The Terribly Biting Impact on Earnings of Inflation – EP3

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Who cares about inflation? You probably don’t even notice it.

If you’re an American. A percentage or two a year is slow acting; like rust on stainless steel.

Merchandisers had to re-sticker the stuff on supermarket shelves two or three times a day in Brazil. Inflation was over one thousand percent in the eighties.

That’s right. Clack-clack-clack went their price guns.

All day and all-night long no matter. They were slapping new price stickers over others a few hours old whenever I shopped.

Oxford Club Lead Investment Analyst Alex Green  Praises Dr. Brown

Making cash was just the start of the problem for store owners. Retailers had to get daily revenue out of the worthless Brazilian money into something stable.

Hi I am Dr. Scott Brown and I am the co-founder of the Rhodes Society. That was when I lived in Salvador de Bahia and Aracaju. The black market for stable currency was fierce.
Exchanging my dollars for Brazilian money was a harrowing experience. I remember being picked up by armed escorts on motor bikes for transport to illegal bankers who would buy my dollars.

Once there they stood facing the door with machine guns while we transacted.

I saw piles and piles of Euros, Pounds and Greenbacks in strange rooms, in strange buildings in strange parts of the city. It was insane.

Where did all the cash come from? The same black-market currency exchange system serviced retailers nightly.

Households were less nimble. The salaried middle class had their net worth creamed.

And I don’t ever want to go through it again.

According to professor Crack in his essential pocketbook How to Ace Your Business Finance Class that you should own by now, inflation is the change in the price of some real good or service. He directs readers to an interesting take on inflation and investing in the classic paperback, The Intelligent Investor by long deceased Columbia professor Benjamin Graham.

This is the same book that inspired a nineteen-year-old Warren Buffett to greatness as Graham’s underling.

Graham recognized that stock prices and inflation are not correlated. Furthermore, he knew that inflation was so difficult to forecast as to be perhaps unpredictable.

As such he warned his readers to disregard inflation hedging. You’ll understand why in a second.

Inflation increases the cost of living but not corporate profits. Since inflation does not impact the earnings rate on capital investment Graham explains that stock prices do not rise with inflation.

Unit costs of public utilities in electricity and gas don’t rise as fast as the consumer price index due to government regulation. These firms may have a stronger strategic position during periods of high inflation. But inflation increases the cost of corporate borrowing because it is imbedded in the interest rate.

However, utility companies are entitled by law to charge rates that guarantee an adequate return on invested capital. Graham says that this protects utility company shareholders.

He warns investors to ignore inflation in stock investing and futures trading.

Today, in New Zealand MIT trained professor Crack explains that inflation can be confusing for his students. He walks through the common thinking errors.

The Bureau of Labor Statistics, also called the BLS tracks inflation of consumer prices. You would think that calculating inflation would be simple.

Apparently, it takes a room full of PHDs for the BLS to pull it off. The result of all this think tank level Keynesian brain power is the dissemination of several consumer price index series for different uses.

The rate of inflation is calculated from the consumer price index.

A big mistake among finance students when learning to discount cash flows is adding inflation to the discount rate. If a bank offers a three percent return to savers this is the nominal rate.

If inflation is one percent the real return to the saver is shaved down to two percent.

The three percent return must compensate you not just for waiting but also for the degradation of your investment from inflation. See now?

Ignore inflation hedging. Incidentally, waiting is another way to say time preference.

If rates are highly volatile or if you invest in long term bonds you face additional interest rate risk.

Professor Crack points out that when interest rates are artificially depressed as they have been in the aftermath of the big short, that the nominal rate won’t even compensate you for inflation. Naive savers ended up losing money in certificates of deposit during this period.

There is also liquidity risk to deal with if you are buying bonds. This worsens when no ready and willing buyers will help you sell out before maturity.

New Zealand housing is expensive where doctor Crack lives. A typical house in Dunedin was about eighty thousand twenty-five years ago.

Today the average house costs three hundred thousand. Not surprising for a nice country that scores third on the Mercer Quality of Living Survey.

This calculates to a five-point four percent rate of inflation.

At that rate the average house will cost over a million in another twenty-five years. We can use the same concept to determine whether salaries professors at the University of Puerto Rico earn make us better or worse off than twenty-five years ago.

Puerto Rico has been through a twenty-year depression that ended in bankruptcy and a category five hurricane named Maria. My sixty-five thousand dollar a year salary was frozen a decade ago, but inflation was not.

This sets the stage for the disconnect.

Assessing real estate prices for inflation looks like discounting and compounding but it is not. Again, the discount rate already has inflation embedded.

Do not add inflation to the interest rate when discounting or compounding. Nominal futures cash flows are discounted at the nominal interest rate. Exceptions to this rule are rare.
Professor Crack gives us a chilling warning about inflation. Savers who excessively fear the investment and stuff their money under a mattress suffer a “terribly biting impact” on earnings.

What’s in this for you? Always sweep your cash into the money market in your savings, checking, and trading accounts to combat inflation.

Go order Benjamin Graham’s investment classic The Intelligent Investor from Amazon today. And if you have not already done so go to Rhodes Society dot org if you want to get on our training list.

And hey, by the way. Here is another cool read. It’s a story portraying the American communist movement by John Steinbeck from the thirties. The book is In Dubious Battle. It will needle your memory of the last podcast episode on the king of slobs, Karl Marx. Steinbeck was a journalist by trade. Hence, you will get a fresh perspective on the dark forces that led to McCarthyism.

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