Warren Buffett Part 3 Sustainable competitive advantage

 Sustainable Competitive Advantage

Competitive advantage refers to a company's ability to produce products or services that its customers want more than its competitors. It can also refer to the ability to produce them more cheaply, or both. The more sustainable a competitive advantage is, the harder it is for competitors to achieve it. A company with a sustainable competitive advantage generates more money for its owners than companies that compete fiercely with others. Companies with a sustainable competitive advantage use business models in which they offer unique products, services, or buy and sell products or services that people use constantly at a low price.

Buffett describes a company's competitive advantage compared to companies in the same industry as a moat. The wider the moat, the greater and more sustainable its competitive advantage. For Buffett, the most important task of an investor is to assess a company's competitive advantage and its sustainability. The moat rarely stays the same. Every action a company or its representative takes either increases, decreases, or keeps the width the same.

A friendly smile from a customer service representative increases the moat, and bad customer service narrows it. A wide moat is reflected, among other things, in a company's high profit margins and stable financial situation. Just because you can't see a company's moat doesn't mean it can't exist. According to Buffett, you have to find it if you want to invest in a company. A company's competitive advantage has two requirements: It must generate more than its cost of capital and it must have higher profit margins than its competitors on average.

The sustainability of competitive advantage excludes many companies and industries from consideration. A company must have at least a decade of history of demonstrating its competitive advantage so that an investor can distinguish it and assess the width of the moat. According to Buffett, an investor must believe that the competitive advantage will likely exist for another 25-30 years for the company to be worth investing in. New technologies offer opportunities for fabulous returns, but finding the companies that best utilize them is a guesswork for him. The prospects for long-term competitive advantage are largely obscure. In the early 1900s, there were a couple thousand different car manufacturers in the United States, and today there are only a handful. Choosing the right companies has been a matter of luck.

A company’s moat can have one or more sources. The following things can form a moat:

1. Supply-side economies of scale

2. Demand-side economies of scale

3. Brand

4. Regulation

5. Intellectual property

6. Corporate culture

When a company’s costs decrease as it increases the number of services or products it produces, supply-side economies of scale come into play. This gives the company greater purchasing power, which lowers unit costs. Large companies can specialize in products or services. In addition, larger size offers geometric advantages. A brewery can use larger tanks to brew beer, which lowers unit costs. In a market economy, industries tend to move toward a smaller number of market participants. Before long, a few players will share almost all of the turnover, with a few smaller companies competing in their own areas of specialization. Investors should focus on the market leaders or number twos. They share the majority of the market and are likely to be the most profitable companies in the industry. Even leaders in small areas of specialization have relative economies of scale.

When a product or service becomes more valuable to customers as more people use it, the company benefits from economies of scale on the demand side. Facebook and Twitter, among others, have this advantage. The same is true for credit card companies, which get more revenue the more companies accept their cards. Some companies benefit from economies of scale on both the supply and demand sides, such as Amazon. As its business grew, the prices of the products it sold dropped, which increased the number of customers. This increased revenue, which attracted more sellers, which lowered prices further, increasing the number of customers. This feedback loop worked to everyone's advantage. It doesn't work forever, but it has its limits.

Products or services create images in you that you associate with their name. The more you use them, the more it influences the images your brain creates. The value of brands depends on the collective images of large groups of people and their sum. The best brands have a greater sum of positive images than other brands. The best brands don't just sell products or services, they sell experiences. Customers are willing to pay more for brands, which increases a company’s profit margins. Brands add value to a company when they increase customers’ willingness to pay or reduce company costs.

Brands not only increase profits, but they also make customers buy products and services again and again based on the brand name. They also increase customer numbers through psychological peer pressure. Many people switch to a particular brand because others use it. Brands act as moats because the images they create own part of people’s brain circuits. The more you use the same products or services, the stronger the connections are formed. The easier it is to buy products and services from the same brand. The biggest mistake a company can make with its brand is to change it. Customers need to understand what kind of image they have of the product or service. Coca Cola came close to changing its main product, which would have resulted in disaster.

Some companies have a lasting competitive advantage because regulation has created a moat for them. Regulation often helps companies more than it helps customers, which increases profits. Credit rating agencies have a moat because regulation only allows them to participate in bond ratings. Some electric utilities have a moat because they are the only players in their markets due to regulation. Regulation may end, so companies that have a moat should only be invested in if they are certain that it will last.

