Buffett Preps His Portfolio for Inflation

Just as the specter of deflation is gaining ground, Warren Buffett is taking the contrarian view and positioning Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) bond portfolio for higher inflation. Has he lost the plot?

In the second quarter, Buffett continued to rebalance Berkshire's $34.5 billion fixed-income portfolio toward shorter maturity bonds, which bonds are less sensitive to increasing interest rates. When interest rates go up, which, barring a Japanese "lost decade" scenario, will eventually happen, bond values go down -- but the shorter maturity bonds go down less.

Buffett's inflation warning
Back in August 2009, Buffett wrote an opinion piece in the New York Times warning investors that lawmakers will be tempted to simply let the Fed print away the exploding national debt instead of making hard choices, i.e., some combination of raising taxes and reducing government spending.

In this context, Buffett's actions make perfect sense for two reasons:

  • Sure, the immediate risk we face is deflation, but the longer-term risk is, without a doubt, inflation. In that regard, Buffett isn't so much taking a contrarian view as he is taking the long-term view, which is exactly the perspective he has always adopted in his business and investment decision-making.
  • Within a system as complex as the national economy, Buffett knows that inflation doesn't pop up on appointment; the timing is completely unpredictable, and it could happen faster than the market currently anticipates.

An effective inflation hedge
While high inflation is bad for bonds, eating away at the purchasing power of the fixed income stream they represent, equities are an effective hedge against rising prices. That is particularly true of the stocks of businesses with a well-protected franchise and pricing power.

Franchise businesses for the win
Happily for Buffett, these are exactly the type of stocks he favors, and Berkshire's portfolio is chock-full of them. Among the best known are Coca-Cola (NYSE: KO  ) , American Express (NYSE: AXP  ) , and Procter & Gamble (NYSE: PG  ) -- all three of which represent core positions that go back several decades.

To top it all off, high-quality stocks such as these are suitable investments whether the environment is deflationary or inflationary. Even if you don't agree with Buffett on the economic outlook, it's tough to argue with his investing approach.

With the recovery stalling and the economy on the brink of deflation, a sustainable dividend will become increasingly valuable. Jordan DiPietro has identified the best dividend stock. Period.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. American Express, Berkshire Hathaway, and Coca-Cola are Motley Fool Inside Value selections. Berkshire Hathaway is a Motley Fool Stock Advisor pick. Coca-Cola and Procter & Gamble are Motley Fool Income Investor recommendations. The Fool owns shares of and has Write Covered Calls on Procter & Gamble. The Fool owns shares of Berkshire Hathaway and Coca-Cola. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 11, 2010, at 3:23 PM, eaglessoar wrote:

    Done a bit of analysis on my own but what do you (Alex and other Fools) think about shorting long term treasury notes in the near future, through shorting something like the iShares Barclays 10-20 Year Treasury Bond Fund (TLH) for example. TLH is currently trading at levels higher than the peak of the crisis in 12/08 and it seems rates cannot go much lower. And as mentioned in this article "shorter maturity bonds go down less" so the 10-20 year seem like a good place to get some big gains on shorting big losses.

    Thoughts?

  • Report this Comment On August 11, 2010, at 3:47 PM, TMFAleph1 wrote:

    @eaglessoar,

    Assuming we can sidestep a Japan-style "lost decade", shorting TLH will probably work out well over the medium- to long-term.

    The trouble is that you might have to endure quite a bit of pain along the way. Yes, rates are near/ at all-time lows, but I think they could go yet lower. I can imagine the 10-year yield at 2% and the long bond at 3%. Today, the corresponding maturity Japanese Government Bonds yield 1.02% and 1.65%, respectively.

    I wouldn't dream of owning TLH right now, but I'm not ready to endorse shorting it, either.

    Alex D

  • Report this Comment On August 11, 2010, at 5:56 PM, pinestholdings wrote:

    "Invest in timber because trees are always growing"

    This was legitimately said in Alex's last article. With a straight face. As a serious pitch. Go read it. It is absolutely insane.

