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.