Intellectual property rights, such as patents, can give a company a lasting competitive advantage. They can create a monopoly, but they do not guarantee it. Most patents are evasive. The protection offered by patents is not eternal, as they are usually valid for a maximum of 20 years. Patents work best in businesses where entering the market requires large capital expenditures. Neste’s biodiesel is an example, because its production requires large amounts of capital. This does not yet guarantee a lasting competitive advantage, but strong regulation with patents reinforces it. Individual patents rarely have any real significance, but large numbers of patents can act as a moat.

Corporate culture can be one source of sustainable competitive advantage. Corporate culture determines, among other things, whether mandatory personnel changes affect success. It is shaped over time. It is about ways of thinking. Focusing on long-term success, emphasizing simplicity, and other values ​​that are less often cherished in companies can act as part of the sources of sustainable competitive advantage. They rarely guarantee sustainable competitive advantage.

Warren Buffett part 2 Return on Equity (ROE) and inflation

 Return on equity and inflation

A high return on equity is one of Buffett's most important requirements when looking for investment targets. It tells you how well a company is using its capital. Buffett wants a consistently high return on capital. He studies the returns on equity for the last ten years in companies' earnings data. In the United States, the average returns on equity for the last 10 years have varied between ten and fifteen years. Buffett demands a higher-than-average return on equity in the long term.

Buffett does not see return on equity as a reasonable alternative to measuring the efficiency of financial institutions. Instead, he uses the return on total capital. He hopes this figure is above one percent. Too high a percentage tells Buffett that banks' businesses are too risky. Average returns on equity do not vary significantly over 10-year periods, so the magnitude of inflation directly affects average returns. The higher the inflation, the more it eats into investors' returns. It can also be seen as a tax that eats into profits. A company can improve its return on equity in five different ways:

1. By increasing the turnover rate of capital

2. By using cheaper loans

3. By increasing external capital

4. By reducing income taxes

5. By increasing the profit margins on its sales

Return on equity will decrease if any of the above goes wrong. In the first case, the most important things to consider are accounts receivable, inventory, and fixed assets such as factories and real estate. Accounts receivable increase in proportion to sales growth regardless of whether the reason is inflation or an increase in unit sales, so there is no room for improvement. In the long run, unit inventories follow sales growth, although in the short run the size of the physical inventory may vary. The inventory valuation method LIFO increases the stated inventory turnover rate during inflation. When sales increase due to inflation, inventory valuation either remains constant (if unit quantities do not increase) or follows sales growth (when unit quantities increase). In both cases, sales increase.

In the case of fixed assets, inflation increases the turnover rate, assuming that it affects all products equally. Machinery and other fixed assets must be replaced, but this happens slowly when sales grow faster. The slower fixed assets are replaced, the more the turnover rate increases. This activity stops when the replacement cycle is over. If inflation is constant, sales and the value of fixed assets increase at the same rate. Inflation increases the turnover rate slightly, but it does not matter much. Its size does not produce a large improvement in return on equity.

A company can improve its return on equity with cheaper loans. In the current situation at the end of 2016, this is hardly possible in Finland, as the ECB is buying bonds, which keeps loan prices low. Higher inflation makes borrowing more expensive on average. Strongly accelerating inflation quickly increases the need for capital. In this case, the replacement of existing loans is done at a higher price. This leads to a small decrease in the return on equity.

Additional debt increases returns, but it has its risks. In reality, the best investment targets need a small amount of debt or none at all, but the worst ones never get enough of it. Inflation is therefore irrelevant to the returns of the best companies. On average, the increasing costs of debt override the returns generated by a larger amount of debt. Investors should be wary of large amounts of debt. They should be a warning sign for investors. The average return on equity without debt is superior to the average return obtained with debt leverage.

Corporate taxation is in an interesting situation. The movement of capital around the world is becoming easier all the time and corporate taxation is experiencing downward pressure. This development can also be seen in Finland, where the tax rates paid by companies are on a downward trend. I do not see an end to tax competition. Rising inflation can raise corporate tax rates and reduce returns on capital. It is highly likely that this will have little effect.

Higher profit margins improve returns. The biggest margin reducers are raw materials, employees, energy and many taxes or tax-like charges. The relative share of these costs is unlikely to decrease during inflation. Rising inflation will probably reduce margins slightly. Most large companies, even large ones, cannot get their customers to pay for their inflation-increased costs by raising their prices sufficiently. Only a few companies are able to do this, and Buffett tries to focus on finding such companies.

