Protect Your Portfolio From the U.S. Government

Whether you agree with President Obama's policies or not, you have to admit: $1.84 trillion is a lot of money. That's the forecasted U.S. budget deficit for 2009. Expressed as a percentage of GDP, it would be the largest deficit the country has run since World War II. Expressed in nominal dollar terms, it would be the largest deficit ever.

Sprinkle in a $787 billion stimulus package, a couple of trillion dollars more for the various bank bailout programs, and a national debt already in excess of $11 trillion, and you get one surefire consequence, according to the world's greatest investor:

An "onslaught of inflation"
That's what Warren Buffett envisioned in his most recent letter to Berkshire Hathaway shareholders. "Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel," Buffett wrote. "These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects."

In a recent interview on CNBC, Buffett warned that efforts to stimulate a recovery may lead to inflation rates topping what we had in the 1970s.

Here's why that's a bad thing
To Buffett, inflation is a "gigantic corporate tapeworm" that thrives on corporate earnings. "Inflation is a far more devastating tax than anything that has been enacted by our legislatures," he wrote in a Fortune piece from May 1977. "The inflation tax has a fantastic ability to simply consume capital."

This was a lesson that a young Buffett learned firsthand as he tried to keep the Berkshire Hathaway textile mill afloat amidst rising wages and raw material costs. The mill was ultimately a lost cause, but Buffett's experience in textiles would help shape his stock selection criteria throughout his illustrious investing career.

Lessons learned from the loom
The Berkshire mill was ill-equipped to adapt to rising input costs because it produced a commodity product. The company lacked any semblance of competitive advantage, and so when its costs rose, it was unable to pass these price increases through to its customers.

The Berkshire mill may have been a poor investment for Buffett, but it was an invaluable investing lesson. By switching his focus to companies with sustainable competitive advantages -- what he dubbed economic moats -- Buffett was able to achieve unparalleled long-term investment results, even throughout an era of double-digit inflation.

Buffett concentrated on companies with long-lasting brands, strong financials, and minimal capital expenditure requirements -- which would explain his purchases of American Express (NYSE: AXP  ) and Coca-Cola (NYSE: KO  ) , to take two of his notable portfolio holdings. Such companies can raise prices at or above the rate of inflation, and generate strong free cash flow even as their competitors struggle. Even better, Buffett was able to capitalize on the stock market's pessimistic mood, snapping up shares of these great franchises at significant discounts to his estimate of intrinsic value.

What Buffett isn't buying
I'll provide a few examples of stocks that meet Buffett's criteria in a moment, but first, it's important to understand what types of investments Buffett isn't making right now.

The conventional wisdom holds that the best hedges against inflation are real estate and gold. However, with the housing market on the fritz and gold trading near its all-time high, I don't believe Buffett will buy either of these asset classes.

Another popular option is Treasury Inflation Protected Securities (TIPS), which automatically adjust their principal amount to keep pace with changes in the Consumer Price Index. These instruments ensure that you won't lose any purchasing power to inflation, but due to heavy investor demand, their current yields are hardly attractive.

If history is any guide, Buffett won't turn to these types of instruments to protect his portfolio from the ravages of inflation. Despite the soaring interest rates of the 1970s, Buffett was still able to create real value for Berkshire shareholders by purchasing common stocks -- but not just any company will do.

For instance, I don't think he'll be buying companies like BorgWarner (NYSE: BWA  ) . Although the auto parts manufacturer figures to benefit from the shift toward fuel-efficient, low-emissions engines, this is a capital-intensive business that serves a few powerful customers. When inflation hits, it is unclear whether the company will be able to pass its higher input prices onto its customers.

Similarly, Buffett isn't buying Hewlett-Packard (NYSE: HPQ  ) . As technology improves, HP's devices must become smaller, faster, and more affordable to keep the competition at bay. Without a sustainable technological advantage, it will be difficult for the company to charge higher prices for its computers as its raw materials and labor costs rise.

