Why The S&P 500 May Be A Great Inflation Hedge For Investors
Summary
- After an unprecedented fiscal and monetary stimulus, many economists and investors have warned that inflation looms large.
- In his 1983 and 1984 letters, Warren Buffett explains which businesses are inflation-winners, and which are inflation-losers.
- Applying the Oracle’s principles to the current S&P 500, I argue that just owning an S&P 500 index fund may be a good hedge against inflation.
Inflation Is Coming
The first episode of the blockbuster series Games of Thrones titles: "Winter is coming". After seven seasons, eventually it comes.
The "inflation is coming" rhetoric reminds me a little bit of Games of Thrones. I started investing in the aftermaths of the Great Financial Crisis. At the time, I watched closely for clues about a possible spike in inflation as a consequence of the extraordinary monetary stimulus that central banks were carrying out.
Yet, inflation never materialized. In Europe, we are dealing with the opposite problem.
As a result of a new extraordinary monetary injection, pent-up demand, and a massive fiscal stimulus by the Biden administration, economists believe that the time has come: inflation will arrive.
In the 1970s, a combination of high public spending, positive demographics, and political movements brought ten years of runaway inflation.
The problem with inflation is that it diminishes the real returns earned by corporations. The consensus in the 1970s was so pessimistic about equities that BusinessWeek titled in 1979: "The Death of Equities - How inflation is destroying the stock market".
I am a good student of economic history, but I am also inclined to believe that history does not repeat itself in the same way (it is said that it rhymes).
Whilst I have no idea of whether there is going to be inflation or not, I do not believe that the stock market will be beaten in the same way as it was in the 1970s.
The Oracle's Principles On How To Beat Inflation
In his 1983 and 1984 letters to shareholders, Warren Buffett explains how to beat inflation. We all know his dislike for gold and bonds, in fact he discusses which businesses are inflation winners and which are inflation losers.
Simply put, businesses that gain from inflation are not the ones engaged in natural resources, but those that require little capital to operate.
Inflation requires businesses to put more capital to work just to earn the same amount in real terms: as such, the business that requires the least is the best choice.
That does not mean that capital-light businesses thrive during inflationary periods. It means that, once inflation settles and nominal returns get closer to real returns, the amount invested when inflation was high will result in much higher valuations. This is how businesses win even when inflation rages.
At the time he identifies such favorable businesses in communications and consumer goods: little capital required to expand the business in the first case and strong pricing power in the second.
In the last ten years (even in the 2020 letter) Buffett has often praised the economics of technology businesses, which he describes as having strong moats (mostly a result of network effects) and requiring little capital to grow.
The question now is: could it be that the current S&P500, with its high concentration of technology businesses, is itself a conglomerate made of the type of inflation-winning businesses that Buffett described in the 1980s?
The Evolution of the S&P 500 Index
Source: The Wall Street Journal
At the onset of the Great Inflation, the S&P 500 had only three subdivisions, industrials, utilities, and rails, and was dominated by industrial conglomerates, especially in the automotive and energy sectors.
These were perhaps the worst businesses to deal with inflation: lots of employees concentrated in huge factories (therefore unionized), lots of raw materials needed to run the business, and a complex supply chain involving many suppliers. A price spike in any of these would have commanded automatically either higher final prices or higher costs (or both).
Nowadays industrials and utilities make up only slightly more than 10% of the S&P 500. Energy and basic materials combined represent barely another 5% of the index.
The lion's share in the modern S&P 500 goes to technology and communication services, which account for a huge 35% stake. Consumer staples and healthcare make another 20%.
Strong brands, patents, network effects, little capital requirements: can this S&P 500 withstand inflation, or even be inflation-winner in the aggregate?
A Comparison of the 1970 Vs. 2021 S&P 500 According To The Warren Buffett Rule
Buffett is quite clear that the best measure to understand whether a business is a good deployer of shareholders' capital is the return on invested capital, or ROIC. The higher the ROIC is, the least capital a business needs.
The following is a comparison of the top 20 businesses that made the S&P 500 in 1970 versus 2021. Highlighted is the return on assets (ROA) and weight in the index.
A big disclaimer here: due to the lack of available data, I had to approximate the figures in two ways.
First, I used ROA instead of ROIC. This distorted dramatically the returns for JP Morgan and Bank of America, therefore for these two I used ROE. I also used 2019-ROA for Walt Disney that was disproportionately affected by Covid-19.