These five factors do not increase returns much during high inflation. Investors have been getting roughly the same returns on equity on average from decade to decade. Inflation takes its toll. It averages around 3 percent over the long term in developed economies, but as it rises, average real returns decline at the same rate. Inflation is difficult to predict, so it has to be accepted as part of investing. During periods of average inflation, there is no need to focus on it. Buffett focuses on finding companies that have consistently high profit margins and/or high capital turnover. He also makes sure not to overpay for them.

Warren Buffett part 1 Introduction and definition of investing

Introduction

 “If I wrote a book about investing, no one would believe it was written by me because it would be so short.”

-Warren Buffett

Warren Buffett is perhaps the greatest investor of all time. His Berkshire Hathaway has returned an average of 19.2% on its capital over the past fifty years (1965-2015). During the same period, the S&P500 has returned an average of 9.7%. In reality, his personal annual returns are higher because before Berkshire he ran his own investment firm, Buffett Partnership, which returned an average of 30% per year. I have to use the word “maybe” because many investors have better average returns over several decades, but not over such a long period. After a certain point, the law of large numbers affects average returns, reducing them, so it is difficult to compare the numbers.

Buffett is certainly one of the best of all time, so his achievements cannot be underestimated.

More has been written about him as an investor than anyone else. Many have tried to find the secret to his success. In reality, there are so many reasons that few have found them all. I myself do not belong to this group. He is talented, but that is only one reason. I will not begin to guess all the reasons, but I will highlight a couple of the less understood ones. The first is that he has spent quality time understanding business and investing perhaps more than others. The second reason is that his quality time has been spent in an environment that has guaranteed maximum concentration on the essentials.

Buffett is known for spending about six hours a day studying business since he was young. He can be estimated to have spent about 100,000 hours of his life over seven decades. Such hours are not found in many other people in the world when it comes to investing. He has spent most of this time either in his office or at home in his own room. Both places have been minimally disturbed, so he has been able to focus on studying and understanding business. The benefits of this time are undeniable and he has been able to refine his talent into returns better than other investors.

Warren Buffett's most significant insight can be considered sustainable competitive advantage and its utilization in investment activities. Buffett has been able to create a method that allows him to identify sustainable competitive advantage by studying a company's financial statements over a longer period of time. In addition, sustainable competitive advantage can be sought without studying financial statements. I will focus on this issue in the chapter on Buffett's partner Charlie Munger.

Buffett has been able to simplify complex investment concepts, making things easier to understand. You can get more out of his interviews in a few hours than you ever could from high-paid investment advisors. I recommend getting acquainted with the wonderful world of YouTube. He is an almost perfect investor, but he also makes mistakes. Another way to get acquainted with his thinking is to read his annual letters to his company's shareholders. They contain a lot of useful information.

Definition of Investment

The definition of investment used by Warren Buffett and Charlie Munger can be found in Berkshire's investor letters from 2011, among others. It reads as follows: "Investing means transferring one's current purchasing power to others so that one can reasonably expect to receive greater purchasing power in the future after taxes paid." According to this definition, the risk of investment is the considered probability that an investment will cause a loss of purchasing power during the planned holding period of the investment.

From the definition, it follows that only one thing matters. The purchasing power of the capital being invested must be greater in the future than the present value of its purchasing power. To calculate future purchasing power, you need to evaluate four things:

1. How much money will the company generate for you during the investment period?

2. When will you receive that money?

3. The probabilities of the above?

4. How much will the value of the money received decrease over the entire investment period?

Things seem simple. In reality, figuring out the above-mentioned issues is not easy. Buffett's Berkshire has made most of its income from stocks. It has also invested its money mainly in bonds. He uses the same formula to calculate the future purchasing power of both. The biggest difference is that the amounts of money generated by stocks vary. The bond yields and their timing are known to the investor in advance.

The biggest differences between Buffett and theorists can be seen in what money he counts as owner returns. In addition, the time frame used differs significantly between theorists and him. The main difference is that others count only dividends as returns to owners if the shares are not sold, while Buffett uses, among other things, his own term, owner returns. Theorists use eternity as their time frame, and Buffett, according to my sources, uses ten years. This means that the probabilities are better on Buffett's side. He also doesn't believe he can know the exact numbers, so he uses Graham's safety margin in his investment decisions. In reality, most market participants operate with such a short-term perspective that they don't use calculations, although many do.

Probabilities vary depending on the target, so I won't comment further on them at this stage. Everyone can make their own estimates of the depreciation of money. Buffett believes that stocks can be seen as bonds. The higher the expected real interest rate and the probability of receiving interest, the higher the present value can be calculated for the investment. The cheaper you can buy a business, the better the returns you will get, if everything goes according to plan.

