In 1977, Warren Buffett wrote on article in Fortune: “How Inflation Swindles the Equity Investor”

Here are some key takeaways from the article

"The central problem in the stock market is that the return on capital hasn't risen with inflation. It seems to be stuck at 12%"

Stocks, together with bonds, perform pretty poorly in an inflationary environment. It's simple to understand why bonds perform poorly. When the value of the dollar deteriorates, a security with income and principle payments denominated in those dollars wont be a big winner.

People are however confused as to why stocks perform poorly. Stocks are usually thought of as a hedge against inflation.

What investors fail to understand is that stocks are similar to bonds. The aggregate return on equity capital for stocks has not varied and tends to lie at around 12%. So those who buy stocks receive securities with an underlying fixed return- just like bonds!

So we can view ROE as the "equity coupon".

There are differences between stocks and bonds:

So the main problem is that : As Inflation has increased, the return on equity capital has not.

One would ask what's preventing corporate America from increasing the return on equity capital in response to a permanently higher average rate of inflation.

Unfortunately the return on equity can't increase solely by desire, there are only 5 ways to increase the return on equity capital:

Increase turnover

-inflation will produce some gains in turnover ratios. This could be due to the LIFO inventory valuation models or due to sales rising more rapidly than fixed assets. However these gains wont result in substantial improvements in the return on equity capital

Cheaper leverage

-high rates of inflation generally cause borrowing to become dearer, not cheaper

More leverage

-in an inflationary environment the cost of leverage increases. Thus offsetting the usual benefits of leverage

Lowering corporate incomes taxes

Wider operating margins on sales

-labor, raw materials, energy and various non income tax costs tend to increase with inflation. This thus depresses margins

So we see that in an inflationary environment , increasing the return on equity capital( the equity coupon) is difficult and doesn't occur.

Thus the return on equity capital will not be able to increase upward in response to a higher average rate of inflation.

That’s all for today.