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 princi-pal. 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 institu
tions 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.

By the late 1990s, this advice—which can be appropriate for a foundation or endowment with an infinitely long investment horizon—had spread to indi-vidual investors, whose life spans are finite. In the 1994 edition of his influ-ential book, Stocks for the Long Run, finance professor Jeremy Siegel of the Wharton School recommended that “risk-taking” investors should buy on
margin, borrowing more than a third of their net worth to sink 135% of their assets into stocks. Even government officials got in on the act: In February 1999, the Honorable Richard Dixon, state treasurer of Maryland, told the audience at an investment conference: “It doesn’t make any sense for any-one to have any money in a bond fund.”restricted by law to high-grade bonds (and a few choice preferred stocks).

Our readers must have enough intelligence 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. In this chapter 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.

In this matter, as in so many others in finance, we must base our views of future policy on a knowledge of past experience. Is infla-tion something new for this country, at least in the serious form it has taken since 1965? If we have seen comparable (or worse) infla-tions in living exp
erience, what lessons can be learned from them in confronting the inflation of today? Let us start with Table 2-1, a condensed historical tabulation that contains much information about changes in the general price level and concomitant changes in the earnings and market value of common stocks. Our figures will begin with 1915, and thus cover 55 years, presented at five- year inte
rvals. (We use 1946 instead of 1945 to avoid the last year of wartime price controls.)

The first thing we notice is that we have had inflation in the past—lots of it. The largest five-year dose was between 1915 and 1920, when the cost of living nearly doubled. This com
pares with the advance of 15% between 1965 and 1970. In between, we have had three periods of declining prices and then six of advances at varying rates, some rather small. On this showing, the investor should clearly allow for the probability of continuing or recurrent inflation to come.

Can we tell what the rate of inflation is likely to be? No clear answer is suggested by our table; it shows variations of all sorts. It would seem sensible, however, to take our cue from the rather con- sistent record of the past 20 years. The average annual rise in the consumer price level for this period has been 2.5%; that for 1965–1970 was 4.5%; that for 1970 alone was 5.4%. Official govern-ment policy has been strongly against large-scale inflation, and there are some reasons to believe that Federal policies will be more effective in the future than in recent years.* We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of,say, 3% per annum. (This would compare with an annual rate of about 21/2% for the entire period 1915–1970.)

What would be the implications of such an advance? It would eat up, in higher living costs, about one-half the income now obtainable on good medium-term tax-free bonds (or our assumed after-tax equivalent from high-grade corporate bonds). This would be a serious shrinkage, but it should not be exaggerated. It would not mean that the true value, or the purchasing power, of the investor’s fortune need be reduced over the years. If he spent half
his interest income after taxes he would maintain this buying power intact, even against a 3% annual inflation.

But the next question, naturally, is, “Can the investor be reason-ably sure of doing better by buying and holding other things than high-grade bonds, even at the unprecedented rate of return offered in 1970–1971?” Would not, for example, an all-stock program be preferable to a part-bond, part-stock program? Do not common stocks have a built-in protection against inflation, and are they not almost certain to give a better return over the years than will bonds? Have not in fact stocks treated the investor far better than have bonds over the 55-year period of our study?

The answer to these questions is somewhat complicated. Com-mon stocks have indeed done better than bonds over a long period of time in the past. The rise of the DJIA from an average of 77 in 1915 to an average of 753 in 1970 works out at an annual com- pounded rate of just about 4%, to which we may add another 4% for average dividend return. (The corresp
onding figures for the S & P composite are about the same.) These combined figures of 8%
This is one of Graham’s rare misjudgments. In 1973, just two years after President Richard Nixon imposed wage and price controls, inflation hit 8.7%, its highest level since the end of World War II. The decade from 1973 through 1982 was the most inflationary in modern American history, as the cost of living more than doubled.per year are of course much better than the return enjoyed from bonds over the same 55-year period. But they do not exceed that now offered by high-grade bonds. 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 diff
erent time elements in investment results. The first covers what is likely to occur over the lo
ng-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 ye
ars or less. His frame of mind, his hopes and apprehensions, his satisfaction or discontent with what he has done, above all his deci- sions what to do next, are all determined not in the retr
ospect of a lifetime of investment but rather by his experience from year to year.

On this point we can be categorical. There is no close time con-nection between inflationary (or deflationary) conditions and the movement of common-stock earnings and prices. The obvi
ous example is the recent period, 1966–1970. The rise in the cost of liv-ing was 22%, the largest in a five-year period since 1946–1950. But both stock earnings and stock prices as a whole have declined since 1965. There are similar contradictions in both directions in the record of previous five-year periods.

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. (To some degree the decline was due to the charging of more liberal
depreciation rates. See Table 2-2.) Our extended stud- ies have led to the conclusion that the investor cannot count on much above the recent five-year rate earned on the DJIA group— about 10% on net tangible assets (book value) behind the shares. Since the market value of these issues is well above their book value—say, 900 market vs. 560 book in mid-1971—the earnings on current market price work out only at some 61 ⁄4%. (This relation-ship is generally expressed in the reverse, or “times earnings,”manner—e.g., that the DJIA price of 900 equals 18 times the actual earnings for the 12 months ended June 1971.)
Our figures gear in directly with the suggestion in the previous chapter * that the investor may assume an average dividend return of about 3.5% on the market value of his stocks, plus an apprecia- tion of, say, 4% annually resulting from reinvested profits. (Note that each dollar added to book value is here assumed to increase the market price by about $1.60.)
The reader will object that in the end our calculations make no allowance for an increase in common-stock earnings and values to result from our projected 3% annual inflation. Our justification is the absence of any sign that the inflation of a comparable amount in the past has had any direct effect on reported per-share earnings. The cold figures demonstrate that all the large gain in the earnings of the DJIA unit in the past 20 years was due to a proportionately
large growth of invested capital coming from reinvested profits. If inflation had operated as a separate favorable factor, its effect would have been to increase the “value” of previously existing capital; this in turn should increase the rate of earnings on such old capital and therefore on the old and new capital combined. But nothing of the kind actually happened in the past 20 years, during which the wholesale price level has advanced nearly 40%. (Busi-ness earnings should be influenced more by wholesale prices than by “consumer prices.”) The only way that inflation can add to common stock values is by raising the rate of earnings on cap- ital inve
stment. On the basis of the past record this has not been the case.
In the economic cycles of the past, good business was accompa- nied 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 impor-tant 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 exceed- ing the gains in productivity, and (2) the need for huge amounts of new capital, thus holding down the ratio of sales to capital
employed.
Our figures in Table 2-2 indicate that so far from inflation having benefited our corporations and their shareholders, its effect has been quite the opposite. The most striking figures in our table are those for the growth of corporate debt between 1950 and 1969. It is
surprising how little attention has been paid by economists and by Wall Street to this devel
opment. The debt of corporations has expanded nearly fivefold while their profits before taxes a little more than doubled. With the great rise in interest rates during this period, it is evident that the aggregate corporate debt is now an adverse economic factor of some magnitude and a real problem for many individual enterprises. (Note that in 1950 net earnings after interest but before income tax were about 30% of corporate debt, while in 1969 they were only 13.2% of debt. The 1970 ratio must have been even less satisfactory.) In sum it appears that a signifi-
cant part of the 11% being earned on corporate equities as a whole is accomplished by the use of a large amount of new debt costing 4% or less after tax credit. If our corporations had maint
ained the debt ratio of 1950, their earnings rate on stock capital would have fallen still lower, in spite of the inflation.
The stock market has considered that the public-utility enter-prises 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. 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.