INVESTING STRATEGIES - The Investor and Inflation

The Investor and Inflation
Inflation, and the fight against it, has been very much in the
public’s mind in recent years. The shrinkage in the purchasing
power of the dollar in the past, and particularly the fear (or
hope by speculators) of a serious further decline in the future,
has greatly influenced the thinking of Wall Street. It is clear
that those with a fixed dollar income will suffer when the cost
of living advances, and the same applies to a fixed amount of
dollar principal.
Holders of stocks, on the other hand, have the possibility that a
loss of the dollar’s purchasing power may be offset by advances in
their dividends and the prices of their shares.
On the basis of these undeniable facts many financial authorities
have concluded that (1) bonds are an inherently undesirable form
of investment, and (2) consequently, common stocks are by their
very nature more desirable investments than bonds. We have
heard of charitable institutions being advised that their portfolios
should consist 100% of stocks and zero percent of bonds. This is
quite a reversal from the earlier days when trust investments were
restricted by law to high-grade bonds (and a few choice preferred
stocks).
The investor must be intelligence enough to recognize that
even high-quality stocks cannot be a better purchase than bonds
under all conditions—i.e., regardless of how high the stock market
may be and how low the current dividend return compared with
the rates available on bonds.
A statement of this kind would be as absurd as was the contrary
one—too often heard years ago—that any bond is safer than any stock.
Here we shall try to apply various measurements to the
inflation factor, in order to reach some conclusions as to the
extent to which the investor may wisely be influenced by expectations
regarding future rises in the price level.
Common stocks have indeed done better than bonds over a long period
of time in the past.
This brings us to the next logical question:
Is there a persuasive reason to believe that common stocks are
likely to do much better in future years than they have in the
last five and one-half decades?
Our answer to this crucial question must be a flat no.
Common stocks may do better in the future than in the past, but they are far
from certain to do so. We must deal here with two different time
elements in investment results. The first covers what is likely to
occur over the long-term future—say, the next 25 years. The second
applies to what is likely to happen to the investor—both financially
and psychologically—over short or intermediate periods, say five
years or less. His frame of mind, his hopes and apprehensions, his
satisfaction or discontent with what he has done, above all his decisions
what to do next, are all determined not in the retrospect of
a lifetime of investment but rather by his experience from year
to year.
Inflation and Corporate Earnings
Another and highly important approach to the subject is by a
study of the earnings rate on capital shown by American business.
This has fluctuated, of course, with the general rate of economic
activity, but it has shown no general tendency to advance with
wholesale prices or the cost of living. Actually this rate has fallen
rather markedly in the past twenty years in spite of the inflation of
the period.
In the economic cycles of the past, good business was accompanied
by a rising price level and poor business by falling prices. It
was generally felt that “a little inflation” was helpful to business
profits. This view is not contradicted by the history of 1950–1970,
which reveals a combination of generally continued prosperity and
generally rising prices. But the figures indicate that the effect of all
this on the earning power of common-stock capital (“equity capital”)
has been quite limited; in fact it has not even served to maintain the
rate of earnings on the investment. Clearly there have been important
offsetting influences which have prevented any increase in the
real profitability of American corporations as a whole. Perhaps the
most important of these have been (1) a rise in wage rates exceeding
the gains in productivity, and (2) the need for huge amounts
of new capital, thus holding down the ratio of sales to capital
employed.
The stock market has considered that the public-utility enterprises
have been a chief victim of inflation, being caught between a
great advance in the cost of borrowed money and the difficulty of
raising the rates charged under the regulatory process. But this
may be the place to remark that the very fact that the unit costs of
electricity, gas, and telephone services have advanced so much less
than the general price index puts these companies in a strong
strategic position for the future.3 They are entitled by law to charge
rates sufficient for an adequate return on their invested capital, and
this will probably protect their shareholders in the future as it has
in the inflations of the past.
Alternatives to Common Stocks as Inflation Hedges
The standard policy of people all over the world who mistrust
their currency has been to buy and hold gold. This has been against
the law for American citizens since 1935—luckily for them. In the
past 35 years the price of gold in the open market has advanced
from $35 per ounce to $48 in early 1972—a rise of only 35%. But
during all this time the holder of gold has received no income
return on his capital, and instead has incurred some annual
expense for storage. Obviously, he would have done much better
with his money at interest in a savings bank, in spite of the rise in
the general price level.
The near-complete failure of gold to protect against a loss in the
purchasing power of the dollar must cast grave doubt on the ability
of the ordinary investor to protect himself against inflation by
putting his money in “things.”* Quite a few categories of valuable
objects have had striking advances in market value over the
years—such as diamonds, paintings by masters, first editions of
books, rare stamps and coins, etc. But in many, perhaps most, of
these cases there seems to be an element of the artificial or the precarious
or even the unreal about the quoted prices. Somehow it is
hard to think of paying $67,500 for a U.S. silver dollar dated 1804
(but not even minted that year) as an “investment operation.”4 We
acknowledge we are out of our depth in this area. Very few of our
readers will find the swimming safe and easy there.
The outright ownership of real estate has long been considered
as a sound long-term investment, carrying with it a goodly amount
of protection against inflation. Unfortunately, real-estate values are
also subject to wide fluctuations; serious errors can be made in
location, price paid, etc.; there are pitfalls in salesmen’s wiles.
Finally, diversification is not practical for the investor of moderate
means, except by various types of participations with others and
with the special hazards that attach to new flotations—not too different
from common-stock ownership. This too is not our field. All
we should say to the investor is, “Be sure it’s yours before you go
into it.”
Conclusion
Just because of the uncertainties of the future the investor
cannot afford to put all his funds into one basket—neither in the
bond basket, despite the unprecedentedly high returns that bonds
have recently offered; nor in the stock basket, despite the prospect
of continuing inflation.
The more the investor depends on his portfolio and the income
therefrom, the more necessary it is for him to guard against the
unexpected and the disconcerting in this part of his life. It is
axiomatic that the conservative investor should seek to minimize
his risks. We think strongly that the risks involved in buying, say, a
telephone-company bond at yields of nearly 71⁄2% .
But the possibility of large-scale inflation
remains, and the investor must carry some insurance against it.
There is no certainty that a stock component will insure adequately
against such inflation, but it should carry more protection than the
bond component.