Barron's: Warren Buffett's Wisdom Can Cut Through the Fog of Inflation

Article by Jacques Cesar in Barron's

Stock market investors have enjoyed a roughly three-decade reprieve from the dreaded “i” word, inflation. That could be changing. Investors need to tread carefully.

Inflation is currently running about twice as hot as the Federal Reserve would like to see. The question is whether this bout of inflation is merely temporary or the early stages of a longer-term trend. In its statement yesterday, the Federal Open Market Committee noted “sizable price increases in some sectors” and announced plans to begin tapering asset purchases this month.

There are some obvious and well-chronicled ways inflation hurts stock investors. When inflation surges, the Fed typically tightens financial conditions to slow down the economy. That puts pressure on earnings, and also increases the “equity risk premium,” or the extra return an investor demands to bear the risk of holding stocks rather than a riskless asset. To be sure, not all companies are affected in the same way; those with pricing power and less reliance on commodities will fare better than their less fortunate counterparts.

But there’s another, more insidious way chronic inflation affects stock investors: It causes havoc for anyone trying to place values on individual companies. That’s because accounting standards require most companies during periods of inflation to effectively overstate their true economic earnings, while forcing a smaller subset of others to understate them. Corporate earnings in essence become a fun-house mirror.

The good news is that Warren Buffett knows how to spot these distortions, and by following his lead, investors will have a much better sense of what companies are actually worth when inflation is running hot.

Buffett, the chairman of conglomerate Berkshire Hathaway and possibly the most influential investor of all time, can teach investors how to cut through the fog. In his 1986 annual letter to Berkshire shareholders, he introduced an antidote to inflation-tainted profits that he called “owner earnings,” which he defined as a company’s cash flow minus any money spent to maintain the business. These represent the company’s true economic earnings.

Say you own a bakery. You receive cash from customers, you pay suppliers, employees, a landlord, and so on, and you keep the business in shape by repainting the walls every few years and such. Let’s say you don’t grow the business or milk it dry. What’s left over after all that, is the owner earnings. If there’s no inflation, there’s no problem: The earnings companies report are a fair reflection of owner earnings.

In high-inflation environments, however, most companies are required to overstate their earnings. There are two main reasons for this. It gets complicated, but it boils down to how companies account for depreciation and inventory.

Companies with large inventories tend to understate their cost of goods sold, and therefore overstate their owner earnings.That’s because companies have a choice of which accounting method to use, and many decide to charge what they originally spent on the inventory much earlier—not its replacement cost today.

The distorting effects of inflation came under intense scrutiny in the late 1970s and early 1980s. A 1981 study, for example, found that after adjusting for these factors, the earnings of 111 companies were 53% lower than the figures the companies reported.

The problem for investors now is twofold.

First, the recent uptick in inflation makes it harder to determine the true value of individual companies.

Second, inflation makes a hash of broad market measures such as the S&P 500. Oliver Wyman recently corrected for the impact of inflation going all the way back to 1871. The gap between owner earnings and reported earnings was particularly large in the aftermath of the great inflation period, but still persists. For instance, on a 10-year rolling basis, owner earnings were 33% lower than reported earnings in 1992 and are still 9% lower today.

So the recent uptick in inflation is worrisome: It will make most companies’ earnings seem better than they really are and ......

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