Inflation has gained a lot of attention recently and for good reason. It came back onto my radar in May while watching Berkshire Hathaway’s AGM.
During Buffett and Munger’s annual masterclass, Warren Buffett commented,
“We’re seeing very substantial inflation….we’re raising prices, people are raising prices to us and it’s being accepted….take home-builders, we’ve got nine home-builders, in addition to our manufactured housing operation, which is the largest in the country, so we really do a lot of housing and the costs are just up, up, up!”
Federal Reserve Chairman Jerome Powell has suggested that a recent surge in prices is likely transitory, and that price pressures will reduce as supply bottlenecks widen. Nevertheless, many investors are starting to think about higher levels of inflation and are wondering what an extended period of high inflation might mean.
While considering Powell’s stance, it’s important to understand that for central bankers, expectations about future inflation are as important as inflation itself. Why? Because if a rational person thinks prices will be higher tomorrow, they’ll buy more today and add to inflation pressures.
My father, who is 93-years-old, has told me before about the high levels of inflation experienced in the UK during the 1970’s. My parents owned a convenience store and as he describes it, “By the time we had sold our inventory, the prices had increased, and we could barely afford to re-supply the store.”
The US endured similarly high levels of inflation at the same time as the UK.
So, what happened to equities during this period? The Dow Jones Industrial Average started the 1970’s at 744 and stood at 876 a decade later. A lost decade as inflation reached double digits. Gold on the other hand, started the 1970s at US$36 per ounce and stood at US$678 per ounce ten years later. An 18-fold increase. This vast difference in relative performance between the Dow and gold, during the 70’s, can be seen in the graph below.
There were many important factors at play in the 1970’s. The Nixon Shock of August 1971 saw President Nixon announce an array of economic measures that included ending the convertibility of the US dollar into gold at a rate of US$35 per ounce. This convertibility had been in effect since 1944.
The Vietnam War, the OPEC oil embargo, Watergate, and a partial nuclear reactor melt-down at Three Mile Island were other notable events of the decade. But from an investor’s perspective, the relative performance of the Dow Jones Industrial Average and gold bullion, during this period of high inflation, was amongst the most startling.
For businesses, the key issue with inflation is whether a business has ‘pricing power’ and can therefore pass on higher input costs to customers. For businesses without pricing power, inflation will erode their profit margins, and in some cases can cause businesses to fail. It’s little wonder that Reagan commented in 1978 that “inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman.”
The gold price
During the 1970’s, gold bullion was a far better place to be invested than equities.
The problem with owning gold bullion, as Warren Buffett points out, is “It doesn’t do anything but sit there and look at you.”. i.e. It doesn’t provide a yield for holding it.
What about gold mining shares? Well, Berkshire Hathaway did make an SEC filing in August 2020, revealing that they had acquired a stake in leading gold mining share Barrick (NYSE:GOLD). But for reasons that are unknown to most, it seems that they subsequently exited the position.
During calendar year 2020, Barrick paid US$0.31 in dividends, a yield of only 1.5% against today’s share price. In May of this year, they did announce, a return of capital distribution of $0.42, in addition to an annual sustainable dividend of US$0.36, bringing Barrick’s yield to a far more respectable 3.8%.
But looking closer at gold mining shares, as an industry they have a poor track record of providing returns to shareholders. The sector median dividend yield (trailing 12-months) is only 1.7% currently, despite gold prices near record highs. There’s an excuse for this.
The gold industry is highly cyclical. When the gold price is low, mining companies have constrained balance sheets and low levels of cash flow from operations. Exploration budgets are cut, and in many cases, high-cost mines are shut down and many employees are made redundant.
Then, when gold prices rise, mines are re-opened, production is increased, and reserves are depleted at a higher rate. As operating cash-flows bolster company balance sheets, exploration budgets are cranked up. Company management will insist that reserves need to be replenished.
But here’s the problem, exploration is an unpredictable endeavour.
Far more predictable a strategy, is to go out and buy another gold mining company for their gold reserves. Therefore, many gold mining companies will divert their rising cash balances into M&A activity rather than returning the cash to shareholders. Management’s excuse being that they need to replace depleting gold reserves.
This is usually a big mistake!
The problem with buying other mining companies when gold prices are high, is that this is almost invariably the wrong time to buy. Management will be competing with other gold companies also flush with cash. Often, buying at this stage of the cycle is value destructive. The shareholders invariably bear the brunt of this value destruction.
So, what are the options for investors, if like me, you:
1) Have a nagging suspicion that inflation may be more persistent than Jerome Powell suggests.
2) Have studied the performance of gold relative to equities through the 1970’s.
3) Want to receive a yield and so don’t particularly want to own gold bullion because it just ‘sits and looks at you’.
4) Have concerns that gold mining companies often lack capital discipline and don’t always reward shareholders adequately.
In the next instalment of this article, I’ll explain what I have invested in.
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