The most successful investors in the stock market probably know a thing or two about inflation. Of the many great quotes about inflation from these investors, perhaps no single quote sums it up better than this one from Charlie Munger:

“I remember the $0.05 hamburger and a $0.40-per-hour minimum wage, so I’ve seen a tremendous amount of inflation in my lifetime. Did it ruin the investment climate? I think not.”

The problem with inflation is that it reduces purchasing power for everyone. In other words, with inflation, a dollar today doesn’t buy as much as a dollar tomorrow.

That said—there is still money to be made even with inflation.

Charlie Munger has had to deal with inflation all of his life, and yet he still earned fantastic returns in the stock market for himself and his shareholders.

In this post we’ll look at some famous quotes about inflation, and use them to improve our own investment returns by learning its implications on business and the stock market.

The Basics of Inflation

What can make inflation particularly insidious is that its effects aren’t always obvious, and its confiscation of wealth (through loss of purchasing power) can happen overtime.

Worst yet, consumers might not realize that their currency has been devalued from inflation, as can stock investors. If investors aren’t comparing their returns to inflation, they might not realize that their returns from the market didn’t actually generate as much wealth as they might’ve thought, due to the reduction in value of the actual currency.

The 1970s and early 1980s was a great example of this; the after-inflation returns (“real” instead of “nominal” returns) during this period were so poor to only be rivaled by the Great Depression.

So although the stock market rose in this period, after accounting for the double digit inflation of the time the investors’ “real returns” were actually negative.

This can be hard to conceptualize for most people, which Warren Buffett adeptly pointed out with this quote:

“It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation or pays no income tax during years of 5 percent inflation. Either way, she is ‘taxed’ in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 100 percent income tax but doesn’t seem to notice that 5 percent inflation is the economic equivalent.”

Jason Zweig in his commentary for The Intelligent Investor made a similar observation, pointing to the high interest rate period of the early 1980s and how the psychology of investors didn’t always match the economic reality when it came to returns against inflation:

“Likewise, investors were delighted to earn 11% on bank certificates of deposit (CDs) in 1980 and are bitterly disappointed to be earning only around 2% in 2003—even though they were losing money after inflation back then but are keeping up with inflation now.”

With all of that said, investors who do understand inflation’s role in the economy and stock market might still become ensnared and see their post-inflation returns reduced, if they don’t invest in ways that reduce the impact of inflation on their investments.

As Buffett’s mentor Benjamin Graham said,

“Investors feelings and reactions regarding inflation are probably more the result of the stock market action that they have recently experienced than the cause of it.”

You can imagine that the fickle minds of investors and the emotional Mr. Market can be swayed greatly by recent events—this is a well known behavioral bias and is seen commonly in the stock market.

Another great example of the way that inflation has influenced investors and the way they think and feel about the stock market was this combination of quotes by Peter Lynch:

“Investors bail out of stocks because they worry that companies can’t grow their earnings fast enough to keep up with inflation…

…You have to have faith that inflation will cool down eventually, and that recessions will thaw out.”

Those ideas form the crux of how inflation can really hurt investors by encouraging behavior which runs counter to long term investing success.

Bailing out of stocks because of fear or uncertainty is one of the worst things you can do as a long term investor!

The reality of the stock market is that it can be very volatile over the short term. This makes timing the market impossible.

But, if you hold stocks over the long term, you should get very good results.

This is because the stock market has continued to increase over the very long term, alongside the economy which has increased in a similar fashion.

Just as the economy contracts and expands, the stock market swings up and down, but these things tend to happen in cycles; over the long term the ebbs and flows smooth out and form sustained growth.

But investors are only best positioned to achieve returns commensurate with that growth if they buy stocks and hold them even when they aren’t doing well.

And especially when stocks aren’t doing well against inflation.

Business Performance and Inflation

It makes sense that businesses generally struggle with inflation. When you are having rising prices, you have rising costs, and that includes labor as well as raw materials and other sorts of expenses that going into selling a product or service.

If a business is not able to raise their prices alongside these increases in costs, whether because they are afraid of losing market share or for other reasons, then they will predictably see its profits get squeezed.

As profits are squeezed, a company’s stock price will probably decrease, especially if its valuation (price) was predicated on the assumption that there would not be this bad of an inflationary environment.

This plus market psychology can cause the stocks of even the best companies to sell-off, and investors’ results over the long term are bound to suffer if it causes them to sell when they should just hold.

This is because over the long term, stocks outperform all asset classes regardless of inflation, even though stocks may lag other asset classes in certain years or even over a decade or two.

The famous economist Irving Fisher probably said it best when he said,

“In steadiness of real income, or purchasing power, a list of diversified common stocks surpasses bonds”.

