One thing I keep thinking about and has been put in the spotlight for me by Horizon Kinetics' Q4 2020 review, is inflation. With the Fed increasing the money supply of the dollar with ~40% and a GDP decline, high inflation is inevitable this decade.
[If you think you understand inflation and don't want a short clarification, you can skip this part.]
You would maybe argue that the CPI last year just increased 2%. Yes, but now you are talking about the short-term. Let's look at the long-term and put together a scenario where money supply doubled in a country. GDP or the products and services produced in a country can only grow at a maximum of 5% per year. But let's say GDP does not grow and there's double as much money as before.
Now, what's going to happen is that people are going to buy more things because they have twice as much money, but then the demand will be bigger than the supply. Everyone also knows that when demand for products/services is bigger than the supply, the prices will rise or supply needs to increase to reach the equilibrium again. Supply can, in normal circumstances, increase just a little, but we assumed no growth in GDP, so no growth in supply. Therefore the supply and demand gap needs to be closed by rising prices. As a result, prices will double as well.
So... How should we adjust our investment approach for the years to come?
You need to choose for yourself, of course, but unless you are already investing in asset-light business, I think everyone should adjust his approach in some way to buying and holding asset-light businesses.
What are asset-light business exactly?
Companies that need little additional assets to increase their revenue/earnings. Examples are royalty companies, service companies and platform/internet companies.
But why are asset-light companies better than asset-heavy companies in inflationary periods?
Let's take two companies: company A and company B. Company A has $10 million worth of assets, company B $30 million worth of assets and they both earn $5 million. In our scenario inflation is so high that prices of products and services double.
The revenues and costs of both company A and B would also double, and therefore earnings would still be $5 million. But because the purchasing power of one dollar has been cut in half to 50 cents (because prices of goods and services are twice as high), the purchasing power of the earnings of both A and B have also been cut in half. For both companies to keep the purchasing power their earnings had before, they need to double their income. That can be achieved by doubling their assets.
For company A it costs an additional $10 million (because they earned $5 million on $10 million worth of assets) to double earnings. For company B it will cost them $30 million to get $10 million in earnings.
So, would you rather spend $10 million or $30 million to keep your purchasing power?
That's right! $10 million. In this case company A is the asset-light business and has a huge benefit over company B in an inflationary environment.
[Special thanks to Warren Buffett, where I copied this example from.]
That's why most commodity companies aren't a great hedge against inflation, because most of the time they need a lot of capital to earn some money and therefore fall under the asset-heavy class.
I, myself, own Texas Pacific Land Corp. (TPL) which is a royalty company with great assets and a great track record. They own a lot of land in Texas, where oil can be found, and collect royalties from oil companies that want to extract oil from their lands. The only thing they need to do is collect the money and distribute it to shareholders.
They are a asset-light business and, as I have explained, have a big advantage over other companies when inflation arises.
Then there are some common traits for asset-light businesses to screen for: operating margin and return on capital/return on equity.
I would argue for at least a 20% operating margin, 20% ROC and 20% ROE.
Lastly, there's bitcoin and all the other crypto currencies, which can't be forgotten. They could be used as a nice hedge against inflation as well because there are 21 million bitcoins and the amount of bitcoins can't be increased. I have some money in crypto but that's more some kind of speculation because you still rely upon other people, their believe in that specific coin and hope that the trust will increase or stay the same, so the 'value' of that coin will not decrease. I have way more believe in money producing assets, and specifically in businesses.
Why? Because the value of a business can be calculated and the return on the long-term of businesses, in general, has always been better than other assets classes and I believe it will be in the future.
Those are my thoughts for this week. I hope you have learned something and I would be pleased if you would share your thoughts on this little article (or whatever you want to call it).