Second, the data for 1970 are from the Fortune 500 list. As a proxy for market cap, I ordered them based on the profits made in 1970. The weighting is also based on profits, using the following formula: company profits / total Fortune 500 1970 profits.
Source: Author based on Morningstar and CNN Money
Two things are apparent.
First, the S&P 500 was concentrated even in 1970. The first 10 companies accounted for 29.44% of the index, and the top 20 39.19%.
This matches almost perfectly the current concentration, at 28.07% for the top 10 and 37.24% for the top 20.
Second, the average rate of return of American business has risen dramatically. Even after the inclusion of Tesla, the top 20 S&P 500 companies in 2020 earned an average return on assets of 11.79%.
In 1970, that figure was only 7.39%.
Yet for the Buffett test to be applied correctly, we need to sort out what the ROIC was in 1970.
Another big disclaimer: due to lack of data, I had to reconstruct the ROIC for the S&P 500 in 1970 by myself.
The average ROA for the whole 500 companies in 1970 was 6.14%. In order to get to the ROIC, I used a multiplier that I derived from three top-notch American industrial companies: 3M, Honeywell, DuPont.
The average multiplier for the three businesses is around 1.7.
If we apply this number to the average ROA for the S&P 500 in 1970, we obtain an average ROIC of a bit more than 10%.
According to Morningstar, in 2020 the average ROIC for the S&P 500 was 15%.
Technology has definitely brought higher profitability and more efficiency in American corporations.
Hence, American companies should be able to withstand inflation much better than in the 1970s.
First, according to the Buffett rule, one dollar invested in the current S&P 500 would yield 50% more than in 1970 once the dust settles.
Second, real returns would get negative at a higher inflation rate.
The following is the graph of the Great Inflation in the US.
Source: OECD
It is called Great Inflation but in fact the average rate of inflation in the 1970s in the United States was only 7.25%. Even with a ROIC of 10%, shareholders should have received positive real returns for the full decade.
What really sent equities down was the perception of runaway inflation in the late 1970s.
Should that happen now, the improved ROIC of 15% would provide a cushion to shareholders: even with inflation at 10% per year, real returns would still be 5%.
Not excellent, but not bad either: a bond would need to yield at least 12% to be competitive, and such yields have not been around for a long time.
In the whole last century in the United States, inflation has never been more than 10% for a 10-year period, with the worst time being the teens During World War One.
Final Thoughts
Should we ignore TIPS, gold, real estate, and just seat tight on this new inflation-resistant S&P 500?
I do believe that technology has played a role in making businesses more efficient and profitable, and hence more resilient in case of inflation.
If we look at the S&P 500 China, another technology-heavy index (technology and communications account for almost a quarter of the index), the average ROIC is 12.5%.
In Japan and Europe, which are dominated by more industrial businesses, although highly competitive, the average ROIC is 6.92% and 8.76% respectively.
However, I leave investors with three caveats.
First, although I believe I have reconstructed the figures in a way that makes sense, my analysis could be completely flawed due to a lack of data. If you know any resource that can be used freely to access complete historical data, please share it in the comments.
Second, technology could have contributed not only to more efficiency, but also to establishing monopolies. The enhanced ROIC could be attributable to strong network effects more than just productivity improvements. We can see evidence of this in Japan. The FTSE Japan index is composed of technology and communications for roughly 24%, yet its ROIC is low. If we look at the businesses in more detail, such as Sony, we see that many are classified as technology but lack the monopolistic network effects that American and Chinese businesses have.
If this is the case, investors should pay attention to stronger antitrust intervention. It is well known that before 1980 the antitrust used to be tougher on American business. Should that approach return, network effects could be in danger and with them, possibly, the high ROIC.
Third, I have said nothing about valuation. In Europe, luxury goods companies have appreciated dramatically in the past year: low debt and strong pricing power make them a great hedge against inflation. I suspect something similar is happening in the technology sector in the US. The P/E for the S&P 500 is 22. Far from outrageous, but in Europe, Japan, and even China the same ratio is about 17.
If what I have written is true, then the premium is warranted. Yet investors should consider that, if expectations are not met, the S&P 500 could suffer. Personally, I find this unlikely.
This article was written by
Analyst’s Disclosure: I am/we are long IVV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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