This is what investing is essentially about, namely increasing future purchasing power.

In Buffett's opinion, investing is overly complicated. It has its own categories, such as value and growth investing or business investing, but the goals are the same. These categories are not needed for anything. Using them can tell you few different things, depending on the person.

1. They don't understand enough,

2. They pretend to be smarter than they are, 

3. They try to stand out from the crowd. 

4. They can also be a combination of all of these or two. 

Alarm bells should always ring when dealing with people who use many categories.

Philip Fisher Part 17, His Mistakes and Summary

 Mistakes are inevitable and no one avoids them. How you react to them is more important. Fisher made them. They were concentrated at the beginning and end of his investing career. Early mistakes are inevitable. Most investors learn nothing, but the best ones learn even more. They have learned more from mistakes than from success, and successful investors are no exception. Fisher's late-career mistakes, according to his son, were largely due to his poor health.

Fisher was also a victim of the great stock market crash that began in 1929. He thought stock prices were expensive, but he still put his money in three stocks that seemed cheap with low P/E ratios. He lost almost all of his investments by 1932. He put his money in a locomotive manufacturer, a roadside advertising company, and a taxi company. From this he learned that a seemingly cheap price does not guarantee a successful investment. It can be a sign of weakness. Fisher also tried market timing three times. Each time, he made profits, but found them too small for his time, so he stopped the business when it was unprofitable. In addition, he struggled in the early days to set a suitable purchase price. As a result, he often missed out on stocks that would have brought him big profits.

It is not easy to expose errors in thinking, but I think Fisher’s belief in the importance of top management in good investments is excessive. To quote Buffett, “when a company with a bad reputation meets a company with a good reputation, the company’s reputation is what remains.” I think Fisher never understood that human irrationality can lead to a lasting competitive advantage. This is one reason why he was not good at investing in companies that sell consumer goods. On the other hand, he was good at focusing on the companies that he understood best.

Constantly worrying about everything bad was a characteristic of Fisher. It made him feel more secure. Even small details could make him worry about the risks associated with an investment. This made him abandon many investments because he did not dare to take even small risks associated with them. His returns were lower due to this character trait. He did not dare to take as calculated risks as many other top investors.

Summary

Fisher was the father of qualitative thinking. His process was long and demanding. It is not for everyone. It is easier to implement if you are extroverted and ready to talk. For introverts, it is difficult and perhaps too demanding. I do not recommend it for them. Fisher succeeded well at it for one reason or another, so it is not impossible for those who do not care about other people. Fisher believed that luck equals in the long run, so for him, continued investment success depends on skill and sound principles. Fisher's book Developing An Investment Philosophy contains eight principles that he used, which crystallize his investment philosophy:

1. Buy stocks of companies that have disciplined plans for long-term profit growth and the inherent qualities to let others enjoy their profits.

2. Focus on the above-mentioned companies when they are not popular in the market.

3. Hold the shares until the company undergoes significant changes or has grown to a point where it cannot be expected to grow faster than the general economic situation.

4. Investors focused on appreciation should downplay the importance of dividends, because the best opportunities for returns are found in profitable companies that pay little or no dividends.

5. Making mistakes is a necessary price to pay for large investment profits.

6. There are a limited number of great companies. Their shares are usually not available at attractive prices, so the investments must be large when the opportunities arise. Investments should be concentrated only in the best targets. Owning more than 20 shares indicates incompetence.

7. The basic ingredient of investment management is not to directly accept the views of investors or to oppose them without understanding reality.

8. Success in stock investing depends on hard work, intelligence and honesty.

Philip A. Fisher part 16 Mergers and Acquisitions

Mergers and acquisitions can be seen as threats and opportunities. They are both. They can be a good way to grow both business and profits. They often contain more hopes than the above. The wrong acquisition or merger can weaken a company's operating opportunities for a long time. This is especially true in a situation where the sizes of the companies do not differ much from each other. In individual cases, buying or merging with much smaller companies does not have much impact on the success of the investment target. Too many small acquisitions too quickly can be a problem.

The biggest risks for buyers come from the fact that sellers know more about the weaknesses and strengths of their company. They are also better able to assess the value of the business they are selling. This applies to cases where the operating performance of the sold companies is not in a weak position. The risks for the buyer depend a lot on the competence of the top management, according to Fisher. Bad managers can destroy the investment target with one wrong acquisition. Every merger and acquisition is different. Fisher developed general guidelines for evaluating them.