    Read Buffet's bird in the hand speech from the 1999 Sun Valley Investors Conference. He doesn't care about inflation or deflation. He makes that very clear in the speech (which you might want to google if you are going to write an article on buffett and inflation). Rather, Buffett positions himself for interest rates, not inflation. For example, when he thought the economy was overheated and interest rates must rise, he bought General Reinsurance to get its $22 billion bond portfolio (see The Snowball). Read that speech, and you'll have Buffett's views on inflation. To say that Buffett is buying what he believes are top-quality stocks as a hedge against inflation is borderline more ridiculous than your timber comment. Buffet always buys top-quality stocks at below-market prices. Thats what he does. He isn't doing it as a hedge against future, non-existant inflation. In fact, I would argue that Buffett is successful because he is the anti-Alex Dumortier - he ignores these silly macro trends you focus on and finds great companies at cheap prices - how about an article about one of those, instead of drivel about timber and about how - get this - Warren Buffet is buying value stocks because he needs a hedge against inflation. That is such a silly statement I don't know where to start.

    I'll probably get this deleted or something, but I feel the need to pop up and remind people of that ridiculous timber recommendation in case they ever decide to take you seriously.

  • Report this Comment On August 11, 2010, at 9:13 PM, MMTInvestor wrote:

    @pinestholdings,

    I doubt your post will be deleted, in part because you make some good points (as you have elsewhere on many occasions). But you will, in the eyes of this and perhaps other Fools, be viewed as a borderline jerk, plain and simple. It's not what you say; it's how you say it. In more than half your posts, you're patently rude. If you don't have a constructive, charitable way to make your critique, then please just refrain from sharing it. I, for one, will be ignoring you.

    For further reading, see Paul on "resounding gong" and "clashing cymbal."

    Foolishly,

    Scott

  • Report this Comment On August 11, 2010, at 10:04 PM, RegLeCrisp wrote:

    @pinestholdings,

    Borderline jerk is actually quite charitable, you should send the above poster a thank you note. Also, I have a feeling the terms 'inflation' and 'deflation' may come up when Buffets discusses interest rate strategy with his fixed income people.

  • Report this Comment On August 11, 2010, at 11:40 PM, pinestholdings wrote:

    Let me apologize, and let me be clear as to why I am a jerk. The timber recommendation hit close to home.

    I have been a jerk in three posts:

    (1) the post where the CFA author listed annally capital managment as a "dividend stock" in an article about how adding dividends is a conservative strategy to protect you in a down market. The advice was downright dangerous - NLY isn't a divdend stock, its a huge leveraged play on interest rates. It was clear all the author did was run a screen for companies with a certain book/price, p/e, and dividend yield and just pasted the results into an article aimed at begining investors looking for a conservative strategy. Further, it *isn't* a dividend, its an earnings distribution from an investment-purpose partnership (no capital gains rate allowed). Meaning anyone who buys it outside an IRA will get a nasty surprise when the 15% yield the author touts turns into 9% after taxes. Finally, the author calls the stock "beaten down" and "historically cheap", when it is trading a dollar below its 52 week high.

    (2) The article where alex advises people to invest in timber because "trees are always growing" - in fact, a reason NOT to invest in timber - and then advises people to buy a timber REIT for its dividend - except it isn't a dividend, its a distribution, which are completely different. The only reason to buy that timber reit is because of the amazing depreciation tax benefits you can reap due to depreciation on its natural resources. Without use for those tax benefits, you have an enourmously speculative real estate holding company that yields 6%. Thats NOT a conservative play on timber. If you go back and read that article and you have any experience at ll in the timber business, you quickly realize the author has zero idea what he is talking about.

    (3) This article, where the author tries to portray Warren Freaking Buffett's value investments in equities as a hedge on inflation. The author goes on to state that this is how Buffett has "always" been a "contrarian", giving begining investors the impression that by doing what is not what everyone else is doing buffett is successful. this is a gross misrepresentation of buffett's philosophies, and a really silly article.

    Really, the big issue i have is that i am involved with the timber industry in a support capacity. I have seen so many people wade into timber having no idea what they are doing based on advice just like Alex's in the last article, they lose their shirt, and they get mad. Those articles cited above are aimed at beginners and contain just downright horrible and dangerous advice.

    Thats why i feel the need to be a jerk. These authors hold themselves out to be experts, the motto of the site is that it is "easy to understand" and is "aimed at beginners" and target people looking for conservative investments - then they spout off absolute nonsense. If these articles were on seekingalpha i would just ignore them, because the site isn't aimed at beginners. i just think its really crappy to aim your site at people who are learning, tout it as easy to understand, put a bunch of licenses by your name so people think you know what you are talking about, and then spout dangerous - and downright wrong - investment ideas.

    Thats my issue. Read this thread, where i responded to a request for info. in a (i think) very nice way:

    http://caps.fool.com/Blogs/the-windup-and-the-pitch-atvi/425...

