MG Book Club – The Intelligent Investor: The Investor and Inflation (Chapter Two)
The Investor and Inflation
This is the third discussion of the ModernGraham Book Club’s reading of The Intelligent Investor by Benjamin Graham (affiliate link).  In last week’s discussion, we talked about the first chapter, dealing with the results to be expected by Intelligent Investors..  This week we will discuss the second chapter, which is entitled “The Investor and Inflation.”  I encourage you to purchase the book (preferably by clicking the link to Amazon, because a purchase through that link will help support the club) and join in with us as we read through a chapter each week; however, even if you don’t have the book I think you will find our discussions to be very useful in your own understanding of value investing, and you can still bring a lot to the discussion from your own experiences as an investor.  Whether this is the first day you’ve ever been interested in investing, or you have decades of experience with the stock market, we’d love to hear your thoughts in the comments below!
In this chapter, Graham explains that the Intelligent Investor must always be aware of the potential risks of inflation and must take steps to protect against that risk. Â Graham explores the common concept among financial advisors that due to the risk of inflation, “(1) bonds are an inherently undesirable form of investment, and (2) consequently, common stocks are by their very nature more desirable investments than bonds.” Â Graham looked primarily at the data from the 55 year period from 1915-1970 in order to reach the conclusion that it is important to keep some of one’s portfolio in both bonds and stocks, and that “there is no certainty that a stock component will insure adequately against such inflation, but it should carry more protection than the bond component.”
Please feel free to leave a comment on this post with your own responses to the questions, along with any other thoughts you have, and return throughout the next couple of days to see what others have said. Â We’ve had some great discussions the last few weeks, so keep it up!
ModernGraham’s Comments
Ben
When I read through this chapter, I had a couple of thoughts come to mind relating to the economic environment we’ve seen the last few years. Â First, the price of gold saw a significant increase during and after the financial crisis, largely because of investors seeking to protect against inflation. Â In light of this, I thought Graham was particularly proficient in his statement that “the standard policy of people all over the world who mistrust their currency has been to buy and hold gold . . . [but] the holder of gold has received no income return on his capital.” Â This is yet another reminder of how history does repeat itself in the stock market, and the fact that a lot of Graham’s teachings are still relevant today. Â So many people turned to gold in 2007-11 when they lost some faith in the currency situations, and while it is true that many of them saw some significant gains on their investments, they missed out on the dividends and interest paid by stocks and bonds. Â In contrast, those who invested in a blended portfolio of stocks and bonds saw both an income return as well as a gain in capital as the market recovered from the losses seen in 2008.
Second, Graham touched on the common notion that real estate investment is a bit of a hedge against inflation because it is so often considered a “sound long-term investment.” Â However, Graham specifically stated that “unfortunately, real estate values are also subject to wide fluctuations.” Â That statement is clearly true in the wake of the collapse of the housing bubble, and it serves as a reminder yet again that a majority of the drops in prices that we see when investing can be foreseen. Â Of course, we can’t predict exactly when a significant drop in price will occur, but through careful analysis of history and financial statements, we can determine when a particular investment’s price may indicate a greater level of risk.
HeatherÂ
A few weeks ago I asked a commenter to elaborate on why they sold all of their bonds this past year. This chapter was a perfect explanation of the relationship between stocks and bonds and gave me a much better understanding of the relationship between the two. I also now recognize how inflation should impact our decision making process. I really appreciated Graham’s detail to history in particular how he notes the trends that the market has gone through, such as how at times bonds are seen as essential and at others foolish. This chapter has helped put into perspective that when considering investments, it is important to not only take into account the viability of the company, but the current status of the economy and the market. Another point that Graham makes well is the dangers in investing in material things such as gold. This article from the BBC reminds me of the perils of investing in things; they are only valuable when people maintain interest in them. I can’t help but wonder what will happen to the value of maps when collectors move onto the next hot item.
