Given the recent jitters in the markets driven by inflation data, talks about tapering and rising interest rates, I thought I’d write an article discussing the issue at hand. Don’t get me wrong, I have previously shared about the futility of attempting to predict macroeconomic trends and my view has not changed. However, it is still important to understand these fundamental concepts and what they mean for investors.

Inflation

Inflation in layman terms is an increase in prices. This phenomenon is caused by an imbalance between supply and demand. As the pandemic threatened to force the global economic machine to a grinding halt in 2020, governments around the world rushed to prop up demand by flooding the markets with liquidity. However, the production of goods could not keep up with surging demand, driving prices up.

In other words, inflation results from efforts to get something for nothing. If the governments gave away money by taking away an equal amount through taxation, no inflation would result as the balance between supply and demand would be unchanged.

Consensus amongst most economist seems to be that a low and stable inflation is desirable for economic growth while deflation and persistently high inflation are both detrimental to economic growth.

Interest

Interest is the price of time. It measures the cost of having or doing now what we hope to be able to pay for later. Anything bought with borrowed money will cost more than buying with cash upfront. The difference is the price of time. This is true whether the borrower is an individual, a company, a city or country.

The buyer of time takes on an obligation to return the borrowed money and pay for the right to use the money now. In other words, debt.

There is nothing inherently good or bad about debt and interest. Debt is a merely a tool. Whether it is beneficial or detrimental depends on how one uses it. Many people have been ruined by debt. Many others have made their fortunes with borrowed money. The difference is whether the time borrowed is used profitably so that it is worth it.

Time value of money

This is a concept that is central to investing. Simply put, a dollar today is worth more than a dollar tomorrow. This is true for the following reasons

  1. Inflation means that a dollar can buy more today than the same dollar can tomorrow
  2. The ability to invest means that you may incur a opportunity cost
  3. The risk of not being paid back as the entity that owes you money may go bankrupt means that you would want to be paid as soon as possible

These three factors have similar effects. The promise of being paid $1,000 ten years later is worth less than $1,000 today. In fact, you will likely accept $800 if you believe that you are able to get a fair rate of return by investing your money elsewhere.

When we invest, we are forgoing spending that sum of money today. In order for this to be worthwhile, we must receive the same amount of money in face value plus some as compensation for the erosion of purchasing power, opportunity cost and the risk that we are undertaking.

Tying it all together

The relationship between interest rates and inflation is as such.

Nominal interest rates = Inflation + Real interest rates

The higher the rate of inflation the greater the cost of buying time – in other words, the higher the interest rate.

One of the greatest delusions is that the government can keep interest rates low while continuing to inflate the money supply. Sounds awfully familiar? This delusion stems from the widespread belief that the FED controls interest rates. In reality, the FED does not dictate interest rates as they are merely one of the factors that influence interest rates.

Looking at the divergence between inflation and interest rates today, it is only a matter of time before both converge.

However, the million dollar question isn’t “when will interest rates rise?” or “is hyperinflation coming?” No one has the answers to these questions. Instead, investors should all ask this question: “what type of businesses do well regardless of inflation?”

Traditional wisdom says that businesses with the greatest tangible assets will do well during times of inflation. This sounds intuitive but there is actually one type of business that does even better during periods of high inflation.

During periods of high inflation, the capital light business will do much better. The winning formula is intangibles of lasting value with relatively minor requirements for tangible assets. All things equal, the less capital intensive business will do better than asset-heavy businesses in the face of inflation.

By intangible assets, I am not referring the intangible assets and goodwill stated on their balance sheets that are likely not worth anything close to their stated value. When I refer to intangible assets, I mean economic goodwill in the form of competitive advantages that are difficult to quantify. This exists in various forms such as pervasive reputation with consumers based on past experiences with products and personnel (Amazon), brand name (Apple, Coke), being the low cost provider (Costco), network effect (Facebook) and many more.

Why do these companies do better than others during inflationary periods?

It goes without saying that when we invest, we want our investments to grow in real terms (ie be able to purchase more goods and services). This is done by achieving a rate of return in excess of inflation. And the best way to do so is to invest in businesses that are able to raise prices easily without investments in a lot of assets. Companies with these two qualities are able to earn returns far in excess of inflation (think about the companies mentioned above).

Note that throughout the entire article I give no thought to what the FED is going to do, whether inflation is here to stay or what interest rates will be tomorrow. It’s not that these are unimportant. They do influence the markets but they are simply unpredictable. Investors will do much better if they focus their efforts on things that they can control, such as picking excellent companies.

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