    I have all the time in the world to talk stocks that makes sense, is based in fact, and isn't deceptive.

    I just have problem with people like Alex who get licenses and hold themselves out to be experts and then advise people to invest in timber REITs that are incredibly risky, and whose prices are determined by real estate prices that vary widely and tax issues that are complex, with crap like "its a 6% yield, and trees are growing all the time!".

    Advice like that which Alex gives here and in the timber article and in the NLY article are what is wrong with the investment advisory industry. They don't discuss the risks and they have little idea of the investments they are suggesting. Its infuriating, dangerous, and dishonest.

    How about a fool article that might really help beginners, like how to read a balance sheet? or how to read an income statement? or that takes a single equity and dissects it in a rational (heck, or even technical, way).

    When I see an author who is supposedly a CFA or CFP give advice that is (1) wrong and (2) highly risky with no disclaimers I feel the need to be a jerk to make my point. Its really makes me angry.

    With all that said, maybe i was harsh. If so, I apologize, and i will try to tone it down in the future.

  • Report this Comment On August 11, 2010, at 11:46 PM, pinestholdings wrote:

    As a side note, it would be different if there was a heading on the article that said "Note: I am not an expert in timber. These are quick ideas that require further investigation. You should not buy these equities without a full understanding of the risks and the properties you are purchasing." instead, we get a guy who clearly doesn't know anything about these investments without a disclaimer, who touts his government licensure to give people advice. Just burns me up.

  • Report this Comment On August 12, 2010, at 6:29 AM, humbledutch wrote:

    @ pinestholdings - I like the comments you made on this article and the arguments you used. But I also agree with sjf2005, your comments are to rude and I almost skipped them. Starting with "I strongly disagree and this is why" would attract more attention I think. And yes, information how to understand financial reports and balance- and cashflow sheets - for specific branches, because REIT's need other understanding then financials - would be much appreciated.

  • Report this Comment On August 12, 2010, at 11:08 AM, IlliniBanker wrote:

    Can anyone remember a time with The Motley Fool published an article advising people to get completely out of the stock market? They've posted a lot of purely bullish articles in the past, but I've never seen them publish a bearish one.

    If you're worried about inflation or interest rate hikes, this might sound a little crazy, but it's probably safest to just stick your money in a CD with easy early withdrawal terms. Ally.com right now is offering about 3% on a five year CD with a (please check- may have changed) 60-day early withdrawal penalty.

    Let's say the fed hikes rates from 0.25% to 5%. The markets take a big hit- and the stocks mentioned above lose 10-15% of their value.

    You do an early withdrawal on your Ally.com CD, taking a 0.5% hit while your buddies who were invested more heavily in the stock market get clobbered. You reinvest half the money in a CD at 5% and the other half in your buddies' stocks.

    In two years, if those stocks are up 10-15% from where they've started, you've made out better than your friends (rates are higher than dividends) with less risk.

    In a secular bear market, if you're worried about a sudden (but not severe) increase in inflation and the interest rates that come with them, the built-in put option of an FDIC-insured CD is always safer than being a sitting duck in the stock market.

    Series I savings bonds offer similar- if not better protection if you're willing to trust the CPI numbers and lock your money in for a year. I know, it seems quaint, but they're the best guarantee of "real" returns for up to thirty years with an early withdrawal option after a year.

    Just wanted to make sure we got the case for avoiding the stock market posted, as well. If you believe in the 35-year economic cycle, we should be expecting negative real returns in the stock market for the next 5-10 years and just wanted to make sure investors knew about some of the alternatives.

  • Report this Comment On August 12, 2010, at 11:10 AM, inplainenglish wrote:

    @pinestholdings - thanks for your solid insights. pls keep posting your thoughts. i read every word.

  • Report this Comment On August 12, 2010, at 12:12 PM, dmerns wrote:

    Eaglessoar, I agree in fact I shorted 100 shr TLH and covered it after a quick $250 profit last month. When it went back up i tried to do this again but TD -Ameritrade killed my order saying it wasn't available for shorting. Don't know what broker you use but you may run into trouble finding shares to borrow and short.

  • Report this Comment On August 12, 2010, at 1:03 PM, pinestholdings wrote:

    I'm not totally anti-Alex, its just obvious when Alex works hard and does his homework and when he doesn't. For example, this article:

    http://www.fool.com/investing/general/2010/07/30/this-energy...

    is quite good. Notice the disclaimer in the last paragraph. Its concise, to the point, and gives an interesting idea that requires follow up. It recommends a risky investment, but accurately outlines the risk and how to measure it, and is a nice little idea. Compare that article to his article on timber. Its night and day. If he put out that kind of quality all the time, you wouldn't hear from me. But he puts out drivel and recommends risky investments with no reservation with that "CFA" next too it all too often and i think its wrong.

