenance on your car - an essential service that you need it's going to be in high demand, because if people need it, they'll pay a lot more for the service

And if you can learn how to do maintenance on your cars, oil change, construction on your house, etc. this will have a lot of value.

Let’s say that right now it costs about $100 an hour – car maintenance and $65 an hour for construction. In case of a high inflation or hyperinflation - this is going to go a lot higher, and if you learn how to transform your time into value, then you can protect yourself.

All those skills that you learn you essentially can transform into money then or you can do your own house, you can do your own floors, you can buy your own product and work with it.

All of these decrease the impact of hyperinflation when you learn something, when you transform, when you look at doing the oil change. It takes 15 minutes to do your old change and you save about 30 to 40 USD.

And you multiply that by 4 - that's a lot of value in a little bit of time, that you can transform your time into.

3. Use debt to your advantage
So, the  inflation devalues the value of currency. This is something that a lot of wealthy people utilize. They use debt to get richer, because if you're saving money then that currency is being devalued at a very fast rate.

And if you're investing and you're using debt and if you can have long-term fixed debts, you could use that debt and use inflation to pay it off. But make sure that interest rates are lower than inflation if inflation is at 5-10%, make sure that your interest cost is lower.

Hyperinflation destroys the value of the currency by like 50% a month. That’s the worst-case scenario, if you have $100000 in the bank what's going to happen it goes from 100k to 50k, than it goes down to 25k and then 12,5k in just a couple of months.

When you use debt, that inflation will devalue the value of that long-term debt.

4. Invest in hard assets
invest in real estate, invest in gold, in silver, invest in land and commodities.

The only thing you need to be careful with gold and silver right is the huge premium when you want to buy it. There's not a lot of people that are selling it and if they're selling it, they're selling it with a huge premium.

And you would need insurance to store that gold so if you have it at home. There's a lot of companies that insure all your assets at home.

So gold, silver and land commodities, real estate are the best to invest in when hyperinflation or even high inflation hits.

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So, those 4 points cover at least the basics on how to protect yourself from inflation or hyperinflation, let us know in the comments which one is your favorite.

What is the state of the US real estate market (May ’21)

Today’s topic is about the US hyperinflation, and how is it going to impact the real estate market. And let’s start by quickly mentioning that the real estate market is crazy right now and the real estate prices are up 20%. Also, we’ve got stocks mostly up with some small exception, we've got commodity prices up. We're seeing prices of everything going up and it's because of the FEDs money printer.

The whole situation is  leading people with assets and wealth to have more of it, which allows them to shop for more real estate. More institutional buyers get into the rental real estate market. More people buying houses directly from ‘open door ‘or ‘zillow’ instant offers. Large landlord entities taking those properties away from other home buyers.

And this all creates more demand for real estate and drives up prices even more. Everybody with a pre-approval letter is immediately going to shop for a home. And the market is on pins and needles waiting to see what happens with longer term inflation. We have most investors right now knowing that we have massive inflation happening and we expect this inflation to continue due to supply shortages.

Over the near term the Federal Reserve takes the stance not to worry, as this is only transitory, and these issues are going to go away. We're told that these issues will not stay for the long term, inflation will come down, we'll balance out around two percent. And the rates will be risen slowly.

A lot of people in the investing markets, however, don't believe this. They're concerned that the Federal Reserve is going to lose control, that we're going to have hyper-inflation and maybe the mortgage rates are going to go through the roof and real estate prices will be going down.

We already know that there is a clear link between mortgage rates and home prices, or rental property prices, or cap rates on commercial real estate. Quick easy rule is the rule of 10x! For every 1% that mortgage interest rates increase - home prices rental property prices go down 10%.

If you get a half percent increase in rates, prices tend to go down five percent. A quick example of this happening in history – look at May of 2018. What you're going to find is the Federal Reserve started raising interest rates, resulting in real estate prices falling instantaneously within a matter of a few weeks. We saw real estate prices tank 10% - 12%. They recovered by the end of the year but only because the FEDs started reversing course.

Fast-forward to May 2021, the FEDs are saying ‘we're considering maybe injecting less cash into the markets.’ And the first target they'll likely look at is reducing their purchases of mortgage-backed securities. And here's what's happening right now. The Federal reserve is buying 40 billion a month of mortgage-backed securities.

When they stop buying these bonds mortgage rates are going to go up. And if you want to get into the real estate – you probably want to get into real estate before the taper. You can then lock in a 30-year fixed rate mortgage but be prepared for some potential volatility.

There are a two possible scenarios to occur in the following months. Scenario one is the inflationary direction. By September or October ‘21, the taper may have already started getting priced in. Mortgage rates might be higher, but the market's going to anxiously be looking if the rates are going to continue going up. And it will heavily depend on the inflation – is it going to stay, go up or down. This will determine if there is to be a crash or even further inflation.

In short-term – if you're trying to buy now, you probably want to get in before the FED starts talking about tapering mortgage-backed securities. Once that happens, probably the mortgage rates are going to jump up a good chunk, probably half percent would not be unreasonable, very quickly within a day.

You just want to lock in then, if you're thinking about buying after September, October, wait for September, October watch what happens – we will probably know then if the inflation is temporary. At that time, we would be getting the Q3 reports – so we will get an overview how are companies seeing inflation, what are company margins looking like, is inflation here to stay, is inflation starting to inflict downwards.

If we start seeing an inflection to the downside we might be at a place where we say the FED was right - we didn't get big long-term inflation. If that scenario happens - real estate prices could stay stable and potentially continue to trend in the current direction. Probably, not at those 20% rates, but more like 4-5% natural growth if the supply stabilizes.

The second scenario is if in September, October we start seeing inflation ramp up and not down. The short-term transitory nature of inflation we're expecting doesn't happen to be short-term – but long-term instead.  It happens to be systemic and lasts for 3-4-5 years.

The FED has to then raise rates much sooner than expected. That will force mortgage rates up even faster so the taper's going to push rates up. The FED freaking out pushes rates up and real estate prices could literally collapse.

if the fed had to raise rates say 2% in the matter of a month, be prepared for that potential change in market value. If you are locked in on a 30-year fixed rate mortgage - doesn't matter. Your payment doesn't change, nobody can margin call you, you're not going to lose your house

And if you have short-term variable rate - financing rates might change, and you should be prepared to have to start paying more on your mortgages. This is a risk factor if you have a 30-year fixed-rate mortgage you don't have that issue you can ride this out if you're looking to buy after September, October ’21.

The market is weird, right now, and a good advice would be only to buy properties if you can get them a hundred thousand dollars under market value. As an example, a property in California that is closed on $500 000, and could be sold at about $700 000, once the renovation of about $40 000 – $50 000 is done is a good investment.