Earlier this month, the U.S. Federal Reserve decided to undertake a third round of quantitative easing as part of worldwide efforts to bring the lurching economy back onto firmer ground. And investors have been flocking to gold as a safe haven, as they’re wont to do in times of economic uncertainty. And though the Fed has promised to avoid inflation, what if they can't stick to that promise?
In Warren Buffett’s book, The Essays of Warren Buffett: Lessons for America, the Oracle of Omaha spends considerable time discussing the notion of investing in an inflationary environment, as Nat Stewart explains on Seeking Alpha. The idea of the book in general is weighing accounting versus economic goodwill, and asset light, high ROI capital businesses versus hard asset, lower ROI businesses.
When businesses can utilize their net tangible assets to generate a superior rate of return, then that premium value over the net tangibles is economic goodwill.
And of course, when a business is bought out at a price above its net asset value, that’s accounting goodwill. In simple terms, real economic goodwill doesn’t slide downward over time, but instead rises nominally alongside the inflation rate.
Popular investing advice will suggest that capital-intensive businesses are good investments in an inflationary environment. The Oracle begs to differ. According to Buffett, asset-light businesses that command high economic goodwill make for far better investments.
It’s interesting to note why he believes this is the case. First, asset-heavy businesses have to continually reinvest just to maintain their relative market position and sales figures. Second, when prices rise all around, any advantage of higher sales prices are nearly negated by the rising costs associated with higher capital spending.
On the other hand, an asset-light business is less capital-intensive; as such, it can afford to invest less and still maintain its relative position within an inflationary environment. On top of that, it can even afford to raise prices to consumers, and it can consequently earn more on every dollar it invests.
The key thing to realize is that these businesses tend to appear more expensive compared to asset-heavy, low ROI businesses. But as Buffett’s logic indicates, these businesses are in truth worth more, and their relative value only grows in an inflationary environment.
You can figure out the after-tax return on tangible capital with a mathematical problem to determine if a business qualifies as a good inflation hedge. It's one that a savvy investor could apply to the current economic scenario and, if they’re astute, even make off with a bit of profit while the Fed continues printing more and more money.