In 1977, Warren Buffett wrote an article on the stock market and noted that the return on capital had not kept pace with inflation and remained stuck at 12%. Despite inflation and interest rates rising to 10% and potentially 15%, corporations struggled to increase earnings to compensate for the decline in the value of the dollar. As a result, stocks fell in correlation with bonds. Buffett saw stocks as "equity coupons" that offered the potential for internal compounding at 12% compared to bonds at only 3-4%. In the stock market, many investors engage in attempts to outperform each other, but this leads to increased costs from fees and charges, as well as a thriving options market that consumes resources without contributing to overall productivity. These costs reduce the investor's share of equity coupon. He believed the 12% return on equity capital (ROE) could not be improved and explored the ways investors hoped to increase ROE like increasing leverage or getting cheaper debt. Despite using these ways, every debt rollover was at a higher rate over a long enough term and the increased debt became burdensome. Buffett did not believe debt and equity were interchangeable and preferred measuring profitability by ROE instead of ROIC. He has only used debt when the return was sufficient to justify the risk and has not issued significant debt for Berkshire's capital needs.

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Inflationary v/s Deflationary market

Buffett recognized the benefits of investing in low-capital companies early on. One of his notable investments was See's Candy, which he bought for $25 million in 1972. With only $15 million additional capital, he received pre-tax cash flow of $2 billion, a return of 8,000% on his original investment. This investment became the blueprint for Buffett's investment strategy of investing in high-quality publicly traded companies with strong brands and competitive advantages that could increase sales with minimal capital expenditure and raise prices without significant loss in sales volume. Buffett's strategy proved successful in both inflationary and disinflationary environments, as the key principle behind it was strong return on capital, which is independent of external factors like inflation and deflation. The only challenge posed by the low-capital model is finding enough opportunities to reinvest surplus cash flow. To address this issue, Buffett started buying whole companies that could compound capital within Berkshire as subsidiaries, particularly regulated capital-intensive businesses like utilities. This approach allowed for internal reinvestment at a good rate, but it could not fully use up Berkshire's cash flow, which surpassed $100 billion, about 20% of market cap.

‍Difference in a stock coupon v/s bond coupon

Stocks and bonds are two forms of securities that offer different benefits and drawbacks to investors. Stocks are perpetual, meaning they have no maturity date, and are stuck with the return corporate America earns. The stock investor's equity coupon is partially retained by the company and reinvested, unlike bond investors who receive their entire coupon in cash. On the other hand, bonds eventually come due and the bond investor can renegotiate the terms of the contract if current and prospective rates of inflation make the coupon inadequate. Unlike bonds, stock investors cannot opt out nor renegotiate their commitment, which is actually increasing due to new equity flotations and retained earnings. Despite these differences, both forms offer an underlying fixed return, with bonds offering more flexibility. However, the bondholder receives their entire coupon in cash, while the stock investor's coupon is partially retained and reinvested.

Attractiveness

The stock market experienced a period of growth in the mid-1960s, with investors receiving a return on their investments that was far above prevailing interest rates, as well as a bonus due to the increase in the price of the Dow Jones industrials. This situation was caused by the high return on equity capital earned by corporations and the reinvestment of a portion of that return at rates that were unattainable elsewhere. However, the era of inflation and higher interest rates led to a reversal of this marking-up process, reducing the value of fixed-coupon investments and making the equity return of 12% and the reinvestment "privilege" less attractive. As a result, stocks are now considered riskier than bonds and investors are starting to expect a higher return on equity to compensate for the additional risk. Despite the fluctuations in the equity coupon, the group of stock investors can't completely exit the market, only achieving a lower level of valuation and incurring substantial costs in the process. Stock investors are slowly realizing that they also have a "coupon" that is not immune to inflationary conditions, just like bond investors.

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Higher ROE

The return on equity capital can adjust itself upward to reflect a permanently higher average rate of inflation. This can be achieved through an increase in turnover, cheaper leverage, more leverage, lower income taxes, or wider operating margins on sales.

