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This is Part 2 of this article.

One of my favorite essays written by Warren Buffett and contained in the book "The Essays of Warren Buffett: Lessons For America" is his analysis of See's Candy found on pages 218-222 (second edition). This essay contains remarkable insight on how to profitably invest in an inflationary environment.

The general topic is accounting goodwill vs. economic goodwill, and asset light, high return on investment capital businesses vs. "hard asset" capital intensive (lower return on investment capital) businesses. To some this may sound deadly boring, however if you are interested in prospering in an inflationary environment, I strongly suggest that you continue reading.

Rather than regurgitate the contents of the essay and his specific examples (He uses See's candy vs. a hypothetical "capital intensive" business with the same level of total profit) I want to summarize the points that I think are most relevant to our topic.

What is economic goodwill?

  • Businesses are worth more than their net tangible assets when these assets can be deployed to earn a superior rate of return. This premium value over net tangible assets represents the economic goodwill.

Sources of sustainable economic goodwill include:

  • Customer franchises: Accumulated positive experiences, reputation and experiences that inspire brand or company loyalty.
  • Government franchises not subject to profit regulation (Such as broadcasting rights)
  • A sustainable position as the low cost producer within an industry.

When a business is acquired at a price above net asset value, Accounting goodwill is created on the balance sheet. When Buffett wrote this essay, accounting goodwill was amortized (expensed) over time, and its accounting value on the balance sheet was reduced. Accounting rules have now been updated, so that goodwill is only reduced when it passes GAAP tests for impairment.

Buffett spends considerable time explaining that real economic goodwill does not decline over time, but rather rises nominally with the inflation rate.

With these basics covered, lets move to the real meat of his analysis with regards to investing in an inflationary environment.

Buffett believes that contrary to conventional wisdom, capital intensive businesses make for worse investments in inflationary environments. Asset light businesses with durable franchises (economic goodwill) make for superior investments. This is true even if the high return on capital, asset light business is "more expensive" relative to its total profitability. Why? Let me outline again:

  • Asset heavy businesses must continually reinvest in order to maintain sales and their competitive position in the marketplace
  • When prices rise, rising cost associated with this required capital spending will offset the advantage of rising sales prices that the business receives
  • An asset light business, however, because it is less capital intensive, must invest less under inflationary conditions in order to maintain its competitive position, yet it is still able to raise prices to its consumers. Consequently, it is in a position to earn more than one dollar in return for each dollar it must invest.

The "catch" is that these businesses will tend to look more expensive relative to "asset heavy" lower return on capital businesses. However, this is not really a catch, because these businesses (as Buffett demonstrates) are indeed worth more, and their relative value grows in an inflationary environment.

I believe an excellent example of a Buffett "inflation hedge" type of stock is the small-cap company Mesa Laboratories (MLAB), which:

…develops, manufactures and markets, high-quality process validation and monitoring instruments as well as dialysis calibration and verification meters, standard solutions and accessories that are relied upon by businesses worldwide… Mesa Lab's products are used to assure product quality, control manufacturing processes, and to solve problems in niche markets in industrial, pharmaceutical, medical and food processing applications. [Company website here.]

Why does Mesa Labs fit the bill? First, lets evaluate the after-tax return on tangible capital (ROTC):

By our calculations, the after-tax return on tangible capital is a very high 52%. In Buffett's example, See's Candy was earning a 25% after-tax return on invested capital, so MLAB passes Buffett's "high ROTC" test.

The next question becomes, does MLAB have real economic goodwill that will allow it to keep earning a high return on invested capital in the future? I believe that It does.

Mesa Labs operates and acquires high ROIC businesses in niches that are below the radar of larger, highly capitalized competitors. One key component of the Mesa strategy is a relatively narrow focus on regulated markets. The company has found that regulation creates specialized niches that are often too small to be trifled with by larger competitors, yet (do to regulation) have a steady and growing demand from end users. A more extensive write up on the company's strategy can be found here.

Mesa's Recent acquisition of Bios International is a perfect example of its high ROIC strategy. Almost the entire value of Bios is found in its proprietary processes and intellectual property, (including patents) - not tangible assets. As such, the acquisition has been recorded on Mesa's balance sheet almost entirely as goodwill and Intangible assets.

This would normally signal a "red flag" situation for value investors, as at first glance it appears that Mesa might have overpaid for Bios. However, I don't think that this is the case. I believe it is highly likely that Bios has the type of genuine economic goodwill that will allow it to continue to earn a high ROIC in the future, and as such it is worth a premium. This will be particularly true in an inflationary environment.

I believe the odds suggest that Mesa Labs will continue to do a fine job of executing on its corporate strategy, and that the company has a long runway for future growth. With a current market cap of around $160M I would not be surprised to see this stock move to a $350M+ market cap within the next five years (Measured in constant dollars - Inflation may create a higher nominal return).

If I were to add anything to the above, it is that financing can allow an asset heavy businesses to hold its own in an inflationary environment. The ability to, for example, purchase a tangible asset-based business that is generating an adequate (but not exceptional) return on capital with a long term, fixed rate loan acts as the great equalizer (so long as inflation expectations are not yet factored into the interest rate). The inflation protection/hedge/profit comes from the ability to pay back the loan in cheaper future dollars.

While financing does create additional business risks, it i clear that capital structure must be considered when evaluating an equity owner's ability to profit in an inflationary environment.

Source: Warren Buffett On Profiting In An Inflationary Environment