  • Report this Comment On August 12, 2010, at 4:27 PM, eaglessoar wrote:

    Dmerns, in the case of no shares of TLH being available to short what are your opinions on the Short etfs. I can only find one that would simulate a scenario of shorting TLH closely which is TBF but this one has less of a track record whereas TLH goes back quite some time. Also what are your thoughts on the UltraShorts, I am usually skeptical of them.

    I ran analysis on TLH taking samples of the close price every 2 weeks going back 50 weeks (about 2 years) and compared it to (10 yr rate + 20 yr rate)/2 to simulate TLH's weighted avg maturity of 14.55. Turns out there is a -.75 correlation over 2 years and -.99 correlation since april 2010 and a -.96 correlation during the financial crisis nov 08 to jun 10, which is quite reassuring that there is such high correlation between tsy rates and price of TLH

    in addition i found that the current price of TLH is over 2 standard deviations away from the typical ratio of the 10&20 tsy rate avg to the price of TLH (it is currently higher than it was at the peak of the crisis despite the fact that rates were lower then)

    so combining the macro elements that there is a tsy bubble developing (?) and rates are questionably low with the micro elements of TLH being over 2 std devs away from the normal ratio mentioned in the previous paragraph it would seem that TLH can only come down, the only question is timing

    what are your thoughts?

  • Report this Comment On August 12, 2010, at 5:06 PM, TMFAleph1 wrote:

    Thanks for all the comments.

    The article obtained front-page placement on Yahoo! Finance and, as result, I'll be discussing this topic on the Gabe Wisdom Show on the Business Talk Radio Network next Monday (08/16) at 4-5 PM PST (7-8 EST):

    http://www.gabrielwisdom.com/gabe_wisdom_radio_show/index.ht...

    http://www.businesstalkradio.net/weekday_host/Archives/gw.sh...

    Alex D

  • Report this Comment On August 12, 2010, at 5:21 PM, BMFPitt wrote:

    @eaglessoar

    I have a chunk of money in TYO, which is a short ETF against the 10yr T-Bill. I find that I feel safer with something like that than actually shorting which can wipe you out.

    I'm down 25% since I got in at what I saw as the absolute lowest that yields could possibly go, then Greece drove them lower. No worries for me though, as I shouldn't need that money for at least a few years and sooner or later a better "safe haven" will be found that drives inflation through the roof.

  • Report this Comment On August 12, 2010, at 5:41 PM, TheDumbMoney wrote:

    Pine: Hasn't timber actually been the best-performing commodity investment of 2010? I think I remember reading that on Infectious Greed. Or, timber had been tops up until about May, I think, when everyone started freaking out about deflation instead of inflation. Now I suppose it has sunk. I view all commodities with suspicion, as all are inherently in my view far more speculative than the high quality stocks I try to invest in. But timber is not worse than all, and is better than some. The Fool writers make mistakes, but that's what the comments are for, to point them out. That can be done politely (though I too have failed in some of my replies on TMFSinchruna posts -- sorry again, Christopher). Overall, I learn a great deal here, and appreciate the agnostic breadth of the topics and views covered. My biggest critique would be that certain of the investment suggestions/ideas on this site are fairly short-term, which seemingly conflicts with the tagline, "The Official Website of the Long-Term Investor." I would have to agree that telling people to invest in a timber ETF, or to short stocks, or buy options, etc., is arguably inconsistent with long-term investing, at least as I understand that term.

  • Report this Comment On August 13, 2010, at 12:06 AM, MLinvestor wrote:

    I feel compelled to chime in here (I’m usually a lurker as I don’t feel qualified to post anything meaningful).

    I’m a Fool of eight years………still learning a lot.

    Pinestholdings, you appear to have nice insights and expertise into the timber industry and investments within this and other MLP, REIT, etc, etc vehicles. I hope you can share your expertise and opinions on some of the discussion boards here specific to these topics. But you can certainly get your points across with a less caustic tone.

    I am considering investments in NLY and CIM and have an open limit order for BIP. But this only after ~2 months of serious DD. The biggest thing I’ve learned with the Fool is you have to do your own research and ultimately make decisions for yourself. It’s splattered all over the place around here.