1. Turnover increase: Accounts receivable go up proportionally with sales, and the situation with inventories is more complex as it can fluctuate over the short term. The use of last-in, first-out (LIFO) inventory-valuation methods can increase the reported turnover rate during inflationary times. During the 1970s, there was a trend towards LIFO accounting, which has slowed down but still exists and will result in some further increase in the reported turnover of inventory.

• Leverage: Cheaper leverage is unlikely as high rates of inflation cause borrowing to become more expensive. More leverage is also not feasible as American business has already heavily leveraged its equity capital. Lenders are becoming less willing to provide debt capital to low profitability enterprises, especially in the context of inflation, as they are aware that these companies often require large amounts of capital to sustain their operations. However, corporations may still turn to increased leverage to shore up equity returns, but this will result in higher costs and lower credit ratings, offsetting any benefits. The cost of leverage is likely to rise due to rising interest rates, and there is already a large amount of hidden debt in the form of pension obligations that are not reflected in conventional balance sheets. Shareholders should view the idea of increased leverage with skepticism as a debt-free business with a 12% return is better than the same return with a high amount of debt.

• Income Taxes: Investors in American corporations own what is referred to as a Class D stock. The Class A, B, and C stocks represent the income-tax claims of federal, state, and municipal governments. These tax-claiming investors receive a large share of the corporation's earnings, which can be increased at any time by the vote of a "stockholder" class, such as the Class A stock represented by congressional action. This results in a decrease of the portion of earnings remaining for the Class D stock held by ordinary investors. It is unlikely that the owners of the Class A, B, and C stocks will vote to reduce their share of the business in the future.

• Operating Sales Margin: Demands on the sales dollar, including labor, raw materials, energy, and non-income taxes, are unlikely to decline during an age of inflation. Furthermore, recent statistical evidence shows that margins did not widen during a period of high inflation in the 1970s. Most businesses are unable to raise prices based on replacement costs and this results in declining corporate earnings. Buffet concludes that none of the five factors are likely to improve returns on common equity during periods of high inflation.

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Retuns and Taxes

The return on equity investment is governed by three factors: the relationship between book value and market value, the tax rate, and the inflation rate. A consistent market value at book value will result in a 12% return for the investor, but if the stock sells at a premium or discount, the return will decrease or increase, respectively. Federal, state, and local taxes will likely average 50% on dividends and 30% on capital gains, reducing the after-tax return to around 7%. This suggests that stocks may be regarded as equivalent to 7% tax-exempt perpetual bonds for individual investors. Buffet argues that inflation is a more devastating tax than anything enacted by legislatures as it can simply consume capital, leaving no real income for investors. Buffet believes that future inflation rates will average 7% and that this will result in disappointing returns for investors, even if the stock market rises. Buffet argues that it is unlikely for investors to successfully turn in superior results, as they would still be worse off after paying capital-gains taxes. Buffet also points out that tax-exempt investors, like pension and college endowment funds, are not immune to the inflation tax and would still be paying "income taxes" even though they believe they are tax-exempt.

The Social angle

Inflation affects society as a whole, not just investors. Although investment income is a small portion of national income, if real income could grow at a healthy rate alongside zero real investment returns, social justice could be advanced. A market economy creates unequal payouts for participants and shifting all dividends from wealthy stockholders to wages would only slightly increase real wages. Diminishing the affluent through inflation will not provide material aid to those who are not affluent, as their economic well-being will rise or fall with the general effects of inflation on the economy. High real capital invested in modern production facilities is needed for large gains in economic well-being. If inflation is low, a large portion of earnings can be real growth, but if inflation is high, nothing is left for real growth. Companies facing no real retained earnings will have to improvise, such as reducing dividends or issuing new stock, which diverts capital to the tax collector and underwriters.

We can sufficiently expect the government will try to regulate capital flows to industry as traditional methods of private capital accumulation falter under inflation. The success of this effort will depend on the cultural and historical factors, with Japan being a successful example. However, it is likely that there will be continued problems with underinvestment, stagflation, and failure of the private sector to meet needs.

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Sources:

https://seekingalpha.com/article/4397187-buffetts-1977-fortune-article-on-inflation-yields-clues-for-dealing-deflationary-era

https://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/

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