Why do we invest?

Well, I am going to share with you Warren Buffets observations – relevant in 1979 when these words were written and still relevant today 43 years later.

An obvious answer is to make a real return over the period of investment. In other words, to maintain purchasing power.

As Warren Buffett wrote about in a letter to shareholders in 1979, he is looking for “a reasonable gain in purchasing power from funds committed for you as shareholders”[1]. At this time, the US inflation rate was circa 11.4%[2].

Warren went onto say that if you put money into a 3% savings bond or an 8% Treasury bond, these investments have been “transformed by inflation that chew up, rather than enhance purchasing power”.

Buffett brought this altogether into an investor’s ‘misery index’, which is:

• The rate of inflation or put another way, the annualised loss of purchasing power
• The tax paid on an investment (income tax, dividend tax, CGT)

[1] https://www.berkshirehathaway.com/letters/1979.html

[2] Factset

Inflation eats away at the purchasing power of businesses as well. What are their options?

• Pay the higher supply costs and take lower margins
• Pass on these rising costs to their customers

As we have seen, inflation pushes up interest rates which makes the cost of corporate borrowing (existing and new) rise, which impacts the balance sheet. In the real world, this means investors are pricing in the risk.  We have seen this in the UK, and in the US when the Federal Reserve raised interest rates by 75bps (0.75%) last week and the UK by 0.25%.

 

According to Buffett, which businesses are better to own in periods of persistent and high inflation?

Businesses that have:

• Companies with moats: The ability to increase prices without significant loss of market share. Companies with ‘moats’ have better and more resilient pricing power. Think Microsoft, there is no escape if you want Word, Excel etc.
• Scalable companies: If a business cannot pass on costs to the consumer, then they may need to increase the amount of business they are doing. This means lower margins would not impact (or would impact less) the balance sheet.

One question we hear at times like this is should I go to cash with my funds invested.

The graph below illustrates how a hypothetical $100,000 investment in the US S&P 500 Index would have been affected by missing the market’s top performing days over the 20-year period from 1 January 2002 to 31 December 2021.

For example, an individual who remained invested for the entire time-period would have accumulated $616,317, while an investor who missed just five of the top performing days during that period would have accumulated only $389,263.

Many of you will have heard Emma and I say it is time in the market, not timing the market, and it is astounding to show the impact of just being out of the investment market for five days, can make to a portfolio valuation.

"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." – Peter Lynch, Mutual Fund Manager

During periods of heightened financial market volatility, and increased levels of uncertainty, it can be tempting to try and time the market by selling assets and then buying back at a later stage. However, timing the market is virtually impossible, even for the most experienced investors, and staying vested important.

What are the potential economic consequences of the Russia/Ukraine crisis?

The Russian and Ukrainian economies will be the most impacted by the crisis, but businesses and consumers in the rest of the world may also be affected, primarily by the rise in energy prices as a consequence of the invasion and the associated risks this poses to the global economy. The extent to which energy disruption slows economic growth this year will depend on how much of a spike in prices ultimately occurs and how long prices stay elevated. 

The West is blocking the Russian central bank's dollar reserves, preventing Russia from releasing them to support its economy. With its economy and financial system literally shut off from the rest of the world, that effectively leaves them with energy revenue as the only source of finance. Hence the expectation is oil and gas flows from Russia will continue.

If Western governments decide to impose sanctions on Russian oil and gas, this would involve a lot of self-harm, particularly for parts of mainland Europe (Germany in particular), and therefore this course of action still seems unlikely. 

The extent to which central banks will be able to hold off further interest rate rises in the face of an oil supply shock should depend to a large extent on inflation expectations.  If longer-term inflation expectations remain at a reasonable level, central banks would likely be willing to look through the short-term inflationary consequences of rising oil and gas prices, and be more accommodative. Alternatively, if inflation expectations became unanchored, which is what appears to be currently happening, they are becoming much less patient and increase in interest rates are progressing relatively quickly.

The energy market is in many ways self-healing. Higher prices encourage greater supply from OPEC nations and the shale industry (particularly in the US), whilst at the same time reducing short term demand, which together leads to declining energy prices. As ever though, this mechanism takes time to work through the system, with expectations that this will become embedded within the next 9-12 months.