Discussion Questions
Please leave a comment below and feel free to answer any of these questions, or just give your general thoughts.
- What quote from this chapter do you think best summarizes the point Graham is making?
- What projection do you have for the inflation rate going forward?
- Why do you think that some people choose to ignore inflation when making financial decisions?
- How do you hedge your portfolio against inflation?
Next Week’s Discussion: Chapter Three
Chapter Title – A Century of Stock-Market History: The Level of Stock Prices in Early 1972
When reading the next chapter, try to think about how the history of the stock market before 1972 could have been a predictor of things to come in the period from 1972-2014. Â Think also about how remembering history may be useful in your investment decisions going forward.
What are some other ways to participate?
If you are a blogger, you can give your thoughts in a post on your own site, link to the discussion here on ModernGraham, and I will be sure to let our readers know that the conversation is going on over at your site as well.
In addition, you can use the hashtag #MGBookClub in social media to talk about the book on Twitter or Facebook!
5 thoughts on “MG Book Club – The Intelligent Investor: The Investor and Inflation (Chapter Two)”
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1. Regarding inflation and corporate earnings Graham states, “The only way that inflation can add to common stock values is by raising the rate of earnings on capital investment. On the basis of the past record this has not been the case.” Then in the conclusion he states, “There is no certainty that a stock component will insure adequately against such inflation, but it should carry more protection than the bond component.”
I am not sure how inflation can raise ROIC unless it is driven strictly by increased demand on finished goods without that increased consumer demand causing production cost increases resulting from increased demand for raw materials, energy, and labor This scenario seems very unlikely because all this activity increases the demand for oil and therefore the price of oil which effects everything from energy cost in production to transportation costs of getting materials to producers and product to market.
The take-away for me was in Grahams conclusion which I understand to mean, every investment suffers during raising inflation but stocks seems to suffer the least.
2. My crystal ball tells me inflation in the US will not raise its ugly head in any significant way for about 20 years. I base this on demographics which is what drives the demand side of the equation. As a baby-boomer, the generation behind mine is about one-half as large as the baby-boomer generation. However, the generation behind that generation is larger than the baby-boomer generation. So if you want a crystal ball view into the stock market 20 years from now re-read chapter 2 of the Intelligent Investor.
3. I would say most people ignore inflation when making financial decisions. This is because most people don’t make financial decisions based on long term results but rather on satisfy-me-now results. For others, 2-3% inflation is a slow drag on buying power and is is not all that noticeable year to year. Now when we start seeing 4-5% inflation in another decade or so it will start to become much more noticeable to people as they look back at their expenses 3-4 years earlier.
4. My hedge against inflation has been to get a good running-start in the stock market while the appreciation-rates of share prices are good. When the US gets bogged down with raising inflation again, I will suffer the least amount of pain possible by, confining myself to the shares of important companies with a long record of profitable operations, in strong financial condition and operating in countries with a long record of operational integrity. After the feds have slain the dragon of raising inflation and the inflation-rate starts dropping again, then, and only then, will I consider expanding the bond segment of my portfolio from its current 18% stake.
1. What quote from this chapter do you think best summarizes the point Graham is making?
Stocks, as other asset classes, will be affected by inflation. Graham states, which I think is essential for any investor to remember, that “…the possibility of large-scale inflation remains, and the investor must carry some insurance against it. There is no certainty that a stock component will insure adequately against such inflation, but it should carry more protection than the bond component.â€
2. What projection do you have for the inflation rate going forward?
In general I think that the inflation rate going forward will be higher (the question being “How high?) than it has been during the last 5 to 7 years. The financial crisis has kept inflation at a low level. At the same time we have seen large interventions made by central banks around the world. Any projection made should take into account that the future inflation rate will probably not be the same as in the last 5 to 10 year period. Maybe I should have a better grasp, but at the moment I don’t. I focus on buying businesses that I think, in some way, can protect themselves against inflation – see question four below.
