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.

Benjamin Graham about owners and inflation

 According to Graham, owners do not really care about their own interests. They let management act as they please when it is not in the owners' interest. Most owners never even consider the option of management acting against them. As a result, management controls the company and the owners as a larger group submit to its will. A company should always primarily act in the best interests of the owners and not give management the power to act the way they want. The owners, as a larger group, can decide how the company operates and, if necessary, get rid of managers who do not pursue their interests.

On average, managers know more about the company's business than the owners. This does not mean that they think in the owners' interest or that they are always capable of doing their jobs. Owners should not give managers the opportunity to act as they please, even though they are more likely to be right. Investors should investigate the actions of management if they find an attractive investment or owns part of the company. Many companies are poorly managed, which costs the owners lots of money.

The interests of owners and management are not always the same. In particular, compensation systems can destroy the value of a company. Options can generate significant income for management at the expense of owners. They can make management focus more on increasing the share price than on the value of the company. Options often create destructive incentives for managers, which hurts owners. Compensation systems that are higher than normal are always a red flag. The amount of compensation received by management is not directly proportional to their efficiency. Management can also grow the company in order to justify their increasing compensation.

In addition to the management team, listed companies also have a board of directors. The owners elect them at the general meeting. The board of directors must promote the interests of the owners. This works in theory, but in practice it is often overlooked. This is because management often proposes board members to the general meeting. In this case, board members can promote the interests of management because they receive a salary. This can happen if a board member does not promote management's interests. Often, the board of directors and the management team work in symbiosis, pursuing each other's interests while the owners are less concerned. Understanding the internal dynamics of the management team helps to understand whose songs the board representing the owners is singing.

The interests of the owners are not identical. In Finland, the owners of a listed company do not always follow the same line in terms of taxation. An ownership stake of more than 10% means tax-free dividends. This pushes the owners into different positions. It can change the dividend policy to favor large owners, which should reduce the attractiveness of the company as an investment. In the United States, on the other hand, the interests of the owners intersect, for example, when index funds own companies. There, the company management is allowed to decide, for example, on the management of pension assets, so index funds may have a conflict of interest with other owners. The management can threaten to transfer pension assets to another fund company if the index fund interferes with its proposals. This is one of the disadvantages of the growth of index funds.

The owner must guard his interests. Few owners do that. Individual owners can rarely influence the investment targets, but nothing prevents them from gathering a larger group of shareholders and thus influencing the company management or board. One option is always to sell the shares, but few owners do so even when there are reasons to do so.

Graham on inflation

Inflation is a creeping income trap. It eats away at investors’ returns year after year. About once a century it peaks, and once a century there is a longer period of deflation. Both are exceptional cases. They affect investors’ returns significantly in the short term, but over decades the effects of both even out. Graham’s Intelligent Investor states that from 1915 to 1970, the average inflation rate in the United States was 2.5%. In the 1970s and 1980s, inflation was much higher. After this exceptional period, inflation leveled off and has been roughly at the 1915-1970 levels.

From these starting points, we can conclude that inflation will probably be high at some point. This happened in 2021 and 2022. No one knows when that will happen gain. In the long run, stocks are the most effective inflation hedge, but in shorter time frames, there may be better alternatives. This applies especially to companies that can either increase their efficiency more than inflation destroys profits or companies that can raise the prices of their products more than costs rise. In the best case, a company can do both. Graham believed that assets on a company's balance sheet, such as real estate, machinery, and raw materials, protect investors more effectively than direct investments in gold or real estate.

When inflation becomes exceptionally high, most companies are unable to increase their earnings enough to offset the increase in costs caused by inflation. This increases the debts which increases costs. This makes bonds, among other things, more attractive alternatives. This exceptional situation will not continue for decades, but it makes bonds better options for investors than stocks. Investors need to monitor cost developments because it is not easy to notice the acceleration of inflation. It almost always takes a part of the investor's returns. Deflationary environments are an exception. At least the United States offers investors the opportunity to buy inflation-protected government bonds. Hedging against inflation is not free, so everyone should decide how much it is worth paying for it.