"The Intelligent Investor" by Benjamin Graham: 2 - The Investor and Inflation

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Hi Steemians,

I am very excited to share my thoughts regarding the second chapter of this extraordinary book. Let's get right into it!

Historically, investors have always been cautious regarding inflation and how it affects the cost of living. We are all aware that as investors we always expect more inflation to occur over the years but the rate of inflation is unpredictable. Through 1965-1970 prices rose at an average of 4.5%, the average inflation during the 20 years prior to it was 2.5% and in 1970 alone, we experienced 5.4% of rises in the cost of living.

We are all humans and we have our own misjudgements. One of Graham’s many few misjudgements was regarding inflation. He was an optimist and during 1970’s he thought the federal government will effectively manage the rate of inflation. After expressing his optimism, President Nixon imposed price controls causing inflation to hit 8.7%. Moving on, from 1973 to 1982 Americans experienced price hikes of over 100%. Graham only expected prices to rise by an average of 2.5% per year for the same period.

During those days (like today) many investors had lost faith in bonds. They implemented 100% stock investments, and even some prolific professors recommended people to buy securities at a margin. Based on historical studies (55 years), stocks outperformed bonds with an 8% return on investment. But the key question Graham asked was ‘will the trend continue?’ Graham’s answer to this is it doesn't matter, the goal of the intelligent investor is to reduce his risk and that strategy does not satisfy.

Analyzing the rise in price of common stocks, there is no historical evidence that inflation increases the value of shares. The prime factor in the rise of securities are increased earnings and reinvestment of capital (dividends) back into the business. The only way inflation could impact the price of a stock is if it also raises the rate of a stock’s earnings. According to graham, Inflation has never had an effect on a business’s earning.

Economists often think inflation is good because it rises the price of goods and increases the the earnings of businesses. We have seen over the long-haul that the standard of living and prosperity of America has been rising as the cost of living went up. Graham warns that inflation is damaging when:

The cost of labor rises faster than productivity
A faster rise in the cost of capital to sales ratio hinders the ability of revenues to deploy capital

Graham goes on and warns us regarding the dangers of inflation and how many economists have been too naive regarding this topic. He addresses the five-fold growth in corporate debt compared to EBIT growth of ‘little more than double’ of businesses. He states that the rise in earnings has been only due to cheap debt, something I believe we are experiencing in the markets today.

To create a conservative investment portfolio, one should not have all his money invested in stocks. During the boom/bust of 1929-1932 it took 25 years for common shares to recover their losses. Graham states:

For then, if another bull market comes along, he will take the big rise not as a danger signal of an inevitable fall, not as a chance to cash in on his handsome profits, but rather as a vindication of the inflation hypothesis and as a reason to keep on buying common stocks no matter how high the market level nor how low the dividend return. That way lies sorrow.

Graham describes gold investing as a way to hedge against the mistrust of governments and their currencies, but he dislikes it. He says it's money that does no work and has a high maintenance cost. He compares it's sluggish growth to savings accounts in banks (during those times the banks paid more interest on savings than gold’s annual return). The following year of him writing the statement, gold showed a robust ability to outpace inflation. Peter Bernstein then called him out and it is generally accepted that an average investor should invest 2-5% of his portfolio in gold ETFs or mutual funds that have a lower than 1% annual management fee. Graham also refuses to give advice on real estate investing and concludes by saying “be sure it’s yours before you go in it”.

Overall Graham wants the intelligent investor to be aware of inflation, whether it’s portrayed as cost of living or speculative markets. An investor is advised to lower his risk by not holding overpriced assets and rebalancing his portfolio across different asset classes. It all sounds very easy to do and we should have been all rich by now :)

Key points:

Always measure how much you made after inflation
From 1969-mid 2000’s 70% of the world’s financially developed countries suffered at least one year of 25% inflation reducing the purchasing power of their people by 50%. Believing that America is exempt from such events are unrealistic
It is in the interest of a any government that borrows money for its spending to lower the price of its currency to pay off its debts
REITS and TIPS could also be a good way for the intelligent investor to protect itself against inflation

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