3. Why do you think that some people choose to ignore inflation when making financial decisions?
Most people don’t have a long-term horizon when it comes to buying stocks, they’re in it for the short-term – i.e. more kind of speculators than investors. That’s the main reason why I think inflation is not a big issue for them. For someone only in it for the short run the issue about inflation won’t be as important to them compared to someone who’s to buy and hold for 10 to 15 years.
4. How do you hedge your portfolio against inflation?
I try to hedge against inflation by buying great businesses with high and stable cash flows, low capex requirements, financially strength and pricing power. Inflation is one aspect in my investment analysis and when I look at a business I try to understand how it will be affected by inflation. Is the business asset heavy, i.e., a lot of fixed assets needed to run the business, high capex requirements etc. I also look at the expense structure of the business, competitors, industry, and then I try make a reasonable assumption as to whether the business will be able to pass on higher future input costs to customers?
This post has also been published at http://hurricanecapital.wordpress.com.
1) The quote that I feel summarizes Graham’s point best is,â€â€¦high-quality stocks cannot be a better purchase than bonds in 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.â€
Graham emphasizes that stocks and bonds must be in your portfolio because it is hard to tell exactly how the two directions, inflation and deflation, of the pendulum will affect various investment classes. We do know relatively reliably that when interest rates rise, your current bond holdings loose value and your stocks gain value, and when interest rates fall the opposite happens. We do not have the same reliable relationship with inflation and deflation. Inflation as measured by the consumer price index http://data.bls.gov/pdq/SurveyOutputServlet by the Bureau of Labor Statistics (I tried to input a graph but it did not work) has been on a steady rise even during the recession. This supports Grahams next quote, “There is no close time connection between inflation (or deflation) conditions and the movement of common-stock earnings and prices.â€
2) Inflation rose every year, according to the BLS data http://data.bls.gov/pdq/SurveyOutputServlet , with an average increase of 1.945% from 2004 to 2013 and I expect the average will continue for the near few years: 2004 to 2005 increased 2.187%; to 2006 increased 2.489%; to 2007 increased 2.345%; to 2008 increased 2.298%; to 2009 increased 1.699%; to 2010 increased 0.959%; to 2011 increased 1.659%; to 2012 increased 2.110%; to 2013 increased 1.763%. (I tried to input a graph but it did not work)
3) I feel the main reason people ignore inflation in their investment decision is risk aversion, and it is not salient in their minds. Many people do not use the actual data to make a decision, and they rather rely on emotion. Investing rationally is very hard, and relying on quantitative facts and numbers is not easy. It is scary to try to account for the qualitative factors moving investment prices. This brings into focus what Buffet said about the market – it is a short run voting machine, and a long run weighing machine. Gold and other various stores of value have more value in the short run recently because it was a safe haven as it has been historically (very salient in the recession and in unstable political structure countries). Real estate is betting on a grand scale with margin (home loan), and this is normally the largest investment of a household.
4) I am a strong proponent of stocks, but the recession reminded me that bonds must not be forgotten. I had about 5% of my value in various bonds, and I missed the great appreciation in their value during that time for bonds. I am currently more in stocks, but I have since been doing more study, so I do plan to move my portfolio to 75% stocks and 25% bonds in the coming months.
1. To parahrase my favorite quote the changes in prices and earnings of companies are not correlated with inflation.
2. I think that after all the deleveraging has work through the system and all the excess money printed by the Fed manifest itself we will have a demand pull inflation that will be similar to the 1970’s and early 80’s. The difference is that was a cost push inflation (oil).
3. Many people ignore inflation because they are too yuong to have experienced it. It is just an intellectual concept to them.
4. To hedge againt inflation I like to invest in micro cap companies selling below $10 and at least a 50% discount to their net current asset value. It is becoming difficult to find them in the U.S. markets so I am beginning to look at foreign stocks.