How Buffett bypasses inflation
Rather than dabble in unfamiliar asset classes or second-tier companies, Buffett beats inflation by seeking out companies with low capital reinvestment needs and a sustainable competitive advantage.

For instance, he loves companies with strong, time-tested brands like Procter & Gamble (NYSE: PG  ) . This consumer goods champ boasts a mind-boggling 44 brands that generate more than $500 million in sales each year, including Gillette razors, Bounty towels, and Pampers diapers. It's no wonder P&G is Berkshire's fifth-largest holding. 

Buffett also likes companies that benefit from geographical barriers to entry, like his railroad companies, Burlington Northern Santa Fe (NYSE: BNI  ) and Union Pacific. If commodity costs rise along with inflation, rail transportation should pick up steam, since it serves as a cheap shipping alternative. That likely explains why Buffett boosted his stake in both companies during the first quarter.

Finally, Buffett loves tollbooth-like businesses, where users must pay a recurring fee to use a product. Although his aversion to all things technological would likely keep him from purchasing Autodesk (Nasdaq: ADSK  ) , this company enjoys a dominant position in 2-D and 3-D design software. About 30% of Autodesk's $2.3 billion in annual revenue is recurring in nature -- cash its customers must pony up each and every year. In addition, Autodesk boasts a rock-solid balance sheet, with $981 million in cash and no long-term debt.

Inflate your profits
You don't need to alter your investing strategy to sidestep the impending onslaught of inflation Buffett foresees. Just concentrate on identifying companies with low capital reinvestment needs and strong competitive advantages. And the best part? Not only should these companies be able to pass along price increases when inflation hits, but given the market mayhem of 2008, they're generally trading at their cheapest levels in years.

Our team at Motley Fool Inside Value follows a disciplined, value-oriented approach, just like Buffett. Also like Buffett, the Inside Value team is amazed at the bargains they're finding in today's market. To see which stocks the team likes best for new money, click here to try the service free for 30 days.

The only thing inflated about Rich Greifner is his ego -- and his biceps. Rich does not own shares of any company mentioned in this article. The Motley Fool owns shares of Berkshire Hathaway, Procter & Gamble, American Express, and Autodesk. Berkshire, American Express, and Coca-Cola are Inside Value recommendations. Berkshire and BorgWarner are Stock Advisor selections. Procter & Gamble and Coca-Cola are Income Investor picks. The Fool has a disclosure policy.


Read/Post Comments (2) | Recommend This Article (22)

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 May 26, 2009, at 8:29 PM, ctangus wrote:

    Your article echoes how I've been positioning myself IRL (I've added some PG for example). I definitely have fears of future double-digit inflation. Coupled with that would be a likely drop in the USD - after all we've already started to monetize our debt.

    I'm also looking for foreign exposure (whether US or foreign-based) and/or commodity exposure. The former hedges against currency risk and the latter is a hedge against inflationary risk. XOM, BP, BHP, PCU are a few that meet both criteria.

  • Report this Comment On September 18, 2009, at 10:48 PM, Retirefunds wrote:

    Your article has some good points. It is true that some believe that hyper inflation will save our bacon. (heaven forbid). But what happens when the Commercial Real estate Market begins to unravel due to a lack of trust in financing over the next year?

    Add to that the fact that all of those toxic derivatives (the elephant that is still sitting in the room) will have to be counted by the U.S. banking sector at some point.

    Now when these two monsters collide in mid 2010, while everyone is busy trying to find value "outside of the U.S. dollar",I don't want to be anywhere near the roller coaster created by the Gluttons of Wall Street.

    Does anyone believe the U.S. Taxpayer will allow further, more extreme bailouts for the financial sector once this occurs?

Add your comment.

DocumentId: 906669, ~/Articles/ArticleHandler.aspx, 7/28/2014 1:32:56 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement