10-K Diver @10kdiver:
1/
Protecting ourselves from inflation
Over the last few weeks, I've been asking myself:
IF high inflation is here to stay, what are some ways we can insulate ourselves from its impact?
Here are some thoughts:
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10-K Diver @10kdiver:
2/
For most of us, the path to financial independence consists of 3 steps:
- Earning consistently,
- Saving diligently, and
- Investing intelligently.
High inflation makes all 3 difficult to do.
10-K Diver @10kdiver:
3/
Let's take them one by one.
First, "earning consistently".
Many of us depend on our jobs to derive the bulk of our income.
But inflation can put our jobs in danger.
This can make it hard to "earn consistently".
10-K Diver @10kdiver:
4/
Why does inflation endanger our jobs?
It's like this. When inflation is high, companies face rising costs. Rent, raw materials -- all cost more.
Such rising costs put pressure on profits.
To preserve margins and profits, companies may lay off employees. Hence, job losses.
10-K Diver @10kdiver:
5/
So, our first defense against inflation must be to *preserve our earning power*.
How do we do this when our jobs may no longer be secure?
I can think of 2 ways:
- Being the best at what we do, and
- Building diversified income streams.
10-K Diver @10kdiver:
6/
Being the best at what we do.
If we have a marketable skill, and we work hard to become very good at it, we'll likely be in high demand.
This will let us command a high price for our skill -- preserving our earning power.
As Warren Buffett put it:
twitter.com/10kdiver/statu…
10-K Diver @10kdiver:
I love this nugget from Warren Buffett in today’s Berkshire meeting:
The best defense against inflation is to be the best at what you do.
If you’re the best doctor in town, people will willingly pay you — inflation or not.
In other words, excellence commands pricing power.
10-K Diver @10kdiver:
7/
Building diversified income streams.
Relying heavily on a job for income creates a single point of failure.
When good engineers design systems, they build *redundancies* -- so a single event doesn't take down the whole system.
We should adopt this idea for our income:
10-K Diver @10kdiver:
8/
Second, "saving diligently".
Inflation can cause our expenses to rise quickly.
This makes saving hard -- particularly if our income doesn't keep pace with inflation.
So, our second defense against inflation should be to *embrace frugality*.
As Charlie Munger said:
10-K Diver @10kdiver:
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Of course, embracing frugality is easier for some of us than others.
For example, it's easier for an extravagant person to save an extra $100/month -- than for a person who's already watching their expenses pretty carefully.
10-K Diver @10kdiver:
10/
But there's usually *some* fat we can all trim -- if we look closely enough.
And it's much easier to trim this fat *pre-emptively*.
It's much less fun to be *forced* to do it -- to make ends meet.
10-K Diver @10kdiver:
11/
One money-saving tip that has worked for me is to remind myself of the "hedonic treadmill" before buying expensive things.
The joy that comes from such purchases is likely to be short-lived:
10-K Diver @10kdiver:
12/
For more inspiration and concrete money-saving ideas, I recommend following @mrmoneymustache and going through his website.
For example, this post:
mrmoneymustache.com/2011/04/15/get…
10-K Diver @10kdiver:
13/
Third, "investing intelligently".
When inflation is high, investing becomes a challenge.
That's because we want to put our money into companies that are -- as far as possible -- immune to inflation.
And very few companies fit the bill.
10-K Diver @10kdiver:
14/
I like to look for 3 economic characteristics that tend to make companies robust to inflation:
- Pricing power,
- Capital lightness, and
- Judicious use of debt.
10-K Diver @10kdiver:
15/
Pricing power.
A company has pricing power if it can raise the price of its products and services -- and still not see a reduction in demand for them.
Usually, this happens when customers consider the company's products/services *essential* -- with NO adequate substitute.
10-K Diver @10kdiver:
16/
Companies that have such pricing power tend to leave clues in their financial statements:
- High gross margins and operating margins,
- High returns on invested capital, and
- High Free Cash Flow conversion (ie, owners can take out most of their *earnings* in *cash*)
10-K Diver @10kdiver:
17/
Capital lightness.
Companies usually need *capital* to produce *earnings*.
Capital includes:
1) Working capital -- raw materials (ie, inventory), dues from customers (ie, receivables), etc. And,
2) Fixed assets -- factories, distribution centers, etc.
10-K Diver @10kdiver:
18/
During times of high inflation, many companies report higher revenues and earnings.
But this alone doesn't make them robust to inflation.
Because much of their "earnings" may simply go towards increasing their own "capital" -- which is *required* for these very earnings!
10-K Diver @10kdiver:
19/
It's like having a goose that produces a golden egg every day.
And each day's egg is BIGGER than the previous day's.
BUT the goose also has to eat its egg every day -- just to survive until the next day.
What good is that goose to its owner?
10-K Diver @10kdiver:
20/
So, it's NOT enough if a company just raises its *prices* in response to inflation.
It also has to raise its *return on capital*.
That is, it has to grow its *earnings* to offset inflation WITHOUT taking any additional *capital* to grow these earnings.
That's difficult!
10-K Diver @10kdiver:
21/
For more on this, I recommend reading Warren Buffett's excellent 1977 Fortune article:
How Inflation Swindles The Equity Investor
Link: tilsonfunds.com/BuffettInflati…
10-K Diver @10kdiver:
22/
Judicious use of debt.
Inflation helps *borrowers*.
That's because they get to borrow money in today's (more valuable) dollars -- and pay it back using tomorrow's (less valuable) dollars.
So, companies that use debt *judiciously* can benefit from inflation.
10-K Diver @10kdiver:
23/
But debt is also a double-edged sword.
Too much of it can make a company fragile -- unable to meet its obligations if the slightest disturbance should occur.
For more on how much debt is OK for a company to have:
twitter.com/10kdiver/statu…
10-K Diver @10kdiver:
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Get a cup of coffee.
This is a thread that @ruima and I wrote jointly.
In this thread, we'll help you estimate how much "margin of safety" a company has when it's loaded with debt.
Understanding this will help you avoid Evergrande-type fiascos in your own portfolio.
10-K Diver @10kdiver:
24/
Here's a picture that summarizes the main points in this thread: