Warren Buffett has been thinking about inflation for a long time. The legendary 90-year old investor had the dangers of inflation drilled into him by his Republican Congressman father, according to biographers, and has repeatedly commented on the subject throughout his investing career.
“We’re seeing very substantial inflation,” Buffett said at last month’s Berkshire Hathaway annual meeting. “We’re raising prices, people are raising prices to us. And it’s being accepted.”
Consumer prices jumped 4.2 percent in April 2021 compared to the prior year, the largest increase since September of 2008. The increase has unnerved investors, with some wondering if we could be headed for a return to the 1970s when inflation reached double digits.
So why is inflation such a concern for investors? Inflation, or a general increase in prices, causes you to lose your purchasing power over time. For investors, this can turn what appears like a positive return into a negative one if inflation gets high enough. Owning a bond paying 5 percent interest annually may sound like a solid investment, but if inflation reaches 6 percent, your “real” return goes negative.
How to beat inflation, according to Warren Buffett
With prices sharply on the rise again as the economy recovers from the COVID-19 pandemic, it’s worth revisiting some of Buffett’s best suggestions for combating what he once referred to as a “gigantic corporate tapeworm.”
1. Invest in good businesses with low capital needs
Buffett has long advocated for owning businesses that earn high returns on the capital invested in the business. During inflationary times, businesses with low capital needs that are able to maintain their earnings should fare better than ones that are required to invest more money at ever higher prices just to maintain their position.
Buffett once equated the challenge posed by inflation to “running up a down escalator.”
2. Look for companies that can raise prices during periods of higher inflation
“The single most important decision in evaluating a business is pricing power,” Buffett told the Financial Crisis Inquiry Commission in 2010. “You’ve got the power to raise prices without losing business to a competitor, and you’ve got a very good business.”
If a business can increase its prices, it has a big advantage during periods of high inflation because it’s able to offset its own increasing costs.
Buffett once said that an unregulated toll bridge would be the ideal asset to own in an inflationary world because you would have already built the bridge and could raise prices to offset inflation. “You build the bridge in old dollars and you don’t have to keep replacing it,” he said.
3. Take a look at TIPS
Treasury Inflation-Protected Securities, or TIPS, is another investment endorsed by Buffett for investors who are concerned about rising inflation. TIPS pays investors a fixed interest rate twice a year, but the principal amount is adjusted for inflation, as measured by the Consumer Price Index.
4. Steer clear of traditional bonds
“Bonds are not the place to be these days,” Buffett wrote in his 2020 letter to Berkshire’s shareholders. With interest rates still hovering near record lows, bond investors could be hurt significantly in an inflationary environment.
Buffett has pointed out that purchasing a 10-year bond yielding 2 percent is similar to paying 50 times earnings for a business, a key difference being that the bond’s earnings can’t grow.
“Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future,” he said.
What about gold?
Notably, Buffett has shunned gold, an asset often thought of as being a great inflation hedge. Fans of gold are especially fearful of inflation’s impact on paper money, a concern Buffett shares. But as he noted in 2011: “If you own one ounce of gold for an eternity, you will still own one ounce at its end.” Instead, he prefers to own productive assets such as stocks, real estate or farmland that generate dividends, income and food for their owners.
Recently, cryptocurrencies have occasionally been referred to as the digital version of gold, but Buffett is highly skeptical of these as well.
“Bitcoin has no unique value at all,” he told CNBC in 2019. “It doesn’t produce anything. You can stare at it all day, and no little Bitcoins come out or anything like that. It’s a delusion, basically.”
Bottom line
It’s still too early to tell if the current spike in inflation is likely to last or if it will prove to be temporary.
If you’re concerned about rising inflation, consider taking Buffett’s advice and own productive assets such as high-quality businesses with low capital needs and stay away from low-yielding bonds that don’t increase payments along with inflation rates.
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Article initially appeared on bankrate.com
Credit: bankrate.com, Merrill Lynch, NYSE
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