Over a period spanning more than eight decades and amassing a net worth exceeding US$90 billion, few people have experienced more in the investing world than the iconic Warren Buffett.
During his time, the 'Oracle of Omaha' has diligently selected stocks throughout wars, countless corrections and crashes, and numerous crises. However, it is the timeframe known as 'The Great Inflation' in the 1970s, which draws an uncanny resemblance to the challenging environment investors are tasked with navigating right now.
Fortunately, we have the benefit of reflecting upon how Buffett journeyed through a time of outlandishly high inflation and interest rates all those years ago. Perhaps some of the lessons can be applied at a time when the inflation rate is at 6.1% in Australia.
So, how did Warren Buffett invest during a time not too dissimilar to now?
Awake to the reality
To pick the brain of one of the greatest capital allocators of our time, I reviewed the letter to shareholders on behalf of Berkshire Hathaway Inc (NYSE: BRK) between 1978 and 1980. This snippet lines up with a moment in time when US inflation rose from 7.6% to 13.6%.
The first Buffett-ism to arise in my reading was the frank acknowledgment of the situation. In 1980, when inflation peaked, the Berkshire chair extensively detailed the devastating effect of high inflation on real returns, writing:
At present inflation rates, we believe individual owners in medium or high tax brackets (as distinguished from tax-free entities such as pension funds, eleemosynary institutions, etc.) should expect no real long-term return from the average American corporation, even though these individuals reinvest the entire after-tax proceeds from all dividends they receive.
To insulate against such a fate, Buffett noted that companies needed their capital to be 'truly indexed'. This is to say, the company's earnings need to rise at a greater pace than inflation without any additional capital employed to produce said rise.
Surprisingly, Buffett admitted there were very few companies that could achieve such a feat — and Berkshire Hathaway was not one of them. This meant the 'Oracle' believed real returns were likely going to be negative throughout this inflationary timeline, yet still chose to invest — why?
Staying the course
Faced with a high rate of inflation, Warren Buffett — through Berkshire Hathaway — continued to accumulate portions of ownership in businesses he believed fit four all-important criteria.
- Businesses we can understand
- With favourable long-term prospects
- Operated by honest and competent people; and
- Priced very attractively.
Turning to Berkshire's 1979 letter, Buffett highlighted his preference for equities over bonds as a way of realising greater returns. This has always been important for Berkshire Hathaway due to its involvement in the insurance industry, whereby premiums are invested to cover future potential claims (and, still return a profit).
To try and deliver on this goal, Berkshire invested heavily in the face of inflation. From 1978 to 1980, the company increased its equity outlay from US$134 million to US$325 million.
At the peak of US inflation in 1980, Warren Buffett and his team had built sizeable positions in relatively defensive companies, including:
- GEICO Corporation (insurance) — market value of US$105.3 million
- General Foods Inc, acquired by Kraft Heinz Co (NASDAQ: KHC) (consumer staples) — market value of US$59.9 million
- Handy & Harman (silver and gold refiner) — market value of US$58.4 million
- Safeco Corporation (insurance) — market value of US$45.2 million
Building wealth, Warren Buffett style
Finally, there are two essential tenets to how the famed investor operated during the last major bout of inflation — opportunism and measure.
In 1980, the Berkshire conglomerate raised US$60 million via the issuance of debt. Unlike other companies at the time, this was not out of necessity to improve its own operational liquidity. Instead, Warren Buffett explained:
[…] we borrowed because we think that, over a period far shorter than the life of the loan, we will have many opportunities to put the money to good use. The most attractive opportunities may present themselves at a time when credit is extremely expensive — or even unavailable.
At such a time we want to have plenty of financial firepower.
This isn't to say the average investor should use debt to fund buying in the downturn. The point is: Buffett ensured there was capital available to go shopping while share prices were depressed.
However, Berkshire remained tactful during the widespread opportunity. As noted in the 1980 letter, Warren Buffett and the team set their sights on businesses that generated cash. Despite the appeal of taking on more debt, Berkshire Hathaway maintained a high level of liquidity.
Since 1982, the stock price of Berkshire Hathaway has grown by more than 65,000%. Evidently, the decision to invest through inflation has paid off in spades.