There are three main sources of problems in mergers and acquisitions. The first is a fight for top management positions. This can cause internal tensions and inflamed relations, even though top management should be blowing out the coals. The second is a situation where top management dominates the business of an industry in which it has no experience. This can lead to a decrease in top management's efficiency. The third situation is the seller's advantage in pricing its business. The buyer may pay too high a price for the acquired company.

Mergers and acquisitions in which the buyer moves down the value chain rarely pose a high risk to the owners. This applies, for example, to a situation where a company that manufactures and sells a final product buys its subcontractors. This applies to situations where the buyer can improve its cost efficiency and quality by doing things itself. Usually, the buyer then knows in advance what he is getting. In addition, the three main sources of problems are usually conspicuous by their absence in these situations. These acquisitions rarely have any significance for the owners. The same principles can be applied to moving up the value chain as moving down. There is an exception to this when a company buys a business that competes with its customers. In this case, the end result is almost always unpleasant for Fisher.

When a company buys a company that is much smaller than itself, the risk to shareholders is small, as is the reward. There are a couple of exceptions to this. The first is the opportunity to develop a new and significant business for the buyer with the help of the acquired company. The second is to get top managers on the company's payroll through this. For Fisher, the best chances for a successful acquisition or merger arise between companies that operate in the same industry and know each other's business inside out, understanding the problems each other faces. The opposite situation, where companies do not know each other and whose business areas are different, is likely to produce a poor end result.

The most successful companies in M&A rarely do so. They do not actively seek opportunities and act when the timing is most favorable for all factors related to their own business. In addition, they focus on companies in industries that are closely related to their core business. Risks increase when a company is constantly looking for opportunities to grow through M&A. This is likely to lead to excessive diversification of business operations and expensive acquisitions. Operational risks increase when the CEO spends a significant amount of time on acquisitions or considers them to be one of his most important things.

Buying a not-so-attractive business may not be wise, even at a low price. The reason for the attractive price is likely that it has nothing to offer the buyer. Fisher considers attractive purchases to be those that are a perfect fit for the buyer. Their price may be high, but they will bring him the greatest benefits in the long run. Buying several weak companies can kill the management's ability to develop the business in the long run. This is usually justified by the idea of ​​diversifying the business, which should strengthen the business being owned, but it has the opposite effect. Excessive diversification creates unnecessary strain on top management. It is difficult to find a single rule of thumb for the amount of diversification, but its speed provides significant clues to the investor as to its wisdom.

Philip A. Fisher part 15 Top Management

 Fisher puts the weight of top management in the quality of an investment at around 90%. I see this as an exaggerated figure, as many companies can be managed by almost anyone, such as Coca Cola. Even exceptionally good management cannot work miracles if the company is in the wrong industry. Poor management can destroy any business if given the chance, so the ability of top management matters. A wrong assessment of management ability can lead to a wrong investment. At the time of investment, an investor using Fisher's fifteen points as a guide will likely have enough information about the abilities of top management, but assessing the successors of managers can be difficult. The departure of previous managers is the moment when an investor is most likely to make a wrong assessment of top management.

Top management can reward an investor in at least two ways. The first and less significant way is by significantly increasing the P/E ratio since the time of purchase. There are limits to the growth of the P/E ratio. A more significant way is the growth of the earnings per share received by the investor compared to the purchase price. With good management, the company grows its earnings much faster than the market average for a long time, which enables top returns. According to Fisher, few people on Wall Street in his time could justify the goodness of an investment by saying that “senior management has begun to demonstrate its ability to increase shareholder value without the market noticing.”

The CEO is the most important person in the company. He must strive to maximize shareholder value in the long term, not the short term. In addition, he must surround himself with competent people and give them areas of responsibility to handle without interfering in their actions. They must work together to achieve clearly defined goals without internal power struggles. One clue to whether a company revolves around the CEO is the salaries of other top executives. He should not have an unreasonable salary for the next managers in the pecking order. This is a warning sign for investors. Salaries should be reduced gradually.

Even the best members of the management team and teams have traits that are undesirable. The good traits of great management more than offset the bad ones. When an investor carefully examines a company, he can notice possible weaknesses in its management. Fisher listed four different weaknesses that are relatively easy to spot. They may not be the most important, but not requiring that much expertise from the investor to spot them.

The first sign of weakness that an investor may see is a company’s board of directors, which does not have enough people who are involved in the actual business. This is especially true of companies where the CEO also serves on the board. In this case, the CEO usually wants to be responsible for both managing the company’s actual operations and the board’s work. He either does not have enough faith in the other board members or believes that he is always right.

