How to make money during inflation

How to make money during inflation?

• Warren Buffet

1. Cash is trash - Ray Dalio

Money that you put in your savings account or your dresser drawer at home is loosing value with each passing day.

If your investments give you 10% return a year. Is that great? Depends on what the inflation rate is.

To get the real return on investments, you need to subtract the impact of inflation.

If inflation is 7% and your return is 10%, your real return is only 3%.

In 2007, the income of the average American (just under $34,000) went up by at most 5%. But the cost of living rose by 4.1%. So, in real terms, Mr. Average actually became just 0.9% better off. Allowing for inflation, the income of the median household in the United States has in fact scarcely changed since 1990, increasing by just 7% in 18 years.

2. Next worst option in the hierarchy is Fixed interest rate Bonds.

According to conventional wisdom, these investments are very safe. But Buffet says, when you factor in the effect of inflation, these are not very safe.

The current yield on a 10 year US Government Bond is 1.8%. i.e., if you purchase one if these bonds today, you would have locked in a 1.8% return every year for the next decade. Lets say inflation rises 4% over the next decade. So, your annual real return is -2.2% (negative).

During inflation, people that own fixed rate debt like government bonds loose during times of inflation. On the flipside, people that borrow money in a long-term structure at a fixed rate are winners during inflation. e.g. people that use mortgage to buy a property.

Inflation eats away at the value of mortgage debt month after month and year after year. As inflation makes each dollar worth less and less, you get to repay mortgage debt with devalued dollars.

It wipes out the mortgage and you still have the home.

In Weimar Germany, they gave you the mortgage back at the end.

3. Next one in the hierarchy is Unproductive Assets.

Gold, silver and other previous metals.

These are not terrible. With all else being equal, as the prices of things rises during inflation, these things should at least keep up with inflation - in theory.

However, these will not increase your purchasing power either.

4. Productive assets (Average businesses)

Unfortunately, most businesses do not come out well during inflation. Their earning may go up a fair amount over time but they are compelled to put more and more dollars into the business just to stay in the same place.

Worst kind of business is one that makes you put more money on the table than the returns that it gives you.

e.g.

1. A company that rents out bulldozers to construction companies.
2. Lets say each bulldozer costs $1 million.
3. During the lifetime of the bulldozer, it earns 20% - which means, at the end you will have $1.2 million.
4. When it is time for you to buy another bulldozer, if the new bulldozer costs $1.2 million, the profits that you earned with the first bulldozer has to be poured right back into the business.

Capital intense businesses face challenges during inflation.

According to Charlie Munger, there are two categories of good businesses.

1. One is the business where the whole reported profit just sits there in surplus cash at the end of the year. And you can take it out of the business and the business will do just as well without it as it would if it stayed in the business.
2. The second business is one that reports a profit but there is never any cash. It reminds me of the used construction equipment business of my old friend. And he used to say, “In my business, every year you make a profit, and there it is, sitting in the yard”. And there are an awful lot of businesses like that, where to just keep going, to stay in place, there is never any cash.

You want to avoid businesses without pricing power.

What is a company that has pricing power?

Apple - a loyal customer base that will pay whatever the company wants to charge for its products.

Contrast this to a company that sells products to customers for which the only considering factor is price.

A company makes plain white T-shirts. And thats all it does. This company has no pricing power. Someone is going to make T-shirts cheaper and the customers will buy those instead. This company has no ability to raise prices higher than its competitors because, if they raise prices, they will loose customers. During inflation, the cost of materials to make the shirts go up. Cost to pay workers to make the shirts go up. Cost to ship the shirts to customers are also increasing. The only thing that cannot increase is the price the company can charge the customers for the shirts.

5. Productive assets - great businesses

1. Instead of buying a bulldozer with $1 million, if you build a software that help people to do something.

2. At the end of the year, if the revenue is $1.2 million, the profit is $200K.

3. If the inflation is 20%, you can charge 20% for the software this year than last year.

4. Now the revenue will be $1.44 million.

5. You do not have to re-invest any more money back into the business.

6. Upgrades and maintenance will take some money but not all of it.

7. This is the opposite of a capital intensive business.

8. This is a capital light business.

9. The amount of money that needs to go into the business to keep it operational is very minimal.

10. You can take the profits out of the business.

Companies that are good investments during inflation:

Strong brands: Apple, Coca Cola, See’s candies

Companies with minimal physical assets: Software companies (Microsoft, Facebook)

Pricing power: It is difficult to identify these. Clues are:

1. How will the customer react if the company increases the prices by 10%?
2. During inflation, you want to own companies that can easily increase prices for their goods.

The best investment of all, invest in yourself. If you are the best mechanic, lawyer, dentist, plumber or accountant, you make yourself immensely valuable to other people. You get to charge whatever you want for your services and customers will be happy to pay it.

With high interest rates, make your money work smarter, even when inflation is sky high

Whether or not there is an inflation, while cutting back on discretionary spending is a highly recommended strategy, you can also win by flipping the perspective—and making the money you do have work smarter.

We can increase savings by using what we have. We can’t do anything about the inflation rate, but we can control how we react to it. One way to stretch our money is to create additional income with your savings. Here are some ideas:

1. Chase high interest rates: Historically, when the inflation rate goes up, so do the interest rates on many savings accounts. Certificates of deposit (CDs) are also a smart investment because they provide guaranteed returns. The longer the term of a CD, the higher the interest rate—and the more money you can make.

If you see a rate difference between various savings accounts or CDs, consider moving your money. Depending on the amount you’ve saved, even a half of a percentage point could be significant.