Buffett's Inflation Conundrum

When your net worth is larger than the GDP of many sovereign nations, you've got some wiggle room in how you apply your money. While Berkshire Hathaway (NYSE:  BRK-B  ) Chairman and CEO Warren Buffett has been rightfully hailed as an exemplar of financial affairs, his latest move might not make the list of his finer investing moments.

No, I'm not talking about his recent foray involving Mars' takeover of Wrigley (NYSE: WWY  ) , or his railroad bet on Burlington Northern (NYSE: BNI  ) . I'm sure those will do just fine. I'm talking about his 10-year bet with money management firm Protege Partners.

Betting on success
Buffett bet that the returns over the next 10 years from a group of "funds of funds" -- essentially hedge funds that invest in other hedge funds -- will fall short of the S&P 500 average, net of all costs, fees, and expenses. Protege took the other side of the bet. Both Buffett and Protege put $320,000 ($640,000 total) in a zero coupon bond that will be worth $1,000,000 in 10 years. The winner will donate the proceeds to charity.

Who will likely win this wager? Standing in Buffett's corner is probably a good bet. Hedge funds typically charge in the neighborhood of 2% of assets and 20% of profits every year. Funds of funds normally tack fees on top of that. When those fees are included, it's nearly certain a good amount of funds will trail the major averages. From that standpoint, Buffett probably made a good bet.

The inflation beast
But here's a different way to look at it. The two parties put $640,000 in a 10-year, zero coupon bond. For that bond to be worth $1,000,000 in 10 years, its annual return comes out to just more than 4.5% -- before tax, of course. Accounting for inflation -- the most recent CPI numbers show a 4.2% year-over-year increase -- how much will Buffett and Protege make on their wagered cash? In real terms, it could end up being less than zero, provided inflation keeps charging ahead. Alas, if Buffett and Protege wanted to prove to each other a thing or two about beating the S&P 500 average, they're not off to a good start.

I know, I know. Buffett and Protege obviously weren't seeking anything but the safest-of-safe returns for the cash. No matter. Use Buffett's wager as a reminder of an investment rule that all too often lapses our minds: Inflation can be a silent killer that erodes returns over time.

There are several great solutions for overcoming this little conundrum. Investing in gold and other commodities is always a favorite, but those choices have a fair number of drawbacks. Gold is more of a wealth preserver than a wealth builder. Over the next 10 years, there's a chance that Buffett's wager money will outdo the S&P, but history isn't on his side for this one. Since 1928, stock returns have averaged just less than 10%, bonds around 5%, and inflation 3.17%. The distortion inflation puts on long-term real returns is huge.

What should you do?
If you've got a long-term time horizon, an adequate emergency fund, and enough iron in your gut to make it through bouts of volatility, bonds aren't where you want to be right now. With the state of the banking industry in shambles, unemployment on the rise, and housing still singing the blues, it's likely that low interest rates will stick around for a while, despite the inflationary pain. That could easily mean bonds' real return will be slim to nil for the foreseeable future.

When inflation is factored in, stocks are likely to beat the pants off bonds going forward. But not just any stocks. Companies that will be able to overcome inflation constraints over the next several years include those with significant international exposure -- such as Coca-Cola (NYSE: KO  ) or Philip Morris International (NYSE: PM  ) -- and those that can raise prices at least in line with inflation, including Starbucks (Nasdaq: SBUX  ) and Johnson & Johnson (NYSE: JNJ  ) .

Of course, Buffett is well aware of inflation's effect on investments. Last year, he told CNBC, "I've worried about inflation every day since I learned about the phenomenon, 60 years ago," which is exactly what you should be doing, too. Successful investing isn't just measured in the dollar amount by which your portfolio increases, but how much that increase will benefit you once it comes time to sell.

Further fully inflated Foolishness:

Johnson & Johnson is a Motley Fool Income Investor pick. Starbucks, Coca-Cola, and Berkshire are Motley Fool Inside Value picks. Starbucks and Berkshire are Motley Fool Stock Advisor selections. The Fool owns shares of Starbucks and Berkshire. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Morgan Housel owns shares of Berkshire and Philip Morris International, but none of the other companies in the article. He appreciates your questions, comments, and complaints. The Fool's disclosure policy still has its faith in Buffett.


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  • Report this Comment On June 24, 2008, at 1:25 PM, rsand35 wrote:

    This is a great example of how the Motley Fool brand is quickly being diluted. Misleading article titles and junk content make me not even want to click on TMF articles anymore. I just wasted 2 minutes of my life reading this article--I mean, what the heck is this author talking about. Everyone on this website is now dumber for having read this article.

  • Report this Comment On June 27, 2008, at 10:23 AM, JAlexandratos wrote:

    I am very disappointed in this article. The title is very misleading. The author has a weak criticism of Warren Buffett's personal bet- not even an investment! The point the article finally gets around to making is that "inflation is bad". This is a not very profound conclusion to a rather poorly written article.

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