No. of Recommendations: 22
Considering the essay written by Buffett, (http://csinvesting.org/wp-content/uploads/2017/04/...), does it not imply that earnings fail to keep up with inflation?
From a layman's perspective, as I think of simple cases, it seems challenging for companies to maintain earnings growth. Let's take the example of a bottle of shampoo that used to sell for $10 say at Walmart. with Walmart's net profit being around 30 cents (3%). If the price of the shampoo increases to $10.50, it is likely that the profit margin may stay at 3% or even decrease. ...Well, regarding Mr Buffett's famous essay, bear in mind that it is not his finest work.
Truthfully, there is some very muzzy thinking in there, but let's ascribe it to infelicitous phraseology.
The biggest obvious one is the conflation of price and value, not a distinction you would normally expect Mr Buffett to blur.
But a key part of his argument is that the typical equity return on equity is very nearly a constant 12% (no reason at all to think that to be true),
and does not allow for the notion that even if true,
it would be the return on the true current real value of those assets, not the mis-stated book value of the equity that has shrunk in real terms because of inflation.Inflation will drive down the apparent book value of physical earning assets in real terms, but that is no reason to suppose that those assets will have any lower real return.
In effect, inflation will (on average) cause reported ROE and ROA to rise. (same real return on same real assets, but understated asset value).
If a machine makes 20 widgets an hour, then the price of everything (including new widget machines) doubles due to inflation, it can still produce 20 widgets, not 10.
The real return on that asset is unchanged. The apparent return (naively calculated ROE in nominal dollars) doubles.
A much better line of reasoning goes like this: assume we have broadly-based inflation of (say) 10%.
The purchasing value of a currency unit falls. Everything goes up in nominal price, but the real price of everything stays the same.
All salaries go up a nominal 10%. All product and service selling prices go up a nominal 10%. All energy and material input prices go up a nominal 10%.
The inevitable consequence is that profits will go up a nominal 10%, and margin percentages will remain unchanged.
So, it is clear than in the case of evenly distributed inflation, real profits will be unaffected.
So the things to concern yourself about are only the company specific exceptions, and the smaller effects.
The main company specific exception is debt, which is fixed in nominal terms.
Companies with net debt will benefit from the erosion of the real value of their debts, and companies with (say) bond ownership will take a hit.
There are also effects because
changes in inflation hit different companies at different speeds, which mean inputs and revenues may mismatch for a while.
This is largely a function of pricing power...everybody will raise their prices, but some companies will feel free to do it sooner than others.
Some companies will have distortions in their
reported earnings, quite separate from possible distortions in their real earnings.
Railroads are the usual example: they have massive long-lived assets requiring maintenance capex, so their accounting depreciation will substantially understate their real economic depreciation:
the replacement cost of a worn-out piece of track might be a big multiple of its old depreciating book value in current nominal dollars.
In other words, reported profits will be higher than true profits (owner earnings). A lot of what looks like expansion capex will really be maintenance capex.
Another accounting quirk is the book value of real estate, which will cause firms with land to have book assets lower than their true real value.
But, the base line situation is inflation is pretty much a wash for real corporate profits, with the caveats mentioned above.
(on average across the economy but not every specific firm, after cyclical adjustment, and not inflation so high that the economy fails)
A rise in inflation often coincides with or precedes an earnings recession, but that will pass.
Once the dust settles, companies in general keep on making real profits on about the same old trend.
This makes sense in theory--if everything else goes up in price the profits will too--and matches the historical data.
Jim