    Sadly, there will always be folks who read a quick article and call up their broker to place an order.

    Respectfully,

    Dan

  • Report this Comment On August 13, 2010, at 3:01 AM, richsage wrote:

    I have some good news and some bad news.

    The good news is, this is my first post here and I hope you will consider my analysis and opinions after professionally trading in my own account for 35 years.

    The FED. will continue to print massive amounts of dollars leading us into hyperinflation. The U.S. dollar will lose its status a the world's reserve currency, replaced by SDR's within three years. All paper in the U.S. will burn in this cycle. There is no hedge in paper at all.

    I shifted my entire portfolio to physical gold in 2000 when gold double bottomed at $252/oz.

    I expect gold prices and the DOW to cross at 5000 within three years.

    I was called a conspiracy theorist on many national radio and TV shows I did in the 80's and 90's. Unfortunately our beloved America is in the death spiral I predicted and it is now to late to reverse.

  • Report this Comment On August 13, 2010, at 7:16 AM, d4winds wrote:

    So, in your highly informed opinion, Buffett is completely ignoring TIPS spreads to Treasuries, which at some durations have actually gone negative & are at all durations uniformly both very low by historical standards & steadily decreasing by duration. Buffett's reduction in the maturity structure of his bond portfolio is for one reason only: he is very bullish about a long term recovery. Recoveries increase real interest rates. The proof of his recovery bullishness is his all-in bet on a railroad.

  • Report this Comment On August 13, 2010, at 8:10 AM, TMFAleph1 wrote:

    @d4winds,

    Thanks for your comment, but I'm not sure where you see a contradiction between what you wrote and what I wrote. One of the main points of the article is that Buffett is positioning his fixed-income portfolio based on a long-term view of the economy.

    Best,

    Alex D

  • Report this Comment On August 13, 2010, at 9:14 AM, TopAustrianFool wrote:

    Inflation is already here. How do you explain profits and no growth in employment? The CPI is none sense. House prices are not dropping but they are not being sold or built. Explain that without inflation. Banks are not lending unless you accept a high interest rate. Explain that without inflation.

  • Report this Comment On August 13, 2010, at 9:16 AM, TopAustrianFool wrote:

    "The FED. will continue to print massive amounts of dollars leading us into hyperinflation."

    Although the above its true.

    "The U.S. dollar will lose its status a the world's reserve currency, replaced by SDR's within three years."

    This in correct, because the rest of the world prints at a much faster rate. We will remain ahead of everyone else for the foreseable future. Our FED is not as bad as everyone elses.

  • Report this Comment On August 13, 2010, at 9:38 AM, TMFAleph1 wrote:

    @TopSecretFool,

    Thanks for your comment, but I fail to see how any of the phenomena you point to are evidence of inflation. Perhaps you can describe the relationship explicitly.

    Alex D

  • Report this Comment On August 13, 2010, at 1:37 PM, inplainenglish wrote:

    Alex, when do you predict the 10 year yield will bottom out at 2% and how long do you think it will stay down? I'd appreciate your thoughts.

  • Report this Comment On August 13, 2010, at 2:15 PM, TMFAleph1 wrote:

    inplainenglish,

    I make it a rule not to try to predict things that are fundamentally unknowable. I'm anything but certain that the 10-year yield will reach 2%, but, as I wrote above, I can certainly imagine a world in which it occurs.

    I would imagine that a 2% 10-year yield can only occur with a very substantial deterioration in economic conditions and investor sentiment.

    If you are thinking of putting together a trade that requires you to have a firm view on both of the questions you asked, my recommendation is to focus something easier. The question of whether the 10-year yield will reach 2% is complex enough as it is without trying to nail down the timing.

    Good luck,

    Alex D

  • Report this Comment On August 13, 2010, at 2:38 PM, inplainenglish wrote:

    Thanks Alex - no trades planned. Just curious if you had a timetable in mind.

  • Report this Comment On August 14, 2010, at 1:05 AM, 650nm wrote:

    @pinestholdings:

    Despite what I perceived as the acerbic tone of your first 2 posts, I did read them entirely (though, as a novice, I didn't entirely understand them).

    I think you're really missing an opportunity here by leaning your posts at all against the author. Just the hard evidence is enough help intelligent folks make their decisions. Anything else, and well, let's just say I don't think most people want to have to grit their teeth while reading informed views such as yours.

  • Report this Comment On August 14, 2010, at 11:23 AM, inplainenglish wrote:
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