Another sign of weakness can be a member of senior management whose sole task is to grow the company’s business through mergers and acquisitions. Only a few mergers and acquisitions are profitable. The mindset of such individuals shifts to pursuing their own interests, because corporate restructuring is the only way to justify salary payments. Before long, corporate restructurings are done only for their own sake, without caring about the interests of shareholders.

The third sign of weakness is when one or more members are hired to the company's board of directors whose expertise is based on a narrow area of ​​board work. In board work, each member must be able to view the business strategy and its implementation with sufficient judgment. Each member must be able to warn the top operational management when the company is not performing according to expectations or strategy. Seeking narrow expertise for the board indicates that something has been done or is being done wrong in that area, or that weaknesses are being addressed in the wrong way.

The fourth sign of weakness mostly affects smaller companies. When a company operates in too many separate business areas for its size, it is a sign of difficulties or that top management does not know what it is doing. Fighting on too many fronts means that resources are dispersed, which makes it difficult for a company to operate. A mixed bag of tricks rarely produces maximum returns in the long run.

Philip A. Fisher part 14 Inflation

Inflation reduces real income, as Fisher sees it. He saw it moving with social trends. These trends primarily regulate government spending. He believed that government was the main culprit. He believed that increased government spending created a self-reinforcing inflationary spiral. The spiral produced temporarily high inflation. He saw the cure for inflation as increasing efficiency and achieving it through science and product development projects. He believed that mediocre companies’ stocks would not fare well in the fight against higher inflation, but that quality companies would even benefit from it. Inflation eats into returns as both costs and taxes paid on profits increase.

Fisher believed that most investors misunderstood the origin of inflation. He defined inflation as meaning that the amount of services and goods available for the same dollar is less than before. He believed that the more people saw the government's responsibility to increase or maintain the amount of services provided to citizens, the more likely inflation was to be inevitable. The worse times got, the more pressure the government felt to increase spending. This increased inflation. Many see increased spending as a necessary evil in bad times, but Fisher disagreed.

Increased spending can lead to an inflationary spiral, where far-sighted people begin to prepare for faster price increases when they see the first signs of inflation. They buy products they will need in the future before their prices increase. Demand causes the prices of these products to rise more than expected. Others wake up to it too, and the spiral continues, growing larger. Storing unnecessary products causes inefficiency because it is not free. Fisher also believes that high interest rates contribute to the inflationary spiral, because they limit businesses' investment in cost-effective development inputs. Only the best of them are implemented and the others are postponed or abandoned.

Price increases are rarely endless and inflation does not often run rampant. Investors need to see it impacting returns and think about it in the long term. Investments must be able to increase returns more than inflation and investors need to understand that buying the right investment at the right time is more important than quickly hedging against inflation. True top investments are never made because of short-term factors, such as higher inflation.

Investors want to increase their real purchasing power, so the impact of inflation must be reduced by buying shares. A company that can significantly increase its earnings with high profit margins acts as an excellent inflation hedge because it can finance its growth internally. Such companies best increase investors' real returns. Companies that do not require large investments also often act as better inflation hedges, but there are exceptions to this rule.

Companies that are able to operate more cost-effectively by increasing their machinery can use economies of scale to combat inflation. As unit costs decrease, they can quickly pay back their large investments, even if the machinery becomes more expensive. Companies that have to keep their capital tied up in fixed assets, such as land, can also benefit from inflation, because the real price of land usually does not fall. In addition, many companies that receive their payments in cash do not suffer as much. In particular, service companies that do not have to wait for their payments or those service companies that do not have to tie up their capital in inventories can cope during higher inflation.

Not all capital-intensive industries are as bad as investors think. Rapid technological development in a capital-intensive industry weakens a company's ability to hedge against inflation. This is especially true for industries whose demand is not affected by rising inflation, and industries that do not have a shortage of supply. Demand gaps improve the ability of even capital-intensive companies to price their products. The product portfolios of capital-intensive companies ultimately determine their ability to act as inflation hedges. Capital-intensive and price-regulated companies act as some of the worst inflation hedges because, during periods of higher inflation, regulation cannot keep up with price changes.

Companies that are able to control their prices have the best inflation hedges. Companies that are able to pass on their increased costs directly to prices and quickly to customers will fare best when inflation rises. Fierce competition, high supply relative to demand, and regulation pose the biggest problems for companies when inflation rises. An investor doesn't need to fear inflation when they understand how well a company adapts to it.