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.
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