To understand this quote let’s go back to the basics of stock ownership and what it means.

The Basics of Owning Stocks and Inflation

What Fisher was trying to get at with his quote is something that can be observed with the decades of data that have been collected about stock market, bond market, and other asset classes and their returns.

Though in the short term, bonds, commodities or even inflation might beat stocks, over the very long term stocks have always beat every other asset class—it’s because of what stock ownership is.

A diversified portfolio of stocks is simply a collection of shares.

Shares represent partial ownership of a company.

Whoever owns the majority of shares owns the majority of a company, and is entitled to the majority of its profits.

When a company goes public (IPO), they divide the company into shares and allow the public to bid for these. As investors, we can choose to buy the shares of any company we want, as long as we are happy with the price we pay for those shares.

From there, the company can continue to grow, and this makes everyone’s ownership stakes more valuable.

Why?

Because the more profit a company can generate, the more it can eventually distribute to its owners, and so the higher each share (partial ownership stake) becomes worth.

What’s great about a share of stock is that its supply generally doesn’t become inflated over time.

As companies mature into cash generating machines, they usually don’t sell additional shares to the public, and so the base of shares remains constant (or lowers as companies do stock buybacks).

Where inflation happens because the supply of dollars is increasing, inflation doesn’t generally happen with stock ownership because the supply of shares of bigger, more successful companies is usually fixed (or decreasing).

With shares that remain constant, an investor’s 10% of a business still represents 10% of that business tomorrow, regardless of if a dollar is worth $1.00 or $0.50 tomorrow.

So inflation can erode a currency, and destroy businesses that can’t raise prices, but it can’t directly erode the actual ownership stakes of stocks—making them fantastic inflation hedges in this way.

The Best Kinds of Stocks Against Inflation

Even better, the best companies usually can raise prices to match inflation, because they are the best companies.

This was something I highlighted in a recent email to our free newsletter list, using See’s Candies as an example of a best-in-breed business:

“One fabulous example of this was Warren Buffett’s purchase of See’s Candies during the inflation gripped 1970’s.

See’s Candies does not take much in the way of expenses to operate, and doesn’t require heavy capital expenditures in order to consistently grow its profits every year.

Because consumers are loyal to the See’s brand, they eagerly absorb any pricing increases even during economic uncertainty and/or inflation.

With that valuable asset which is not accounted for on the balance sheet, See’s Candies is able to see its revenues grow as it increases prices while other expenses also rise.

But because those expenses are minimal, and See’s doesn’t take much capital to continue to mint free cash, its damages experienced from inflation are minimal, and the company is able to earn fantastic compounding rates of return for investors.”

The same forces which contribute to the heavy competitive advantage of See’s Candies and its great growth, also protect investors against the insidious effects of inflation.

The fact that the company doesn’t require huge investments of capital or large expenses in order to generate a lot of cash means that inflation’s impact is limited, since inflation can greatly elevate the costs of expenses and large investments.

That, combined with its pricing power, allows the company to continue to excel despite high inflation, and become a fantastic investment for Warren Buffett, who understands the types of businesses that do well during inflationary environments and those that don’t.

Hard Asset Companies and Inflation

The capital light model of investing is counterintuitive to the traditional way investors seem to always try to beat inflation through stocks, by looking at commodity producers and miners of precious metals.

Gold is often seen as a great inflation hedge, and so as its price rises with inflation the miners who produce commodities like Gold also tend to see a similar boost.

But, like I mentioned in the email, while revenues skyrocket their expenses follow right alongside them—because of inflation.

The capital intensive nature of most commodity producers make the process of mining/ producing that much more expensive, and many of the benefits which accrue to the top line don’t end up flowing to the bottom line (and free cash flows) due to those additional costs.

The Reality of Inflation

Though we can do our best as investors to prepare against inflation and position our portfolios in a way to shield against it, we still can’t deny the fact that inflation has been a necessary evil to doing business over the last 100+ years.

We might think of inflation as a beast on its own, but it can also be compared to a tax just like any other tax that is levied on average citizens:

“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital.”

Warren Buffett

This last quote is a bit sombering because it shows the relative lack of control most of us have when it comes to inflation.

Politicians can all play their role, and some have influenced the rate of inflation in our country more than others, but the fact remains that inflation is bigger than any one person.

It’s just one of those things we all have to live with.

Hopefully, you’ve gotten some good insight into how to handle it with your own investments.

And hopefully, we won’t have to deal with heavy inflation (or hyperinflation) like has been seen throughout history in other countries. Because it is a real destruction of capital, in the sense that it destroys the value of it.

Too much of that is not good for anyone.