One Stock to Beat Inflation

"Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation." -- Warren Buffett

Those words, written by Buffett for his 1983 letter to Berkshire Hathaway shareholders, are often overlooked by investors, perhaps because the point is not well understood. If you believe as I do that long-term inflation is knocking at our door again, perhaps we should analyze his statement in more detail. Along the way, we'll see which stocks are well-positioned to flourish in an inflationary environment.

Remove the heels
Net tangible assets include all of the assets and liabilities required to run a business -- those things we simply cannot take out without sacrificing earnings power. To calculate the figure, we ignore all items -- such as goodwill and debt -- that aren't needed to create the operating earnings that drive value.

Eventually almost every remaining item, from inventory, to receivables and payables, to the corporate jet, needs to be replaced -- at inflation-adjusted prices. Of course, sometimes financial games are played using debt to pull cash out of businesses and boost per-share earnings and returns on equity, but I try to ignore this stuff when evaluating the real merits of most non-financial businesses. After all, not adjusting for leverage is like comparing the heights of two women -- one wearing heels and the other flats.

How Buffett analyzes businesses
The following Buffett quote, taken from the same letter to shareholders, is crucial to understanding why some companies are hurt less by inflation than others: "What a business can be expected to earn on unleveraged net tangible assets ... is the best guide to the economic attractiveness of the operation."

A mighty strong statement coming from the Oracle. Return on unleveraged net tangible assets is certainly not a common metric, and I didn't find a standard definition available, but the table below shows you how I calculate returns on unleveraged net tangible assets, using Heinz (NYSE:HNZ) and Nike (NYSE:NKE) as examples. By the way, if you're going to try this at home, a proper analysis would use your own estimates of future earnings, rather than relying on past figures, as displayed below.

Returns on unleveraged net tangible assets (all figures in billions)*

Source: Company annual reports, author calculations. *Balance-sheet figures are year-over-year averages.

Now that you have the calculation down, here are a few more returns on unleveraged net tangible assets (which I'll officially dub as ROUNTA) from various companies in different industries.

Source: Company annual reports, author calculations. Calculation method is the same as above. **Earnings for these companies exclude impairment charges to goodwill and intangible assets.

As you can see, the returns range from 11% for Steelcase to a lofty 57% for 3M.

A story of two businesses
To understand why these figures are so important, imagine two fictitious businesses, Poor Retailer Inc. and Rich Chocolate Inc. Each one earns $10 each year. Poor Retailer has $100 in net tangible assets, while Rich Chocolate operates with only $20 in honest-to-goodness net assets. What would happen if inflation doubled prices everywhere?

As their balance sheets expand, Poor Retailer would need to invest an additional $100 in its business, whereas Rich Chocolate would only be  required to come up with an additional $20. These incremental investments are needed to replace each company's "stuff" at higher inflation-adjusted prices -- they do not add any real earning power. Because inflation also causes revenues and costs to double, profit margins stay steady and each company can be expected to earn twice as much, or $20 per year.

Let us suppose that before prices doubled, we purchased stock in each company for $100, or a P/E of 10. If we apply the same multiple to the new earnings of $20, we see that our stock value increases to $200, or $100 more than we paid previously. Although both businesses' values increased by $100, Poor Retailer required an additional $100 of capital while Rich Chocolate required only $20. To paraphrase Buffett, less really is more.

Am I crazy? Maybe
It may sound strange, but we are actually worse off in both cases than we were before inflation. Perhaps you wonder, "How can we possibly be worse off with Rich Chocolate if our company's value has doubled while requiring only an incremental $20 investment?" Without diving into all the sticky details of how inflation works (I reserve that for when my wife has trouble sleeping), the idea is that $200 tomorrow is the same as $100 today. We have $200 in stock after inflation, but we spent more than $100 ($100 initially to buy the stock plus our additional $20 investment in net tangible assets) to get it.

Get it? One-hundred dollars spent on your favorite walking shoes might have been a better investment because shoes generally don't require additional investment. Assuming the rubber doesn't crack and fashions don't change, you'll have $200 in comfort tomorrow because that is what it would cost you to buy those shoes new in the store if you wait until inflation raises prices.

Now about that stock ...
Let's glance back at the tables above. If all other characteristics are equal, such as management quality and growth prospects, then companies like Coca-Cola and 3M are inherently more attractive businesses than are Steelcase and Quiksilver, because Steelcase and Quiksilver by nature of their operations take more assets to bring forth each dollar of earnings. But unless the earnings of these companies grow faster than the rate of inflation, inflation's nasty habit of requiring a continual flow of incremental investment dollars will erode investors' spending power.

That is why I seek companies that, in addition to the above qualities, have truly unusual growth prospects and significant enough competitive advantages to profit from those prospects.

One of my favorite examples of such a growth company is Volcom. This hip apparel designer is expanding both at home and in Europe and is looking forward to expanding in South Africa, Australia, and Brazil as licensee agreements expire over the next four years. Its $79 million cash and zero debt balances at year-end are definitely competitive advantages in this sickening retail environment, which is why I expect CEO and founder Richard Woolcott and his talented team to continue aggressively pursuing smart growth. I hope to dig deeper into Volcom for you in a future story.

The bottom line is that, while it's true that some boats are engineered in such a way as to reduce drag and go faster than others, we would get to our destination a lot faster if we jump into a boat with a fast motor and plenty of gas. Follow Buffett's advice by hunting for companies with high returns on net tangible assets (less drag), fantastic growth prospects (fast motor), and solid balance sheets (plenty of gas), and you will give inflation a run for its money.

For related Foolishness:

• Warren Buffett's Priceless Investment Advice
• What If Warren Buffett Were a Strategic Asset Allocator?
• Warren Buffett Is a Growth Investor

Start investing today -- just $7 per trade with Scottrade. Or find the broker that's right for you.