10-K Diver @10kdiver:
1/
Get a cup of coffee.
Many of us are grappling with high inflation. We are worried about how inflation is going to impact our portfolios, and our costs of living.
In this thread, I'll walk you through why inflation is so dangerous for businesses and investors.
10-K Diver @10kdiver:
2/
Imagine we own a chain of coffee shops.
We sell $5M worth of coffee each year.
And each year, we pocket $1M of that $5M as profits.
So, we have:
Annual Revenues = $5M,
Costs = $4M, and therefore
Annual Profits = $1M.
10-K Diver @10kdiver:
3/
IF inflation is *zero*, let's say we'll repeat this performance each year.
That is, each year, we'll get to take out $1M of *cash* from our coffee shops.
That's great: a steady, reliable source of income.
10-K Diver @10kdiver:
4/
How will this change if inflation is 10% per year instead?
Let's say our customers love our coffee.
So, if inflation runs at 10% per year, let's say we'll be able to *raise* our coffee prices 10% per year as well -- with NO drop in demand.
Awesome, we have *pricing power*!
10-K Diver @10kdiver:
5/
So, next year, our price increases will cause our revenues to grow 10%. We'll make $5M * 1.1 = $5.5M.
But of course, our costs (rent, coffee beans, employee salaries, etc.) will *also* grow 10% -- because that's what inflation does.
So, our costs are now $4M * 1.1 = $4.4M.
10-K Diver @10kdiver:
6/
That leaves $5.5M in Revenues - $4.4M in Costs = $1.1M in Profits -- a 10% year over year increase.
That doesn't seem so bad.
Sure, inflation is 10% per year.
But offsetting that, our revenues and profits are also growing at 10% per year.
So, what's the problem?
10-K Diver @10kdiver:
7/
In a word, the problem is: Capital.
Our coffee shops need *inventory* (eg, coffee beans) and *fixed assets* (eg, espresso machines).
When inflation is high, the cost of continuously buying *new* inventory and fixed assets to replace the *old* keeps GROWING.
10-K Diver @10kdiver:
8/
That is, whether we like it or not, we'll have to keep pouring in *new* capital into our coffee shops -- to pay for inventory and fixed assets.
And every dollar of new capital we put IN is one dollar that's not available for us to take OUT of the business.
10-K Diver @10kdiver:
9/
Let's put some numbers to this.
Suppose our coffee shops have $3M of Capital that we've put into them. That's $0.60 of Capital for every $1 of Revenue.
On this $3M investment, if inflation is zero, we'll take out $1M in profits each year.
That's a ~33% return. Pretty good!
10-K Diver @10kdiver:
10/
But when inflation is 10% per year, that $3M of Capital (in the form of coffee beans, etc.) will also likely grow.
If we assume that our ratio of "$0.60 of Capital for every $1 of Revenue" remains roughly the same, that means Capital *also* has to grow at 10% per year.
10-K Diver @10kdiver:
11/
So, *next* year, we'll need $3M * 1.1 = $3.3M of Capital.
The *additional* $3.3M - $3M = $300K of Capital comes from our Profits.
That is, of our $1M in Profits, we'll have to *compulsorily* re-invest $300K back into the business -- leaving us with only $700K to take out.
10-K Diver @10kdiver:
12/
That's the problem with inflation.
The cash we can take out of our business is no longer $1M per year.
It's more like $700K per year -- a 30% drop, even though inflation itself is only 10%!
10-K Diver @10kdiver:
13/
And what makes it WORSE is that this $700K is in "less valuable" dollars -- dollars that have lost part of their value due to inflation.
So, it's really more like $700K/1.1 = ~$636K.
By contrast, the $3M we put into our business was in last years' MORE valuable dollars.
10-K Diver @10kdiver:
14/
So, on our $3M investment, we get to take out something like ~$636K per year in inflation adjusted terms. That's a return of only ~21%.
In other words, inflation has brought down our *real* return from ~33% to ~21%.
10-K Diver @10kdiver:
15/
And that's assuming we have *pricing power*.
If we don't, our real returns will drop even MORE sharply.
10-K Diver @10kdiver:
16/
So, when investing for inflationary times, we have to select businesses that have 2 characteristics:
1) Pricing Power, and
2) Capital Lightness -- so the business doesn't eat up a big chunk of its owners' profits in compulsory re-investments each year.
10-K Diver @10kdiver:
17/
This is why the stocks of retailers -- like Target, Walmart, Home Depot, etc. -- tend to go down a lot when inflation runs hotter than expected.
Retailers typically need to keep a lot of *inventory* on their shelves. And that requires capital!
10-K Diver @10kdiver:
18/
So, that's the mechanism behind how inflation *reduces* returns for investors and business owners.
For more on this, I recommend reading Warren Buffett's excellent 1977 Fortune Magazine article: How Inflation Swindles The Equity Investor.
Link: tilsonfunds.com/BuffettInflati…