Editor’s note: The No. 1 worry on many readers’ minds today is what to do if inflation strikes. So over the last week, we’ve shown you several steps you can take to preserve and grow your wealth in an inflationary environment. You can read them here, here, here, and here. In this last piece of the series, we’ll show the single-best way to grow wealth in a crisis…
Most people think Warren Buffett became the richest investor in history – and one of the richest men in the world – because he bought the right “cheap” stocks.
Legions of professional investors tell their clients they’re “Dodd and Graham value investors… just like Warren Buffett.”
The truth of the matter is entirely different. And if you want to prosper during the inflationary crisis I see coming, it’s critical you understand that difference…[ad#Google Adsense 336×280-IA]Until 1969, Buffett was a value investor, in the style of David Dodd and Benjamin Graham.
That is, he bought stocks whose stock market capitalization was a fraction of their net assets.
Buffett figured buying $1 bills for a quarter wasn’t a bad business.
And it’s not.
But it’s not nearly as great of a business as investing in safe stocks that can compound their earnings for decades.
Take shares of Coca-Cola (KO), for example – they’re the best example of Buffett’s approach.
Buffett bought his Coke stake between 1987 and 1989. It was a huge investment for him at the time, taking up about 60% of his portfolio.
Later, other investors would bid up the shares to stupid levels. Coke was trading for more than 50 times earnings by 1998, for example. But Buffett never sold. It didn’t matter to him how overvalued the shares were, as long as the company kept raising the dividend. Coke’s latest quarterly dividend was about $0.25, so it’s paying out about $1 a year. Adjusted for splits and dividends already paid, Buffett paid less than $2 per share for his stock in 1988.
Thus, Coke’s annual dividend, 24 years later, now equals 50% of his total purchase price. Each year, he’s earning 50% of that investment – whether the stock goes up or down.
How could Buffett have known Coke would be a safe stock… and that it would turn into a great investment? Well, like Einstein said famously about God, Buffett doesn’t roll dice. He only buys “sure things.”
In his 1993 shareholder letter, Buffett wrote about his Coke investment and his approach – buying stable companies with the intention of holding them forever so their compounding returns would make a fortune.
At Berkshire, we have no view of the future that dictates what businesses or industries we will enter. Indeed, we think it’s usually poison for a corporate giant’s shareholders if it embarks upon new ventures pursuant to some grand vision. We prefer instead to focus on the economic characteristics of businesses that we wish to own…
Is it really so difficult to conclude that Coca-Cola and Gillette possess far less business risk over the long term than, say, any computer company or retailer? Worldwide, Coke sells about 44% of all soft drinks, and Gillette has more than a 60% share (in value) of the blade market.
Leaving aside chewing gum, in which Wrigley is dominant, I know of no other significant businesses in which the leading company has long enjoyed such global power… The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles.
Buffett is looking for companies that produce high annual returns when measured against their asset base and that require little additional capital. He is looking for a kind of financial magic – companies that can earn excess returns without requiring excess capital. He’s looking for companies that seem to grow richer every year, without demanding continuing investment.
In short, the secret to Buffett’s approach is buying companies that produce huge returns on tangible assets without large annual capital expenditures. He calls this attribute “economic goodwill.” I call it “capital efficiency.”
These kinds of returns shouldn’t be possible in a rational, free market. Fortunately, people are not rational. They frequently pay absurdly high retail prices for products and services they love.
Buffett explained how another of his holdings, See’s Candy, earned such high rates of return on its capital in his 1983 annual letter, which I urge everyone to read. In explaining See’s ability to consistently earn a high return on its assets (25% annually, without any leverage), Buffett wrote…
It was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price…
That’s the whole magic. When a company can maintain its prices and profit margins because of the value placed on its product by the purchaser rather than its production cost… that business can produce excess returns – returns that aren’t explainable by rational economics.
Those, my friend, are exactly the kind of companies you want to own.
And… you especially want to own these stocks during inflationary periods. As things get more and more expensive in the coming years, capital-efficient companies will have to buy less than other companies, on average.
The result will be that inflation tends to lift their profits, rather than reduce them. In the inflationary crisis I see ahead, this is the single-best way for stock investors to grow wealth, rather than lose it.